2008/09 Assessment of Clearing and Settlement Facilities in Australia 3. Developments in the Clearing and Settlement Industry in 2008/09

Volatility in financial markets rose to extremely high levels during the assessment period as strains continued to be felt throughout the global financial system. Accordingly, traded volumes and values in a number of the markets served by Australia's CS facilities declined, in some cases substantially. The turbulence in financial markets and associated concerns with some firms' financial positions also resulted in an increase in the risks faced by the central counterparties. While Lehman Brothers was not a direct participant in either central counterparty or ASTC, the investment bank's failure also posed some challenges. Nevertheless, all four licensed CS facilities were resilient to the turbulent conditions during this period.

The financial market events of the past two years have also highlighted the lack of transparency and build-up of risk in some OTC derivatives markets. International regulatory and industry efforts have accordingly been directed towards improving the clearing, settlement and other infrastructure supporting these markets. The Australian financial authorities are encouraging similar steps in the domestic OTC derivatives market.

Activity in the Licensed CS Facilities

Reflecting the difficult market conditions over the past year, the value of equities and derivatives transactions processed by the licensed CS facilities declined in 2008/09. In the cash equity market, after very strong growth in recent years, average daily trading volumes increased by a more modest 16 per cent (Graph 1). In value terms, daily cash equity transactions fell by 30 per cent, reflecting the substantial decline in share prices during the year. Average transaction size therefore continued to fall, with this also reflecting the longer term trend towards breaking up large orders for gradual release into the market.

The decline in traded values in the cash equity market has been reflected in a commensurate decline in values settled in CHESS. The average value of daily net securities transfers declined by 29 per cent to $9.5 billion over the period. The fall in average daily cash-settlement values on each side of the daily net CHESS settlement batch was more moderate, declining by 2 per cent to $620 million in 2008/09.

The slower growth in trading activity in 2008/09 reflected an increase in risk aversion among market participants in the face of the financial market turbulence. Market volatility had been elevated since September 2007 when financial market strains first emerged, but was particularly high in late 2008 following the bankruptcy of Lehman Brothers (Graph 2). The ban on covered short selling imposed by ASIC in September 2008 – due to concerns about its potential to contribute to unwarranted price fluctuations in an already volatile market – may also have limited trading activity to some extent. The ban was subsequently removed in November 2008 for non-financial stocks and in May 2009 for financial stocks.

Activity in the ASX and SFE derivatives markets declined substantially during the year in response to the turbulent market conditions, with only a modest recovery late in the assessment period, at least for the major interest rate contracts. Volumes traded on the SFE market fell by 28 per cent in 2008/09, with average open interest in the government bond contracts in particular declining by around a third, and open interest in the 90-day bank accepted bill futures contract declining by 5 per cent. Volumes traded on the smaller ASX derivatives market fell by 18 per cent in 2008/09.

Trading in debt securities was also relatively subdued, after strong growth in recent years. The value of debt securities settled through Austraclear (comprising outright purchases and sales, as well as repos of debt securities) was broadly flat in 2008/09 at a daily average of $42.3 billion. There was, however, some variability within the year, including a sharp increase in repo activity in September and October as market participants' demand for liquidity rose during the financial market turbulence (Graph 3).

Risk Management in the Licensed Central Counterparties

Notwithstanding the decline in trading activity, the risks faced by the licensed central counterparties – as measured by the value of margin collected from participants – increased during the past year as market volatility rose. The central counterparties' participant monitoring also intensified as strains in the financial system threatened the financial standing of some clearing participants.

In the case of ACH, average daily exposure to participants' settlement obligations arising from cash equity trades on the ASX market (almost three-quarters of which are novated to ACH) was $993 million in 2008/09.^[1] This represents a decline of 23 per cent relative to the 2007/08 assessment period, due to the decline in traded values. However, taking into account the increased market volatility, the risks faced by ACH in relation to these exposures increased. ACH does not routinely collect margins in respect of participants' cash equity positions, but does calculate a notional margin amount for ASX 200 stocks. Average daily notional initial margin calculated rose by 10 per cent to $175 million, with average mark-to-market margin little changed at $41 million.

Similarly, while derivatives traded volumes and open interest declined, the risk associated with remaining positions rose as market volatility increased. Both ACH and SFECC raised initial margin levels sharply in late 2008. For ASX-traded derivatives, the daily average of initial (risk) and mark-to-market margin required by ACH was broadly constant at around $1.6 billion in 2008/09, despite the decline in positions (Graph 4). Initial margin collected in respect of trades on the SFE market increased by 26 per cent to a daily average of $3.6 billion in 2008/09, after a 4 per cent reduction in 2007/08.

Performance of the Licensed CS Facilities during the Market Turbulence

Despite the more difficult market conditions during the past year, Australia's licensed CS facilities continued to operate robustly. The ASX central counterparties intensified their risk management, taking actions in several areas: reassessment of participants' internal credit ratings (ICRs); more intensive monitoring of participants that were experiencing or at risk of financial distress; application of a lower threshold for intraday margin calls; more frequent reviews of initial margin intervals; and revision to stress-test scenario parameters. These measures are discussed in more detail in Sections 5.1 and 5.2.

Lehman Brothers participated indirectly in the Australian CS facilities, with the exception of Austraclear. In the event of the bankruptcy of its US parent, Lehman's pre-existing cash equity trades and open derivatives positions were settled or closed out relatively smoothly by its clearers. Some increase in equity settlement fails was observed, however, as delays occurred in obtaining approval from the European administrator for the release of Lehman's securities. Settlement fails increased further following the imposition of the ban on short selling by ASIC, as some securities lenders were reluctant to lend securities due to initial uncertainties as to the scope of the ban.^[2] Nevertheless, the fail rate remained low by international standards and the increase was temporary. The downward trend in the fail rate – which had commenced in mid 2008 – resumed, with the rate settling at around 0.1 per cent during the first half of 2009 (compared with 0.24 per cent at the start of the assessment period). This would seem to reflect the enhancements to the settlement-fails regime implemented during 2008/09, including an increase in penalty fees applied in the event of a failed settlement delivery, and a requirement to close out positions remaining unsettled on the fifth business day after trade date. These enhancements are discussed further in Section 5.3.

Prospective Changes in the Clearing and Settlement Landscape

Consistent with international developments, the Australian cash equity market faces the prospect of competition in trading. Three applications for licences to provide trading platforms for ASX-listed equities are awaiting decision by the Minister for Financial Services, Superannuation and Corporate Law. If these licences are granted, arrangements would need to be made to enable the new trading platforms to clear and settle trades. ASX has consulted with industry and market licence applicants on how these platforms might connect to ACH and ASTC and in December 2008 published draft high-level business requirements for the provision of clearing and settlement services to non-ASX trading platforms. The Reserve Bank has been in regular dialogue with ASX and ASIC on this matter.

Against a background of turbulent financial markets, a number of international regulatory and government groups have looked closely at the infrastructure underpinning OTC derivatives markets. The Financial Stability Board^[3] and the International Organization of Securities Commissions, among others, have issued recommendations in this area, and major global OTC market participants have strengthened their commitments to US and European regulators to enhance market practices. Initiatives include market reporting to improve transparency, central counterparty clearing of trades where possible, and improved risk management and governance.

In Australia, a working group comprising the Australian Prudential Regulaton Authority (APRA), ASIC and the Reserve Bank is in dialogue with industry to promote similar developments in the Australian market.^[4] In time, this may see an extension of the activities of the existing Australian CS facilities and/or new entrants to clear transactions in Australia's OTC derivatives market.

Footnotes

The daily exposure faced by ACH arises from unsettled trades through the three-day settlement cycle. ACH's average total settlement exposure from a single day's trades was $466 million in 2008/09, down by 24 per cent from the previous year. [1]

ASIC subsequently published a ‘no-action’ letter, stating that sales of securities that were on loan within securities lending programmes would not be deemed short selling as long as the securities were recalled within a reasonable time frame after executing the sale. [2]

An international group comprised of representatives from central banks, finance ministries, supervisory agencies and various international organisations. [3]

For more details, see Survey of the OTC Derivatives Market in Australia published by APRA, ASIC and the Reserve Bank, available at <https://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/otc-deriviatives/survey-otc-deriv-mkts/sotcdma-052009.pdf> [4]