2006/07 Assessment of Clearing and Settlement Facilities in Australia Attachment 1: Detailed Assessment against the Financial Stability Standards

A1. Financial Stability Standard for Central Counterparties

The Financial Stability Standard for Central Counterparties requires that:

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.

There are ten measures that the Reserve Bank considers relevant in determining whether a facility has met the standard. The Bank has assessed ACH and SFECC against each of these measures; these assessments are outlined below. The full text of the measures is available on the Bank's website.

A1.1 ACH

1. Legal framework

The central counterparty must have a well-founded legal basis.

ACH Pty Limited is a wholly owned subsidiary of ASX Limited. It acts as the central counterparty for equities, equity derivatives, certain interest rate products and warrants traded in ASX markets.

The legal basis for ACH's operation is set out in its Clearing Rules. Under s822B of the Corporations Act, these rules have effect as a contract under seal between ACH and each of its participants, and between each participant and each other participant. Furthermore, the netting arrangements contained in ACH's Clearing Rules are protected as a ‘netting market’ under Part 5 of the Payment Systems and Netting Act. This provides certainty for the netting process in the event of the insolvency of a participant (see Attachment 2).

ACH's Clearing Rules define the nature and scope of its obligation to provide clearing support to participants, and describe the conditions under which final and irrevocable settlement of obligations has occurred. The Clearing Rules also set out the rights and obligations of participants, including in the event of default or suspension.

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.

At the end of June 2007, ACH had 67 participants. Sixty-five of these were also participants of ASX markets, while two provided specialist third-party clearing and settlement services.

ACH's participation requirements are designed to promote the safety and integrity of the central counterparty. Participants are subject to a risk-based capital requirement, which is determined according to the markets they serve and the exposures they face through counterparty, position and operational risks.[¹] Participants must report their capital position on a monthly basis, with more stringent reporting requirements applying where a participant's capital falls below certain thresholds. The monitoring, assessment and investigation of matters relating to financial requirements is dealt with by the Prudential Risk Management section of ASX Markets Supervision, which is a separate subsidiary within the ASX group, with its own Board.

ACH participants are also subject to requirements regarding business and management integrity which are aimed at ensuring compliance with the ACH Clearing rules. Other requirements also pertain to technical and connectivity issues, as well as business continuity arrangements.

ACH has wide-ranging powers to sanction its participants in order to preserve the integrity of the central counterparty. ACH may terminate a participant's authority to clear all, or any, category of market transactions in the event of a default, or a breach of the Clearing Rules which ACH considers may have an adverse impact on the central counterparty.

Fair and open access to the central counterparty is maintained through the objectivity of participation requirements. Transparency is aided through the publication of these requirements, which are part of the Clearing Rules and procedures. The Clearing Rules also provide for an appeal process where applicants for participation are rejected or where a participant is terminated.

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.

ACH's Clearing Rules and procedures are comprehensive and publicly available. The rules and procedures explain the role and responsibilities of each category of participant and ACH. Some background information on ACH's operations and risk management is also available on the ASX website.

ACH must lodge any changes to its Clearing Rules with ASIC. Under s822E of the Corporations Act the Minister has 28 days to disallow any rule changes made by a licensed CS facility. ACH consults with its participants on important rule changes, and notifies participants of all changes to the Clearing Rules or procedures.

4. Novation

The rules and procedures governing the central counterparty must clearly identify:

the nature and scope of novation; and
the point in the clearing process at which trades are novated.

The nature and scope of novation is set out in ACH's Clearing Rules. Through the process of novation, ACH takes on the financial obligations of the seller to the buyer, and the buyer to the seller. The obligations of ACH are to each clearing participant as principal, irrespective of whether that participant is acting as an agent on behalf of a client.

The point at which trades are novated is set out in the Clearing Rules. These specify that a broker-to-broker transaction on ASX markets is novated to ACH upon the acceptance and registration of the details of that market transaction within the clearing system operated by ACH. For physical equities transactions, novation occurs soon after the matching of the trade on the market. In the case of derivatives transactions, novation normally takes place on the evening of the day of the trade, when trade details are allocated to participants' accounts.

5. Settlement

Settlement arrangements must ensure that the central counterparty's exposures are clearly and irrevocably extinguished on settlement.

Settlement of obligations between a central counterparty and its participants can involve two processes:

the exchange of one asset for another – mainly physical equities transactions. In this case, ACH utilises the settlement facility provided by ASTC; or
payments to or from the central counterparty, such as in the case of margin payments relating to derivatives positions. In this instance, the facilities provided by either ASTC or Austraclear may be used.

In either case, ACH calculates bilateral net positions between itself and each of its clearing participants. These positions reflect payment obligations as well as securities obligations. These netting arrangements contained in ACH's Clearing Rules are protected as a ‘netting market’ under Part 5 of the Payment Systems and Netting Act (see Attachment 2).

The ASTC settlement process for the exchange of assets and settlement of other payments in relation to derivatives involves the use of a model 3 delivery-versus-payment (DVP) mechanism, whereby settlement of payments occurs in a multilateral net batch. ASTC calculates the settlement obligations of each of its settlement participants each day. These obligations may include net equities and derivatives transactions involving ACH as central counterparty, margin and other payments to and from ACH, and settlement of equities transactions not novated to ACH. The end result of this process is that ASTC participants have net payment positions to or from ASTC, and a net position in each type of equity security.

Once these net obligations have been calculated, ASTC confirms that sufficient securities are present in each participant's settlement account in ASTC's Clearing House Electronic Sub-register System (CHESS). These accounts are then locked. The net payment obligations are forwarded for settlement between providers of cash settlement nominated by ASTC participants. Cash settlement between payment providers occurs as a batch across Exchange Settlement (ES) accounts held at the Reserve Bank in the Reserve Bank Information and Transfer System (RITS). Once this settlement has occurred, ASTC effects the net transfer of securities within CHESS.

Where a participant elects to settle cash derivatives obligations using Austraclear, settlements are made via cash transfers. These settle in real-time through RITS across ES accounts.

ACH also clears grain and wool futures, which may be physically settled. Grain and wool futures are settled through commodity warehouses, where ACH holds title and transfers it to the buyer if, and only if, payment is received by the seller.

Settlement through either ASTC or Austraclear is final and irrevocable. ASTC's Settlement Rules state that settlement according to the terms of those rules is irrevocable. Furthermore, the netting undertaken by ASTC is reinforced through its approval under Part 3 of the Payment Systems and Netting Act. Settlement according to Austraclear's Regulations is final and irrevocable by virtue of its approval under Part 2 of the Payment Systems and Netting Act. Interbank transactions arising from settlements in ASTC and Austraclear are settled across ES accounts held with the Reserve Bank. Payments within this system are also final and irrevocable; this is again reinforced through the approval of RITS under Part 2 of the Payment Systems and Netting Act (see Attachment 2).

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.

ACH's Clearing Rules set out notification requirements which participants must meet in relation to a default. A participant is required to inform ACH should it default under the Clearing Rules, which outline a range of incidents which constitute a default. These include the appointment of an external administrator (or a reasonable expectation that one will be appointed), a breach of ACH's capital requirements, or a failure to meet payment or settlement obligations to ACH.

The Clearing Rules provide ACH with the authority and flexibility to deal with a participant default and to ensure that settlement of novated positions occurs. For equities, ACH is able to reschedule any settlements involving the failed participant, or those affected by its failure. ACH may enter into market transactions to sell or purchase securities to ensure that final settlement of novated transactions occurs. For derivatives, ACH has the ability to close out a defaulted participant's positions, or to seek to transfer the client positions of the defaulted participant to a surviving participant. These rules are supplemented by an internal default management plan, which was finalised during the assessment period.

ACH also has a range of financial resources available to enable it to act on the default powers set out above and to meet its obligations as central counterparty (see Risk controls, below).

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:

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
undertake regular and rigorous stress testing to ensure the

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.

The risk controls of a central counterparty are crucial in providing a high degree of confidence that it is able to meet its obligations in the event of a participant failure. The inability of a central counterparty to do so could be extremely disruptive to the financial system. The focus of the Reserve Bank in this area is not on specifying which risk controls a central counterparty should use, but rather on ensuring that the combination of risk controls that is relied upon achieves a very low probability of a failure of the central counterparty.

The tools used by ACH to control risks operate at three broad levels: calling collateral based on participants' positions; pooled financial resources to cover the failure of a participant; and stress testing aimed at assessing the adequacy of financial resources overall and monitoring the risks being undertaken by individual participants. These risk controls are supplemented by ACH's participation requirements (Measure 2) and sophisticated monitoring and supervisory arrangements.

ACH levies margins on equity derivatives products, but not cash equity products. Margins protect the central counterparty should a participant default on its obligations and prices move against the central counterparty before it can close out the participant's positions. Premium margins are called on sold option positions to reflect their close-out price, and are updated on a daily basis to ensure that they are current. Variation margins are called on futures positions in order to ‘mark-to-market’ by settling gains or losses arising from price movements over the preceding day. Risk (or initial) margins are calculated for each derivative instrument to cover potential price movements over the period until a defaulted position could be closed out.

ACH calculates total risk margin requirements across each participant's portfolio using the internationally accepted Theoretical Inter-market Margining System (TIMS) methodology, developed by the Options Clearing Corporation. Margins are calculated overnight based on closing contract prices each day, and are notified to participants the next morning. Margin obligations must be met by 10.30am that day. Participants generally meet these obligations through cash, although they may also use collateral, such as equities and warrants.

Should conditions warrant, ACH is able to call margins intraday. Participants are generally required to meet such calls within two hours of notification. ACH is currently only able to calculate intraday margin calls on the basis of price movements, not on the basis of changes to participants' positions during the day. ACH anticipates that upgrades to its Risk Management System will allow intraday monitoring of participant positions in the near future.

In March 2007, ACH implemented a system of Contributions based on participants' equities exposures. These differ from margins in that they are intended to cover potential losses from very large positions with the central counterparty in extreme, rather than normal, market conditions. Where a participant has a total net long position exceeding $600 million, it must contribute collateral equivalent to 25 per cent of that excess to ACH. Where a participant has a net short position exceeding $1.5 billion, it must contribute collateral equivalent to 10 per cent of that excess. This system is designed to provide a high degree of confidence that the central counterparty will be able to meet its obligations, even where losses from a participant default exceed ACH's ‘Risk Resource Requirement’ of $150 million (see below). Participants are notified of their contributions by 9.30am and are required to meet them within two hours, either through a transfer of cash through the Austraclear system or through the provision of a bank guarantee from an approved authorised deposit-taking institution.

Some enhancements will be made to the Contributions system in December 2007, including linking it directly to the new stress testing framework and the establishment of an equivalent margining regime for equity derivatives.

ACH maintains financial resources to protect against losses in excess of margins and other assets of a defaulting participant should a default occur. ACH's core financial resources – the ‘Risk Resource Requirement’ – consist of funds paid into a restricted capital reserve from the National Guarantee Fund (NGF) in 2005 and other ACH capital. The Risk Resource Requirement was increased during the assessment period and now totals $150 million. In addition, ACH holds default insurance of $100 million. ACH also has the ability through its Clearing Rules to levy its participants up to $300 million collectively in ‘Emergency Assessments’ should a loss caused by a participant's default exceed its other resources.

The liquidity needed to enable a central counterparty to meet its obligations in a timely manner may be quite different to the financial resources needed to meet losses arising from a default. For instance, additional liquidity may be required to allow cash market settlement to proceed even if the failed participant's positions can ultimately be liquidated without loss. ACH holds liquid assets (referred to as its Default Liquidity Requirement) of $300 million. This is made up of the Risk Resource Requirement of $150 million, as well as a bank credit line, also of $150 million.

ACH uses daily stress tests to monitor the risks undertaken by individual participants and the adequacy of the central counterparty's financial resources. In June 2007 it implemented a new range of stress test scenarios which significantly increase the information it has to undertake this analysis. Stress tests are now based on 24 scenarios covering market-wide events, sector-specific scenarios and individual equity movements for major stocks. Volatility shifts are now incorporated in addition to price movements. While the new framework allows more nuanced analysis, the largest market-wide fall embodied in the tests has been reduced from 25 per cent to 15 per cent.

ACH also uses a subset of the new stress test scenarios to calculate a measure of the liquidity that would be required in the event of a participant default. This new model takes into account the practical processes that would need to be followed by the central counterparty to settle outstanding obligations, such as the rescheduling of settlements and any transfers of client accounts to surviving participants. ACH uses the results from this analysis to assess the adequacy of its Default Liquidity Requirement, which is currently $300 million.

During the assessment period, there were a number of occasions when stress tests identified a potential loss from default in extreme market conditions in excess of ACH's Risk Resource Requirement and default insurance, although these excesses could have been covered by Emergency Assessments. Since Contributions were introduced in March, no potential losses have exceeded the combination of the Risk Resource Requirement, default insurance and Contributions. The Bank is satisfied that this meets the Financial Stability Standard for Central Counterparties.

8. Governance

The central counterparty must have effective, accountable and transparent governance arrangements.

The ACH Board is responsible for oversight of the operation of the central counterparty. It meets between six and eight times each year, and receives detailed reports on ACH's business and operations, risk management and financial performance. It is responsible for approving capital, liquidity and stress testing arrangements.

The ACH Board consists of ten directors. These include four members of ASX management (including the CEO and CFO), four ASX directors, and two external directors (one of whom chairs the Board). The ten directors filling these positions are also on the Boards of SFECC, ASTC and Austraclear. ACH and ASTC share a common chair, as do SFECC and Austraclear.

As a result of post-merger reorganisation within ASX, the risk policy and risk operations areas have been separated, with each having separate functions and reporting lines to the ACH Board. In addition, an internal Capital and Liquidity Committee has been established in order to provide greater focus to capital and liquidity issues across the ASX group.

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.

ACH's key systems are the Derivatives Clearing System (DCS) and the Clearing House Electronic Sub-register System (CHESS). Operational risk in the CHESS system is dealt with in the assessment of ASTC.

DCS has been highly operationally reliable, with the system available for 100 per cent of the time over the period of this assessment. DCS also has sufficient capacity to meet future requirements. The average number of trades processed per day was around 4,650 (30 per cent of system capacity) with a peak number of daily trades of around 6,510.

The security of the DCS system is supported by access controls which are subject to external audit. External penetration testing of DCS is also conducted regularly.

ACH has arrangements in place to allow the timely recovery of its usual operations in the event of a contingency. It maintains an unmanned remote back-up facility which replicates the systems at the primary site. ACH has detailed contingency procedures which focus on the potential effects of a disruptive event. The plans focus on systems availability, access delays, capacity, continuity and the risk of loss of personnel supporting the system.

A test is completed annually to demonstrate that normal functions can be carried out using systems located at the back-up site. ACH also regularly tests its ability to operate its primary systems from its back-up site. A more extensive test, involving utilisation of back-up systems as the production environment for a day, took place subsequent to the assessment period. Through its Clearing Rules, ACH also requires its participants to have appropriate disaster recovery arrangements.

ACH sources its key resources from ASX Operations, a subsidiary of ASX Limited, which is responsible for supplying the ASX Group with personnel and technological resources. ACH has a written support agreement with ASX Operations which helps to ensure its access to these resources in the event of external administration of ASX Operations, to the extent permissible by law.

10. Regulatory reporting

CS facility licensees are required to meet certain reporting obligations to the Reserve Bank under the Financial Stability Standards. These obligations include obligations to report breaches of the standard or breaches of its risk management requirements. There are also obligations to report financial and stress-testing results on a quarterly basis. ACH satisfied all reporting obligations during the assessment period.

ACH has also voluntarily undertaken to report stress test outcomes that exceed its capital and default insurance – currently $250 million.

A1.2 SFE Clearing Corporation (SFECC)

1. Legal Framework

The central counterparty must have a well-founded legal basis.

SFE Clearing Corporation Pty Limited (SFECC) is a wholly owned subsidiary of ASX Limited. It acts as the central counterparty for the SFE market.

The legal basis for SFECC's operation is set out in its Clearing Rules. Under s822B of the Corporations Act, these rules have effect as a contract under seal between SFECC and each of its participants, and between each participant and each other participant. Furthermore, the netting arrangements contained in SFECC's Clearing Rules are protected as a ‘netting market’ under Part 5 of the Payment Systems and Netting Act. This provides certainty for the netting process in the event of the insolvency of a participant (see Attachment 2).

SFECC's Clearing Rules define the nature and scope of its obligation to provide clearing support to participants, and describe the conditions under which final and irrevocable settlement of obligations has occurred. The Clearing Rules also set out the rights and obligations of participants, including in the event of default or suspension.

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.

At the end of June 2007, SFECC had 15 participants. Thirteen of these were also participants of the Sydney Futures Exchange, while two provided specialist clearing and settlement services.

SFECC's participation requirements are designed to promote the safety and integrity of the central counterparty. They cover minimum capital and financial obligations, business and managerial requirements, operational resources, business continuity arrangements, and risk and liquidity management arrangements.

Participants are subject to a minimum net tangible asset requirement of $5 million, with management discretion to impose a higher requirement. Participants are obliged to lodge a detailed financial report with SFECC on a monthly basis, or more frequently where their net tangible assets fall below certain thresholds. These monthly reports are used to calculate the capital based position limit, which restricts a participant's initial margin obligations to twice its net tangible assets requirement. The monitoring, assessment and investigation of matters relating to financial requirements is dealt with by the Prudential Risk Management section of ASX Markets Supervision, which is a separate subsidiary within the ASX group, with its own Board.

Under the Clearing Rules, a clearing participant may be automatically suspended under a number of circumstances, including where the participant is in default, if external management has been appointed, or if it has breached financial requirements and not rectified that breach. The SFECC Board can also suspend a clearing participant for misconduct, breaches of the Clearing Rules or if it ceases to satisfy the admission requirements. The Clearing Rules require SFECC to provide notice of a suspension, and detail appeal procedures for participants.

3. Understanding risks

SFECC's Clearing Rules and procedures are comprehensive and publicly available. The rules and procedures explain the role and responsibilities of participants and SFECC. Substantial background information on SFECC's operations and risk management is also available on the ASX website.

SFECC must lodge any changes to its Clearing Rules with ASIC. Under s822E of the Corporations Act, the Minister has 28 days to disallow any rule changes made by a licensed CS facility. SFECC consults with its participants on important rule changes. Announcements affecting participants are issued as ‘SFE Notices’ which are targeted to participants and market users.

4. Novation

The rules and procedures governing the central counterparty must clearly identify:

the nature and scope of novation; and
the point in the clearing process at which trades are novated.

The nature and scope of novation is set out in SFECC's Clearing Rules. Through the process of novation, SFECC takes on the financial obligations of the seller to the buyer, and the buyer to the seller. The obligations of SFECC are to each participant as principal, irrespective of whether that participant is acting as an agent on behalf of a client.

The point at which trades are novated is set out in the Clearing Rules. These specify that a transaction on the SFE market is novated to SFECC upon the registering of a matched trade by the market. Non-market trades are novated once their details have been approved and registered by SFECC.

5. Settlement

Settlement arrangements must ensure that the central counterparty's exposures are clearly and irrevocably extinguished on settlement.

The vast majority of settlements undertaken to extinguish exposures of SFECC involve cash payments to or from the central counterparty. These include margin payments and the settlement of cash-settled derivative contracts. Settlement of payments generally occurs on a net basis. Each day SFECC calculates the net positions of each of its participants. SFECC participants who have a net short cash position with the central counterparty are required to make payments to SFECC in Austraclear by 11.00am each morning. Once these payments have been received, SFECC makes payments to participants who have a net long cash position with the central counterparty. Interbank settlement of the these payments occurs between providers of cash settlement assets across Exchange Settlement (ES) accounts held at the Reserve Bank in the Reserve Bank Information and Transfer System (RITS).

In some cases, the settlement of derivatives contracts cleared by SFECC involves the transfer of a security or physical asset with a corresponding transfer of cash. For each type of security or asset, SFECC's arrangements ensure that delivery occurs if, and only if, payment occurs and vice versa.

For 90-day bank bill futures, SFECC utilises the standard settlement process in Austraclear. SFECC makes use of the ASTC settlement system for the settlement of deliverable equity futures. In this case, the buyer makes payment to SFECC's Austraclear account and the payment is only released to the seller when both the buyer and the seller have confirmed the transfer of securities. Similar procedures exist for the delivery of New Zealand equities with the transfer of securities occurring in the New Zealand Stock Exchange's settlement system. The delivery of greasy wool is via a warehouse, with SFECC retaining title documentation until payment has been made.

The settlement of obligations is final and irrevocable according to the terms of SFECC's Clearing Rules and SFE's Market Rules – which set out contract specifications, including the means of settlement. For payments and securities obligations settled through Austraclear, finality is reinforced by Austraclear's Regulations and its approval under Part 2 of the Payment Systems and Netting Act. Any interbank transactions arising from these settlements are settled across ES accounts held with the Reserve Bank. Payments within this system are also final and irrevocable; this is again supported through the approval of RITS under Part 2 of the Payment Systems and Netting Act. The settlement of equities through ASTC is also final and irrevocable according to the terms of ASTC's Clearing Rules, which are also supported through an approval under the Payment Systems and Netting Act (see Attachment 2).

6. Default arrangements

SFECC's Clearing Rules set out notification requirements which participants must meet in relation to a default. Participants are required to inform SFECC immediately should they default according to the Clearing Rules, or if they reasonably expect that this will occur. An event of default under the Clearing Rules includes where a participant becomes subject to external administration, is unable to meet any obligations relating to open contracts, or is in breach of the central counterparty's risk control requirements, such as meeting margin or other payments to the central counterparty.

The Clearing Rules provide SFECC with the authority and flexibility to deal with a participant default. SFECC has the ability to close out any open contracts, to exercise or abandon open contracts, or to transfer client positions along with related margin payments. These formal rules are supplemented by an internal default management plan.

SFECC also has a range of financial resources available to enable it to act on the default powers set out above and to meet its obligations as central counterparty (see Risk controls, below).

7. Risk controls

The CS facility licensee as operator of a central counterparty must:

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
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.

The tools used by SFECC to control risks operate at three broad levels: calling collateral based on participants' positions; pooled financial resources to cover the failure of a participant; and stress testing aimed at both assessing the adequacy of financial resources overall and monitoring the risks being undertaken by individual participants. These risk controls are supplemented by SFECC's participation requirements (Measure 2) and sophisticated monitoring and supervisory arrangements.

SFECC levies margins on the derivatives products it clears. Margins protect the central counterparty should a participant default on its obligations and prices move against the central counterparty before it can close out the participant's positions. Initial (risk) margins are calculated for each derivative instrument so as to cover a minimum of 99 per cent of the distribution of underlying two-day price movements. SFECC calculates total initial margin requirements across each participant's portfolio using the internationally accepted Standard Portfolio Analysis of Risk (SPAN) methodology, developed by the Chicago Mercantile Exchange. Margins are calculated overnight based on closing contract prices each day, and are notified to participants by 7.00am the next morning. Margin obligations must be met by 11.00am. Participants generally meet these obligations using cash, although they may also use collateral, such as eligible debt securities and equities, and foreign currency deposits. All collateral is subject to haircuts.

SFECC also levies variation margins on derivatives positions in order to ‘mark-to-market’ by settling gains or losses arising from price movements over the preceding day. Should conditions warrant, SFECC is also able to call variation margins intraday, based on movements in positions and prices. Participants are usually given up to two hours from the notification of an intraday margin call to meet this obligation. Both variation and intraday margin obligations must be met using cash.

SFECC also uses a system of additional initial margins (AIMs), based on participants' exposures in SFE's four largest contracts. AIMs are intended to cover potential losses from very large positions with the central counterparty in extreme, rather than normal, market conditions. SFECC calculates potential exposures using a system of stress tests (see below). Participants must contribute cash or collateral equivalent to the excess of any exposure above their stress test exposure limit (STEL). This limit is $200 million for highly-rated participants. For lower-rated participants, the limit is calculated as 50 per cent of a participant's net tangible assets, up to a maximum of $100 million. This system is designed to provide a high degree of confidence that the central counterparty will be able to meet its obligations, even where losses from a participant default (or the default of two lower-rated participants) exceed SFECC's capital and insurance resources (see below). Like other margins, AIMs are calculated overnight, notified to participants at 7.00am the next day, and must be met by 11.00am. Participants may meet these obligations using cash or collateral, including Commonwealth Government securities and bank bills or letters of credit from authorised deposit-taking institutions.

SFECC maintains financial resources to protect against losses in excess of margins and other assets of a defaulting participant should a default occur. SFECC's core financial resources include SFECC capital of $80 million and participant contributions of $60 million. In addition, SFECC holds default insurance of $60 million. SFECC also has the ability through its Clearing Rules to levy its participants a further $30 million.

SFECC uses daily stress tests of its four major contracts to monitor the risks undertaken by individual participants and the adequacy of the central counterparty's financial resources. The scenarios utilised during the assessment period stressed different contracts unevenly and had in some cases become less relevant over time. This was particularly the case for share price index scenarios, given the strong rise in share prices over recent years. In response, SFECC has developed a new suite of portfolio and single-contract stress test scenarios based on statistical analysis of historical market movements. These provide more consistent tests across contract types and are tailored to SFECC's risk tolerance, as defined by its Board. Stresses applied to equity index contracts are significantly stronger than under the existing framework.

Implementation of the new framework was deferred twice during the assessment period to allow additional time for consultation with both industry participants and the Bank. The Bank did not object to these delays, recognising that any new arrangements had to consider the overall risk management framework and the efficiency of the market. SFECC implemented its new framework, for all but the individual share price index scenarios, on 20 November 2007. It is seeking to introduce the remaining individual share price index scenarios in the first quarter of 2008, in conjunction with a significant increase in its financial resources.

8. Governance

The central counterparty must have effective, accountable and transparent governance arrangements.

The SFECC Board meets around seven times each year. At each meeting it receives reports on participant activity, management of treasury and risk functions, financial position, and operational performance. It is responsible for approving capital, liquidity and stress testing arrangements.

The SFECC Board consists of ten directors. These include four members of ASX management (including the CEO and CFO), four ASX directors, and two external directors (one of whom chairs the Board). The ten directors filling these positions are also on the Boards of ACH, ASTC and Austraclear. ACH and ASTC share a common chair, as do SFECC and Austraclear.

As a result of post-merger reorganisation within ASX, the risk policy and risk operations areas have been separated, with each having separate functions and reporting lines to the SFECC Board. In addition, an internal Capital and Liquidity Committee has also been established in order to provide greater focus to capital and liquidity issues across the ASX group.

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.

SFECC's key system is SECUR. OMX manages the primary and back-up sites for the SECUR system. SECUR has been highly operationally reliable, with the system available for 99.98 per cent of the time over the period of this assessment. SECUR also has sufficient capacity to meet future requirements. The average number of trades processed per day was 22,059 (around 12 per cent of system capacity) with a peak number of daily trades of 51,382.

The security of SECUR is supported by access controls which are subject to external audit. External penetration testing of systems is also conducted regularly.

SFECC has arrangements in place to allow the timely recovery of its usual operations in the event of a contingency. OMX maintains an unmanned remote back-up facility which replicates the systems at the primary site. SFECC maintains a separate back-up site for other systems, including clearing risk systems. SFECC has detailed contingency procedures which focus on the potential effects of a disruptive event. The plans focus on systems availability, access delays, capacity, continuity and the risk of loss of personnel supporting the system.

Critical areas regularly test their ability to operate from the back-up site using systems at the primary site. Back-up systems are usually tested at least annually, although a full test of back-up systems was not held over the assessment period. A more extensive test, which will see back-up systems operated as the production environment for a day, will be undertaken by the end of 2007. Through its Clearing Rules, SFECC also requires its participants to have appropriate disaster recovery arrangements.

Within its key outsourcing arrangement with OMX, SFECC has a prescribed disengagement plan that provides access to required infrastructure and resources to continue operation in the event that OMX becomes insolvent. SFECC also sources some key resources from ASX Operations, a subsidiary of ASX Limited, which is responsible for supplying the ASX Group with personnel and technological resources.

10. Regulatory reporting

CS facility licensees are required to meet certain reporting obligations to the Reserve Bank under the Financial Stability Standards. These obligations include obligations to report breaches of the standard or breaches of risk management requirements. There are also obligations to report financial and stress-testing results on a quarterly basis. SFECC satisfied all reporting obligations during the assessment period.

A2. Financial Stability Standard for Securities Settlement Facilities

The Financial Stability Standard for Securities Settlement Facilities requires that:

The standard only applies to CS facility licensees that provide a facility where the value of financial obligations settled in a financial year exceeds a threshold value of $100 million. When this threshold is exceeded for the first time, the provider of the facility must meet the standard by the beginning of the next financial year.

The threshold value for the application of the standard was established to ensure that small securities settlement facilities, which are unlikely to affect the overall stability of the Australian financial system, are not subject to unnecessary regulation.

There are eight measures that the Reserve Bank considers relevant in determining whether a facility has met the standard. The Bank has assessed ASTC and Austraclear against each of these measures; these assessments are outlined below. The full text of the associated measures is available on the Reserve Bank's website.

A2.1 ASX Settlement and Transfer Corporation (ASTC)

1. Legal Framework

The securities settlement facility must have a well-founded legal basis.

ASTC Pty Limited is a wholly owned subsidiary of ASX Limited. It provides settlement services for ASX markets, as well as for a small number of transactions undertaken on the National Stock Exchange (NSX).

The legal basis for ASTC's operation is set out in its Settlement Rules. Under s822B of the Corporations Act, these rules have effect as a contract under seal between ASTC and each of its participants, and between each participant and each other participant. The Settlement Rules set out the rights and obligations of participants and ASTC, including in the event of default or suspension.

During the assessment period, the netting arrangements undertaken by ASTC with respect to its participants' obligations were approved as a netting arrangement under Part 3 of the Payment Systems and Netting Act. This provides certainty for the netting process in the event of the insolvency of an ASTC participant or a payments provider (see Attachment 2).

2. Participation requirements

The requirements for participation in the securities settlement facility must promote the safety and integrity of the securities settlement facility and ensure fair and open access.

At the end of June 2007, ASTC had 115 participants. Its participation requirements are designed to promote the safety and integrity of the facility. They address financial and business integrity issues, as well as operational and technical matters. Performance bonds must be lodged by participants that are not subject to prudential supervision as an ADI or under the ACH Clearing Rules or ASX Market Rules. ASTC may call upon these bonds for compensation of loss incurred due to a participant contravening the Settlement Rules.

ASTC's Settlement Rules allow it to suspend or terminate a participant from its facility in the event of a failure to comply with the Settlement Rules, or where a payments provider fails to authorise a participant's payment for interbank settlement.

Fair and open access to the securities settlement facility is maintained through the objectivity of participation requirements. Transparency is aided through the publication of these requirements, which are part of the Settlement Rules and procedures. The Settlement Rules also provide for an appeal process where applicants for participation are rejected or where a participant is terminated.

3. Understanding risks

The securities settlement facility's rules and procedures must enable each participant to understand the securities settlement facility's impact on each of the financial risks the participant incurs through participation in the facility.

ASTC's Settlement Rules are comprehensive and publicly available. The rules and procedures explain the role and responsibilities of each category of participant and ASTC. Substantial background information on ASTC's operations and risk management is also available on the ASX website.

ASTC must lodge any changes to its Settlement Rules with ASIC. Under s822E of the Corporations Act the Minister has 28 days to disallow any rule changes made by a licensed CS facility. ASTC consults with its participants on important rule changes, and notifies participants of all changes to the Settlement Rules or procedures.

4. Certainty of title

The CS facility licensee as operator of the securities settlement facility must ensure that under the facility's rules and procedures, participants, or where relevant, their clients, have a clear and unambiguous title to, or interest in, securities held, deposited or registered on their behalf, including in circumstances where the solvency of the operator of a securities settlement facility is in doubt.

All securities held by ASTC are dematerialised and held in its Clearing House Electronic Sub-register System (CHESS). Title is held in the name of clients of ASTC participants. The system does not record any details of encumbrances, other than collateral lodged in favour of ACH. CHESS sub-registers form part of the issuer's securities register.

The transfer of title to securities in CHESS is effected by book entry, with ownership details updated electronically. Settlement occurs through a delivery-versus-payment (DVP) process which is effected via a daily scheduled batch settlement cycle. ASTC's Settlement Rules also provide for transferring securities without payment, where required.

In the event of ASTC's insolvency, the rules and arrangements for title within ASTC provide a high degree of assurance that participants' securities will be immune from claims by ASTC's creditors. ASTC is not the legal owner of any participant or client assets, which are recorded in CHESS in the name of the participant or sponsored client.

5. Settlement

The CS facility licensee as operator of a securities settlement facility must ensure that its operations do not expose its participants, or the financial system more broadly, to unacceptable levels of risk. The operator of a securities settlement facility must pay particular attention to ensuring settlement finality and the use of high-quality settlement assets in payment for securities:

The operation of a securities settlement facility must eliminate principal risk between its participants and ensure that settlements, once completed, are final and irrevocable.
The assets used to settle the payment obligations in respect of a transaction in the securities settlement facility must carry little or no credit or liquidity risk.
Exposures between providers of cash settlement assets must be settled finally and irrevocably.

Settlement of securities transactions in ASTC occurs on a model three delivery-versus-payment (DVP) basis.^[2] This involves the transfer of net payment and net securities obligations between buyers and sellers together at the end of the processing cycle. ASTC also provides for the settlement of cash obligations in relation to derivatives, which are also settled on a net basis. ASTC's Settlement Rules establish that settlement according to the terms of those rules is final and irrevocable. This is reinforced through legislation (see Legal Framework, above).

“Payment providers” hold Exchange Settlement (ES) accounts at the Reserve Bank and act on behalf of ASTC settlement participants. Payment obligations are settled between payment providers in the Reserve Bank's RITS system in a single daily multilateral net batch. Hence settlement is in central bank money. ASTC is notified immediately upon settlement of the batch and securities holdings in CHESS are adjusted, thus ensuring DVP settlement.

The finality of the ASTC's settlement process is reinforced by its approval under Part 3 of the Payment Systems and Netting Act. In addition, the payments between payment providers as part of the multilateral net batch are protected by virtue of the approval of RITS as a real-time gross settlement (RTGS) system under Part 2 of the Payment Systems and Netting Act. This approval protects payments from being voided in the case of a payments provider entering external administration (see Attachment 2).

6. External administration

The rules and procedures for the securities settlement facility must contain mechanisms to deal with the external administration of a participant, or a provider of cash settlement assets, in such a way as to limit the operational and financial impact on both the securities settlement facility and its participants.

ASTC's Settlement Rules allow it to cancel or suspend a participant or a payment provider if they become subject to external administration, or if they reasonably suspect that it may occur. Participants and payment providers are required to notify ASTC if they, or any other participant or payment provider, become subject to external administration or where they reasonably suspect it may occur.

ASTC's Settlement Rules allow participants to nominate a new payment provider if their current provider is subject to, or is reasonably likely to become subject to, external administration.

ASTC's Settlement Rules allow it to remove transactions from batch settlement under certain circumstances, including where a participant is subject to external administration. ASTC has procedures and mechanisms in place to allow it to recast a batch ensuring that settlement would be carried out in a timely manner.

7. Operational risk

The CS facility licensee as operator of a securities settlement facility must identify sources of operational risk and minimise these through the development of appropriate systems, controls and procedures.

ASTC's key system is the Clearing House Electronic Sub-register System (CHESS).

CHESS has been highly operationally reliable, with the system available for 100 per cent of the time over the period of this assessment. CHESS also has sufficient capacity to meet future requirements. The system capacity of CHESS was upgraded in December 2006, to a target of 1,000,000 transactions per day. Since this upgrade, the average number of trades processed per day has been around 270,000 (27 per cent of system capacity) with a peak number of daily trades of around 340,000.

The security of the CHESS system is supported by access controls which are subject to external audit. External penetration testing of CHESS is also conducted periodically.

ASTC has arrangements in place to allow the timely recovery of its usual operations in the event of a contingency. It maintains an unmanned remote back-up facility which replicates the systems at the primary site. ASTC has detailed contingency procedures, which focus on the potential effects of a disruptive event. The plans focus on systems availability, access delays, capacity, continuity and the risk of loss of personnel supporting the system.

A test is completed annually to demonstrate that normal functions can be operated using systems located at the back-up site. ASTC also regularly tests its ability to operate its primary systems from its back-up site. A more extensive test, involving utilisation of back-up systems as the production environment for a day, took place subsequent to the assessment period. Through its Settlement Rules ASTC also requires its participants to have appropriate disaster recovery arrangements.

ASTC sources its key resources from ASX Operations, a subsidiary of ASX Limited, which is responsible for supplying the ASX Group with personnel and technological resources. ASTC has a written support agreement with ASX Operations, which helps to ensure its access to these resources in the event of external administration of ASX Operations, to the extent permissible by law.

8. Regulatory reporting

CS facility licensees are required to meet certain reporting obligations to the Reserve Bank under the Financial Stability Standards. These include obligations to report breaches of the standard or breaches of risk management requirements. There are also obligations to report financial results on a quarterly basis. ASTC satisfied all reporting obligations during the assessment period.

A2.2 Austraclear

1. Legal Framework

The securities settlement facility must have a well-founded legal basis.

Austraclear Limited is a wholly owned subsidiary of ASX Limited. It provides settlement services for the over-the-counter debt market and for derivatives traded on the SFE and ASX markets.

The legal basis for Austraclear's operation is set out in its Regulations. Under s822B of the Corporations Act, these rules have effect as a contract under seal between Austraclear and each of its participants, and between each participant and each other participant. The Regulations set out the rights and obligations of participants and Austraclear, including in the event of default or suspension.

The finality of settlements undertaken by Austraclear is reinforced by its approval as a real-time gross settlement (RTGS) system under Part 2 of the Payment Systems and Netting Act. This approval protects the finality of payments made through Austraclear in the event of a participant entering external administration (see Attachment 2).

2. Participation requirements

The requirements for participation in the securities settlement facility must promote the safety and integrity of the securities settlement facility and ensure fair and open access.

Austraclear has 736 participants. Its participation requirements are designed to promote the safety and integrity of the facility. They address financial and operational aspects of participation, such as capital adequacy, business integrity and business continuity arrangements. Austraclear's Regulations allow it to suspend or terminate a participant from its facility in the event of a participant breaching the Regulations.

Fair and open access to the securities settlement facility is maintained through the objectivity of participation requirements. Transparency is aided through the publication of these requirements, which are part of the Regulations and procedures. The Regulations also provide for an appeal process where applicants for participation are rejected or where a participant is terminated.

3. Understanding risks

Austraclear's Regulations and procedures are comprehensive and publicly available. The rules and procedures explain the role and responsibilities of each category of participant and Austraclear. Background information on Austraclear's operations, technical arrangements and risk management is also available on ASX's website.

Austraclear must lodge any changes to its Clearing Rules with ASIC. Under s822E of the Corporations Act the Minister has 28 days to disallow any rule changes made by a licensed CS facility. Austraclear consults with its participants on important rule changes. Announcements affecting participants are issued as ‘SFE Notices’ which are targeted to participants and market users.

4. Certainty of title

Austraclear's Regulations identify title for three different classes of securities: paper securities, non-paper securities and dematerialised securities.

Paper securities are negotiable instruments such as certificates of deposit, promissory notes and bills of exchange. Austraclear holds these securities for the participant as bailee. The participant retains legal and beneficial title. Non-paper securities are electronic securities which are not registered within the Austraclear system. They include Commonwealth Government securities, registrable state and semi-government securities and corporate debt. Austraclear holds legal title in each of the registries for the participant as nominee. The participant retains beneficial title. Dematerialised securities are electronic securities which are registered in the Austraclear system rather than externally. They include electronic certificates of deposit, electronic promissory notes and electronic bank-accepted bills of exchange. A dematerialised security is held by a participant as a ‘chose in action’.^[3] This legal structure imposes rights and obligations which replicate the rights and obligations of a negotiable instrument.

The transfer of title to securities in the Austraclear system is effected by book entry. Paper securities are transferred through updates to participants' security records. Austraclear also uses ‘allonges’^[4] which maintains the negotiability of paper securities. Non-paper securities are transferred through the passing of beneficial title from the seller to the buyer. Austraclear retains legal title in the relevant registry. Transfers of dematerialised securities are transfers of contractual rights within the Austraclear system.

In the event of Austraclear's insolvency, the rules and arrangements for title within Austraclear provide a high degree of assurance that participants' securities will be immune from claims by Austraclear's creditors. Austraclear is not counterparty to any transactions settled in its system.

5. Settlement

The operation of a securities settlement facility must eliminate principal risk between its participants and ensure that settlements, once completed, are final and irrevocable.
The assets used to settle the payment obligations in respect of a transaction in the securities settlement facility must carry little or no credit or liquidity risk.
Exposures between providers of cash settlement assets must be settled finally and irrevocably.

Settlement of securities transactions in Austraclear occurs on a model one delivery-versus-payment (DVP) basis. This involves the simultaneous transfer of payment and securities obligations between the buyer and seller on an item-by-item basis through the settlement cycle. Austraclear also provides for one-way cash transfers between participants, which are also settled on an item-by-item basis. Austraclear's Regulations establish the basis for settlement of transactions entered into the system.

“Participating banks” hold Exchange Settlement (ES) accounts at the Reserve Bank and act on behalf of other Austraclear participants. Delivery of payment obligations occurs between participating banks across ES accounts on a RTGS basis. As such, settlement occurs in central bank money. Austraclear is notified immediately upon settlement of the payment leg. For securities transactions, title is then transferred immediately between participants, ensuring DVP settlement.

The finality of Austraclear's settlement process is reinforced by its approval under Part 2 of the Payment Systems and Netting Act. In addition, the payments between participating banks are also protected by virtue of the approval of RITS as RTGS system under Part 2 of the Payment Systems and Netting Act (see Attachment 2).

6. External administration

Austraclear's Regulations allow it to cancel or suspend a participant or a payment provider if they become subject to external administration, or if it reasonably suspects that it may occur. Participants and payment providers are required to notify Austraclear if they, or any other participant or payment provider, become subject to external administration or where they reasonably suspect it may occur.

There is no restriction within the Austraclear Regulations from a participant changing its payment provider, including where that provider is insolvent.

Austraclear does not have arrangements for dealing with the unsettled transactions of its participants, although its model one DVP arrangement ensures that principal risk does not arise. The markets Austraclear serves trade on an over-the-counter (OTC) basis without the presence of a central counterparty. Consequently, replacement risk for any trade left unsettled due to an insolvency is borne directly by trade counterparties.

7. 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.

Austraclear's key system is EXIGO, which replaced the FINTRACS system in August 2006. OMX manages the primary and back-up sites for the EXIGO system.

During the assessment period EXIGO was operationally available for 99.33 per cent of the required time. Austraclear's availability target for EXIGO is greater than 99.9 per cent during its opening hours, which are 11 hours per day in winter and 13 hours per day during Australian Eastern Daylight Time.

There were nine outages during the assessment period, including three in excess of two hours. These outages were caused by a range of factors, including insufficient hardware capacity, database problems and software faults. At other times EXIGO has performed slowly or participants have had difficulty connecting. These problems were in part caused by higher than expected use of the facility. The number of users of the new system was significantly higher than anticipated and the new functionality offered in EXIGO led to more intensive use of data query functions.

Austraclear has responded in a number of ways to these issues. It has upgraded and reconfigured system hardware and has modified its database management processes. A number of software patches have been implemented to address faults and streamline querying functionality. At a higher level, Austraclear has also conducted a review of system architecture and software code. The Bank recognises that Austraclear has taken these problems very seriously and has devoted considerable resources to overcoming them.

At times during the assessment period, loads on EXIGO were in excess of some of the key maximum performance indicators set out in the service level agreement between ASX and its outsourcing partner, OMX. These excesses included the peak volume of settlement instructions processed by EXIGO, both in daily and hourly terms. Although there were no apparent performance issues as a result of these higher than agreed loads, it is important that Austraclear and its users be confident that the system can accommodate peak volumes and that this is reflected in contractual arrangements. Austraclear has recognised this and significantly higher performance standards have now been established in a revised service level agreement implemented in July 2007. Under the new agreement, 30,000 settlement instructions per day will be accommodated, compared with 18,000 under the old agreement. Peak hourly instructions accommodated will rise from 4000 to 10,000.

The security of the EXIGO system is supported by access controls which are subject to external audit. External penetration testing of EXIGO is also conducted periodically.

Austraclear has arrangements in place to allow the timely recovery of its usual operations in the event of a contingency. OMX maintains an unmanned remote back-up site which replicates the systems at the primary site. Austraclear has detailed contingency procedures which address a range of events. The plans detail arrangements for communications, computer systems and key personnel.

Austraclear tests back-up arrangements quarterly. Due to the operational issues discussed above, Austraclear has also utilised its back-up systems as part of the production environment several times during the assessment period. Through its Regulations, Austraclear requires its participants to have appropriate disaster recovery arrangements.

Within its key outsourcing arrangement with OMX, Austraclear has a prescribed disengagement plan that provides access to required infrastructure and resources to continue operation in the event that OMX becomes insolvent. Austraclear also sources some key resources from ASX Operations, a subsidiary of ASX Limited which is responsible for supplying the ASX Group with personnel and technological resources.

8. Regulatory reporting

CS facility licensees are required to meet certain reporting obligations to the Reserve Bank under the Financial Stability Standards. These obligations include obligations to report breaches of the standard or breaches of its risk management requirements. There are also obligations to report financial results on a quarterly basis. Austraclear satisfied all reporting obligations during the assessment period.

Footnotes

Participants who only clear futures transactions may be subject to alternative prudential requirements under the ACH Clearing Rules. [1]

There is provision for DVP to occur on a trade-by-trade basis using CHESS RTGS, but this option has yet to be used. [2]

A legal right to intangible property. It allows the holder (in this case, the relevant Austraclear participant) to direct Austraclear to deliver to it securities of a specified description and number. [3]

Separate sheets of paper attached to a bill of exchange for the purpose of documenting endorsements. As a bill of exchange is transferable through endorsement, the allonge attached to the bill acts as a legal extension of the document. [4]