2013 Self-assessment of the Reserve Bank Information and Transfer System Appendix A: Detailed Self-assessment

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Introduction

This Appendix sets out the Bank's 2013 detailed Self-assessment of how well RITS observes the Principles, developed by the CPSS and IOSCO. In its assessment, the Bank has applied the rating system used in the Disclosure Framework. Under this framework, observance of each of the applicable Principles is rated according to the following scale:

Observed – Any identified gaps and shortcomings are not issues of concern and are minor, manageable and of a nature that the facility could consider taking them up in the normal course of its business.
Broadly observed – The assessment has identified one or more issues of concern that the facility should address and follow up on in a defined time line.
Partly observed – The assessment has identified one or more issues of concern that could become serious if not addressed promptly. The facility should accord a high priority to addressing these issues.
Not observed – The assessment has identified one or more serious issues of concern that warrant immediate action. Therefore, the facility should accord the highest priority to addressing these issues.
Not applicable – The standard does not apply to the type of facility being assessed because of the particular legal, institutional, structural or other characteristics of the facility.

The Bank's ratings of RITS against the relevant Principles are supplemented by detailed information under each Key Consideration that is relevant to the Bank's assessment.

Note: Principle 6 (Margin), 10 (Physical deliveries), 11 (Central securities depositories), 14 (Segregation and portability), 20 (FMI links) and 24 (Disclosure of market data by trade repositories) are not applicable to systemically important payment systems and have therefore been omitted.

1. Legal basis

A payment system should have a well-founded, clear, transparent and enforceable legal basis for each material aspect of its activities in all relevant jurisdictions.

Rating: Observed

RITS is owned and operated by the Bank. The RITS Regulations form the legal basis for all material aspects of RITS. The Reserve Bank seeks external legal advice on material amendments to the RITS Regulations and associated contractual agreements, including, where relevant, on the interaction of such amendments with Australian and New South Wales laws and regulations. While the RITS Regulations are comprehensive, changes in functionality and activity since its launch have added to their complexity. The Bank has commenced a comprehensive review of the RITS Regulations with the aim of identifying areas where the clarity of the RITS Regulations could usefully be enhanced.

Based on this information, the Bank's assessment is that RITS has observed the requirements of Principle 1 during the 2013 Assessment period. The legal basis of RITS is described in further detail under the following Key Considerations.

1.1 The legal basis should provide a high degree of certainty for each material aspect of a payment system's activities in all relevant jurisdictions.

The legal basis of RITS is set out in the RITS Regulations, which cover the operation of RITS, and the rights and obligations of participants and the Bank. Standard agreements are executed to bind each participant to the RITS Regulations. In addition to the RITS Regulations, the following key aspects of RITS activities are supported by Australian legislation and additional contractual arrangements.

RTGS feeder systems

RITS accepts settlement instructions from approved feeder systems. Admission as a feeder system is by specific reference in the RITS Regulations. The RTGS feeder systems are the SWIFT PDS, Austraclear and the CHESS RTGS.^[1] The SWIFT PDS is administered by the APCA under its HVCS. The Bank and APCA each have contractual arrangements with SWIFT covering the SWIFT PDS. The Austraclear and CHESS RTGS feeder systems are operated by Austraclear and ASX Settlement, respectively. Both entities are wholly owned subsidiaries of ASX. The Bank has separate contractual arrangements with Austraclear and ASX Settlement, respectively, covering these feeder systems.

Settlement finality

The RITS Regulations state that settlement is final when the ESAs of the paying and receiving participants in RITS are simultaneously debited and credited, respectively. The irrevocability of payments settled in RITS is protected by RITS's approval as an RTGS system under Part 2 of the Payment Systems and Netting Act. With this approval, a payment executed in RITS at any time on the day on which a RITS participant enters external administration has the same standing as if the participant had gone into external administration on the next day. Accordingly, in the event of insolvency all transactions settled on the day of the insolvency are irrevocable and cannot be unwound.

Similarly, the irrevocability of settled transactions originating from the Austraclear and CHESS RTGS feeder systems is supported by their respective approvals as RTGS systems under Part 2 of the Payment Systems and Netting Act.

Netting arrangements

In the unlikely event that RITS is unavailable for a significant period of time, payments arising from Austraclear and the SWIFT PDS can be settled using ‘fallback arrangements’. These arrangements involve the multilateral netting and settlement of transactions arising from those systems. The irrevocability of settlement under these fallback arrangements is supported by the approval of Austraclear and HVCS as netting arrangements under Part 3 of the Payment Systems and Netting Act. The approval of HVCS establishes the legal basis for the netting of SWIFT PDS payments.

While RITS is primarily an RTGS system, it also provides for the final settlement of net obligations arising in other payment systems. This is either through the LVSS or the batch feeder functionality. RITS's approval under Part 2 of the Payment Systems and Netting Act does not ensure the legal certainty of the netting of the underlying obligations. Nevertheless, the majority of the value of obligations settled in these multilateral batches originates from the APCA clearing streams and transactions settled in the CHESS batch, which are approved netting arrangements under Part 3 of the Payment Systems and Netting Act.

Enforceability of repurchase agreements

The enforceability of repos in the event of a default also requires a high degree of legal certainty. Repos with the Bank are governed by an international standard agreement – The Bond Market Association (TBMA)/International Securities Market Association (ISMA) Global Master Repurchase Agreement (2000 version) – as amended by exhibits under the RITS Regulations.^[2] This agreement sets out, among other things, what constitutes default and the consequential rights and obligations of the parties. In the event of a default, the agreement allows the non-defaulting party to terminate the agreement, calculating the net obligation based on the prevailing market value at the time the contract is closed out. Close-out netting provisions included in repo contracts with participants provide for the immediate liquidation of collateral in the event of default. This right is supported by Part 4 of the Payment Systems and Netting Act.

1.2 A payment system should have rules, procedures, and contracts that are clear, understandable, and consistent with relevant laws and regulations.

To facilitate a clear understanding of RITS rules and procedures, the RITS Regulations are supplemented by information papers and user guides that explain RITS requirements and functions. This material facilitates existing and prospective participants' understanding of the RITS Regulations and the resulting risks they face by participating in RITS. Notwithstanding the above, changes in functionality and activity since RITS's launch have added to the complexity of the RITS Regulations. The Bank has commenced a comprehensive review of the RITS Regulations with the aim of identifying areas where the clarity of the RITS Regulations could usefully be enhanced.

The Bank also seeks external legal advice on material amendments to the RITS Regulations and associated contractual agreements, including, where relevant, on the interaction of such amendments with Australian and New South Wales laws and regulations.

1.3 A payment system should be able to articulate the legal basis for its activities to relevant authorities, participants, and, where relevant, participants' customers, in a clear and understandable way.

At a high level, the legal basis for RITS is articulated in a clear and understandable manner on the Bank's website.^[3] The information paper on the RITS Regulations provides further detail on RITS's legal basis.^[4]

1.4 A payment system should have rules, procedures, and contracts that are enforceable in all relevant jurisdictions. There should be a high degree of certainty that actions taken by the payment system under such rules and procedures will not be voided, reversed, or subject to stays.

To ensure that the RITS Regulations and associated contractual agreements are enforceable, the Bank seeks external legal advice on material amendments to these documents.

There have been no court cases that have tested the RITS legal framework.

1.5 A payment system conducting business in multiple jurisdictions should identify and mitigate the risks arising from any potential conflict of laws across jurisdictions.

The RITS Regulations are governed by New South Wales law and require that all participants submit to the non-exclusive jurisdiction of the courts of New South Wales. Since 2011, the Bank has required foreign RITS applicants to provide a legal opinion affirming that the RITS membership legal documents constitute valid, legally binding and enforceable obligations.^[5] This opinion must cover whether the courts in the home jurisdiction of the applicant will give effect to the choice of New South Wales law as the governing law and whether the judgement of an Australian court would be enforceable in the home jurisdiction without retrial or re-examination.

2. Governance

A payment system should have governance arrangements that are clear and transparent, promote the safety and efficiency of the payment system, and support the stability of the broader financial system, other relevant public interest considerations, and the objectives of relevant stakeholders.

Rating: Observed

RITS is owned and operated by the Bank. Since it is not operated as a separate entity, the management and operation of RITS fall under the governance structure of the Bank, and are subject to the Bank's normal oversight, decision-making and audit processes. The Bank has clear and transparent governance arrangements, which are publicly available on the Bank's website. The Bank has recently updated its website to articulate its specific objectives in relation to its operation of RITS. These are consistent with the high-level objectives of the Reserve Bank, which emphasise the stability of the broader financial system and the welfare of the Australian people. The Bank accordingly aims to provide infrastructure through which settlement obligations arising from the exchange of high-value payments and debt securities settlements can be extinguished in a safe and efficient manner. To ensure that the interests of relevant stakeholders are taken into account, the Bank engages in routine liaison with participants and consults on material changes to operational arrangements. Oversight of RITS is carried out by the Payments Policy Department, under the governance of the Payments System Board.

Based on this information, the Bank's assessment is that RITS has observed the requirements of Principle 2 during the 2013 Assessment period. Details of RITS's governance arrangements are described under the following Key Considerations.

Note: Paragraph 3.2.7 of the Principles states that ‘[c]entral bank-operated systems may need to tailor the application of [the governance] principle in light of the central bank's own governance requirements and specific policy mandates’. The Bank's view is that since RITS is owned and operated by the Bank as an internal function, rather than a separate legal entity, Key Considerations 3 and 4 of this Principle should not constrain the composition of the Bank's governing body or that body's roles and responsibilities.

2.1 A payment system should have objectives that place a high priority on the safety and efficiency of the payment system and explicitly support financial stability and other relevant public interest considerations.

The high-level objectives of the Reserve Bank are set out in the Reserve Bank Act. The Bank's duty is to contribute to the stability of the currency, full employment, and the economic prosperity and welfare of the Australian people. Stability of the financial system is also a longstanding responsibility of the Reserve Bank – a mandate reconfirmed by the Australian Government when it introduced significant changes to Australia's financial regulatory structure in July 1998.^[6]

The Bank's website states its specific objectives in relation to its operation of RITS. In particular, the Bank's objective in developing and operating RITS is to provide the infrastructure through which settlement obligations arising from the exchange of high-value payments and debt securities transactions can be extinguished in a safe and efficient manner. The design of RITS ensures that there is no build-up of settlement exposures associated with high-value transactions, which in turn promotes the stability of Australia's financial system. Reflecting the critical importance of RITS to the Australian financial system, the Bank aims to operate RITS at an extremely high standard of availability and resilience, and to ensure that its settlement services continue to evolve to meet the changing needs of the broader payments system.

Decisions concerning the operation of RITS and ESAs are required to be consistent with the policy environment determined by Payments Policy Department, under the governance of the Payments System Board. The broad mandate of the Payments System Board, which is also set out in the Reserve Bank Act, places a high priority on the safety and the efficiency of the wider Australian payments system.^[7]

2.2 A payment system should have documented governance arrangements that provide clear and direct lines of responsibility and accountability. These arrangements should be disclosed to owners, relevant authorities, participants, and, at a more general level, the public.

Information on the Bank's governance arrangements for RITS is documented on the Bank's website.^[8]

The Bank's governance arrangements reflect relevant provisions of the Reserve Bank Act. In accordance with this Act, the Governor is responsible for the management of the Reserve Bank, and is therefore ultimately responsible for the operation of RITS. The Governor is assisted and supported in this responsibility by the Executive Committee, which is comprised of the Bank's most senior executives. The Executive Committee is the key decision-making committee of the Bank for matters of an administrative and management nature that have strategic, Bank-wide or external significance. Accordingly, major decisions related to RITS are considered by the Executive Committee.

Decisions affecting the day-to-day operations, customer relations and development of RITS have been delegated to the Bank's Payments Settlements Department. Payments Settlements Department is part of the Bank's Banking and Payments Group, which is headed by an Assistant Governor who reports to the Deputy Governor. Clear internal procedures are in place to elevate day-to-day operational matters within Payments Settlements Department and other areas of the Bank, as appropriate.

Oversight of RITS is carried out by the Bank's Payments Policy Department, under the governance of the Payments System Board. Payments Policy Department is separate from Payments Settlements Department in the Bank's organisational structure, with separate reporting lines up to and including the level of Assistant Governor (see Section 4.1 for more details). The two departments nevertheless meet regularly to discuss policy issues and operational developments, and the Payments System Board is periodically updated on relevant developments.

As an independent central bank and statutory body, the Bank is ultimately accountable to the Parliament of Australia. Since 1996, the Governor and senior officers of the Bank have appeared twice yearly before the House of Representatives Standing Committee on Economics to report on matters under the responsibility of the Bank. The Reserve Bank Act also requires that the Bank inform the Australian Government of its policies ‘from time to time’. In addition, to fulfil its obligation under the Commonwealth Authorities and Companies Act 1997, the Bank prepares an Annual Report, for presentation to the Treasurer and tabling in Parliament.^[9] The Payments System Board produces a separate annual report, which is tabled in Parliament, although this is not a legislative requirement.^[10]

2.3 The roles and responsibilities of a payment system's board of directors (or equivalent) should be clearly specified, and there should be documented procedures for its functioning, including procedures to identify, address, and manage member conflicts of interest. The board should review both its overall performance and the performance of its individual board members regularly.

As described in Key Consideration 2.2, the Governor, with assistance from the Executive Committee, is ultimately responsible for the management of the Bank, including the operation of RITS. The roles and responsibilities of the Governor are set out it in the Reserve Bank Act. The roles and responsibilities of members of the Executive Committee are set out in internal position descriptions.

In recognition of the Governor's responsibility for maintaining a reputation for integrity and propriety on the part of the Bank, the Governor and other members of the Executive Committee, as well as the Governor, are subject to the Code of Conduct for Reserve Bank Staff, which places a high priority on integrity and has provisions that address conflicts of interest. There are also specific Bank policies that deal with potential conflicts of interest arising from the Bank's roles as the principal regulator of the payments system and as provider of banking services to the Australian Government.^[11]

2.4 The board should contain suitable members with the appropriate skills and incentives to fulfil its multiple roles. This typically requires the inclusion of non-executive board member(s).

In accordance with the Reserve Bank Act, the Governor is appointed by the Treasurer. Since RITS is owned by the Bank, and is not operated as a separate legal entity, the skills and qualifications of the Governor are determined in accordance with the Bank's broader responsibilities. The Bank has human resources policies in place to help ensure that senior staff, including members of the Executive Committee have the appropriate skills and incentives. These policies are described in Key Consideration 2.5.

2.5 The roles and responsibilities of management should be clearly specified. A payment system's management should have the appropriate experience, a mix of skills, and the integrity necessary to discharge their responsibilities for the operation and risk management of the payment system.

The roles and responsibilities of the management responsible for the day-to-day operation of RITS are clearly documented in position descriptions.

The Bank has human resources policies in place to help ensure that management positions are filled with employees with the appropriate skills, incentives, experience and integrity to perform their duties. The Bank has a formal performance management program, which helps to clarify the expectations of supervisors and employees, and ensure that timely feedback is provided. Recruitment and selection at the Bank is based on the suitability of an applicant to carry out the specific requirements of the position to be filled, having regard to the applicant's: ability to perform the duties; relevant experience; relevant training and qualifications; and willingness to meet any particular requirement specified in the job description. Bank staff are subject to the Code of Conduct for Reserve Bank Staff (see Key Consideration 2.3).

The Bank also aims to offer remuneration packages that attract employees able to perform their duties to a high standard. To this end, independent consultants are engaged to ensure that remuneration policies are consistent with market practice. The Remuneration Committee of the Reserve Bank Board is also kept informed of the remuneration arrangements for Bank staff.

2.6 The board should establish a clear, documented, risk-management framework that includes the payment system's risk tolerance policy, assigns responsibilities and accountability for risk decisions, and addresses decision making in crises and emergencies. Governance arrangements should ensure that the risk-management and internal control functions have sufficient authority, independence, resources, and access to the board.

The Bank has a well-established risk management framework that facilitates the identification, assessment and treatment of all non-policy risks – including those arising from its operation of RITS – at both an enterprise (‘top-down’) and business (‘bottom-up’) level. This is set out in the Bank's Risk Management Policy.^[12] Risk management is seen as an integral part of the management function within the Bank. Line managers have the responsibility to evaluate their risk environment, put in place appropriate controls, and monitor the effectiveness of these controls. Management is supported in this role through the development and maintenance of a culture that acknowledges the need for careful analysis and management of risk in all business processes.

The risk management framework is governed by the Risk Management Committee, in accordance with the Risk Management Committee Charter. Structurally, this Committee consists of members of the executive team who are responsible for the Bank's operational areas or key support functions. It is chaired by the Deputy Governor and comprises: the Assistant Governors for Banking and Payments, Corporate Services, Currency and Financial Markets; the Chief Financial Officer; the Chief Information Officer; the Heads of Audit Department, Human Resources Department and Risk Management Unit; the General Counsel; and the Deputy Secretary.^[13] The Risk Management Committee meets six times a year or more frequently if required, and reports on its activities both to the Executive Committee and the Board Audit Committee.

The Risk Management Committee is assisted in its responsibilities by the Risk Management Unit. Risk Management Unit's main role is to assist individual business areas to manage their risk environment within a broadly consistent framework. Risk Management Unit also monitors risk and performance associated with the Bank's activities in financial markets and provides support to business areas in the implementation of fraud control and business continuity. The Risk Management Unit reports directly to the Deputy Governor.

The Audit Department also supports the framework for managing risk, complementing but remaining separate from the work of Risk Management Unit. In addition to providing assurance that the Bank's risk management policies are effective, Audit Department has a separate, independent brief to test the adequacy of procedures and controls at all levels of the Bank. Audit Department reports to the Deputy Governor and Reserve Bank Board Audit Committee.

Crisis and emergencies

In circumstances including a significant disruption to the Bank's operations that affects several business areas, the Governor may delegate responsibility for coordination of the Bank's response, either to the Bank's Crisis Management Group or an individual. The Crisis Management Group's membership would vary with the nature of the disruption and would typically comprise executives from a number of areas of the Bank.

Payments Settlements Department also maintains plans that address decision-making in crises and emergencies. These plans cover operational disruptions (see Principle 17) and the default of a RITS participant (see Principle 13). The plans are required to set out how Payments Settlements Department would communicate with the Crisis Management Group during a disruption.

2.7 The board should ensure that the payment system design, rules, overall strategy, and major decisions reflect appropriately the legitimate interests of its direct and indirect participants and other relevant stakeholders. Major decisions should be clearly disclosed to relevant stakeholders and, where there is a broad market impact, the public.

The Bank's governance arrangements ensure accountability and transparency to RITS participants and other relevant parties. To ensure the interests of relevant stakeholders are taken into account, the Bank engages in routine liaison with participants and consults on all material changes to operational arrangements (See Principle 21 for further details). All decisions affecting the operation of RITS are advised to participants. Policy decisions that impact upon RITS are also advised by media release. Major decisions and the reasons for them are explained in the Bank's Annual Report and, if relevant, in the Payments System Board Annual Report.

3. Framework for the comprehensive management of risks

A payment system should have a sound risk-management framework for comprehensively managing legal, credit, liquidity, operational, and other risks.

Rating: Observed

The Bank has a well-established risk management framework which facilitates the identification, assessment and treatment of all non-policy risks – including those arising from its operation of RITS – at both an enterprise (‘top-down’) and business (‘bottom-up’) level. Under the Bank's Risk Management Policy, Payments Settlements Department aims to identify in a single Risk Register all risks that might impact its ability to operate RITS in a safe and efficient manner, including those arising from interdependencies with other participants, other FMIs or service providers. The Risk Register is updated at least annually, or when material changes to operations or the business environment occur. Payments Settlements Department also designs and applies appropriate controls to mitigate identified risks. This high-level framework is supported by more detailed policies (see Principles 4, 5, 7 and 17) and a governance structure to oversee the Bank's risk management activities (see Key Consideration 2.6).

Based on this information, the Bank's assessment is that RITS has observed the requirements of Principle 3 during the 2013 Assessment period. The framework for the comprehensive management of risks in RITS is described in further detail under the following Key Considerations.

Note: It is the Bank's view that expectations around recovery planning and the organisation of operational arrangements to support resolution actions will not typically apply in the case of a central bank-owned and -operated system. Accordingly, the Bank has not assessed RITS against Key Consideration 3.4 of this Principle.

3.1 A payment system should have risk-management policies, procedures, and systems that enable it to identify, measure, monitor, and manage the range of risks that arise in or are borne by the payment system. Risk-management frameworks should be subject to periodic review.

The Bank's risk management framework is set out under Key Consideration 2.6. Under this framework, Payments Settlements Department is required to identify all of the risks that might impact its ability to operate RITS in a safe and efficient manner in a single register. Risks are categorised at a high level into strategic, credit, liquidity and operational risks, and further sub-categorised into more detailed risk groups (e.g. legal and information technology risks are sub-categories of operational risk). For each risk that has been identified, Payments Settlements Department sets out the potential impact and probability of the risk occurring, and also identifies existing controls and mitigation strategies (including contingency plans) to reduce the likelihood and/or impact of the risk crystallising. Where a risk is co-managed by another business area – for example, some RITS operational controls are implemented by the Bank's Information Technology Department – this must be acknowledged by the other business area.

The Bank's Risk Management Policy requires that Payments Settlements Department reviews and updates its register of risks annually, and after any major change to the Department's risk environment, to reflect any changes in risks and controls that have occurred.

3.2 A payment system should provide incentives to participants and, where relevant, their customers to manage and contain the risks they pose to the payment system.

The design of RITS means that participants do not pose liquidity or credit risks to the Bank as operator of RITS (see Principle 4 and 7). RITS participation requirements are designed to reduce the likelihood that an individual participant would disrupt the operation of RITS. If a participant does not meet these participation requirements, the Bank may apply sanctions to or impose additional requirements on that participant (see Principle 18 for more detail).

3.3 A payment system should regularly review the material risks it bears from and poses to other entities (such as other FMIs, settlement banks, liquidity providers, and service providers) as a result of interdependencies and develop appropriate risk-management tools to address these risks.

The Bank, in operating RITS, reviews the material risks that it bears from and poses to other entities. This is done in the context of its ongoing review of risks (such as the annual update of its Risk Register), and its processes for identifying risks associated with major changes to its risk environment, such as new activities or system changes. This is also part of the Bank's change management framework (see Key Consideration 17.1). The tools used to manage risks from other entities include service level agreements, customer support packages and documented operational and contingency procedures (see Key Consideration 17.7).

4. Credit risk

A payment system should effectively measure, monitor, and manage its credit exposures to participants and those arising from its payment, clearing, and settlement processes. A payment system should maintain sufficient financial resources to cover its credit exposure to each participant fully with a high degree of confidence.

Rating: Observed

The Bank is not exposed to credit risk from the settlement of payments between participants in RITS. These payments are settled using funds in participants' ESAs, which cannot be overdrawn, and the Bank does not guarantee any transaction submitted for settlement in RITS. In the event of a default, the Bank would not be exposed to a loss in its role as operator of RITS. Accordingly, RITS does not maintain financial resources to cover the default of a participant. In addition, the RTGS mode of settlement in RITS is designed to ensure that unintended credit risk does not arise between participants during the settlement process: payment messages are exchanged between participants simultaneously with the transfer of funds across ESAs.

The Bank does, however, incur credit risk through the provision of liquidity to participants in support of payments activity. This risk is managed by taking high-quality collateral under repo, applying a conservative haircut to the securities, and collecting mark-to-market margin (see Principle 5).

Based on this information, the Bank's assessment is that RITS has observed the requirements of Principle 4 during the 2013 Assessment period. Credit risk in RITS is described in further detail under the following Key Considerations.

Note: Key Considerations 4.4, 4.5 and 4.6 do not apply to RITS as it is not a CCP. Consistent with footnote 45 of the Principles, which notes that a central bank often avoids putting limits on the credit it extends to a participant because of its role as a monetary authority and liquidity provider, the Bank's view is that this Principle should not constrain central bank policies on the provision of credit, or the terms or limits of such provision.

4.1 A payment system should establish a robust framework to manage its credit exposures to its participants and the credit risks arising from its payment, clearing, and settlement processes. Credit exposure may arise from current exposures, potential future exposures, or both.

The Bank is not exposed to credit risk in its role as operator of RITS. Payments in RITS are settled using funds in participants' ESAs, which cannot be overdrawn, and the Bank does not guarantee any transaction submitted for settlement in RITS. Accordingly, in the event of a participant default the Bank would not be exposed to a loss in its role as operator of RITS.

The Bank does, however, incur credit risk through the provision of liquidity to participants, in part to support payments activity. This risk is primarily managed by taking collateral under repo, in accordance with the Bank's risk management framework. Under this framework, responsibility for approving and reviewing collateral policy is the responsibility of Domestic Markets Department, with oversight from the Risk Management Committee. The policies, procedures and controls implemented to mitigate credit risk are subject to audit by Audit Department. The Bank's risk management framework is reviewed annually. (See Key Consideration 2.6 for further detail on the Bank's risk management framework.)

The RTGS mode of settlement in RITS is designed also to ensure that unintended credit risks do not accumulate between participants during the settlement process: payment messages are exchanged between participants simultaneously with the transfer of funds across ESAs.

4.2 A payment system should identify sources of credit risk, routinely measure and monitor credit exposures, and use appropriate risk-management tools to control these risks.

Under the Bank's risk management framework, Domestic Markets Department has responsibility for identifying and managing the credit risks that arise from its activities. For each credit risk identified, the Department sets out the potential impact and probability of the credit risk crystallising, and, where possible, the existing controls and mitigation strategies. These controls are reviewed and signed off by management annually, or when there are material changes to the Bank's risk environment.

The Bank incurs credit risk through the provision of liquidity to RITS participants through repos. This credit risk is mitigated by accepting only high-quality collateral, applying an appropriate haircut to the collateral, and collecting mark-to-market margin daily (see Principle 5 for further detail). Participation requirements in RITS also help to reduce the probability of a participant default (see Principle 18). The Bank monitors the liquidity it extends to RITS participants and the composition of collateral that it holds on a daily basis. This information is readily available in the Bank's collateral management system (see Principle 5.6 for further detail).

4.3 A payment system should cover its current and, where they exist, potential future exposures to each participant fully with a high degree of confidence using collateral and other equivalent financial resources (see Principle 5 on collateral). In the case of a deferred net settlement payment system in which there is no settlement guarantee but where its participants face credit exposures arising from its payment, clearing, and settlement processes, such a payment system should maintain, at a minimum, sufficient resources to cover the exposures of the two participants and their affiliates that would create the largest aggregate credit exposure in the system.

The Bank's credit risk in providing liquidity to RITS participants is related to the value of liquidity provided under repo. This risk is mitigated by accepting high-quality collateral under repo, which could be closed out immediately after a participant default. The Bank also faces a potential future loss, which would crystallise in the event that a participant defaulted and the market value of collateral securities fell below the amount of credit provided under repo. This risk is mitigated by applying a haircut to the collateral, calibrated to cover the maximum expected decline in the market price of the collateral, over a conservative liquidation horizon, at a high level of confidence. The Bank also collects mark-to-market margin daily to cover past changes in the value of its collateral. (See Principle 5 for further detail on collateral eligibility, haircuts and mark-to-market margin.)

RITS is not a deferred net settlement payment system and accordingly the requirement to maintain sufficient resources to cover the exposures of the two participants and their affiliates that would create the largest aggregate credit exposure in the system does not apply.

4.7 A payment system should establish explicit rules and procedures that address fully any credit losses it may face as a result of any individual or combined default among its participants with respect to any of their obligations to the payment system. These rules and procedures should address how potentially uncovered credit losses would be allocated, including the repayment of any funds a payment system may borrow from liquidity providers. These rules and procedures should also indicate the payment system's process to replenish any financial resources that the payment system may employ during a stress event, so that the payment system can continue to operate in a safe and sound manner.

As explained under Key Consideration 4.1, in the event of a participant default the Bank would not be exposed to a loss in its role as operator of RITS. Accordingly, RITS participants would not have any obligations to the Bank as operator of RITS in the event of a default. Nevertheless, the Bank maintains internal procedures that set out the course of action it would take after a participant default (see Principle 13 for further details).

5. Collateral

A payment system that requires collateral to manage its or its participants' credit exposure should accept collateral with low credit, liquidity, and market risks. A payment system should also set and enforce appropriately conservative haircuts and concentration limits.

Rating: Observed

The effective implementation of monetary policy is the primary driver of the Bank's collateral policy. Notwithstanding this, the Bank's collateral eligibility policies as provider of liquidity to RITS participants are broadly consistent with this Principle. The Bank only accepts highly rated debt securities denominated in Australian dollars as collateral for liquidity in ESAs. Collateral is conservatively valued, and subject to haircuts and daily mark-to-market margin calls.

Based on this information, the Bank's assessment is that RITS has observed the requirements of Principle 5 during the 2013 Assessment period. The Bank's collateral policies are described in further detail under the following Key Considerations.

Note: Paragraph 1.23 of the Principles acknowledges that ‘central banks may have separate public policy objectives and responsibilities for monetary and liquidity policies that take precedence’. Accordingly, it is the Bank's view that nothing in this Principle should constrain the Bank's policies on collateral eligibility criteria for its lending operations.

5.1 A payment system should generally limit the assets it (routinely) accepts as collateral to those with low credit, liquidity, and market risks.

The Bank provides liquidity in participants' ESAs through repos. Under these repos, outright title to collateral is exchanged in return for credit of funds to the participant's ESA, with an agreement to reverse the transaction at some point in the future (see Section 2.4.2 for more information on repos and liquidity provision in RITS).

The Bank only accepts highly rated debt securities denominated in Australian dollars as collateral for repo. This policy covers all of the Bank's repo activity, including both intraday repos and open repos (which are aimed at providing liquidity in RITS), as well as term repos (which are primarily for open market operations). This policy is publicly available on the Bank's website.^[14] Eligible collateral is generally restricted to highly liquid securities issued by entities with high credit quality, including those issued by: the Australian Government; the central borrowing authorities of the state and territory governments (semi-government securities); certain supranational organisations, foreign governments and government agencies with an explicit government guarantee; and ADIs. In October 2007, in light of developments in securities markets and the relative scarcity of government securities, the Bank expanded its collateral eligibility criteria to include certain highly rated asset-backed securities and other private securities as collateral for repos.^[15]

In addition, any security accepted must meet the following criteria:

The security must be denominated in Australian dollars.
The security must be lodged and active in Austraclear, which is the central securities depository for fixed income securities in Australia.
Securities accepted as collateral must generally meet a minimum credit rating. This requirement does not apply to Commonwealth Government securities, semi-government securities and securities with an Australian Government guarantee, which do not need a minimum rating.
Asset-backed securities must be tradeable in the secondary market and must be based on a true sale of assets into a bankruptcy remote special purpose vehicle.
Securities sold to the Bank under a repo must not enter the closed period to maturity (the ex-interest period before maturity) during the term of the repo.

In addition, the Bank will not accept what it deems to be highly structured securities, such as collateralised debt obligations backed by other asset-backed securities.

If the above conditions are met, securities issued by the Australian Government or by the central borrowing authorities of the states and territories are automatically eligible collateral. All other securities are subject to an approval process. The Bank will not accept such securities as collateral until the approval process is complete and the securities appear on the Bank's list of eligible collateral.^[16]

In order to assess the eligibility of the security, the minimum credit rating assigned to a security or its issuer by any of the major rating agencies will be used (except certain credit-enhanced securities such as covered bonds). For ADI-issued securities with a residual maturity greater than one year, at least two major credit rating agencies must rate the security or the issuer. For covered bonds issued by ADIs, where two or more security ratings are available, only the ratings on the security will be considered. If two security ratings are not available for ADI-issued covered bonds, the minimum issuer rating will also be considered.

The Bank routinely monitors events such as credit downgrades to ensure that its list of eligible collateral remains current. If a particular collateral security is no longer eligible, counterparties with outstanding repos in that security with the Bank will be required, on a same-day basis, to substitute eligible collateral.

Wrong-way risk

To avoid wrong way risk, the Bank will not accept collateral from a RITS participant if it deems that participant to be materially related to the credit quality of the security. Where applicable, the Bank's list of eligible collateral denotes those RITS participants considered to be related to specific securities. The Bank considers any entities that are members of the same corporate group to be the same entity and therefore materially related. Similarly, where one entity has an ownership stake in another entity that exceeds 15 per cent, the two entities will be deemed to be equivalent.

The Bank accepts related party asset-backed securities, but these securities are subject to an additional haircut. The Bank considers each of the following parties to be related to an asset-backed security: the sponsor of the issuing trust, the loan originators, servicers, swap counterparties, liquidity providers and guaranteed investment contract providers to the issuing trust. The magnitude of any additional haircut will depend on the nature of the relationship between the participant and the asset-backed security.

In the event of insolvency, the close-out netting provisions included in the repo agreements allow the Bank to close out or terminate the second leg of the repo immediately. This right is protected by Part 4 of the Payment Systems and Netting Act. Where a participant provides securities issued by a third party as collateral, both the participant and the issuer would have to fail for the Bank to experience a total loss. Where a participant provides asset-backed securities, the Bank would have access to the assets behind the security if the participant were to fail.

5.2 A payment system should establish prudent valuation practices and develop haircuts that are regularly tested and take into account stressed market conditions.

Valuation

The Bank values securities accepted as collateral using available market prices, except for Commonwealth Government securities, which are valued using publicly available pricing formulae.^[17] When a timely market price is not available or reliable, the Bank uses conservative valuation formulas: government-related securities are valued using a yield of 50 basis points above an equivalent maturity swap rate referenced to the 3-month Bank Bill Swap reference rate, while private securities are valued at a price equal to 90 per cent of the face value of the security.

Haircuts and mark-to-market margin

The Bank applies haircuts to all securities bought under a repo.^[18] For operational simplicity, uniform haircut rates are set for broad groups of securities rather than for individual securities. Haircut rates are set to cover the maximum expected decline in the market price of the collateral, over a conservative liquidation horizon, at a confidence level of at least 95 per cent. The key inputs to this calculation are market prices, the maturity of the securities in the relevant asset classes and the credit ratings of the securities. Haircut rates are publicly available on the Bank's website.^[19]

The Bank also collects mark-to-market margin to cover changes in the value of its collateral.^[20] To do this, the Bank revalues all securities held as collateral using the aforementioned valuation practices at the start of each business day. Where the Bank's net exposure to a counterparty is greater than $1 million and represents more than 1 per cent of the net repurchase amounts agreed with that party, the Bank will call for mark-to-market margin equal to its net exposure.^[21] Similarly, the Bank will meet requests for mark-to-market margin from counterparties to which the Bank has a net exposure greater than $1 million and where that net exposure represents more than 1 per cent of the net repurchase amounts agreed with that party.

5.3 In order to reduce the need for procyclical adjustments, a payment system should establish stable and conservative haircuts that are calibrated to include periods of stressed market conditions, to the extent practicable and prudent.

The Bank generally applies haircuts that are calibrated to include periods of stressed market conditions. Indeed, in February 2012, haircuts were modified to capture the stressed markets conditions following the default of Lehman Brothers in late 2008. This reduces the need for procyclical haircut adjustments during periods of stress.

5.4 A payment system should avoid concentrated holdings of certain assets where this would significantly impair the ability to liquidate such assets quickly without significant adverse price effects.

The Bank routinely monitors transaction and collateral summary reports to ensure that the Bank is not exposed to large collateral concentration and liquidation risks. The key factor considered by the Bank is the depth of the market for each security when compared with the Bank's holdings of that security. This mitigates the risk of a price impact from liquidation of a large collateral holding.

5.5 A payment system that accepts cross-border collateral should mitigate the risks associated with its use and ensure that the collateral can be used in a timely manner.

The Bank mitigates the risks associated with cross-border collateral by imposing additional restrictions. In particular, the Bank currently accepts only very highly rated Australian dollar denominated securities issued or guaranteed by a foreign government or issued by a supranational. These securities must be issued under and governed by Australian law. In addition, because certain cross-border securities may be less liquid than domestic securities, the Bank applies higher haircuts to these securities. There is no operational risk associated with differences in time zones since all collateral must be lodged in Austraclear, and the Austraclear system and RITS operate at similar times.

5.6 A payment system should use a collateral management system that is well-designed and operationally flexible.

The Bank relies on a well-designed and operationally flexible system to manage its collateral. This system is a widely used integrated trading, middle-office and back-office system, which has been customised for the Bank. All transactions involving the exchange of collateral are recorded and tracked in this system. In addition, the system facilitates the calculation and execution of haircuts and margin calls. Using this system, the Bank has the capacity to produce a wide variety of reports and can easily transfer its collateral in a timely manner. The Bank ensures that there are sufficient resources to maintain its collateral management system to a high standard.

In April, the Bank agreed to become a Foundation Customer of ASX Collateral. ASX Collateral is a centralised collateral management service, which automates the allocation and optimisation of securities held as collateral in Austraclear. It is expected that RITS participants will have the option to use ASX Collateral services for some repos. While ASX Collateral itself is not subject to direct regulation as an FMI, the Bank has carried out a detailed assessment of the implications of interdependencies between ASX Collateral and the Austraclear system, in the context of its assessment of Austraclear against the Bank's Financial Stability Standards for Securities Settlement Facilities (SSF Standards).^[22],^[23] In particular, the Bank has sought to establish that the standards for operational resilience at ASX Collateral are appropriate for a critical system and consistent with those that apply to the Austraclear system.

The Bank does not re-use collateral it receives under repo.

7. Liquidity risk

A payment system should effectively measure, monitor, and manage its liquidity risk. A payment system should maintain sufficient liquid resources in all relevant currencies to effect same-day and, where appropriate, intraday and multiday settlement of payment obligations with a high degree of confidence under a wide range of potential stress scenarios that should include, but not be limited to, the default of the participant and its affiliates that would generate the largest aggregate liquidity obligation for the payment system in extreme but plausible market conditions.

Rating: Observed

RITS conducts its settlements on an RTGS basis and does not guarantee settlement. The Bank, as operator of RITS, does not therefore assume liquidity risk through these operations. Accordingly, many of the requirements under this Principle – including those around liquidity stress testing, monitoring, and the maintenance of a pool of liquid assets – do not apply.

However, settling payments on an RTGS basis does impose liquidity requirements on participants. RITS assists participants in the management of these requirements through its liquidity-efficient design, the provision of liquidity under repo, and the provision of real-time information on transactions and ESA balances. The Bank's operational staff also continuously monitor settlement activity and participant balances in RITS for evidence of any disruption to the flow of liquidity, which could occur if a participant experienced an operational or financial problem. RITS's participation requirements aim to reduce the probability that such problems arise.

Based on this information, the Bank's assessment is that RITS has observed the requirements of Principle 7 during the 2013 Assessment period. Liquidity risk in RITS is described in further detail under the following Key Considerations.

Note: Key Consideration 7.4 does not apply to RITS as it does not operate a CCP. Key Consideration 7.8, which refers to an FMI's access to central bank services, does not apply to RITS as it is owned by the Bank and operated as an internal function.

7.1 A payment system should have a robust framework to manage its liquidity risks from its participants, settlement banks, nostro agents, custodian banks, liquidity providers, and other entities.

RITS conducts its settlements on an RTGS basis and does not guarantee settlement. The Bank, as operator of RITS, does not therefore assume liquidity risk in its operations. Since participants face liquidity risks, however, RITS assists participants in their liquidity management through its liquidity-efficient design, the provision of liquidity under repo, and the provision of real-time information on transactions and ESA balances. Furthermore, RITS's participation requirements aim to reduce the probability that a participant experiences an operational or financial problem that could disrupt the flow of liquidity in the system (see Principle 18).

7.2 A payment system should have effective operational and analytical tools to identify, measure, and monitor its funding flows on an ongoing and timely basis, including its use of intraday liquidity.

Since RITS does not assume liquidity risk, there are no relevant funding flows for RITS to measure and monitor. As discussed in Section 2.4, RITS provides tools for participants to manage their liquidity. In managing operational risk the Bank's operational staff also continuously monitor the flow of liquidity and payments at both a system and participant level for evidence of any disruption to the flow of liquidity, which could occur if a participant experienced an operational or financial problem (see Principle 17). If such a disruption were observed, the Bank would liaise with participants to mitigate the impact. To further mitigate possible disruption under such a scenario, participants are required to inform the Bank in the event of any operational problem, and the RITS Regulations also set out actions that the Bank may take in response to a participant default (see Principle 13).

7.3 A payment system, including one employing a DNS mechanism, should maintain sufficient liquid resources in all relevant currencies to effect same-day settlement, and where appropriate intraday or multiday settlement, of payment obligations with a high degree of confidence under a wide range of potential stress scenarios that should include, but not be limited to, the default of the participant and its affiliates that would generate the largest aggregate payment obligation in extreme but plausible market conditions.