2012/13 Assessment of ASX Clearing and Settlement Facilities 3. Assessment of Clearing and Settlement Facilities against the Financial Stability Standards

3.1 Introduction to the ASX Clearing and Settlement Facilities

The ASX Group operates four clearing and settlement (CS) facilities: two central counterparties (CCPs) and two securities settlement facilities (SSFs). Each of these facilities holds a CS facility licence, and each is required under the Corporations Act 2001 to comply with applicable Financial Stability Standards (FSS) determined by the Reserve Bank (the Bank) and to do all other things necessary to reduce systemic risk.

3.1.1 Central counterparties

A CCP acts as the buyer to every seller, and the seller to every buyer in a market. It does so by interposing itself as the legal counterparty to all purchases and sales via a process known as novation. These arrangements provide substantial benefits to participants in terms of counterparty risk management as well as greater opportunities for netting of obligations. At the same time, however, they result in a significant concentration of risk in the CCP. This risk can crystallise if a participant defaults on its obligations to the CCP, since the CCP must continue to meet its obligations to all of the non-defaulting participants. Accordingly, it is critical that the CCP identifies and properly controls risks associated with the operation of the CCP and conducts its affairs in accordance with the Bank's Financial Stability Standards for Central Counterparties (CCP Standards) in order to promote overall stability of the Australian financial system. Primary responsibility for the design and operation of a CCP in accordance with the CCP Standards lies with a CS facility licensee's board and senior management.

The ASX Group includes two CCPs that are required to observe the CCP Standards:

• ASX Clear Pty Limited (ASX Clear), which provides CCP services for a range of financial products traded on the ASX and Chi-X Australia Pty Ltd (Chi-X) markets, including cash equities, pooled investment products, warrants, certain debt products and equity-related derivatives.
• ASX Clear (Futures) Pty Limited (ASX Clear (Futures)), which provides CCP services for derivatives traded on the ASX 24 market, including futures and options on interest rate, equities, energy and commodity products. In July 2013, ASX Clear (Futures) began offering a clearing service for Australian dollar-denominated over-the-counter (OTC) interest rate derivatives (see Section 4).

3.1.2 Securities settlement facilities

An SSF provides for the final settlement of securities transactions. Settlement involves transfer of the title to the security, and transfer of cash. These functions are linked via appropriate delivery-versus-payment arrangements incorporated within the settlement process. Since SSFs are important financial market infrastructures (FMIs) that are critical to the smooth functioning of the financial system, it is critical that each SSF identify and properly control risks associated with its operation and conducts its affairs in accordance with the Bank's Financial Stability Standards for Securities Settlement Facilities (SSF Standards) in order to promote overall stability of the Australian financial system. Primary responsibility for the design and operation of an SSF in accordance with the SSF Standards lies with a CS facility licensee's board and senior management.

The ASX Group includes two SSFs that are required to observe the SSF Standards:

• ASX Settlement Pty Limited (ASX Settlement), which provides for the settlement of cash equities, debt products and warrants traded on the ASX and Chi-X markets. ASX Settlement also provides a settlement service for non-ASX listed securities.
• Austraclear Limited (Austraclear), which offers securities settlement services for trades in debt securities, including government bonds and repos.

3.2 Activity in the ASX Clearing and Settlement Facilities

In 2012/13, price volatility was generally lower than in the previous year for markets cleared and settled by the ASX CS facilities. Daily average values for cash equity trades cleared by ASX Clear and debt securities settled by Austraclear fell, while the number of derivatives contracts traded on ASX 24 continued to grow.

3.2.1 Cash equities

The average volatility in equity prices, as measured by the average of absolute daily percentage changes in the S&P ASX All Ordinaries Index, was lower in 2012/13 compared with 2011/12, decreasing from 0.9 per cent to 0.5 per cent (Graph 1). In response to renewed concerns about European sovereign debt, volatility rose above the 10-year average in late February and remained above this level for much of the remainder of the financial year. Peaks in volatility in 2012/13, however, were well below peaks in previous years.

Trends in the growth of the number and value of cash equity trades continued to diverge over 2012/13. The daily average number of such trades increased by 6 per cent in 2012/13, while the daily average value fell by 11 per cent (Graph 2). As a result of this divergence, which is a continuation of a long-term trend associated with the growth in algorithmic trading, the average size of trades in 2012/13 declined by 16 per cent. Further contributing factors include market fragmentation from the break-up of large orders across venues, and the increasing prevalence of automated or semi-automated processing.

Settlement values differ from trade values because they reflect both market traded and non-market transactions, as well as multilateral netting of participants' obligations. The average daily value of securities transactions settled by ASX Settlement decreased by 12 per cent in 2012/13, to $8.2 billion.

3.2.2 Derivatives

The daily average number of derivatives contracts traded on the ASX 24 market rose by 12 per cent in 2012/13. This included significant increases for several major contracts, most notably 10-year Treasury bond futures (up 24 per cent), 3-year Treasury bond futures (up 12 per cent) and 90-day bank bill futures (up 20 per cent). The volume of ASX SPI 200 futures contracts traded was, however, down by 13 per cent. The average daily number of equity options contracts traded on the ASX market also decreased by 4 per cent in 2012/13.

3.2.3 Debt securities

In 2012/13, the average daily value of debt securities settled through Austraclear decreased by around 5 per cent to $38 billion. This includes outright purchases and sales of securities, and securities transferred to effect repurchase agreements (other than intraday repurchase agreements with the Bank).

3.3 Risk Management in the ASX Central Counterparties

A CCP is exposed to potential losses arising in the event of participant default. ASX Clear and ASX Clear (Futures) manage this risk in a number of ways, including participation requirements, margin collection, the maintenance of pooled risk resources, and risk monitoring and compliance activities.

3.3.1 Participation requirements

Participants in each CCP must meet minimum capital requirements. While capital is only a proxy for the overall financial standing of a participant, minimum capital requirements offer comfort that a participant has adequate resources to withstand an unexpected shock, perhaps arising from operational or risk-control failings.

• ASX Clear requires Direct Participants that clear cash equities or derivatives to hold at least $5 million in core capital, with a higher requirement for General Participants (which clear on behalf of third parties) of $20 million. See Section 3.5.6 for further discussion of participation requirements at ASX Clear.
• ASX Clear (Futures) requires participants to hold at least $5 million in net tangible assets (NTA). Over time, ASX Clear (Futures) plans to increase this NTA requirement to $10 million, with a higher requirement for those that clear for third parties. Further to the launch of the OTC derivatives clearing service on 1 July (see Section 4), ASX has introduced higher minimum NTA (or Tier 1 Capital) requirements for OTC derivatives participants. Further, participants in the OTC derivatives clearing service must be authorised deposit-taking institutions (ADIs) or related entities.

3.3.2 Margin collection

The CCPs cover their credit exposures to their participants by collecting several types of margin.

• Variation margin. Variation (or ‘mark-to-market’) margin is collected on positions to cover gains or losses arising from observed price movements over the previous day.
• Initial margin. The CCPs are also exposed to credit risk arising from potential changes in the market value of a defaulting participant's open positions between the last settlement of variation margin and the close out of these positions by the CCP. To mitigate this risk, both CCPs routinely collect initial margin from participants.
• Additional initial margin. The CCPs may also make calls for ‘Additional Initial Margin’ (AIM) when exceptionally large or concentrated exposures are identified through stress testing, or when predefined limits on the ratio of positions to capital are exceeded.

ASX Clear has historically collected margin only in respect of derivatives exposures, but since June 2013 has also begun to collect both initial margin and mark-to-market margin on cash market transactions (see Section 3.5.1).

As measured by margin requirements, the CCPs' total credit exposure increased in 2012/13.

• Margins held by ASX Clear against equity derivatives increased by 12 per cent in 2012/13 (Graph 3, top panel). This was largely the result of an increase in share prices, which increases the value of contracts written on equities, and, to a lesser extent, the introduction of the CME SPAN margin methodology (see Section 3.5.1). By contrast, initial margins calculated by ASX Clear for the cash equity market decreased by 34 per cent in 2012/13, reflecting a number of factors including lower volatility and smaller net end-of-day positions (on which margin is calculated).
• Margins held by ASX Clear (Futures) increased by 39 per cent in 2012/13, reflecting a higher value of participants' end-of-day exposures, as well as an increase in trading volumes (Graph 3, bottom panel).

The CCPs call margin on an intraday basis when exposures due to changes in market value and the opening of new positions exceed predefined limits. Intraday margin calls include both variation and initial margin.

• ASX Clear calculates margin when there is a significant market movement, with margin called from participants if the calculated call amount exceeds $100,000, or if there is an erosion of initial margin of 40 per cent or greater.
• ASX Clear (Futures) calculates intraday margin at 8.00 am and 12.00 pm, and at other times if there are significant movements in the prices of individual contracts. As with ASX Clear, margin is called if the calculated call amount exceeds $100,000, or if initial margin is eroded by at least 40 per cent.

During the Assessment period, there were 77 intraday margin calls at ASX Clear totalling $119 million, and 531 calls at ASX Clear (Futures) totalling $1,409 million. The larger number and value of calls at ASX Clear (Futures) in part reflects the larger size of exposures. Intraday calls at ASX Clear (Futures) may also result from arrangements for the allocation of positions to accounts, with delays in participants' allocation of positions to client accounts resulting in calls on their house accounts (to which positions are initially allocated by default). The average amount of intraday margin called (on those days when calls were made) for ASX Clear and ASX Clear (Futures) was $3.8 million and $6 million, respectively, or less than 1 per cent of average daily initial margin called in either facility. The highest intraday margin call for a single participant over 2012/13 was $15 million for ASX Clear and $73 million for ASX Clear (Futures).

The CCPs conduct regular and ad hoc margin reviews to ensure that margin rates are set at levels appropriate to the prevailing risk environment. During the Assessment period, ASX Clear made a total of 117 margin rate changes across all its derivatives products, although scheduled reviews were not held during the March Quarter of 2013 owing to the introduction of the CME SPAN margin methodology (see Section 3.5.1). In the Assessment period, ASX Clear (Futures) made six changes to the price margin intervals (‘price scanning range’) of its five major futures contracts (SPI 200, 30-day interbank cash rate, 90-day bank accepted bills, 3-year government bonds and 10-year government bonds).

To validate their margin rate settings, the CCPs compare margin rates with observed price movements. Margin breaches are recorded whenever mark-to-market losses exceed 30 per cent of initial margin collected. During the Assessment period, 51 margin breaches were recorded for ASX Clear and 231 breaches were called for ASX Clear (Futures). Breaches at ASX Clear (Futures) were predominantly due to volatility in contracts with low liquidity, such as electricity futures.

3.3.3 The maintenance of pooled financial resources

The margin and other collateral posted by a participant would be drawn on first in the event of that participant's default. Should this prove insufficient to meet the CCP's obligations, it may draw on a fixed quantity of pooled financial resources.

• During the majority of the Assessment period, ASX Clear's prefunded pooled financial resources totalled $250 million (Graph 4). This comprised $3.5 million of own equity, $71.5 million paid into a restricted capital reserve from the National Guarantee Fund in 2005, and fully drawn-down subordinated loans totalling $175 million provided by ASX Clearing Corporation (ASXCC), of which $100 million was funded by a principal-reducing commercial bank loan facility. The $100 million commercial bank loan was repaid on 28 June 2013 and replaced with $100 million of own equity. If exhausted, prefunded resources may be supplemented by ‘emergency assessments’ of up to $300 million, which surviving clearing participants must pay within a reasonable time frame if called.
• During the majority of the Assessment period, ASX Clear (Futures)' prefunded pooled financial resources remained at $370 million (Graph 5). This amount comprised $30 million of ASX Clear (Futures)' own capital, $120 million of prefunded participant contributions, and a $220 million fully drawn-down subordinated loan from ASXCC, in turn funded by a $150 million principal-reducing commercial bank loan facility, and a $70 million subordinated loan from ASX Limited. The $150 million commercial bank loan was repaid on 28 June 2013 and replaced with $100 million of own equity.

Since the Assessment period, ASX has conducted a significant capital raising, which has led to changes in the composition of both CCPs' pooled financial resources, and an increase in the size of ASX Clear (Futures)' pooled resources. ASX Clear (Futures) has implemented rule changes to increase participant contributions in support of the introduction of OTC derivatives clearing. Further details are provided in Section 3.5.1.

In order to assess the adequacy of its risk resources, the CCPs perform daily capital stress tests which compare their available prefunded resources against the largest potential loss in the event of the default of a participant (and affiliates of the participant) under a range of extreme but plausible test scenarios.

• ASX Clear's maximum projected stress-test losses remained well below the total prefunded pooled financial resources (Graph 6).
• ASX Clear (Futures)' maximum projected stress-test losses exceeded the prefunded pooled financial resources for 17 days in the March 2013 quarter, peaking at $44 million above the level of prefunded pooled financial resources ( Graph 7). These results were investigated by ASX Clear (Futures), but since they were due to temporary trading activity by particular participants, an increase in pooled financial resources was not considered necessary.

Since 16 August, ASX Clear (Futures) has commenced stress testing the adequacy of its financial resources against requirements to meet obligations in the event of the default of the largest two participants and their affiliates (by exposure) in extreme but plausible circumstances. This reflects the Bank's supplementary interpretation of certain FSS, issued in the context of an EU regulatory equivalence assessment (see Section 3.5.1 and 3.7).

The CCPs call additional initial margin (AIM) when capital stress-test results are in excess of stress-test exposure limits (STELs), which are based on ASX's internal credit ratings of participants. During the Assessment period, the introduction of initial margining for cash equities allowed ASX Clear to move from a system of ‘contributions and additional collateral’ (CAC), which contained a pooled component for cash equities, to the AIM methodology that provides participant-specific cover. Since B- or lower-rated participants have STELs lower than the total prefunded resources at both CCPs, AIM can be called even when stress-test exposures do not exceed total resources.

ASX Clear (Futures) made STEL AIM calls on three participants across 58 days, with the largest call totalling $119 million. ASX Clear made AIM or CAC calls on 14 days against six participants, with the largest totalling $33.5 million. ASX Clear allows for discounts on AIM calls for highly rated (A-rated and B-rated) participants in times of low volatility; however, these discounts were suspended in April 2010 and they have not since been reapplied.

The CCPs also perform daily liquidity stress testing in order to verify that they have sufficient financial resources readily available to make payments in the event of a participant default.

• ASX Clear conducts separate liquidity stress tests based on a range of close-out scenarios to give a daily maximum potential liquidity requirement, which is then compared with the available financial resources (AFR) (Graph 8). To be considered a breach, a stress-test result must exceed the AFR for more than three days, reflecting the three-day cash market settlement cycle. During the Assessment period, stress-test results at ASX Clear exceeded the AFR on 17 occasions, but only one of these constituted a breach. ASX reviews all breaches, but concluded in this case that its financial resources were adequate.
• ASX Clear (Futures)' liquidity stress-test scenarios are based on the same scenarios as used in its capital stress tests. During the Assessment period, there were no sustained or widely distributed breaches at ASX Clear (Futures) that would call into question the adequacy of its liquidity arrangements.

3.3.4 Risk monitoring and compliance

The two CCPs actively monitor their exposure to financial risk. This includes monitoring of day-to-day developments regarding, among other things, financial requirements, risk profiles, open positions and settlement obligations to the CCPs. The CCPs carry out a range of participant monitoring spot checks and other examinations designed to validate the accuracy of the financial and operational information that participants are required to submit to the CCPs. The CCPs also determine and review participants' internal credit ratings, drawing in part on information provided by participants in their regular financial returns to ASX, and maintain a ‘watch list’ of participants deemed to warrant more intensive monitoring.

The CCPs have wideranging powers to sanction participants in order to preserve their financial and operational integrity. The CCPs may suspend or terminate a participant's authority to clear all market transactions in the event of a default, or in the event of a breach of the Operating Rules and Procedures that may have an adverse impact on the CCP. The action taken in the event of a breach will depend on a number of factors, including the participant's history of compliance and whether the breach implies negligence, incompetence or dishonesty. Where a breach has been identified and the participant has taken appropriate steps to rectify it, the CCPs will typically continue to monitor the participant closely for a period of time.

As an example of these risk management activities, in July 2012 a participant of ASX Clear was unable to meet a CAC call. As a result, this participant: was required to provide additional general cover; had conditions placed on its trading and clearing participation; had its STEL significantly reduced; and was subject to an external audit of its risk management framework. The participant was also placed on ASX's watch list. Another participant was placed on the watch list in April 2013 due to concerns about internal controls, but was taken off in May after these concerns were reviewed. The only other participants on the watch list during the Assessment period were the three MF Global subsidiaries, which were placed on the watch list and suspended after the default of MF Global in November 2011, until their formal resignation in February 2013.

3.4 Operational Performance of the ASX Clearing and Settlement Facilities

ASX manages its operational risks in the context of its group-wide Enterprise Risk Management Framework, applying consistent operational risk controls across all of its CS facilities. Key operational objectives are minimum availability of 99.8 per cent (99.9 per cent for Austraclear) and peak capacity utilisation of 50 per cent. These objectives were met over the Assessment period (Table 5). For all systems, availability was 100 per cent and peak usage was below the target of 50 per cent.

As indicated by the availability statistics for ASX's CS facilities, the Assessment period was free of major operational incidents. There were some less serious incidents, two of which are discussed below. ASX is also improving its capacity to directly manage operational risk at Austraclear through an insourcing project to take over all support of the core EXIGO system. The CS facilities must also manage operational interdependencies with their participants. These and other operational performance matters are described in the detailed assessment in Appendix B.

3.4.1 Minor incidents

There were two notable minor incidents in the Assessment period: a reporting issue at ASX Clear, whereby a database problem lead to the failure of key risk management reports, and a problem leading to the incorrect calculation of margin at ASX Clear (Futures). In response to these issues, ASX has further strengthened its systems and procedures for overnight processing. The Bank is satisfied with both ASX's initial response to these issues and ASX's ongoing work to strengthen its operational processes.

Risk management reporting incident at ASX Clear

In late July 2012, a data purging issue in ASX Clear's CORE database lead to a failure of some of ASX Clear's risk management reports. As a result, a call for CAC margin of $1.5 million was not made on that day. An initial workaround to purge the database failed, which led to problems with the production of key risk-management reports. However, the database issues were later successfully corrected and the risk-management reports regenerated. ASX has implemented a number of steps to mitigate the risk of a problem of this nature recurring.

• ASX has cleaned up its CORE database and instituted plans for periodic database purges.
• Improvements have been made to the report generation process, including changes to allow reports to be checked and re-run at the component level (to remove the need to re-run entire reports).
• A procedure was introduced to make reports available earlier in the day, thereby allowing additional time to resolve any problems, as well as a performance requirement that sets a limit on report delays.

ASX is also undertaking a broader review of end-to-end reporting processes, due for completion in late 2013.

Over-margining incident at ASX Clear (Futures)

On 12 February 2013, an operational incident resulted in excess initial margin being called and collected at ASX Clear (Futures). The error arose from a technical issue during a scheduled switch to ASX's backup site, which was being used for several days as part of ASX's business continuity testing. During the switch, a file containing margin rate parameters for CME SPAN was not successfully replicated from the production site to the backup site. As a consequence, margin calls were calculated at the backup site based on three-month-old margin parameters. This resulted in small errors in the calculation of participant margins collected on 12 February. The issue was corrected before the next end-of-day margin calculation and participants were offered the full cash rate on excess margin posted as compensation.

As a consequence of this incident, ASX has introduced a number of changes to improve its margin processing. Of particular concern was that the system had logged that the parameter file had failed to update, but this did not trigger a system alert. To rectify this, ASX has now fully automated the process to replicate margin files to its backup site. In addition, system changes have been made to ensure that any error will halt processing and to require human intervention to recommence processing.

3.4.2 EXIGO insourcing

EXIGO is the core system used by Austraclear. During 2011/12, Austraclear commenced an insourcing project to take over EXIGO's third-level operational and software support (requiring expert knowledge of the core system), which is currently provided by a third-party vendor. This project has the potential to significantly reduce operational risk by giving ASX control over future development of the system, both in terms of the nature and the timing of system enhancements. The project will improve operational risk by significantly simplifying the system through the removal of unused components. It should also improve the timeliness of ASX's responses to operational incidents, given the current reliance on highly technical 24-hour support across different time zones. The project is due for completion in 2014.

Insourcing EXIGO will require that ASX can manage the transition process and adequately resource third-level support for Austraclear. ASX has recruited developers for this project and a senior developer from the third-party vendor has been seconded to Sydney during the development phase. As a contingency, ASX also has the option to extend existing third-party support arrangements for as long as required.

3.4.3 Participation in the ASX CS facilities

Table 6 provides summary information on participation levels in the ASX CS facilities. These were broadly steady over the Assessment period. Participation requirements and the effect of participation structures on operational risk management are discussed in Sections 3.5.5 and 3.5.6.

3.5 Material Developments and Recommendations

As foreshadowed in the 2011/12 Assessment, in December 2012 the Bank revoked the pre-existing FSS and determined two new sets of FSS, for central counterparties (CCP Standards) and securities settlement facilities (SSF Standards). The new FSS came into force on 29 March 2013.^[1] Consistent with the Principles on which they are based, the new FSS are more detailed than the pre-existing standards, and also introduce requirements in several new areas. Accordingly, the ASX CS facilities have implemented a number of enhancements over the course of the Assessment period to ensure observance of the new FSS. In addition, the ASX CS facilities have responded to recommendations in previous Assessments, made commercially driven improvements to existing processes and implemented changes related to the launch of new products and services.

3.5.1 CCP risk management

Risk management has been an important focus for the ASX CCPs over the period, and for the Bank in its Assessment. The new FSS set more detailed standards in relation to risk review, stress testing and model validation processes, as well as the coverage of financial resources.

Risk review, stress testing and model validation processes

In 2012/13, ASX adopted an updated and formalised clearing risk policy framework to better align the governance of clearing risk policy with the new FSS (see Section 3.5.2). The Clearing Risk Policy Framework comprises a comprehensive set of clearing and treasury risk policies to support risk management in the ASX CCPs. ASX will continue to refine and update standards covering all relevant aspects of the FSSs, aiming to complete this work by the first quarter of 2014. The Bank will continue to monitor progress in this regard.

As part of this work, in accordance with the FSS, ASX is developing analytical tools to enhance its model review, margin backtesting, sensitivity analysis and reverse stress-testing capabilities. An enhanced daily margin backtesting regime was introduced in July 2013. In respect of model review, ASX has introduced a Model Validation Standard which requires that all models critical to ASX undergo a full annual validation, with less critical models reviewed on a longer cycle. Criticality is measured according to a series of factors, including the internal and external impact of the model, frequency of use and complexity. This naturally includes ASX's margining models and both the capital and liquidity stress-testing models. Validation of the models will be coordinated by internal audit, with external consultation sought where deemed necessary according to the Risk Quantification Group (RQG). The first validations will be undertaken during the 2013/14 Assessment period.

Also under development is an internal standard that formalises and enhances ASX's approach to monitoring and mitigating concentration risks. This includes monitoring of key indicators that measure concentration across clearing participants, across clients and across products. The policy will also address possible mitigating action.

Pooled financial resources

The new FSS strengthen some key requirements, particularly with regard to credit and liquidity risks. Stress testing is carried out daily to gauge the adequacy of the CCPs' financial resources and to monitor the risks associated with individual participants' positions. Capital stress testing estimates the credit exposure that would result from the realisation of extreme but plausible price changes. Liquidity stress testing estimates the liquidity exposure that would result from extreme but plausible price changes.

In accordance with new requirements under the FSS, during the Assessment period stress-testing models were amended to test the adequacy of financial resources to meet obligations arising in the event of the default of the participant and its affiliates to which the CCP has the largest exposure in extreme but plausible circumstances, rather than the default of the largest participant alone. This was only relevant for ASX Clear during the period, since there are currently no affiliated participants in ASX Clear (Futures). Similar changes were made in respect of liquidity stress tests.

Further, ASX Clear (Futures) recently began testing the adequacy of financial resources – both from a capital and a liquidity perspective – to meet obligations in the event of the default of the largest two participants plus affiliates in stressed circumstances (‘cover two’). This follows the clarification that ASX Clear (Futures) is considered ‘systemically important in multiple jurisdictions’, in part reflecting its provision of services to participants established in the European Union (EU) and the need for recognition under EU regulation (see Section 3.7).

In June 2013, ASX conducted a capital raising by means of a stock entitlement offer to support changes to increase the pooled financial resources of ASX Clear (Futures) and alter the composition of resources for both CCPs. ASX raised $533 million, of which $450 million was used to restructure existing resources by replacing $250 million in commercial bank-funded loans across the two CCPs; and, at ASX Clear (Futures), increasing total resources by $180 million, and replacing $20 million of participant contributions. The remaining funds have contributed to an increase in the business risk capital allocated to the CS facilities. More specifically:

• ASX Clear (Futures) is in the process of increasing its pooled financial resources from $370 million to $650 million, in part to reflect the launch of ASX Clear (Futures)' OTC derivatives clearing service, and in part to reflect the transition to cover two stress tests. The magnitude of this increase is based on stress tests of participant portfolios provided to ASX Clear (Futures) as part of a design study for the OTC derivatives clearing service carried out in 2012. The new composition of ASX Clear (Futures)' resources will include $200 million in pooled participant contributions (with an anticipated injection of $100 million from participants in the OTC clearing service) and $450 million of ASX capital (Graph 9). The additional ASX contribution represents a $180 million increase in total resources in the form of equity, $150 million to replace an existing loan from ASXCC funded by a principal-reducing commercial bank loan, and $20 million to replace contributions from existing (futures) participants. In addition, ASX Clear (Futures) has withdrawn its power to call an additional $30 million in promissory commitments from futures participants in the event that prefunded resources are exhausted.
• ASX Clear's total pooled financial resources have not increased. However, $100 million of the capital raising was used to replace an existing loan from ASXCC funded by a principal-reducing commercial bank loan that had previously formed part of prefunded resources. ASX Clear's $250 million of prefunded financial resources now consists of: own equity ($103.5 million); funds held in a restricted capital reserve ($71.5 million); and fully-drawn subordinated loans from ASXCC (totalling $75 million), which are ultimately fully funded by a subordinated loan from ASX Limited (Graph 10).

Both CCPs retain the capacity to require that a participant post additional collateral should stress-test outcomes reveal that the potential loss arising from that participant's positions, as at the close of the previous day, exceeds a predetermined STEL. STELs are calibrated to ensure that prefunded financial resources are not exceeded.

In April 2013, ASX Clear reduced the STEL available to C-rated participants (previously $125 million), while in June 2013 it made changes to STELs consistent with the recalibration of stress tests to take into account affiliated groups. Under the latter changes, where a group of participants are affiliated (i.e. part of the same corporate group), STELs are set such that the sum of affiliated participants' STELs is equal to or lower than ASX Clear's prefunded financial resources. Accordingly, ASX Clear's combined exposure to these affiliated participants cannot increase above its available financial resources without triggering a call for an additional contribution.

In light of the increase in ASX Clear (Futures) financial resources, and the move to stress testing against multiple participant defaults, ASX Clear (Futures) has similarly adjusted participant STELs to ensure that they are consistent with the new level of cover.

Margin

Consistent with the FSS, and also in accordance with previous recommendations by the Bank and ongoing process enhancements, ASX Clear completed the implementation of new margining arrangements for both cash equities and equity derivatives.

On 11 June 2013, ASX Clear began to routinely collect margins on unsettled cash equity transactions, consistent with requirements under the revised FSS and recommendations in previous Assessments. ASX Clear collects both initial and mark-to-market margin. Daily initial margin averaged $140 million in June. The selected methodology for initial margin calculation in respect of actively traded stocks is historical simulation of value at risk (HSVAR). The HSVAR methodology calculates hypothetical changes in the value of a portfolio of securities, using historical price moves, and determines a margin requirement from these taking into account the target level of confidence. For less liquid stocks, or securities with an insufficient price history to apply HSVAR, ASX Clear applies flat rate margins. Margins calculated using HSVAR currently make up around 70 per cent of total margins collected by ASX Clear in respect of cash equities.

In December 2012, ASX Clear replaced its previous proprietary Theoretical Intermarket Margin System with CME SPAN for the margining of derivatives positions. The CME SPAN methodology is a widely used version of the internationally accepted Standard Portfolio Analysis of Risk (SPAN) methodology. Following the introduction of CME SPAN at ASX Clear (Futures) in the last Assessment period, both CCPs are now using a consistent approach to the margining of derivatives, which is sensitive to a broader range of risk factors. Over time, this will permit ASX to improve the consistency of margin reports and margin data.

The adoption of CME SPAN is intended to facilitate better calibration of exposures to ASX Clear's risk tolerance. The CME SPAN methodology calculates initial margin requirements that reflect the total risk of each portfolio – for ASX Clear, each house or client account is considered a separate portfolio. Following the implementation of CME SPAN, ASX worked with the vendor of a third-party system to more closely align its estimates of margin requirements to those calculated by ASX Clear's own systems (see Section 3.5.5).

3.5.2 Governance and comprehensive management of risks

The new FSS impose several more detailed requirements on licensed CS facilities around governance of risk and other aspects of CS facilities' activities. A number of enhancements have been implemented during the Assessment period.

Governance of risk management

During the period, ASX enhanced the governance of risk at the CCPs through the introduction of three new policy committees (see discussion of ASX Group structure in the introduction to Appendix B):

• The Clearing Risk Policy Committee (CRPC) was formed in June 2013 to review and approve clearing risk policies and standards organised under ASX's Clearing Risk Policy Framework prior to submission to the CS Boards. That framework sets out a comprehensive set of clearing and treasury risk policies to support the risk management approach of ASX's CCPs. The CRPC is currently reviewing the framework to ensure that its policies and standards fully align with the FSS. Completion of that review will consolidate observance of Standard 3 (Framework for the comprehensive management of risks). The CRPC is chaired by the Chief Risk Officer (CRO) and includes the ASX Group Legal Counsel, Chief Financial Officer and Executive General Manager of Operations. It generally meets quarterly in line with meetings of the CS Boards.
• ASX also established the RQG in early 2013 to strengthen the technical oversight of risk management policy. The RQG is chaired by the CRO and is made up of key staff from ASX's clearing risk policy and management units most familiar with ASX's margin and other risk management models. The focus of the RQG is the review and application of quantitative risk policies, including oversight of model governance and regular reviews of margining. The group meets at least quarterly, but can (and currently typically does) meet more frequently as required.
• A number of important changes to governance have also arisen from the establishment of the OTC derivatives clearing service. In particular, ASX has established additional formal structures for participant consultation, most notably through the introduction of a Risk Committee for ASX Clear (Futures) which will meet for the first time in late 2013. This committee will be a self-governing body, chaired by an elected member and with membership open to both futures and OTC participants. The Risk Committee will be consulted on changes to the margin methodology, financial resources, position or liquidity limits, participation criteria, new products, and other changes relevant to either the risk model or associated Operating Rules. The Risk Committee's proposals and recommendations will be presented to the ASX Clear (Futures) Board, which will be required to justify any decision not to follow the Risk Committee's advice. The Bank will discuss with ASX whether a risk committee structure similar to that at ASX Clear (Futures) would also be appropriate at ASX Clear.

Conflict handling procedures

The four CS facilities share a common set of eight directors; five of these directors are also members of the ASX Limited Board (see introduction to Appendix B). The new FSS require ASX to address the potential for conflicts created by shared directorships between the CS facilities and other group entities. These include potential conflicts between group-wide commercial interests and the risk management function of the CS facilities. ASX considers that conflicts between directors' roles on the CS Boards and the ASX Limited Board are unlikely to arise given the distinct roles the separate entities perform, and in view of group-wide arrangements to manage matters such as operations and compliance. If a conflict were to arise, a director sitting on multiple CS Boards would be expected to make decisions in the best interests of each facility. The Bank intends to work with ASX to understand better the arrangements in place for conflict handling.

Code of Practice for Clearing and Settlement of Cash Equities

During 2012, the CFR, in collaboration with the Australian Competition and Consumer Commission, undertook a detailed analysis of the implications of competition in the clearing and settlement of ASX-listed equities.^[2] On 11 February 2013, the government accepted the recommendations of the CFR to defer consideration of competition for two years and in the meantime request that ASX develop a Code of Practice for Clearing and Settlement of Cash Equities in Australia (the Code).^[3] The Code is designed to address concerns expressed by industry stakeholders about transparency, access and user representation. It is intended that the Code create and reflect conditions consistent with those that might be expected under a competitive setting for clearing and settlement of cash equities.

Accordingly, in July, following extensive consultation with stakeholders, ASX released the Code, which commits ASX to:

• enhance user engagement through the establishment of an advisory forum, the Forum, comprising senior representatives of users and other stakeholders
• maintain transparent and non-discriminatory pricing of cash equity clearing and settlement services, including via the development of a transfer pricing policy and regular independent benchmarking of costs of clearing and settlement against other international providers
• maintain transparent and non-discriminatory terms of access to its cash equity clearing and settlement infrastructure, including via an access protocol and a commitment to offer access to alternative market operators on terms consistent with those that would exist in a competitive setting.

In conjunction with these commitments, ASX also established a new microsite for detailed information on its clearing and settlement services and announcements in accordance with the Code.^[4]

3.5.3 Participant default rules and procedures

The 2010/11 Assessment included a special topic on Default Arrangements, which described the ASX CCPs' Default Management Framework (DMF). The DMF is intended to assist in the management of a clearing participant default and covers each stage of a default from its identification through to its conclusion. The DMF is intended to be flexible, rather than prescriptive, and may be developed and adapted as appropriate in the circumstances. In the 2011/12 Assessment period, the DMF was updated to incorporate lessons learned from the default of MF Global. In the current Assessment period, ASX undertook a further review of the DMF in light of new requirements of the FSS and the introduction of clearing for OTC interest derivatives at ASX Clear (Futures).

As an input into ongoing review of the DMF, ASX conducts regular ‘fire drills’, in which all relevant ASX decision-makers and supporting staff conduct a real-time simulation of a hypothetical clearing participant default (based on observed participant positions). To date, fire drills have been conducted in-house without participant involvement. At the end of 2012, the Bank began attending as an observer.

ASX has also undertaken analysis of the potential impact of ADI resolution proceedings on a CCP's default management processes. While acknowledging that ADI resolution authorities may have broad powers to intervene in the arrangements of an insolvent ADI participant, the analysis suggests that, in general, resolution proceedings should not impede a CCP's default management processes. ASX will conduct further analysis of the interaction between ADI and FMI resolution once international work on FMI resolution and the proposed domestic regime for FMI resolution have been finalised (see Section 3.6.1).

A number of changes were made to the DMF during the Assessment period to accommodate the introduction of the OTC derivatives clearing service at ASX Clear (Futures). ASX Clear (Futures)' intention would be to hedge the defaulter's OTC derivatives portfolio (including cross-margined futures), before auctioning the hedged portfolio to non-defaulting participants. To provide advice and assist with the hedging process, ASX will convene Default Management Groups (DMGs) with respect to one or more groups of open contracts, comprised of trading and risk professionals drawn from non-defaulting OTC participants, selected on a rotational basis for an annual term. While ASX is not obliged to follow the recommendations of a DMG, it must justify any decision not to do so. ASX will also seek the advice of DMGs on ASX Clear (Futures)' default management policy and processes at regular intervals.

Each OTC derivatives clearing member will also be involved directly in regular default simulations, including testing of the auction process. While ASX has set out a general auction process, it retains the flexibility to tailor the process. In the event of a default, and after consulting with the relevant DMG, ASX will divide the hedged portfolio into auction pools and specify the terms of the auctions.

While all OTC participants are required to bid in any auction of a defaulting participant's portfolio, ASX is still in the process of developing a mechanism to encourage competitive bidding. Competitive bidding in the auction is important since in the event that an auction fails, ASX's only option currently is to hold the hedged position until it can re-run the auction successfully or bilaterally negotiate a sale. To incentivise competitive bidding, ASX is developing a mechanism for ordering the allocation of losses against survivors' contributions to financial resources based on the quality of their bids; for instance, (some proportion of) the contributions of the participants with the ‘worst’ bids could be used before those of the participants with the ‘best’ bids. Such a mechanism is particularly important when managing the default of a participant with a large or complex portfolio. In designing its recovery plans (discussed in Section 3.6.1), ASX will also need to consider the implications for participants' incentives in the auction process.

3.5.4 Business and investment risks

The Bank's 2011/12 Assessment encouraged ASX to carry out a review of its treasury investment policy in consultation with the Bank. In accordance with the treasury investment policy endorsed annually by the CS Boards, ASXCC invests both cash margin collected and pooled risk resources in short-dated highly rated assets. The policy establishes counterparty eligibility criteria and sets investment limits to control investment counterparty risk. The Bank had expressed concerns that, notwithstanding limits on both the absolute level and share of exposure to each of the four large domestic banks, the policy still allowed relatively large and concentrated credit exposures to these banks. The Bank also expressed concern that where an entity related to the issuer counterparty was also a clearing participant, the performance of investments in the portfolio could be correlated with the very default event against which the CCPs' financial resources sought to provide cover.

ASX carried out this review during the 2012/13 Assessment period, concluding that a gradual move towards lower concentration of investments in the major banks and a greater reliance on secured investments would be appropriate. As a first step, ASX has modified the ASXCC Investment Mandate to reduce the unsecured limit on exposures to the large domestic banks. In the event that one of those banks became a clearing participant, ASX would further reduce these limits. ASX plans to review concentration limits to investment counterparties again in 2014 and 2015. Further reductions will be required to fully align ASX's investment strategy with its CCP risk management framework as required under CCP Standard 15. Over the coming Assessment period, the Bank will continue discussions with ASX regarding the reduction in exposure concentrations required to fully observe this Standard.

Also in 2013, ASX revised its approach to business risk capital to take into account the requirements of the new FSS, and requirements arising from its own strategic projects; in particular, the introduction of the OTC derivatives clearing service. Under this revised approach, ASX has calibrated its holdings of general business risk capital for each CS facility to cover the higher of:

• the estimated largest uninsured business loss that each facility may incur, across a range of scenarios, including external shocks such as a pandemic, or an unauthorised funds transfer
• operating expenses required to fund a recovery or orderly wind-down plan (estimated at six months of operating expenses)
• in the case of ASX Clear (Futures), an amount calculated in accordance with business capital requirements under EU regulations (see Section 3.7)
• in the case of Austraclear and ASX Settlement, a charge calculated on the value of securities held in each facility, according to a methodology applied by fund managers, custodians and other SSFs.

The June 2013 capital raising contributed to an increase in ASX's total capital allocations for operational and business risk from $50 million to $225 million across the ASX Group in line with the above requirements. ASX Group has also historically held surplus capital of $200 to $250 million, and a little over half of the increase in capital allocated to operational and business risk represents a specific allocation from that surplus. This formalises ASX's previous approach to business risk capital, under which business losses would be met by the surplus capital held.

Of the $225 million allocation, $15 million has been attributed to ASX Clear, $60 million to ASX Clear (Futures) and $140 million across the two SSFs, with the balance attributed to non-clearing and settlement activities. ASX holds this capital at the group level to ensure that it cannot be applied by facilities to meet losses caused by a participant default. A group-wide capital buffer provides protection to allocated business risk capital against potential losses sustained elsewhere in the group. While ASX considers that its existing framework provides a sufficient legal basis for the use of funds allocated to the CS facilities at the group level to cover a business risk loss, ASX is enhancing its intragroup legal agreements to explicitly reflect the allocation and availability of business risk capital to the CS facilities to support their obligations under the FSS.

3.5.5 Operations

During the Assessment period, ASX's arrangements for managing its operations were tested by the execution of several major projects (see Section 4), and enhanced in response to the requirements of the new FSS and events that highlighted interdependencies with participants and external service providers.

Updates to service agreements

The new FSS place heightened requirements on the arrangements that ASX has with service providers, including that ASX ensures its outsourcing arrangements or dependencies on external service provision are subject to the same operational risk management requirements as its own internally provided operations. In addition, the new FSS require that the Bank be able to access information regarding the performance of service providers.

Over the first half of 2013, ASX developed a set of standard clauses that provide the Bank with the necessary access to information on service providers, and that provide for renegotiation of service agreements where additional enhancements to the service provider's operational risk controls are required. These clauses were included in new outsourcing and service provision contracts relating to the OTC derivatives clearing service in ASX Clear (Futures) and the ASX Collateral service (see Section 4), and were also written into service agreements with all existing critical service providers. Similar clauses were also incorporated into agreements between each CS facility and an ASX Group entity, ASX Operations Pty Ltd, for the provision of internal operational services. In negotiating the insertion of these new clauses, ASX also included clauses requiring that service providers notify the Bank prior to terminating their provision of services, to enable action to support continued service provision under a future resolution regime (see Section 3.6.1).

Resource management

In 2012/13, ASX undertook work on over 30 projects, including major projects such as the OTC derivatives clearing service in ASX Clear (Futures) and the collateral management service for Austraclear (see Section 4). In addition to work on these projects, often to challenging time frames, ASX has undertaken extensive work to enhance its risk management policies in order to meet the requirements of the new FSS. This has tested the capacity of ASX's existing resources. Although targeted deadlines for key projects have largely been met, the Bank observes that the focus on achieving deadlines for the launch of new products creates the risk that work to maintain and enhance the core risk management framework for the CS facilities could be compromised. The Bank is satisfied that this has not occurred to date, but will continue to monitor developments to ensure that this remains the case.

In order to mitigate the risks associated with the increased demand on its resources, ASX has taken steps to increase its resource levels through additional staff, the use of consultants, and partnerships with external service providers. For example, in developing the OTC derivatives clearing service, ASX entered into agreements with third-party consultants, service providers and software vendors. ASX has also employed additional staff in its Clearing Risk Policy unit, including a senior manager and senior analyst brought in to enhance ASX's quantitative framework for CCP risk management.

Dependencies on participant systems

Two matters during the Assessment period highlighted operational interdependencies between ASX and participant systems.

First, the December 2012 introduction of CME SPAN in ASX Clear highlighted the reliance of participants on systems provided by third-party vendors for the estimation of margin requirements. Following implementation, ASX worked with the vendor of a third-party system used by several participants to estimate margin requirements resulting from hypothetical trades to ensure that these estimates were aligned as closely as possible to margin requirements calculated by ASX's margin system. This issue highlighted the importance of close coordination with the providers of vendor systems that are used by multiple participants.

Accordingly, ASX has commenced a program to formalise its relationships with key participant vendors. As a first step, ASX conducted workshops with vendors in preparation for the introduction of cash market margining.

A second incident involved operational problems at a participant that caused a partial failure of settlements for that participant over several days in mid January 2013. While an initial concern related to the participant's use of third-party vendor software, it was ultimately determined that an overseas back-office service provider had caused the operational problems. While the January incident had only a minor impact on system-wide settlements and was resolved within a week, ASX has acknowledged that similar outsourcing arrangements could introduce operational risk to its own systems and is examining options to mitigate these risks. ASX Compliance has initiated a review of participants' outsourcing arrangements that will benchmark selected participants against APRA's prudential standard on outsourcing. In addition, ASX will investigate contingency plans for participant connection to ASX infrastructure.

The Bank welcomes ASX's steps to address operational interdependencies with vendor service providers and participant systems, and will continue to monitor ASX's introduction of additional steps to mitigate these risks.

3.5.6 Participation and access

There were also a number of developments during the Assessment period in relation to participation requirements and access.

Participation by authorised deposit-taking institutions

Although both ASX CCPs currently allow direct participation by ADIs supervised by APRA, levels of ADI participation in ASX Clear have historically been low. At the end of the Assessment period there was only one ADI participant in ASX Clear, while there were seven ADI members of ASX Clear (Futures). Capital incentives for central clearing under prudential standards have led to greater interest among ADIs in becoming members of ASX Clear and ASX Clear (Futures). In recognition of this, ASX has taken steps to accommodate greater ADI participation in the two CCPs, and has made ADI status a requirement for participants in its new OTC derivatives clearing service.

To address the likelihood of greater ADI participation in central clearing, APRA has taken two steps to clarify the capital treatment of bank exposures to CCPs. In April 2013, APRA confirmed that it would treat both ASX Clear and ASX Clear (Futures) as qualifying CCPs (QCCPs) for capital purposes.^[5] ADIs may apply a lower capital requirement for exposures to a QCCP. In June, APRA wrote to all ADIs to outline its policies regarding membership of a central counterparty by ADIs or their affiliates, including that membership must not expose the ADI (or a group member) to an unlimited contingent liability to support the CCP.^[6]

In ASX Clear (Futures), ADI (or related entity) status is a prerequisite for participation in the new OTC derivatives clearing service. ASX requires that OTC derivatives clearing participants are Australian ADIs, or subsidiaries. This requirement provides an additional level of comfort for the CCP (and the Bank as its overseer), since the participant is regulated directly by APRA. Potential OTC derivatives participants must be able to demonstrate to the satisfaction of ASX Clear (Futures) their ability to participate in the default management process, including any auction of a defaulting participant's positions. They are also required to have either minimum Tier 1 capital (if an Australian bank) of $50 million, or net tangible assets of $50 million. These requirements are significantly higher than those for futures participants. This is appropriate in light of the greater complexity of OTC derivatives markets, and the potential that a participant may be required to play a role in default management should a participant default occur.

In ASX Clear, ADI participation has been limited by risk-based capital requirements that apply to participants clearing cash equities or equity options (see discussion below), and which may not be appropriate for ADIs subject to a more comprehensive prudential capital regime. The only current ADI participant in ASX Clear is subject to an alternative capital regime that places reliance on compliance with the regime of a prudential supervisor, but during the Assessment period this alternative was only available to participants clearing futures transactions and not cash equities or equity derivatives. However, in August 2013, this alternative capital regime was extended to participants undertaking clearing activities for all products in ASX Clear. This is expected to support greater ADI participation in ASX Clear.

Review of risk-based participation requirements

At the end of the Assessment period, all but two of ASX Clear's 40 participants were subject to the risk-based capital regime.^[7] Under this regime, participants must hold sufficient ‘liquid capital’ to cover counterparty risk, large exposure risk, position risk and operational risk (the so-called ‘total risk requirement’).^[8] Participants are also required to maintain minimum levels of ‘core capital’: $5 million for participants that do not clear for other brokers; and $20 million for participants that offer third-party clearing services.^[9] These requirements have risen significantly in recent years from a core capital requirement of $100,000 for all participants prior to 2009. A further increase in core capital requirements to $10 million for participants that do not offer third-party clearing services has been under consideration for some time.

In the second half of 2013, ASX will be reviewing whether to implement the proposed increase in core capital requirements, in the context of a broader review of the risk-based capital regime. The increase in core capital requirements has been postponed on several occasions on the basis that there is insufficient depth in the third-party clearing market to accommodate smaller brokers. This is consistent with the recommendations of the Bank and the Australian Securities and Investments Commission (ASIC) in their 2009 ‘Review of Participation Requirements in Central Counterparties’, which concluded that an increase in core capital requirements to $10 million would be beneficial but should be implemented gradually to allow greater depth in the third-party clearing market to develop.^[10] In view of the repeated postponements of the proposed increase in core capital requirements, ASX intends to consult with participants later this year on whether to implement the increase. ASX will also be conducting a broader review of capital requirements across both ASX Clear and ASX Clear (Futures), which will seek to achieve greater consistency in approach across the two CCPs.

A related review will examine the role of the risk-based capital regime in light of the increase in NTA requirements in recent years, and consider the appropriateness of the risk-based formula used in quantifying the risks generated by the activities of larger participants in particular. Although the future role of the risk-based capital regime is subject to question, consideration will need to be given to how valuable information gathered by ASX under the risk-based capital regime may be retained. This information may remain useful for broader risk-monitoring purposes.

Monitoring indirect participation

The new FSS place obligations on the CS facilities to monitor and manage material risks associated with indirect participation. This is of particular importance to the CCPs, where the activities of a large indirect participant could increase the probability of a participant default if not appropriately managed. Under existing arrangements, ASX Clear (Futures) gathers information on indirect participation in the form of daily reports from participants that provide details of client contracts. These data are aggregated and reviewed on a daily basis, with particular regard to potential risks arising from unusual client activity around the expiry of futures options, including potential concentration of client activity. There are, however, some practical limitations with the use of these data for a comprehensive analysis of tiering; in particular, the account codes of an entity or related entities may vary from participant to participant. One solution that ASX Clear (Futures) has considered is the introduction of a suitable client indicator at trade level.

ASX Clear is able to gather information on indirect clearing of equity derivatives by virtue of the individually segregated account structure employed for these products. However, given the commingled account structure for cash equities, ASX is unable to separately identify client positions either at an aggregate or individual level. Enhancing ASX Clear's ability to routinely monitor indirect clearing of securities trades will depend, at least in part, on the outcome of its consultation on account structures (see Section 3.6.2). ASX Clear does, however, monitor potential risks arising from tiered participation arrangements in the third-party clearing market on an ongoing basis in the context of its regular engagement with participants, including third-party clearers. Over the Assessment period, the largest third-party clearer in the cash market represented a relatively small proportion of positions held at ASX Clear. Both CCPs have also conducted a broad review of concentration risk policies in order to identify triggers for further investigation of tiered participation arrangements and possible mitigants.

The SSFs do not bear financial risk exposures to their participants. Nevertheless, indirect participation arrangements have the potential to concentrate operational risks in direct participants. ASX Settlement operates separate participant identifiers for trades settled by settlement participants on behalf of other clearing or trading participants, allowing it to access information on such indirect participation arrangements. Since Austraclear settles for a wholesale market in debt securities, participation is generally direct, as evidenced by the relatively large number of Austraclear participants. Significant activity associated with indirect participation is likely to be recorded in sub-accounts that Austraclear is able to monitor.

3.5.7 Disclosure

All ASX CS facilities make publicly available their Operating Rules and Procedures and a range of additional information on risk management arrangements and other relevant information on activities. As part of its FSS disclosure requirements, each CS facility must also publish details of its operations in accordance with the CPSS-IOSCO Disclosure Framework for Financial Market Infrastructures.^[11] This is intended to ensure that ASX provides comprehensive and detailed disclosures regarding each facility, demonstrating how its governance, operations and risk management framework meet the requirements of the Principles. ASX has published an initial version of a combined disclosure document for all of its facilities, which outlines ASX's approach to meeting disclosure requirements, including a summary of ASX's self-assessment of how its CS facilities meet the applicable Principles. ASX will, however, need to update this document with more detail in order to fully satisfy its disclosure requirements. ASX intends to update the document to reflect information provided to the Bank through the annual Assessment process, adding greater detail on how the CS facilities meet the Principles and corresponding FSSs. ASX plans to update the document at least annually.

ASX also publishes a range of information on its website to meet other aspects of its disclosure requirements. Currently, this information is spread across a range of pages and therefore may be difficult for participants and other interested stakeholders to find and understand its context. The Bank has encouraged ASX to consider a more centralised approach to the presentation of information subject to disclosure requirements on its website.

3.6 Transitional Relief

Acknowledging that international guidance had yet to be finalised in respect of matters related to recovery and resolution of FMIs, and that certain changes required in relation to account segregation and liquidity risk could involve significant industry-wide or legislative change, the Bank granted transitional relief for 12 months in respect of a small number of sub-standards.^[12] The Bank has, however, made it clear to ASX that it is unwilling to extend the period of transitional relief for these sub-standards, except in exceptional circumstances. It is therefore anticipated that the sub-standards for which relief is currently available will become effective from 31 March 2014.

3.6.1 Recovery and resolution

In February 2012, the CFR recommended legislative change to strengthen regulatory powers in respect of FMIs.^[13] These recommendations include the capacity to appoint a statutory manager to a distressed FMI. In parallel, the Financial Stability Board (FSB) has been extending work on bank resolution to FMIs, and CPSS-IOSCO has been developing guidance on recovery plans and tools that a distressed FMI may utilise to restore its financial soundness.^[14] Resolution refers to actions taken by public authorities to either return an FMI to viability or facilitate its orderly wind-down, while recovery refers to actions taken by a distressed FMI itself to return to viability. In parallel, the Bank and other CFR agencies are supporting treasury work to develop a proposal for an FMI resolution regime consistent with international principles on recovery and resolution. From March 2014, the new FSS will place obligations on ASX CS facilities to develop and maintain a recovery plan, and support the taking of resolution actions by the Bank or other relevant authorities.

In principle, by executing an effective recovery plan, supported by provisions in its Operating Rules, an FMI should be able to restore its viability without the need for direct intervention by a resolution authority. To meet the requirements of the relevant standards when they come into effect, each ASX CS facility will need to prepare an appropriate recovery plan based on addressing identified scenarios that may threaten that facility's ability to provide its critical services as a going concern. For ASX Clear and ASX Clear (Futures), these plans will need to address very extreme scenarios under which the CCPs' financial resources are not sufficient to cover credit losses and/or liquidity obligations following a participant default. This will require the development of mechanisms that fully address any uncovered credit losses and replenish financial resources following a participant default, and fully meet any liquidity shortfall. Plans and mechanisms implemented to meet these requirements should be consistent with the forthcoming CPSS-IOSCO guidance on recovery planning. At a minimum, by the end of March 2014, ASX should have articulated a basic recovery plan and a timetable for enhancing that plan to fully comply with the relevant FSS requirements in light of the final CPSS-IOSCO guidance.

In addition, each ASX CS facility will be required to ensure that its operational arrangements are able to support resolution actions under the proposed Australian FMI resolution regime. During the 2012/13 Assessment period, the CS facilities introduced standard clauses into their agreements with service providers requiring that they give the Bank notice of any intention to terminate the agreement as a consequence of the facility's insolvency or failure to meet its obligations. This is intended to give the Bank an opportunity to take action to remedy the breach or otherwise ensure continued service provision under the proposed FMI resolution regime. ASX should review its operational arrangements more broadly to ensure that they are consistent with the form of the regime once finalised.

3.6.2 Segregation and portability

New sub-standards that come into effect in March 2014 will require ASX Clear and ASX Clear (Futures) to have in place account structures that support the segregation of client positions and collateral from participants' proprietary (‘house’) positions and collateral. In addition, the CCPs will be required to maintain effective arrangements for transferring client positions and collateral to another clearing participant in the event that their original participant was to default (known as portability). Together, these requirements are intended to provide additional protection to clients against the default of their clearing participant, and to provide CCPs an alternative to closing out client positions in the event of such a default. A change to legislation in July 2013 removed a key legal impediment to portability, by allowing a CCP to transfer client collateral without the need to seek approval from a defaulting participant's external administrator.^[15]

ASX has commenced work on two initiatives to bring its client account structures at each CCP into line with these requirements.

ASX Clear (Futures)

The existing account structure for futures products in ASX Clear (Futures) segregates client and house positions and collateral between a house account and a single omnibus account for clients, with margin applied to portfolios netted within each account. While this account structure achieves segregation, given the margining of client positions on a net basis in the omnibus account, there may be insufficient collateral to support the transfer of individual client positions to alternative clearing participants. Further, supplementary interpretation of the FSS issued by the Bank in the context of ASX Clear (Futures)' prospective application for recognition under EU regulation clarifies that where a CCP clears a range of derivatives products with different characteristics and for a variety of participant and underlying customer types (such as ASX Clear (Futures)), it should offer a choice of account structures, including individual segregation (see Section 3.7). In anticipation of this requirement, ASX sought market feedback on changes to derivatives account structures in late 2012, and in light of this feedback undertook to develop an alternative account structure for both futures markets and its proposed client clearing service for OTC derivatives, planned for introduction in the first half of 2014.

The alternative client account structure proposed for ASX Clear (Futures) provides the option of segregation of client positions on an individual client basis, with omnibus segregation remaining available to clients for which the costs of additional protection outweigh the benefits. Under the proposed ASX model for client clearing, client positions would be recorded against individual accounts, and a margin requirement calculated on a gross basis at the level of each client account. Margin posted by the participant on behalf of clients would be managed as a commingled pool of collateral by ASX Clear (Futures), but clients would be entitled to the full value of initial margin calculated against their positions in the event of a participant default. This supports portability by ensuring that clients would have sufficient collateral transferred with their positions to ensure that their full margin requirements could be met after transfer.

ASX will be seeking feedback from participants and clients on its proposed model for client clearing in ASX Clear (Futures) during the second half of 2013. It plans to introduce its new client account model for OTC derivatives and futures transactions in the first half of 2014. A second stage would consider arrangements to support the lodgement of excess collateral by clients.

ASX Clear

While ASX Clear offers individually segregated client accounts for derivatives transactions, consistent with the FSS, securities transactions are currently cleared via a single commingled house/client account for each participant. While acknowledging that the scope for transfer of client positions would be limited under any account structure due to the short (three-day) equity settlement cycle, ASX Clear's current account structure for cash equities does not provide the minimum level of segregation that the new FSS will require. In acknowledgement of this, ASX released a consultation paper in July 2013 seeking feedback on the existing single house account structure, and two further options: a client omnibus account and an individually segregated client account structure.^[16]

ASX's consultation paper noted the additional operational costs involved in maintaining individual client accounts, and a loss of netting efficiencies creating additional margin requirements and increased settlement obligations under either model of segregation. However, it also noted that the status quo alone was unlikely to provide the necessary degree of client protection to satisfy new FSS requirements. Stakeholders were asked to comment on their preferred model, as well as to provide details of operational implications. ASX will consider market feedback in the second half of 2013 and develop its proposals.

Both CCPs' liquid resources are currently sufficient to meet the required level of cover for liquidity exposures related to derivatives transactions under CCP Standard 7.3, which comes into effect in March 2014. However, in extreme but plausible market conditions, ASX Clear's liquid resources may not be sufficient to cover the single largest liquidity exposure to a participant and its affiliates arising from cash equity transactions. The size of this liquidity shortfall is potentially large – around $1.2 billion under current market conditions, and around $3 billion at the height of the global financial crisis in 2008. The reason for this large shortfall lies with a mismatch between the timing of payment obligations for securities purchases arising from a participant default, and the receipt of funds realised from the sale of the securities purchased by the CCP in such circumstances. This timing mismatch (typically three days in line with the equities settlement cycle) means that ASX Clear's liquidity exposure to participants in respect of cash equity transactions may be significantly greater than its credit exposure on the same transactions.

ASX Clear would currently address any liquidity shortfall by rescheduling trades. However, this will no longer be permitted under the new FSS requirements for liquidity risk management. ASX therefore consulted in July 2013 on a proposal under which it would enter into committed liquidity arrangements with participants that would replace the need to reschedule transactions. These arrangements would only be used once other liquid resources had been exhausted.

The proposed arrangements would allow the original trades of a defaulting participant to settle when due, but participants due to deliver securities under such trades would enter into a simultaneous stock repurchase arrangement (repo) with ASX Clear. This offsetting transaction would re-deliver to the participant the same securities that it delivered to ASX Clear, and would provide ASX Clear with the funds necessary to settle its payment obligation for the original trade. The offsetting transaction would unwind once ASX Clear was able to liquidate the securities and access the funds required to meet the defaulting participant's payment obligations (see Table 7). Accordingly, the proposed arrangements would replicate the economic effect of current rescheduling arrangements, but would explicitly recognise and formalise the role of participants in providing liquidity to ASX Clear to allow settlement to occur as scheduled.

In the period prior to new liquidity requirements coming into effect in March 2014, ASX plans to develop rule changes to implement committed liquidity arrangements, subject to feedback received from stakeholders during its consultation. It is proposed that the committed liquidity arrangements be governed by amended provisions in the rules of ASX Settlement, rather than via separate contractual arrangements with participants.

3.7 Recognition in Europe

Under the European Regulation on OTC derivatives, central counterparties and trade repositories (EMIR), which took effect in August 2012, non-EU CCPs that provide clearing services to participants established in the EU must obtain recognition from the European Securities and Markets Authority (ESMA). Since three of ASX Clear (Futures)' participants are branches of European headquartered banks, ASX Clear (Futures) must apply to ESMA for recognition by 15 September.

A prerequisite for recognition is that the European Commission (EC) deems the home regime of a CCP seeking recognition to be equivalent in terms of its regulatory framework and rules to that under EMIR. In order to inform its decision, the EC requested that ESMA provide it with advice on the equivalence of certain jurisdictions, including Australia. Accordingly, the Bank and colleagues from the other CFR agencies have for some months been assisting ESMA in the preparation of technical advice for EC on the equivalence of the Australian regime.

While the Bank considers that the EU regulatory framework for CCPs and that in Australia achieve equivalent regulatory outcomes, the technical standards issued by ESMA under EMIR are more detailed than the FSS. There are therefore some areas in which ESMA has sought additional clarification regarding how the Bank interprets the FSS. Accordingly, the Bank has issued supplementary interpretation of a subset of standards, by way of an exchange of letters with ASX.^[17] The letter notes that the supplementary interpretation would apply in the case of any domestically licensed derivatives central counterparty that provides services to participants established in the EU.

The letter also confirms that, given current facts and circumstances, the Bank believes that, in order to be assessed as observed in relation to a CCP Standard specified in column 1 of Table A1 in Appendix A, ASX Clear (Futures) will need to meet the requirements specified in the corresponding row of the second column of the table. The Bank has applied this interpretation of the relevant CCP Standards with effect from 16 August, and will formally assess ASX Clear (Futures) with reference to this interpretation in its published Assessment of ASX Clear (Futures) for the period 2013/14. This interpretation will hold unless and until the Bank notifies ASX Clear (Futures) in writing to the contrary, which the Bank reserves the right to do in response to relevant domestic or international developments.

Among the most substantive matters for interpretation is the requirement around the coverage of a CCP's financial resources. The relevant FSS require that a CCP considered to be systemically important in multiple jurisdictions maintain default resources and liquidity sufficient to cover obligations arising in the event of the default of its two largest participants (plus affiliates) in stressed circumstances. Under EMIR, this cover two requirement applies to all CCPs, whereas under the FSS the cover two requirement only applies to CCPs that are systemically important in multiple jurisdictions. The proposed supplementary interpretation clarifies that recognition requirements in other relevant jurisdictions, including the EU, would be taken into account (alongside other factors) in judging whether a CCP was systemically important in multiple jurisdictions, and therefore subject to cover two requirements. In anticipation of becoming subject to a cover two requirement, ASX recently completed a significant capital raising (see Section 3.5.1), and with effect from 16 August began testing the adequacy of its financial resources against a cover two benchmark.

Footnotes

The standards are available at <https://www.rba.gov.au/payments-system/clearing-settlement/standards/>. [1]

The CFR's advice on competition in clearing of the cash equity market is available at <http://www.treasury.gov.au/PublicationsAndMedia/Publications/2013/competition-of-the-cash-equity-market>. [2]

The Code is available at <http://www.asx.com.au/cs/documents/Code_of_Practice_9Aug13.pdf>. [3]

See <http://www.asx.com.au/cs/> for ASX's microsite. [4]

An exchange of letters between APRA and the Bank and ASIC can be found at <http://www.cfr.gov.au/publications/member-publications/pdf/letter-qccp-status-apra-response.pdf>. [5]

APRA's letter to ADIs is available at <http://www.apra.gov.au/adi/PrudentialFramework/Documents/130604-Letter-to-ADIs-re-CCPs.pdf>. [6]

Participants clearing futures only could elect to be covered by an alternative capital regime, either on a net tangible asset (NTA) requirement or compliance with the regime of a prudential supervisor. As discussed above, the latter alternative was extended to participants undertaking clearing activities for all products in ASX Clear in August 2013. [7]

‘Liquid capital’ is defined by ASX to comprise total tangible shareholders' funds held in liquid assets, net of any guarantees and indemnities. [8]

‘Core capital’ is defined by ASX to be the sum of: all paid-up ordinary share capital; all non-cumulative preference shares; all reserves, excluding revaluation reserves; and opening retained profits/losses, adjusted for current year movements. [9]

ASIC and RBA (2009), ‘Review of Participation Requirements in Central Counterparties’, March. Available at <https://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/consultations/review-requirements/rprcc-032009.pdf>. [10]

Available at <http://www.bis.org/publ/cpss106.htm>. [11]

Details of the scope of transitional relief granted may be found at <https://www.rba.gov.au/payments-system/clearing-settlement/applications/>. [12]

The CFR's letter to the Deputy Prime Minister and Treasurer is available at <http://www.treasury.gov.au/ConsultationsandReviews/Submissions/2012/Council-of-Financial-Regulators-Financial-Market-Infrastructure-Regulation>. [13]

See FSB (2011), ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’, October, available at <http://www.financialstabilityboard.org/publications/r_111104cc.pdf>; and CPSS-IOSCO (2013), ‘Recovery of Financial Market Infrastructures: Consultative Report’, August, available at: <http://www.bis.org/publ/cpss109.htm>. [14]

The relevant legislation amended Part 5 of the Payment Systems and Netting Act 1998. [15]

ASX's consultation paper, ‘Financial Stability Standards Implementation – the way forward’, may be found at <https://www.asxonline.com/intradoc-cgi/groups/derivatives/documents/communications/asx_037706.pdf>. [16]

The Bank's letter to ASX is available at <https://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/pdf/supplementary-guidance-domestic-derivatives-ccps.pdf>. [17]