Financial Stability Standard for Central Counterparties FSS 2003.1 (Cth)
RESERVE BANK OF AUSTRALIA
Corporations Act 2001
Notification of Determination of Financial Stability Standards
The Reserve Bank of Australia (“Reserve Bank”) has, under subsection 827D(1) of the Corporations Act 2001, determined two financial stability standards which must be complied with by clearing and settlement (CS) facility licensees. The standards are listed in the Schedule. The standards are designed to ensure that CS facility licensees conduct their affairs in a way that promotes overall stability in the Australian financial system.
Under subsection 827D(5) of the Corporations Act 2001, the Reserve Bank has specified that the financial stability standards apply to CS facility licensees from 30 May 2003 (“Commencement Date”).
The objective tests contained in the standards are supplemented by a series of measures which the Reserve Bank considers relevant for the purposes of meeting the standards. During a specified transitional period (as set out in the Annex), the Reserve Bank will not consider that a specified CS facility licensee has not met the standards solely because that CS facility licensee has not met the measures specified in the Annex.
Copies of the financial stability standards and this notice are available:
on the Reserve Bank’s website at or
by telephoning 02 9551 9720; or
at the office of the Reserve Bank at 65 Martin Place, Sydney NSW 2000 (reference: Senior Manager, Payments System Stability, Payments Policy Department).
This notice is published by authority of the Reserve Bank under paragraph 827D(7)(a) of the Corporations Act 2001.
Signed
IJ Macfarlane
Governor
Reserve Bank of Australia
29 May 2003
SCHEDULE
Financial Stability Standard FSS 2003.1 – Financial Stability Standard for Central Counterparties
Financial Stability Standard FSS 2003.2 – Financial Stability Standard for Securities Settlement Facilities
ANNEX
Under subsection 827D(5) of the Corporations Act 2001, the Financial Stability Standard for Central Counterparties and the Financial Stability Standard for Securities Settlement Facilities come into force on 30 May 2003 (“Commencement Date”).
The two standards set out a number of measures that the Reserve Bank considers relevant in determining whether the CS facility licensee has met the relevant standard. For the avoidance of doubt, during the periods specified below, the Reserve Bank does not consider that:
ASX Settlement and Transfer Corporation Pty Limited ABN 49 008 504 532 (ASTC) will not have met the Financial Stability Standard for Securities Settlement Facilities solely by reason of:
a. Measure 7ii(b) – ASTC not meeting the requirements of measure 7ii(b) for the period from the Commencement Date until the earlier of:
i.the date the Minister varies ASTC’s CS Facility licence under section 825A(1) of the Corporations Act; and
ii.10 March 2004;
b. Measure 7ii(c) – ASTC not meeting the requirements of measure 7ii(c) for the period from the Commencement Date until the first anniversary of the Commencement Date.
Options Clearing House Pty Limited ABN 48 001 314 503 (OCH) will not have met the Financial Stability Standard for Central Counterparties solely by reason of:
a. Measure 5(b) – OCH not meeting the requirements of measure 5(b) for the period from the Commencement Date until the first anniversary of the Commencement Date;
b. Measure 7 – OCH not meeting the requirements of measure 7 for the period from the Commencement Date until the earlier of:
i.the date the Minister varies OCH’s CS Facility licence under sections 825A and 826A of the Corporations Act; and
ii.10 March 2004;
c.Measure 9ii(b) – OCH not meeting the requirements of measure 9ii(b) for the period from the Commencement Date until the earlier of:
i.the date the Minister varies OCH’s CS Facility licence under sections 825A and 826A of the Corporations Act; and
ii.10 March 2004;
d. Measure 9ii(c) – OCH not meeting the requirements of measure 9ii(c) for the period from the Commencement Date until the first anniversary of the Commencement Date.
RESERVE BANK OF AUSTRALIA
FINANCIAL STABILITY STANDARD FOR
CENTRAL COUNTERPARTIES
FSS 2003.1
Introduction
This standard is determined under section 827D(1) of the Corporations Act 2001 (Cth) and applies to Australian clearing and settlement (CS) facility licensees, under Part 7.3 of the Act, that operate a central counterparty. For the purposes of this standard, a central counterparty is a clearing and settlement facility operated by an Australian CS facility licensee where the CS facility licensee interposes itself between trade counterparties, taking on the trade obligations of trade counterparties to each other. A separate standard applies to CS facility licensees that operate a securities settlement facility.
The objective of this standard is to ensure that CS facility licensees identify and properly control risks associated with the operation of the central counterparty, thereby promoting the stability of the Australian financial system. Primary responsibility for risk control lies with each CS facility licensee’s board and senior management.
This standard sets a general requirement for a CS facility licensee that operates a central counterparty to conduct its affairs in a prudent manner. This objective test is then supplemented by a series of measures which the Reserve Bank considers relevant for the purposes of meeting the standard.
THE STANDARD – FSS 2003.1
A CS facility licensee must conduct its affairs in a prudent manner, in accordance with the standards of a reasonable CS facility licensee in contributing to the overall stability of the Australian financial system, to the extent that it is reasonably practicable to do so.
HOW A LICENSEE MEETS THE STANDARD
Parts 1 - 10 below identify the minimum measures that the Reserve Bank considers are relevant in determining whether a CS facility licensee has met the standard.
The standard is to be interpreted in accordance with its objective, and by looking beyond form to substance. Where the requirements of the measures and those of the Corporations Act 2001 (Cth) and Corporations Regulations are inconsistent, the requirements of the Corporations Act 2001 (Cth) and Corporations Regulations will prevail to the extent of such inconsistency.
The Reserve Bank may, from time to time, issue guidance containing further information on specific aspects of the measures listed below.
Guidance - Introduction
This guidance is issued in relation to the financial stability standard determined under section 827D(1) of the Corporations Act 2001 (Cth) that applies to Australian clearing and settlement (CS) facility licensees, under Part 7.3 of the Act, that operate a central counterparty.
The objective of this guidance is to provide further information and detail on the measures that the Reserve Bank considers relevant for the meeting of the standard. It is intended to assist in the interpretation of those measures, but is not of itself a standard and is not intended to contain obligations that are binding on CS facility licensees.
1. Legal framework
The central counterparty must have a well‑founded legal basis. The CS facility licensee as operator of the central counterparty must:
(a) be a legal entity (whose primary business activity is operating the CS facility) and one which is separate from other entities which may expose it to risks unrelated to those arising from its function as operator of a central counterparty;
(b) have rules which constitute a clear and legally enforceable contract or contracts, in all relevant jurisdictions, between the central counterparty and its participants (and between each participant and each other participant);
(c) have rules which clearly define the nature and scope of any obligation it undertakes to provide clearing support to the participants in the central counterparty;
(d) have rules which identify the conditions under which final and irrevocable settlement of obligations between the central counterparty and the participants in the CS facility has taken place;
(e) have rules which define its rights and obligations, and those of its participants, including in the event of the default or suspension of one or more of its participants;
(f) have rules which will operate according to their terms in the event of external administration; and
(g) to the extent possible, obtain legal certainty for its rules under all relevant legislation.
Guidance - Legal framework
A well-founded legal basis is critical for the safe and reliable operation of a central counterparty, and for minimising the potential for financial system instability to arise from its operation. The operator of the central counterparty is responsible for identifying and minimising legal risk.
The legal basis of a central counterparty includes its operating rules and written procedures, and contractual agreements between participants and service providers. These should be enforceable given the underlying legislative, regulatory and common law framework within which a central counterparty operates.
Measure 1(a) of the Standard
The identification of the operator of the central counterparty as a separate legal entity is of particular importance where an entity related to the operator of the central counterparty is experiencing operational or financial difficulties, including external administration. Related entities which may expose the operator of the central counterparty to risks unrelated to those arising from its function as a central counterparty may include a related securities settlement facility, a financial market, or technology or other service providers.
The legal separation of the operator of the central counterparty from other legal entities may also provide protection to those other legal entities should the central counterparty itself experience operational or financial difficulties.
The measure does not assume, however, that a legal separation will remove all risks that may arise as a result of operational or financial difficulties faced by a central counterparty or related entities.
Measure 1(b) of the Standard
The contract (or contracts) arising from a central counterparty’s legal framework must be enforceable, with a high degree of certainty, in the legal jurisdiction within which the central counterparty operates, is licensed or otherwise regulated. However, rights and obligations arising from a central counterparty’s legal framework may also have a connection to other legal jurisdictions, such as where a central counterparty has participants that are established in another jurisdiction, or where the central counterparty offers services in relation to financial products that are issued in another jurisdiction. These other jurisdictions may be relevant to the central counterparty’s activities such that the central counterparty would want to ensure that the relevant contracts were legally enforceable in those jurisdictions. However, a jurisdiction with a trivial or merely tangential connection to the central counterparty’s activities would be unlikely to be relevant in this context.
The measure may be met by the operator obtaining a written and reasoned legal opinion as to the enforceability of the central counterparty’s arrangements under the laws of each relevant jurisdiction. Such an opinion should include a discussion, to the extent that can be objectively determined, of whether the central counterparty’s activities in the jurisdiction meet the measure in respect of control of legal risk.
Measure 1(d) of the Standard
Settlement refers to the final and irrevocable extinguishment of obligations between participants and the central counterparty.
A transaction cannot be unwound once final and irrevocable settlement has taken place. This does not preclude the central counterparty accepting transactions that have the effect of offsetting other transactions.
Measure 1(e) of the Standard
The legal framework of a central counterparty will necessarily impose certain rights and obligations upon the central counterparty and its participants. The operator of the central counterparty must ensure that any and all rights and obligations arising from participation in a central counterparty are clearly defined and set out in a central counterparty’s legal framework. It is not sufficient for key rights and obligations to be implied.
Where a participant or the operator of the central counterparty is in external administration or is otherwise facing difficulties, there is scope for these events to cause instability in the broader financial system. A high degree of certainty in the legal framework concerning such events can help to limit the capacity for such instability.
It is important that the rules applying to a default situation are set out in advance: this minimises the opportunity for surviving participants to challenge their liability (in a default situation, there are likely to be strong incentives to undertake behaviour to minimise any contribution, and this could amplify systemic risks). A more detailed discussion is contained in the guidance on measure 6: Default arrangements.
Measure 1(g) of the Standard
The operator of a central counterparty should obtain its own legal advice on legislation that offers legal certainty. For example, if the central counterparty has arrangements involving the netting of transactions, then its operator must seek the benefit of the Payment Systems and Netting Act 1998 (Cth). Cross-jurisdictional issues may also be relevant.
2. Participation requirements
The requirements for participation in the central counterparty must promote the safety and integrity of the central counterparty and ensure fair and open access. Participation requirements must:
(a) be based on objective and publicly disclosed criteria;
(b) ensure that participants in the central counterparty are of a sufficient financial standing such that the central counterparty is not exposed to unacceptable credit risks;
(c) require that participants have the operational capacity to settle their obligations with the central counterparty in a timely manner; and
(d) allow the CS facility licensee as operator of the central counterparty to suspend or cancel the participation of an institution which breaches the applicable participation or other risk-control requirements.
Guidance - Participation requirements
A central counterparty’s participation requirements must aim to ensure that all participants have sufficient resources, both financial and otherwise, to meet obligations arising from participation in the central counterparty. The goal of such requirements is to promote the safety and integrity of the central counterparty, and in doing so limit the potential for financial system instability. The operator of the central counterparty should, at the same time, ensure that access to the central counterparty is not restrictive beyond the need for ensuring financial system stability, and make certain that requirements are fair and are applied equitably across participants.
The reference to fair and open access is directed towards transparency and the reduction of systemic risk, rather than towards competition issues, which are dealt with in Australia under other legislation.
Measure 2(a) of the Standard
Participation requirements (particularly those relating to risk) should be set out in the central counterparty’s rules. If tiering exists, each class of participation should be clearly defined and the participation requirements should be the same for all applicants of the same class.
If the central counterparty’s rules require that key personnel be of good character, the operator of the central counterparty should ensure that the process of making this judgement is as objective as possible.
Measure 2(b) of the Standard
The participation requirements should include various financial requirements, such as a minimum credit rating or level of net tangible assets, so as to reduce the exposure of the central counterparty to credit and other risks.
The operator of the central counterparty must have procedures in place to ensure that its financial requirements are met on an ongoing basis. Ordinarily, this requires the operator to receive regular financial reports from each of its participants. It also requires participants to advise the operator of the central counterparty of any material change in their financial standing, including any change to external credit ratings.
Measure 2(c) of the Standard
Each participant should be required to have sufficient capacity to process the expected volumes and values of transactions with the required speed, particularly at peak times and on peak days.
Participation requirements must be ongoing. Any breach or potential breach should be required to be reported to the operator of the central counterparty.
Measure 2(d) of the Standard
An appeals process should not detract from the operator’s ability to suspend or cancel participation. For serious breaches, the preferable approach would provide for the suspension or cancellation to persist during an appeal, with reinstatement upon a successful appeal, rather than the suspension or cancellation being put on hold until an appeal were heard.
3. Understanding risks
The central counterparty’s rules and procedures must enable each participant to understand the central counterparty’s impact on each of the financial risks the participant incurs through participation in the central counterparty.
Guidance - Understanding risks
The operating rules and procedures of a central counterparty play a key role in enabling participants to understand the financial risks they incur. The rules need to be clear, comprehensive and up-to-date to facilitate understanding by participants and prospective participants of the risks they can face through participation in the system. Explanatory material written in plain language, although not necessarily binding legally, can aid understanding of the facility’s design and processes, thus improving understanding of risks that may arise through participation.
Participants and prospective participants should be able to understand the basic design of the system, as that will be an important determinant of their rights and obligations. Rules and procedures should be readily available to all participants and prospective participants and at least the key rules relating to financial risks should be publicly disclosed. Consideration should be given to publicly disclosing all rules.
The rules and procedures should describe the roles of participants and the system operator and the procedures that will be followed in various circumstances (for example, which parties are to be notified of specific events and the timetables for decision-making and notification). They should make clear the degree of discretion parties are able to exercise in taking decisions that can have a direct effect on the operation of the system. There should be clear processes for changing rules and procedures. The degree of discretion the CS facility licensee as operator can exercise to make unilateral changes to the rules or procedures, and any period of notice it must give to participants, should be clear.
Where the operator of a central counterparty allows tiered participation (for example, different classes of participation have different rights and obligations in the facility), rules and procedures should cover the impact of tiering arrangements.
4. Novation
The rules and procedures governing the central counterparty must clearly identify:
(a) the nature and scope of novation; and
(b) the point in the clearing process at which trades are novated.
Guidance - Novation
The identification of the point in the clearing process at which a central counterparty takes on (through novation) the counterparty obligations of participants is important in assessing where risks lie.
Measure 4(a) of the Standard
The nature and scope of novation must be legally certain, and made known to all participants. The way in which the central counterparty interposes itself between counterparties in the novation process should be described.
Measure 4(b) of the Standard
The point in the clearing process at which novation takes place must be legally certain and made known to all participants. This will help to ensure that participants understand the point in the process at which any guarantee (provided by the central counterparty) commences. Ordinarily, a central counterparty would aim to minimise the time between trade agreement or matching between trade counterparties, and the time at which the central counterparty takes on trade obligations.
5. Settlement
Settlement arrangements must ensure that the central counterparty’s exposures are clearly and irrevocably extinguished on settlement. This requires that:
(a) where settlement involves the exchange of one asset for another, it must be done on an appropriate delivery-versus-payment basis; and
(b) where payments, including net payments, are made to extinguish other obligations, payment must be made by real-time gross settlement.
Notwithstanding the existence of risk controls (refer measure 7: Risk controls), circumstances may arise whereby the central counterparty is unable to settle all of its obligations. To deal with such an eventuality, the central counterparty must have rules and procedures that specify how unsettled obligations will be treated.
Guidance - Settlement
This measure is aimed at reducing the risk of systemic disturbance by eliminating principal risk faced by a central counterparty and its participants. It does not preclude the use of netting or batch processing in the clearing process.
A central counterparty must have appropriate arrangements in place to ensure that its exposures are clearly and irrevocably extinguished on settlement. Typically, this will involve either arrangements with a securities settlement facility, or arrangements for settlement of payment obligations. The concept of settlement through a securities settlement facility is dealt with in detail in the financial stability standard for securities settlement facilities.
Measure 5(a) of the Standard
Where settlement involves the exchange of one asset for another (e.g. securities for payment) the operator of the central counterparty must ensure that transactions novated to it are settled on an appropriate delivery-versus-payment (DvP) basis. Typically, DvP is achieved in one of three ways:
·where the final transfer of payment from buyer to seller and the final transfer of security from seller to buyer occur simultaneously and on a trade-by-trade basis;
·where final securities transfers are settled on a trade-by-trade basis, with final payment transfers settled on a net basis at the end of the processing cycle; or
·where both final securities transfers and final payment transfers occur on a net basis at the end of the processing cycle.
The timing of DvP settlement of trades is important. Where the final simultaneous transfer of securities and payment occurs continuously throughout the day, principal risk is eliminated. Where final transfer of securities occurs continuously, but final payment is deferred until some later time, sellers of securities are exposed to principal risk. Where both securities and payments are exchanged with finality at the end of the day there is a prospect that, even though principal risk is eliminated, net obligations may be sufficiently large that a participant default would cause survivors to face significant liquidity pressures, which could result in systemic disruption.
Only where settlement values are not large may the payment transfers and/or final securities transfers occur on a net basis. In those circumstances both securities transfer and payment must occur contemporaneously unless this is precluded by operational requirements. Where netting is involved, the operator of the central counterparty should ensure that steps have been taken to ensure the certainty of netting arrangements. At a minimum, the final and irrevocable settlement of obligations should be completed by the end of the settlement day.
Measure 5(b) of the Standard
Notwithstanding the DvP method chosen, settlement of any obligations between the providers of cash settlement assets must be by an irrevocable real-time payment method, i.e. real-time gross settlement (RTGS).
Where settlement involves the exchange of one asset for another (a DvP transaction), the settlement of obligations requires up to three steps:
·the security (or title over the security) needs to be transferred from seller to buyer;
·payment must be transferred from the buyer’s account at its provider of cash settlement assets to the seller’s account at its provider of cash settlement assets; and
·where the buyer and seller have different providers of cash settlement assets, funds must be transferred from the buyer’s provider to the seller’s provider through Exchange Settlement Accounts held by the providers at the Reserve Bank.
Settlement of obligations between providers of cash settlement assets is often referred to as ‘settlement of the interbank leg’. The term ‘provider of cash settlement assets’ is used in recognition that parties other than banks may be involved in this process.
In the case of a DvP transaction, it is the transfer of funds between the buyer’s provider of cash settlement assets to the seller’s provider that must be made by an irrevocable real-time payment method to meet the measure.
In the case of non-deliverable (such as derivatives) obligations, settlement of obligations consists of payment transactions between clearing participants and the central counterparty (or a provider of cash settlement assets that acts on the central counterparty’s behalf). In this case, the settlement of payments between participants and the central counterparty (or its provider of cash settlement assets) must be made by an irrevocable real-time payment method.
The risk-control requirements of the measure accept that in extreme circumstances the central counterparty may not be able to meet its settlement obligations in full. To limit any systemic disruption that may follow from a failure of the central counterparty, the central counterparty’s rules and procedures must describe how settlement is to be effected in such circumstances.
The rules should ensure that obligations due by the central counterparty to its participants are equitably settled on the day of default to the maximum extent possible and, at a minimum, to the full extent of coverage provided by risk controls.
6. Default arrangements
The CS facility licensee as operator of the central counterparty must ensure that it has clear rules and procedures to deal with the possibility of a participant being unable to fulfil its obligations to the central counterparty. The arrangements for dealing with a default must ensure that in this scenario timely action is taken by the central counterparty and the participants in the central counterparty, and that risks to the central counterparty and its participants are minimised. In meeting this requirement, the CS facility licensee as operator of the central counterparty must:
(a) require its participants to inform it immediately if they:
(i)become subject to external administration, or have reasonable grounds for suspecting that they will become subject to external administration; or
(ii)have breached, or are likely to breach, a risk-control requirement of the central counterparty; and
(b) have the ability to close out, or otherwise deal with a participant’s open contracts in order to appropriately control risk if a participant:
(i)becomes subject to external administration; or
(ii)breaches a risk-control requirement of the central counterparty.
Guidance - Default arrangements
This measure is aimed at avoiding any systemic disturbance that may arise from the default of a participant. To comply with the measure, the central counterparty’s rules and procedures should provide for timely settlement (typically by the end of the settlement day) notwithstanding a default.
There is a difference between external administration and cases where a participant may have sufficient assets to meet its obligations, yet be unable to complete settlement of its obligations due to operational failure or liquidity pressures. This distinction should be recognised in the rules of the central counterparty.
The rules of the central counterparty should outline the steps to be taken once it has determined that a participant is in default. The central counterparty should have the ability to suspend or cancel the participation of a participant in default, thus preventing that participant from continuing to take on trade obligations.
Measure 6(a) of the Standard
The operator of the central counterparty should have a legally binding requirement for participants to notify it should they be in default or reasonably suspect that this is the case. Similar notification should be made in the event of a breach or likely breach of any risk-control requirement of the central counterparty. Any communication should be at an appropriately high level both within the participant organisation and the central counterparty.
7. Risk controls
The CS facility licensee as operator of a central counterparty must have comprehensive risk-control arrangements in place. These arrangements must provide the operator of the central counterparty with a high degree of confidence that, in the event of extreme volatility in relevant markets, the central counterparty will be able to settle all of its obligations in a timely manner. As a minimum, the risk-control arrangements must provide the CS facility licensee as operator of the central counterparty with a high degree of confidence that the central counterparty will be able to settle its obligations in the event that the participant with the largest settlement obligations cannot meet them. In all but the most extreme circumstances, a central counterparty must be able to settle its obligations using liquid assets as defined in this standard.
The CS facility licensee as operator of a central counterparty must:
(a) ensure that its risk-control measures, typically a combination of its own capital, margins, guarantee funds and pre-determined loss-sharing arrangements, provide sufficient coverage and liquidity; and
(b) undertake regular and rigorous stress testing to ensure the adequacy of its risk controls.
The adequacy of risk-control measures must be approved by the board of the central counterparty, or an appropriate body as delegated by the board.
Margins
Where the CS facility licensee as operator of a central counterparty requires margin payments, it must have the ability to:
(a) levy initial and variation margins, as well as intraday margins (e.g. in the event of significant changes in market volatility or a participant’s credit worthiness);
(b) set and rigorously enforce times by which all margin payments must be paid, and set appropriate penalties for failure to pay on time;
(c) take haircuts on non-cash collateral, where such collateral is accepted for margins;
(d) mark-to-market the value of participants’ positions, ordinarily at least once a day, and more frequently during times of market stress;
(e) determine in a timely fashion whether intraday or variation margins are required; and
(f) in the event of default by a participant, use margin payments from the defaulter, together with receipts from the sale of any securities or any other asset due to be delivered to the defaulter, to satisfy its obligations to other participants.
Guarantee fund
Where the CS facility licensee as operator of a central counterparty uses a guarantee fund:
(a) it must have clear rules for access to the guarantee fund; and
(b) the rules must make it clear that the contributions, if any, of all participants, not just those in default, may be called upon in the event of a default of one or more participants.
Loss sharing
Where loss-sharing arrangements are used, those arrangements must be:
(a) documented and legally enforceable; and
(b) acknowledged by all participants in the central counterparty.
Guidance - Risk controls
The risk controls of a central counterparty are crucial in ensuring that the central counterparty is able to provide a safe and efficient service. Meeting the risk-control measure involves the operator identifying, measuring and managing the risks that a central counterparty faces. In meeting the standard, the operator of a central counterparty should carefully consider the advantages of upgrading its risk controls to provide a high degree of confidence in its ability to settle in the event of the default of more than one participant on the same day.
In its risk controls a licensee should address how it would intend to undertake any replenishment of funds used as a result of the failure of one or more of its participants. Such a measure may include insurance arrangements.
Measure 7(a) of the Standard
The measure does not prescribe how the operator of a central counterparty must control risk. The measure leaves it to the operator to choose which risk control, or combination of risk controls, is appropriate for the risks faced in that central counterparty. It does, however, require the operator to monitor the level of risk, and it specifies minimum levels of protection.
Measure 7(b) of the Standard
At a minimum, the operator should conduct stress testing quarterly, but ideally this would be done more frequently. Assumptions used in stress testing should be modified over time as participant obligations vary in size and composition, and as volatility in financial markets changes.
The operator of a central counterparty must ensure, through the use of stress testing, that in all but the most extreme circumstances, it will be able to meet its obligations to participants in the event that the participant with the largest obligations is unable to meet them.
The operator of a central counterparty must also ensure that its risk controls provide coverage that is sufficiently liquid to enable the central counterparty to settle all its obligations on a timely basis, including where the participant with the largest obligations is unable to meet them. An inability to do so increases the potential for systemic disturbance.
Section (i) of Measure 7: Margins
Where margins are used, the operating rules and procedures of the central counterparty should specify how initial, variation, intraday, and any other margins are calculated. This includes margins that may be called in extreme or unusual circumstances.
Section (ii) of Measure 7: Guarantee fund
The operator of a central counterparty may use a guarantee fund to support a guarantee it provides to its participants. The guarantee fund will consist of a range of assets, some of which will be contributions from participants as well as from the operator of the central counterparty. The size of the guarantee fund will depend on the quality (and quantity) of other risk controls – the more rigorous a margining system, for example, the less pressure is likely to be placed on the guarantee fund.
Where a guarantee fund is used, it should be funded and used in such a way that all participants, as well as the operator of the central counterparty, have incentives to ensure that risk controls are effective and well managed. Normally, the rules of the central counterparty would stipulate the order in which funds are to be used in an event of default. For example, the contributions of the defaulting participant would typically be used prior to the contributions of surviving participants.
Section (iii) of Measure 7: Loss sharing
Loss sharing refers to the process whereby a settlement shortfall is allocated between participants. Settlement of revised obligations incorporating this allocation of a settlement shortfall represents settlement of the obligations accepted for settlement by the central counterparty. In effect, the allocation of the settlement shortfall to participants represents loss sharing. Notwithstanding this, the arrangements should not preclude the central counterparty from taking action as a creditor in the external administration of a defaulting participant. In the extreme circumstance where a central counterparty fails, the arrangements should not prevent surviving participants from taking similar action against the central counterparty.
The implementation of loss-sharing rules can add a further level of protection to a set of central counterparty arrangements. Properly constructed, they should provide an appropriate set of incentives for the operator of a central counterparty and its participants to manage the risks they undertake, and help to ensure that operations of the central counterparty do not contribute to instability in the financial system.
It may be possible to design loss-sharing arrangements that provide the operator of a central counterparty with the same protection as liquid assets. At a minimum, this would require that the rules and procedures allow the operator of a central counterparty to adjust settlement positions, on the day of default, to expunge any shortfall following the default of a participant.
8. Governance
The central counterparty must have effective, accountable and transparent governance arrangements. This requires that:
(a) the board of the CS facility licensee have appropriate expertise and independence;
(b) the board of the CS facility licensee be responsible for oversight of the operation of the central counterparty; and
(c) the risk-control function of the central counterparty must not be adversely influenced by its business, marketing or other operations.
Guidance - Governance
The measures in relation to governance apply to the area of management specific to the control of the financial risks faced by a central counterparty. Risk management should be dealt with at very high levels within the operator of a central counterparty.
This measure is not intended to cover wider issues of corporate governance, including obligations in the Corporations Act 2001 (Cth) and good market practice.
Measure 8(a) of the Standard
The board should have the level of experience, knowledge and skills necessary to operate the central counterparty. The nature and degree of the skills, experience and expertise required will depend on the size, scope and nature of the business conducted by the central counterparty. The board should have an appropriate degree of independence from the operator’s management, and from related bodies including its participants.
Measure 8(b) of the Standard
The board should have regard to formal and informal structures and processes in meeting the measure, such as reporting lines and job descriptions. It should also exercise appropriate control over the day-to-day management of the operator of the central counterparty, including with regard to any potential trade-off between the strength of the risk-control measures and the cost-effective provision of the service.
9. Operational risk
The CS facility licensee as operator of a central counterparty must identify sources of operational risk and minimise these through the development of appropriate systems, controls and procedures.
Security and operational reliability
The CS facility licensee as operator of a central counterparty must ensure that:
(a) key systems, such as computer and communication systems, are secure and have robust access controls, with security reviewed and tested periodically;
(b) key systems are operationally reliable, with standards of operational reliability defined formally and documented;
(c) systems have sufficient capacity to process the expected volumes of transactions with the required speed, including at peak times and on peak days;
(d) changes to technical systems and supporting infrastructure do not disrupt its usual operations; and
(e) it has well-trained and competent personnel to ensure that all key systems are operated securely and reliably.
Business continuity procedures
The CS facility licensee as operator of a central counterparty must have in place arrangements to ensure the timely recovery of its usual operations in the event of a contingency. This requires that the operator of a central counterparty:
(a) have detailed contingency plans, including back‑up arrangements for its critical communications and computer systems and key personnel;
(b) require its participants to have appropriate complementary arrangements in the event of a contingency;
(c) undertake regular industry testing of its business recovery arrangements; and
(d) conduct regular reviews of the adequacy of these arrangements and make such changes as are necessary and desirable.
Outsourcing
Security, operational reliability and business continuity procedures must extend to systems and processes which have been outsourced. The CS facility licensee as operator of a central counterparty must ensure that service providers meet the same standards as apply to the operator of the central counterparty with respect to the function outsourced. However, even when systems and processes are outsourced, the operator of the central counterparty remains responsible for those systems and processes.
External administration of a related body
The CS facility licensee as operator of a central counterparty must ensure that it would have access to the necessary staff, technical and other resources needed to continue operating in circumstances where a related body becomes subject to external administration.
Guidance - Operational risk
The aim of this measure is to minimise the risk that deficiencies in information systems or internal controls, or a failure of personnel or management, will result in losses to participants of the central counterparty and potential systemic disturbance.
Section (i) of Measure 9: Security and operational reliability
Measure 9(i)(c) of the Standard
Operational and back-up computer systems, and links between systems, should have ample, scalable capacity for anticipated daily volumes, and be subject to stress testing.
Measure 9(i)(d) of the Standard
All procedures relating to change management should be thoroughly documented. Such procedures should include notification to participants where significant changes occur that may have an impact on the operations of the CS facility.
In the normal course, the operator should ensure that all changes to existing systems and supporting infrastructure are thoroughly tested outside of the production environment.
Section (ii) of Measure 9: Business continuity procedures
The operator of the central counterparty should have comprehensive arrangements in place to address a contingency, i.e. the failure of one or more components of the system.
Measure 9(ii)(a) of the Standard
Business continuity procedures should be available to participants. These procedures should in general seek to ensure that minimum service levels are maintained. In extreme circumstances, the procedures may allow for suspension of services.
The transition to back-up systems should be timely and reliable. In general, back-up systems should be capable of the timely completion of daily transactions.
Measure 9(ii)(b) of the Standard
The participants of a central counterparty should have complementary business continuity arrangements that are appropriate to the nature and size of the business undertaken by that participant. Rules and procedures should clearly and fairly specify the requirements of participants in this regard.
Measure 9(ii)(c) of the Standard
The degree of industry participation in the testing should be appropriate to the nature and size of the business undertaken by individual participants.
Section (iii) of Measure 9: Outsourcing
The central counterparty should ensure that the risks associated with outsourcing key business functions are clearly identified and properly managed. The operator should have a formal policy, determined by its board, which sets out the process for entering into, maintaining and exiting key outsourcing arrangements.
Before an outsourcing arrangement is established, senior management should identify the business, operational and other risks involved and ensure that these risks can be adequately monitored and controlled by the facility.
The board should approve the establishment of any outsourcing arrangement for a key business activity and be informed on a regular basis of the performance of the service provider.
Section (iv) of Measure 9: External administration of a related body
Agreements between an operator and its related bodies should be in place to ensure that, to the extent permissible by law, the operator of a central counterparty is able to ensure that it continues to access key resources.
10. Regulatory reporting
The CS facility licensee as operator of a central counterparty must inform the Reserve Bank as soon as reasonably practicable if:
(a) it breaches, or has reason to believe that it will breach:
(i) the standard; or
(ii) its broader legislative obligation to do, to the extent that it is reasonably practicable to do so, all things necessary to reduce systemic risk;
(b) it becomes subject to external administration, or has reasonable grounds for suspecting that it will become subject to external administration;
(c) a related body to the operator of the central counterparty becomes subject to external administration, or the operator of the central counterparty has reasonable grounds for suspecting that a related body will become subject to external administration;
(d) a participant becomes subject to external administration, or if the operator of the central counterparty has reasonable grounds for suspecting that a participant will become subject to external administration;
(e) a participant fails to meet its obligations under the central counterparty’s risk-control requirements or has its participation suspended or cancelled because of a failure to meet the central counterparty’s risk-control requirements;
(f) it fails to enforce any of its own risk-control requirements;
(g) it plans to make significant changes to its risk-control requirements, its rules, or procedures;
(h) it proposes to grant a security interest over its assets (other than a lien, right of retention or statutory charge that arises in the ordinary course of business);
(i) it proposes to incur or permit to subsist any loans from participants or members unless such loans are subordinated to the claims or all other creditors of the operator of the central counterparty; or
(j) any other matter arises which has or is likely to have a significant impact on its risk-control arrangements.
The CS facility licensee as operator of a central counterparty must also provide to the Reserve Bank, on a timely basis:
(k) audited annual accounts;
(l) management accounts on a regular basis, and at least quarterly; and
(m) a quarterly report on the results of stress testing and on the adequacy of its risk-control measures.
Guidance - Regulatory reporting
The Corporations Act 2001 (Cth) imposes requirements for notification to regulators in certain circumstances. The measure imposes additional reporting requirements.
Oral notification to the Reserve Bank may be appropriate, particularly in circumstances where timely communication is needed. In practice, this should be followed by notification in writing.
To assist in meeting the measure, formal points of liaison will be agreed upon between the operator of the central counterparty and the Reserve Bank.
The Reserve Bank will review information contained in a CS facility licensee’s annual report to the Australian Securities and Investments Commission.
Measure 10(a) of the Standard
This refers to a CS facility licensee’s obligations under subsection 821A(aa) of the Corporations Act 2001 (Cth).
Terminology
In this standard and associated measures:
“cash settlement asset” is an asset which carries little or no credit or liquidity risk and is used to settle payment obligations arising from trades in financial products;
“central counterparty” is a clearing and settlement facility operated by an Australian CS facility licensee where the CS facility licensee interposes itself between trade counterparties, taking on the trade obligations of trade counterparties to each other. The central counterparty enters into a new contract, as principal, with each of the existing counterparties, or with new counterparties who take on the obligations of the original counterparties to the central counterparty. This process is a form of novation (see definition below);
“close out” is the process of offsetting an existing contract by entering into a new contract of an equal and opposite position;
“contingency” is the failure of one or more components of a system;
“delivery‑versus‑payment”, in the settlement of a financial product transaction, means the action of a facility in ensuring that the final transfer of a financial asset occurs if and only if the final transfer of another financial asset (typically, a payment) occurs;
“Exchange Settlement Account” means an account held at the Reserve Bank of Australia which is used for the final settlement of obligations between Exchange Settlement Account holders;
“external administration” has the meaning given to that term in the Payment Systems and Netting Act 1998 (Cth);
“haircut” is the difference between the market value of a security and its collateral value. Haircuts are taken by a lender of funds, that has taken collateral as security, in order to protect the lender, should the need arise to liquidate the collateral, from losses owing to declines in the market value of the security;
“liquid assets” includes funds held at a central bank, funds held at an Authorised Deposit-taking Institution which are available on the same day, and securities that can be converted to cash settlement assets on the same day;
“novation” means the satisfaction and discharge of existing contractual obligations by means of their replacement by new obligations. The parties to the new obligations may be the same as to the existing obligations, or in the case of a central counterparty, there is a substitution of a new party or parties;
“principal risk” is the risk that the seller of the financial product delivers a financial product but does not receive value for the sale of the financial product, or that a buyer of financial products provides value for the purchase of the financial product but does not receive delivery of the financial product;
“related body” has the meaning given to the term “related body corporate” in section 50 of the Corporations Act 2001 (Cth);
“securities settlement facility” is a clearing and settlement facility operated by an Australian CS facility licensee which enables its participants to transfer title to or other interests in securities, typically in return for payment. Securities settlement facilities usually (although not always) also hold physical securities, or an electronic record of title, or other interests in securities, on behalf of their participants; and
“securities” includes any financial product which gives rise to obligations prescribed under the Corporations Regulations for the purposes of section 768A(1)(b) of the Corporations Act 2001 (Cth).
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