Guidance

Collateralising credit exposures protects a central counterparty and, where relevant, its participants against potential losses in the event of a participant default (see CCP Standard 4 on credit risk). Besides mitigating a central counterparty's own credit risk, the use of collateral can provide participants with incentives to manage the risks they pose to the central counterparty or other participants. A central counterparty should apply prudent haircuts to the value of the collateral to achieve a high degree of confidence that the liquidation value of the collateral will be greater than or equal to the obligation that the collateral secures in extreme but plausible market conditions. Additionally, a central counterparty should have the capacity to use the collateral promptly when needed.

5.1.1 A central counterparty should generally limit the assets it (routinely) accepts as collateral to those with low credit, liquidity and market risks. Collateral with low credit, liquidity and market risks comprises assets that may be reliably liquidated or repurchased in private markets, within a reasonable time frame and at a value within the haircut applied or, in extremis and where the collateral taker has access, sold to a central bank under a repurchase agreement or otherwise pledged to a central bank. Certain types of collateral that are not considered to have low credit, liquidity and market risks may nevertheless be acceptable collateral for credit purposes if an appropriate haircut is applied. A central counterparty must be confident of the collateral's value in the event of liquidation and of its capacity to use that collateral quickly, especially in stressed market conditions. Where a central counterparty accepts collateral that does not have low credit, liquidity and market risks, it should demonstrate that it sets and enforces appropriately conservative haircuts and concentration limits (see CCP Standard 5.3).

5.1.2 In general, bank guarantees are not acceptable collateral. However, the use of bank guarantees may be acceptable under certain specified circumstances and under certain conditions, subject to prior approval from the Reserve Bank or other relevant authorities. The Reserve Bank will consider the acceptability of bank guarantees as collateral on a case-by-case basis, taking into account factors including: the credit standing of the bank providing the guarantee; the legal certainty of the arrangement; and whether there is any collateral supporting the guarantee.

5.1.3 Further, a central counterparty should regularly review its requirements for acceptable collateral in accordance with changes in underlying risks. When evaluating types of collateral, a central counterparty should consider potential delays in accessing the collateral due to the settlement conventions for transfers of the asset. In addition, participants should not be permitted to post their own debt or equity securities, or debt or equity of companies closely linked to them, as collateral. More generally, a central counterparty should mitigate specific wrong-way risk by limiting the acceptance of collateral that would likely lose value in the event that the participant providing the collateral defaulted. The central counterparty should measure and monitor the correlation between a counterparty's creditworthiness and the collateral posted and take measures to mitigate the risks, for instance by setting more conservative haircuts.

5.1.4 If a central counterparty plans to use assets held as collateral to secure liquidity facilities in the event of a participant default, the central counterparty will also need to consider, in determining acceptable collateral, what will be acceptable as security to lenders offering liquidity facilities (see CCP Standard 7 on liquidity risk).

5.2.1 A central counterparty's collateral policies may have broader effects than their direct implications for the effectiveness of the central counterparty's risk controls. On the one hand, assets accepted as collateral by a central counterparty may be more likely to then be held by participants or used as collateral in other contexts, and may become more liquid as a result. On the other hand, use of a particular class of assets to meet collateral obligations at a central counterparty may, depending on its supply, restrict the availability of such assets for other uses, or significantly affect liquidity and pricing. A central counterparty should consider such broader effects when framing its collateral policies.

5.2.2 Participants that are required to source unfamiliar assets as collateral may face additional operational, legal or financial risks as a result. A central counterparty should therefore consider allowing the use of collateral that is commonly accepted in each jurisdiction in which it operates. In particular, a central counterparty with material Australian-based participation should consider accepting appropriate Australian dollar-denominated securities as collateral.

5.3.1 To provide adequate assurance of the value of collateral in the event of liquidation, a central counterparty should establish prudent valuation practices and develop haircuts that are regularly tested and take into account stressed market conditions. A central counterparty should, at a minimum, mark its collateral to market daily. Haircuts should reflect the potential for asset values and liquidity to decline over the interval between their last revaluation and the time by which a central counterparty can reasonably assume that the assets can be liquidated. Haircuts also should incorporate assumptions about collateral value during stressed market conditions and reflect regular stress testing that takes into account extreme price moves, as well as changes in market liquidity for the asset. If market prices do not fairly represent the true value of the assets, a central counterparty should have the authority to exercise discretion in valuing assets according to predefined and transparent methods. A central counterparty's haircut procedures should be independently validated at least annually.^[1]

5.4.1 A central counterparty should appropriately address procyclicality in its collateral arrangements. To the extent practicable and prudent, a central counterparty should establish stable and conservative haircuts that are calibrated to include periods of stressed market conditions in order to reduce the need for procyclical adjustments. In this context, procyclicality typically refers to changes in risk management practices that are positively correlated with market, business or credit cycle fluctuations and that may cause or exacerbate financial instability. While changes in collateral values tend to be procyclical, collateral arrangements can increase procyclicality if haircut levels fall during periods of low market stress and increase during periods of high market stress. For example, in a stressed market, a central counterparty may require the posting of additional collateral both because of the decline in asset prices and because of an increase in haircut levels. Such actions could exacerbate market stress and contribute to driving down asset prices further, resulting in additional collateral requirements. This cycle could exert further downward pressure on asset prices. Addressing issues of procyclicality may create additional costs for central counterparties and their participants in periods of low market stress because of higher collateral requirements, but result in additional protection and potentially less costly and less disruptive adjustments in periods of high market stress.

5.5.1 A central counterparty should avoid concentrated holdings of certain assets where this would significantly impair the ability to liquidate such assets quickly without significant adverse price effects, including in stressed market conditions. High concentrations within holdings can be avoided by establishing concentration limits or imposing concentration charges. Concentration limits restrict participants' ability to provide certain collateral assets above a specified threshold as established by the central counterparty. Concentration charges penalise participants for maintaining holdings of certain assets beyond a specified threshold as established by the central counterparty. Further, concentration limits and charges should be constructed to prevent participants from covering a large share of their collateral requirements with the most risky assets acceptable. Concentration limits and charges should be periodically reviewed by the central counterparty to determine their adequacy.

5.6.1 If a central counterparty accepts cross-border collateral, it should identify and mitigate any additional risks associated with its use and ensure that it can be used in a timely manner.^[2] A cross-border collateral arrangement can provide an efficient liquidity bridge across markets, help relax collateral constraints for some participants, and contribute to the efficiency of some asset markets. These linkages, however, can also create significant interdependencies between a central counterparty and other FMIs and risks to the central counterparty that need to be evaluated and managed (see also CCP Standard 16 on operational risk and CCP Standard 19 on FMI links). For example, a central counterparty should have appropriate legal and operational safeguards to ensure that it can use the cross-border collateral in a timely manner and should identify and address any significant liquidity effects. A central counterparty also should consider foreign exchange risk where collateral is denominated in a currency different from that in which the exposure arises, and set haircuts to address the additional risk to a high level of confidence. The central counterparty should have the capacity to address potential operational challenges of operating across borders, such as differences in time zones or operating hours of foreign central securities depositories or custodians.

Collateral management systems

5.7.1 A central counterparty should use a well-designed and operationally flexible collateral management system. Such a system should accommodate changes in the ongoing monitoring and management of collateral. Where appropriate, the system should allow for the timely calculation and execution of margin calls, the management of margin call disputes, and the accurate daily reporting of levels of initial and variation margin. Further, a collateral management system should track the extent of reuse of collateral (both cash and non-cash) and the rights of a central counterparty to the collateral provided to it by its counterparties. Where appropriate, a central counterparty's collateral management system should also have functionality to accommodate the timely deposit, withdrawal, substitution and liquidation of collateral in each jurisdiction in which it operates. In particular, where the scope of Australian participation in the central counterparty is material, and where market conventions dictate, a central counterparty's collateral management system should have the capacity to accommodate the timely deposit, withdrawal, substitution and liquidation of collateral during Australian market hours. A central counterparty should allocate sufficient resources to its collateral management system to ensure an appropriate level of operational performance, efficiency and effectiveness. Senior management should ensure that the central counterparty's collateral management function is adequately staffed to ensure smooth operations, especially during times of market stress, and that all activities are tracked and reported, as appropriate, to senior management.^[3]

Reuse of collateral

5.7.2 Reuse of collateral refers to the central counterparty's subsequent use of collateral that has been provided by participants in the normal course of business. This differs from the central counterparty's use of collateral in a default scenario during which the defaulter's collateral, which has become the property of the central counterparty, can be used to access liquidity facilities or liquidated to cover losses (see CCP Standard 12 on participant default rules and procedures). A central counterparty should have clear and transparent rules regarding the reuse of collateral (see CCP Standard 20 on disclosure of rules, key policies and procedures, and market data). In particular, the rules should clearly specify when a central counterparty may reuse its participant collateral and the process for returning that collateral to participants. In general, a central counterparty should not rely on the reuse of collateral as an instrument for increasing or maintaining its profitability. However, a central counterparty may invest any cash collateral received from participants on their behalf (see CCP Standard 15 on custody and investment risks).