2015/16 Assessment of ASX Clearing and Settlement Facilities 4. Special Topic – Default Management

Default management rules and procedures are developed by CCPs and SSFs to ensure that they could continue functioning in the event that a participant failed to meet its obligations, and to minimise the impact of such an event on the market.

In May 2015, ASX employed its default management procedures to address the default of BBY. ^[32] Overall, the incident was managed without any evident market impact from ASX's default management process, and all costs incurred by ASX in the course of the default covered by margin held. The event nevertheless highlighted several matters related to ASX's default management arrangements that were worthy of further consideration.

Accordingly, ASX initiated a review of experiences gained from the BBY default. The Bank's 2014/15 Assessment of the ASX CS facilities encouraged ASX to complete this review and to enhance its default management arrangements as appropriate. The Assessment also recommended that ASX update its DMF to reflect its new recovery plans, and to integrate the testing and review of the recovery plans into its broader arrangements for testing and review of the DMF. The Bank also undertook to continue monitoring the testing of default management procedures for OTC interest rate derivatives in ASX Clear (Futures).

This Section provides an overview of ASX's default management arrangements and assesses them against each of the sub-standards within the Standard on participant default rules and procedures in the FSS.^[33] The facilities are found to have observed all of the relevant requirements of the FSS. The Bank has nonetheless made a number of recommendations outlining further steps required for the facilities to continue to observe these requirements. The Bank has also identified some additional areas in which ASX should address some minor issues or could usefully enhance its default management approach in the spirit of continuous improvement. Many of the recommendations are consistent with ASX's plans to implement further refinements to its DMF. The ratings and recommendations are presented in Tables 9 and 10, and discussed in Section 4.8.

4.1 FSS Requirements

The key FSS requirements on default management arrangements are contained within CCP Standard 12 and SSF Standard 11 (set out in Tables 9 and 10). These requirements cover five main areas, summarised as follows:

• Rules and procedures. The ASX CS facilities should have powers under their rules and procedures to manage a participant default while continuing to meet any obligations to surviving participants. ASX should have prompt access to the financial resources and other tools that it maintains for meeting losses and mitigating liquidity pressures in an event of default. ASX's default rules and procedures should specify the order in which its financial resources would be used during the management of a participant default, and how these resources would be replenished (CCP Standard 12.1, SSF Standard 11.1).
• Governance and processes. ASX's default management plans should specify the roles, obligations and responsibilities of the parties involved in managing a default (CCP Standard 12.1, SSF Standard 11.1), and ensure that these parties are prepared to carry out their roles. This includes ensuring that the relevant parties have the appropriate tools and expertise to close out or otherwise manage the defaulter's positions (CCP Standard 12.2, SSF Standard 11.2).
• Testing and review. ASX should review and test its default management plan at least annually, and following any material changes to its rules and procedures or service offering. ASX should include all parties that would be involved in the default management process in the testing of these arrangements (CCP Standard 12.4, SSF Standard 11.4).
• Public disclosure. ASX should publicly disclose the key aspects of its default management plans in order to provide certainty and predictability to market participants regarding the actions it may take in a default event (CCP Standard 12.3, SSF Standard 11.3).
• Market impact. ASX should take into account the impact of its default management plans on all relevant financial markets (CCP Standard 12.5, SSF Standard 11.5).

4.2 ASX's Default Management Framework

ASX maintains a documented DMF, which provides guidance on the principles and procedures for managing the default of a clearing or settlement participant. The DMF, which includes the ASX Operating Rules and Procedures, is intended to be flexible, rather than prescriptive. It provides ASX with considerable discretion to adapt its response to every individual event of default based on its assessment of the specific facts and circumstances of that event.

4.2.1 Documentation

Each of the ASX CS facilities has powers under its Operating Rules and Procedures to deal with the default of a participant. The formal rules are supplemented by a collection of internal and public documents that also form part of ASX's DMF for the four CS facilities. This includes several documents that ASX has published on its website, which outline the key aspects of the default management approach for ASX Clear, ASX Clear (Futures) and ASX Settlement:

• a high-level overview of the default management process for exchange-traded products in ASX Clear and ASX Clear (Futures)^[34]
• the OTC Handbook, which explains the default management process for OTC derivatives^[35]
• a client fact sheet that outlines the segregation and portability arrangements in ASX Clear (Futures) and the rights of clients in the event of their clearing participant's default^[36]
• a Guidance Note on the suspension and termination of ASX Settlement participants^[37]
• guidelines on default management in ASX Settlement, including use of the back-out algorithm.^[38]

In 2015/16, ASX undertook a wide-ranging review of its DMF documentation. The new DMF documents, together with any relevant updates to the existing documentation, are due to be finalised in 2016/17 (see Section 4.7.2).

4.2.2 Roles and responsibilities

Ultimate responsibility for the oversight of risks faced by the ASX CS facilities lies with the CS Boards. In managing a participant default, the Boards delegate decision-making responsibilities to the Managing Director and CEO of ASX. The CEO's responsibilities include authorising the declaration of a default and approving the default management strategy to the extent that any actions taken do not incur losses of more than a pre-specified limit in excess of the defaulter's collateral. Actions that might incur losses beyond this approval limit would require approval from the CS Boards. This limit enables ASX management to respond quickly to a participant incident, while maintaining appropriate Board involvement and oversight of the process.

The DMF also assigns specific responsibilities in managing a participant default across a number of internal and external groups.

• Default Management Committee (DMC). The DMC convenes as required to coordinate ASX's response to a clearing participant default. The DMC is chaired by the Chief Risk Officer (CRO) and comprises senior management from ASX's operational, risk management, compliance and legal departments. The DMC's responsibilities include recommending to the CEO whether to declare a default, devising a risk reduction plan and coordinating the implementation of this plan.
• Participant Incident Response Committee (PIRC). The PIRC is responsible for monitoring and managing participant incidents across all ASX markets and CS facilities. Meetings of the PIRC are convened as required to address a participant incident. In the event of a potential default involving a clearing participant, the PIRC would escalate the matter to the DMC. The PIRC would continue to manage ASX's response in the event of a settlement-only participant default. The PIRC is chaired by the Group Executive, Operations and comprises a subset of the DMC members; this facilitates the continuity of action when an incident is referred to the DMC.
• Default Management Group (DMG). The primary role of the DMG, which is comprised of trading and risk experts from ASX's OTC clearing participants, is to advise the DMC on aspects of the management of an OTC participant default specified in the Operating Rules. Although the DMC is not obliged to follow the DMG's recommendations, it would be required to provide reasons where it did not accept such advice. DMG members are also tasked with periodically convening to test and review the OTC default management process. This includes taking part in regular default management ‘fire drills’ (see Section 4.6.1). DMG members are required to abide by the DMG Code of Conduct, which seeks to mitigate potential conflicts of interest and duty, and ensure confidentiality and best execution in the default management process.
• Default brokers. ASX's nominated default brokers would execute the close-out and hedging trades in exchange-traded products on behalf of the CCPs. The DMC may also choose to consult with the default brokers when determining the appropriate close-out strategy for a defaulter's portfolio. ASX currently has two default brokers, which are selected based on factors such as market share, creditworthiness and the ability to execute trades on behalf of both CCPs (i.e. authorised participants of the ASX, ASX 24 and Chi-X markets).

The Default Management Steering Group (DMSG) is responsible for identifying potential enhancements to the DMF through regular review and testing, and monitoring the implementation of any enhancements that are approved by the CS Boards.^[39] Membership of the DMSG is similar to that of the DMC. The DMSG meets on a regular basis. Specific reviews of the SSF default management documents are carried out by the Settlement Risk Policy Committee on at least an annual basis.

4.3 Establishment of an Event of Default

Each ASX CS facility's Operating Rules set out the circumstances in which it may declare a participant to be in default, or when it may otherwise impose restrictions on a participant's rights and activities. In the case of clearing participants, these include scenarios in which a participant becomes subject to external administration, is unable to fulfil the obligations arising from its open contracts, defaults at another exchange or CS facility, or breaches the CCP's risk-control requirements. An event of default may also arise where the CCP suspects that a participant would not be able to fulfil its obligations or otherwise comply with the CCP's rules. The CCPs' participants are obliged to inform ASX immediately if an event of default has occurred or may reasonably be suspected to occur.

ASX's response to a potential clearing participant default would depend on whether the incident was a financial, operational or other compliance breach. This differentiation appropriately reflects the severity of the breach and potential consequences of declaring an event of default.

• A financial breach arises when a participant is unable to meet its existing financial obligations, or there is considerable uncertainty about the participant's ongoing ability to meet such obligations.
• An operational breach occurs when a participant has sufficient assets to meet its obligations but is unable to settle these obligations due to a technical or operational failure.
• Other compliance breaches may result from a participant's failure to otherwise comply with the CCP's Operating Rules.

Similarly, the ASX Settlement Operating Rules set out a number of events of ‘non-compliance’ in which ASX may suspend, terminate or impose restrictions on a settlement participant. These events include entry or anticipated entry into external administration, a significant breach of the Operating Rules, failure to comply with other legal or regulatory obligations, and failure or expected failure of a Payment Provider to authorise the participant's net payment obligation. Provisions in the Standard Payment Provider Deed also allow ASX Settlement to suspend a Payment Provider in similar circumstances. The Austraclear Regulations allow ASX to suspend or terminate an Austraclear participant or Participating Bank that has or is likely to become insolvent, or otherwise fails to comply with the Regulations. ASX Settlement participants are obliged to inform ASX immediately if an event of non-compliance has occurred, while Participating Banks, Austraclear participants and Payment Providers must give notice to ASX if an event of insolvency.

Participant ‘incidents’ (i.e. any financial, operational or compliance breaches) would generally initially be monitored and managed by the PIRC. If the PIRC determined that an incident involving a clearing participant was likely to lead to an event of default, the incident would be escalated to the DMC; potential defaults of settlement-only participants would continue to be managed by the PIRC.

Declaration of default would never be automatic. Instead, ASX maintains the right to investigate the incident first, taking into account the severity of the breach, the potential consequences of declaring an event of default, and any extenuating circumstances. This allows ASX to consider alternative approaches to handling the incident, such as working with the participant to restore viability or implementing an orderly wind-down plan. ASX may impose conditions on a participant during its investigation; these may include restricting the participant's activity, calling for additional collateral, and/or requesting Directors' Solvency Statements.

Should ASX determine to declare an event of default or otherwise suspend or terminate a participant, it would immediately notify the Bank and ASIC, and a market notice would be issued as soon as possible. In the event of an OTC participant default, ASX Clear (Futures) would convene the relevant DMG. As part of its default management process, ASX would develop a communication plan to ensure that the appropriate information was disclosed to all relevant stakeholders throughout the event.

4.4 Default Management of a Clearing Participant

The CCPs' overarching objective in handling a participant default is to minimise the impact of the event on ASX, its non-defaulting participants and the broader market. The CCPs' Operating Rules and Procedures allow ASX to take a variety of actions to close out or otherwise manage the positions of a defaulted participant, and establish the order in which ASX would use its available financial resources to meet any losses or liquidity pressures arising during the default management process. ASX's internal policies and procedures provide further guidance on each stage of a default, including the identification of a default event and the management of the defaulter's positions.

4.4.1 Management of a defaulted participant's portfolio

Following a declaration of default, ASX may suspend the defaulted participant and restrict its access to trading, clearing, settlement and payment systems. Suspension, rather than termination, ensures that the participant remains bound by the CCP's Rules. With a stable set of positions and collateral, the CCP would proceed rapidly to generate detailed account-level position data as a basis for the close-out process.

Recommendations on the appropriate close-out strategy would be submitted by the DMC to the appropriate delegate(s) for approval. The DMC may have regard to matters such as the composition of the defaulter's portfolio and the client account structure, as well as any legal or operational impediments. The DMC may also consider factors such as market conditions, potential contagion and systemic risk implications, and the impact on the CCP's risk profile and financial standing. ASX's internal policies and procedures provide further guidance on the various alternative methods for managing the CCP's exposures arising from the default, including the feasibility of execution and associated costs and benefits. ASX may also consult with its default brokers and the DMG in determining the appropriate close-out strategy.

Position transfer

Where practicable, ASX would seek to transfer, or port, the defaulted participant's clients to another participant. Porting mitigates the costs and potential market disruption associated with the close-out process, provides continuity of positions to the end client, and may reduce ASX's exposure.

A key determinant of the likelihood of portability is the client account structure. The individually segregated account structure offered to derivatives clients at both CCPs supports portability, since it enables the transfer of individual client accounts on a fully collateralised basis. However, the majority of clients of ASX Clear (Futures)' participants have chosen to continue to clear via an omnibus account, and ASX Clear uses a commingled house and client omnibus account structure for all cash market transactions. Since positions in omnibus accounts are margined on a net basis, a fully collateralised transfer of an individual client's positions would be unlikely.^[40] ASX would manage a defaulted participant's omnibus account as a single account – that is, no individual client within an omnibus account would be transferred separately from the others. Since porting requires the consent of the receiving participant and each individual client, the simultaneous transfer of a large number of clients would be challenging.

Even for individually segregated client accounts, however, portability cannot be guaranteed since it relies on clients having established arrangements with alternative clearing participants and the willingness and capacity of those participants to take on the affected clients within a short period. Until the defaulted participant's client positions are ported or closed out, the CCP would remain exposed to market risk. ASX Clear (Futures) has therefore established windows of up to 24 and 48 hours for the porting of individually segregated exchange-traded and OTC derivatives clients, respectively. ASX retains the flexibility to close or extend these porting windows based on market conditions and the likelihood of successful transfers. Although there is no prescribed porting window for ASX Clear, it would be expected to be similarly limited to a one- or two-day period. Given the short porting windows and the impediments to client transfers (see Section 4.7.1), ASX would be unlikely to attempt to transfer clients that did not have prearranged ‘back-up’ clearing arrangements in place at the time of default. Client positions that could not be transferred within the permitted timeframe would be managed alongside those of the clearing participant.

Management of positions in exchange-traded products

Under their Operating Rules, the ASX CCPs are able to employ a number of methods to manage its exposure from the positions of a defaulted participant and its remaining (i.e. non-ported) clients, and restore a ‘matched book’. The primary methods for exchange-traded products include settlement of the defaulted participant's outstanding cash equity transactions, exercise or expiry of contracts, and on- or off-market liquidation.

• Settlement. ASX may seek to carry the defaulted participant's unsettled cash equity positions through to settlement. This would be possible only if: the defaulter was a net receiver of funds in the batch or had approved funding in place for its net payment obligation; the securities were available; and the participant had the operational capacity to continue with settlement. In addition to mitigating the potential market impact from liquidation, this approach may reduce the disruption caused by altering the net settlement obligations of surviving participants if the defaulted participant were not to proceed with settlement (see Section 4.5.1).
• Expiry and exercise. ASX may carry through to expiry positions in out-of-the-money ETOs that have minimal time value. ASX may also choose to exercise particular derivatives positions, although it would have to assess carefully any obligations that this would establish for the CCP and/or the defaulter's clients.
• Liquidation. Remaining positions in exchange-traded products would typically be liquidated, or closed out, by entering into equal-but-opposite transactions. This eliminates the CCP's ongoing exposure to market risk on those positions. On-market liquidation trades would be executed by a default broker on behalf of ASX. ASX could also enter into off-market trades, although this would generally be reserved for extreme circumstances since it would require greater assessment of counterparty risk and may lead to greater pricing scrutiny.

Prior to liquidating a defaulter's remaining positions, ASX may obtain a net position in each security or contract by ‘matching-out’ offsetting positions across all of the defaulter's remaining client and house accounts. Netting down positions allows for faster execution and lower transaction costs, and mitigates the potential market impact arising from the close-out process. ASX has an established process for the allocation of close-out prices where positions have been netted across separate accounts to ensure the equal treatment of clients holding the same positions.

Hedging and auction

ASX Clear (Futures)' preferred approach for managing the default of an OTC derivatives clearing participant is through a process of hedging the defaulter's OTC portfolio (including any portfolio-margined futures), and then auctioning the hedged portfolio to non-defaulting participants. This reflects the structure of the OTC market and the more complex product and risk characteristics of OTC derivatives. The DMG would advise ASX on the OTC default management process and assist ASX in executing the hedging transactions.

Hedging

Following the suspension of a defaulted OTC participant, ASX Clear (Futures) may terminate the open OTC positions of the defaulted participant and its non-ported clients, and immediately move to hedge its exposure. The DMG would develop recommendations for an appropriate hedging strategy, balancing precision against factors such as the speed and cost of execution. Since the hedged portfolio would eventually be auctioned to an OTC participant, hedging instruments are limited to exchange-traded and OTC products cleared by ASX Clear (Futures).

The hedging strategy proposed to the DMC may include details of the recommended hedges and priority of execution, as well as indicative pricing quotes obtained from non-defaulting participants. Following approval from the DMC, the DMG would begin to execute the strategy. The DMC would continue to review the strategy during its execution, and may implement further iterations to the strategy as required. A key objective of hedging is not only to reduce ASX's immediate exposure, but also to promote a successful auction outcome. Since any remaining risk in the portfolio would be assumed by the auction winner, ASX would expect to consider the trade-off between the amount of residual risk in the portfolio and the competitiveness of auction bids that it would be likely to receive.

Ideally, hedging would take place as soon as practicable following a default. Although the DMG is required to convene within two hours of notification by ASX, even this timeframe could impede the rapid neutralisation of risk. ASX is examining the possibility of developing a standing ‘hedge recommendation’ by the DMG, which would specify a predetermined approach to the macro hedging stage. This would allow ASX to begin executing hedge transactions immediately upon declaration of a default, leaving the DMG to make recommendations on the appropriate micro hedges at a later stage.

Auction

Following execution of the hedging strategy, the DMC would expect to proceed to the auction stage. Since hedging would have reduced much of its exposure, ASX would have some flexibility around the timing of the auction, taking into consideration efficiency and liquidity.

All OTC clearing participants that have positions in the relevant products are required to bid in the auction of a defaulter's portfolio. To incentivise competitive bidding, ASX uses a ‘juniorisation’ mechanism. This determines the order in which surviving participants' default fund contributions would be applied if default losses exceeded the defaulter's collateral and the first tranche of ASX capital. The order of application is related to the competitiveness of participants' bids.

The chosen auction format would seek to maximise participation, and provide efficiency and predictability for surviving participants. There are several methods for conducting the auction.

• The defaulter's portfolio could be auctioned off in a single pool to the highest bidder, or split into multiple identical units auctioned to several bidders. In the latter case, the degree of juniorisation would be based on the lowest bid submitted by the participant for any unit.
• Alternatively, the defaulter's portfolio could be broken up into separate pools with specific characteristics (such as by currency, product, tenor or trade volume). Each pool could then be auctioned off in a single unit or multiple identical units. The degree of juniorisation would be based on the ranking of bids in each pool, weighted according to the relative risk of each pool.

The DMG can make recommendations to the DMC on the terms of the auction, including the timing, format, and the minimum bid threshold. The DMC is responsible for finalising the auction strategy and, on the day of the auction, examining the bids and determining the auction winner(s). The auction winner would be notified immediately following the end of the auction, and the auction portfolio would be transferred to that participant's account.

In certain circumstances, the DMC may choose to declare that the auction has failed. These include situations in which all submitted bids were below the reserve price set by the DMC, where the highest bid would result in losses beyond ASX's available financial resources, or there was evidence of errors or other irregularities that may have affected the auction result.

Hedging of exchange-traded derivatives exposures

ASX may also choose to hedge a defaulted participant's positions in exchange-traded products in order to reduce its exposure to market volatility during the close-out period, or where it may be unable to close out the risk of that portfolio in a reasonable timeframe. Since hedging imposes additional obligations on the CCP, an exit strategy from both the existing positions and the hedge transactions would need to be determined as part of the formulation of the hedging strategy.

Termination

In the event that the CCP could not manage its exposures arising from the default using the standard processes listed above, ASX's recovery arrangements would allow the CCP to restore a matched book through a process of partial termination of positions held by non-defaulting participants in the relevant products or contracts (on a pro rata basis to the extent practicable). As a last resort, ASX would have the power to restore its matched book through complete termination of all open contracts.^[41]

4.4.2 Use of financial resources

While managing an event of default, a CCP must continue to meet its payment obligations to surviving participants. This requires having reliable access to the financial resources and tools it maintains to meet any liquidity exposures and close-out losses that may arise in such an event.

ASX would allocate any losses it incurred while managing the default of a clearing participant to the CCP's default waterfall. In the first instance, ASX would meet losses or obligations arising from the default using collateral lodged by the defaulted participant. Losses incurred on a client account may be covered by that client's collateral; where the client's collateral was insufficient to meet losses on its account, the participant's collateral would be used to cover the shortfall.

The DMC would provide recommendations on an appropriate strategy for the realisation of non-cash and foreign currency collateral. Although non-cash collateral would typically be liquidated after the losses on individual accounts had been quantified, ASX retains the discretion to liquidate collateral at any stage in the default management process, taking into account factors such as forecast cash requirements and the market risk of the non-cash collateral pool.

In the event that the collateral lodged by the defaulted participant, including its contribution to the default fund, was insufficient to cover the losses stemming from the default, the CCP could draw upon the remainder of its prefunded pooled financial resources (see Section 3.3.3 and Appendices A1.1 and A1.2, CCP Standard 4.4). In the event that these prefunded resources were exhausted, each CCP would have the power to allocate any further losses to non-defaulting participants via its recovery tools (see Section 3.3.6 and Appendices A1.1 and A1.2, CCP Standards 4.8 and 7.9).^[42] These tools include Recovery Assessments and, for ASX Clear (Futures), the haircutting of outgoing payment obligations to participants. As a last resort, the CCPs could also allocate losses by reducing settlement payments in the context of complete termination of all open contracts. In 2015/16, ASX implemented an enhanced approach for replenishing the CCP default funds in the event that these were drawn upon during the management of a participant default (see Box A).

Prior to completion of the default management process, any losses resulting from the liquidation of the defaulted participant's positions – including any hedging, auction or other execution costs – would need to be allocated to the appropriate accounts of the defaulted participant at the CCP.^[43] Losses incurred on a client account may be covered by that client's collateral; where the client's collateral was insufficient to meet losses on its account, the participant's collateral would be used to cover the shortfall. ASX would provide a detailed financial reconciliation of the liquidation process to the defaulting participant or its external administrator. Following completion of the default management process, ASX would initiate a formal review of the actions taken during the default management process.

4.5 Default Management of a Settlement Participant

ASX's approach to managing the default of an ASX Settlement or Austraclear participant would be guided by the Settlement Default Management Policy and associated standards and procedures. An event of default of a settlement participant that is also a clearing participant would be managed under the clearing participant default management framework (as described in Section 4.4).

Under the Settlement Default Management Policy, a key objective for ASX in managing a participant default is to minimise disruption to the stability and efficiency of the settlement process. ASX Settlement and Austraclear are not exposed as principals to risks in the settlement process and would not be required to meet any obligations on behalf of a defaulted participant in the SSF. Many of the actions taken by the SSFs to manage a participant default are therefore largely procedural in nature. Such a default could, however, affect other ASX participants that relied on the defaulter to effect payments or settlements as an agent on their behalf. In managing a default, the ASX SSFs must therefore take into account the potential impact of any known interdependencies between the defaulter and other ASX participants.

4.5.1 Suspension and termination

If a SSF participant experienced an event of default or non-compliance, ASX would have the discretion to suspend, terminate or restrict the participant's access to the relevant settlement system. This power applies to settlement participants in both SSFs, as well as Payment Providers and Participating Banks. A suspended participant would no longer be able to settle transactions through the relevant facility, and ASX may cancel any of its outstanding non-novated instructions scheduled for settlement. Following termination, all access to the SSF would be removed. Neither suspension nor termination would affect the participant's outstanding obligations to the ASX CS facilities.

Effect on securities holdings

A suspended or terminated ASX Settlement participant is unable to effect transfers of any securities holdings on the CHESS sub-register, including those of its sponsored clients, unless permitted by ASX. In the event of termination, ASX Settlement would remove all of the participant's sponsored securities holdings from its control. In order to allow clients to access their securities, ASX may either transfer their holder identification numbers (HINs) to an alternative settlement participant or convert their securities holdings to issuer-sponsored.^[44] The Operating Rules lay out the process for notifying the defaulted participant's clients of these options.

In the case of a suspended ASX Settlement participant, clients may submit a request to ASX to have their CHESS holdings either converted or transferred to another participant. In the absence of any instructions from the client, and after giving sufficient notice, ASX Settlement may convert the holdings to issuer-sponsored.

Under the Austraclear Regulations, a suspended or terminated Austraclear participant must immediately withdraw its securities from the SSF and make alternative holding arrangements.

4.5.2 ASX Settlement default management process

ASX Settlement performs its cash and securities settlements in a daily multilateral net batch. If a participant was unable to settle its scheduled obligations, including in the event that it was suspended from the SSF, ASX Settlement could remove some or all of that participant's settlement instructions from the daily batch using its ‘back-out algorithm’. If the failed instructions related to a shortfall of funds, the algorithm would remove instructions from the batch that reduced the participant's payment obligations to zero or a small receipt. Failed instructions arising from a securities shortfall would be rescheduled for settlement on the next settlement day. The back-out process is outlined in ASX Settlement's Operating Rules and Procedures.

The back-out algorithm is an important tool used in the management of ASX Clear participant defaults. In the event that the defaulted participant had a net payment obligation, ASX Clear would first consider injecting liquidity to ensure the settlement of novated trades. If it was not possible or prudent to rely solely on available liquid resources, ASX would use the back-out algorithm to identify instructions to be settled by means of OTAs with participants that were due to deliver securities.^[45]

The back-out algorithm removes settlement instructions according to a predefined set of rules, which are designed to avoid increasing other participants' net payment obligations, minimise spillovers to other participants, and maximise settlement values and volumes. Non-novated instructions would typically be backed out first. Hence, while ASX Settlement is not exposed to financial risk from a participant default, the use of the back-out algorithm to reconstitute the batch prior to settlement could alter the obligations of surviving participants. Notwithstanding that the algorithm aims to minimise flow-on effects, the use of OTAs may also impose liquidity pressures on surviving participants.

Further interdependencies may arise in the event of default of a Payment Provider. Commercial bank Payment Providers are used by ASX Settlement participants to effect money settlements on their behalf. If an ASX Settlement participant's Payment Provider was suspended, the participant would be unable to settle its payment obligations until it had established arrangements with a new Payment Provider. Since this would constitute an event of default, ASX may also suspend the settlement participant, at least until new payment arrangements were in place.

4.5.3 Austraclear default management process

The settlement of transactions in Austraclear is on a real-time gross basis. The majority of Austraclear transactions involve the simultaneous transfer of cash and securities between the buyer and seller on a trade-by-trade basis. Austraclear can also be used to settle individual payments or deliver securities free of payment. This settlement model ensures that unintended credit risks do not accumulate between participants during the settlement process. Furthermore, Austraclear does not extend credit to participants or provide a settlement guarantee. Accordingly, Austraclear is not exposed to financial obligations arising from the default of a settlement participant.

Since transactions are settled individually, suspension of an Austraclear participant would not prevent other Austraclear participants' transactions from settling. In the event of a default, Austraclear has the ability to suspend a participant, which would prevent any further transactions from settling. The actions involved in suspending a participant would be taken by the relevant business units.

The default of a Participating Bank in Austraclear, however, could have flow-on effects for other ASX participants. Austraclear participants that are not eligible to hold an Exchange Settlement Account (ESA) at the Bank may nominate a Participating Bank to act as an agent for money settlements on their behalf. In the event that an Austraclear participant's Participating Bank was suspended, that participant may also be suspended until it could establish alternative payment arrangements. If a clearing participant had been using the suspended Austraclear participant as an agent for making margin payments to the ASX CCPs, this suspension could in turn trigger an operational default of that clearing participant (which would be dealt with separately by the DMC).

4.6 Testing and Review

ASX has a testing program in place and reviews the effectiveness and appropriateness of its default management procedures. Responsibility for testing, reviewing and updating the DMF for the CCPs lies with the DMSG and with the Settlement Risk Policy Committee for the SSFs. Formal reviews are carried out at least annually and following any material changes to ASX's rules, procedures or service offering. The primary method of testing the DMF for the CCPs is through regular in-house default management fire drills. ASX may also identify potential enhancements to the DMF through feedback from ASX participants and the Risk Consultative Committees, as well as through experiences gained from actual default events. Changes to the DMF are submitted to the CS Boards for approval.

In recent years, the DMF has been updated on several occasions:

• in 2011/12, to incorporate experience gained from the default of MF Global
• during 2012/13, in anticipation of the launch of the OTC derivatives clearing service
• in 2014, to account for the implementation of OTAs in ASX Clear, new client segregation arrangements and the juniorisation mechanism
• in 2016, to reflect ASX's new recovery planning arrangements, the experiences gained from the BBY default, and learnings from the 2016 fire drills.

A further update is expected in due course to reflect the introduction of the proposed special resolution regime for FMIs.

4.6.1 Fire drills

ASX conducts regular fire drills to test the effectiveness of its default management arrangements and identify areas in which the DMF should be refined. The drills aim to ensure that the relevant ASX personnel, as well as external stakeholders who would be involved in the event of an actual default, are familiar with the default management process and prepared to carry out any discretionary procedures. To date, fire drills for the OTC derivatives clearing service have focused on the role of the DMG, with each OTC participant directly involved in the simulations of the hedging and auction stages. This year's fire drills also tested the decision-making of the DMC based on the advice of the DMG. In contrast, fire drills for exchange-traded products consider only the role of the DMC, without any direct involvement of participants. ASX nevertheless seeks to verify the compatibility of its default brokers' systems by sending a sample order file that would be used to execute close-out trades to each broker following the fire drill.

Fire drills are conducted on an annual basis for each of ASX's major clearing services. ASX discusses the results of the fire drills and any recommended enhancements with its Risk Consultative Committees and the Bank. Among recent enhancements, ASX has completed work to provide DMG members with access to additional reporting and system functionality and to improve the clarity of the auction process. ASX is also working with the DMG to develop a predetermined macro hedging strategy that could be initiated immediately upon the declaration of an OTC participant default.

ASX expects to continue increasing the complexity and diversity of its fire drill scenarios, building up a library of scenarios that test different aspects of the default process. The 2015/16 fire drill for exchange-traded products, for example, was used to test ASX's new recovery arrangements; this was consistent with the Bank's 2014/15 recommendation that ASX integrate the testing and review of its recovery plan into its broader framework for the testing and review of the DMF.

4.6.2 Actual defaults and participant incidents

ASX's default management arrangements have recently been tested in the context of the defaults of BBY in May 2015 and MF Global in November 2011. In accordance with its review policy, ASX undertook assessments of the experiences gained from each of these events, and has subsequently implemented a number of enhancements to the DMF. A number of other participant incidents in recent years have also tested the ASX Settlement and Austraclear default management procedures.

BBY Limited default

In May 2015, ASX Clear employed its default management procedures in response to the appointment of an external administrator to BBY.^[46] BBY's entry into administration occurred two weeks after BBY missed the deadline for an AIM call. This ‘early warning’ gave ASX time to work with BBY to start managing down its clearing business. By the time the default was called, BBY had closed out or transferred client positions representing around a third of its derivatives exposures.

ASX managed the default through a combination of client transfers (where these had already been sufficiently advanced prior to the declaration of default) and the close out or expiry of remaining derivatives positions. Unsettled cash equity positions were closed out since BBY's administrators did not consent to ASX carrying these positions through to settlement.

Upon notification of the appointment of external administrators to BBY, Austraclear placed restrictions on and subsequently suspended BBY's participant status in the SSF. Following discussions with BBY's administrators, ASX initially placed restrictions on BBY's access to ASX Settlement rather than suspending BBY as a participant. This allowed BBY's administrators to process within CHESS client instructions for securities holdings to be transferred to alternative participants or converted to issuer-sponsored holdings, while prohibiting BBY from participating in the settlement process. ASX Settlement ultimately suspended BBY six weeks later.

Overall, the incident was managed without any evident market impact from ASX's default management process, and all costs incurred by ASX in the course of the default covered by margin held. ASX nevertheless identified a number of experiences gained from the event, including in relation to both its risk and default management processes. ASX has begun to implement enhancements to its DMF accordingly (see Section 4.7.1).

MF Global default

In November 2011, ASX managed the defaults of three MF Global subsidiaries, which entered into external administration following the default of their parent company.^[47] In light of widespread concerns about the financial viability of MF Global in the week leading up to the default, ASX imposed conditions on the subsidiaries that participated in its CCPs. Some MF Global clients also began to move their positions to other participants.

MF Global UK, an ASX Clear (Futures) participant, was the only subsidiary with open positions at either CCP at the time of the default. Although ASX was quickly able to close out the broker's outstanding equity and interest rate derivatives positions, MF Global held a dominant share of the open interest in ASX grains and wool futures. ASX suspended trade in these futures products on the day of default to prevent a disorderly market, and subsequently closed out the positions over the course of the following week. All of the losses incurred by ASX in the close-out process were covered by initial margin held. On the day of default, ASX also suspended MF Global's participant status in ASX Settlement and Austraclear.

This was the first clearing participant default faced by the ASX CCPs. One of the key issues highlighted by the event was the complexity of client portability and the various impediments to this process. ASX has since reviewed the circumstances under which it would attempt to port a defaulted participant's clients and made a number of enhancements to its segregation and portability arrangements.

Other participant incidents

There have also been a number of other participant incidents in recent years that have tested the default management arrangements of ASX Settlement and Austraclear.

• On 29 January 2008, Tricom Equities Limited (Tricom), an ASX Clear and ASX Settlement participant, failed to meet its payment obligation into the CHESS batch. ASX Settlement used the back-out algorithm to recalculate the batch, removing a number of off-market transactions under which Tricom was due to receive securities. This left Tricom a small net receiver of funds. A similar issue arose on the following day, although Tricom's Payment Provider ultimately agreed to fund the position.

  Based on the circumstances of the incident, ASX had decided not to declare an event of default. Instead, ASX imposed conditions on Tricom's participation in ASX Clear and ASX Settlement, and worked with the participant to restructure its operations and management. Tricom was also required to commission an independent review of its internal compliance and risk controls, and implement any recommended enhancements. While ASX also imposed a fine on Tricom, it noted that no clients or third parties were adversely affected by the event except the counterparties to the failed settlements in the batch.

• Austraclear has suspended and terminated a number of participants in recent years, either where the participant had experienced an insolvency event or otherwise failed to meet its obligations as a participant. Austraclear has, on occasion, delayed suspension of a participant that had entered external administration, where the administrators were willing to continue meeting that participant's obligations.

4.7 Planned Developments

Reflecting the experiences gained from the fire drills and events of default over recent years, ASX has continued to refine its DMF, and has identified a number of areas in which it plans to make further enhancements. The key planned developments include examining potential improvements to the porting and close-out processes, enhancing the DMF documentation and participant education, and developing additional default management capabilities within its new risk management systems.

4.7.1 Effectiveness of the default management processes

Effectiveness of portability arrangements

The BBY and MF Global experiences demonstrated that the transfer of a client's positions, HINs and collateral could take around 2–3 weeks to arrange. The main impediments to porting are the time required for receiving participants to complete both the regulatory due diligence (i.e. ‘know your customer’) requirements and their own assessment of the client's financial risk, as well as the considerable manual processing and documentation involved. Porting a defaulted participant's clients may therefore not be possible if transfer arrangements had not already been pre-positioned prior to the default. Although many institutional ETO clients already have back-up clearing arrangements, the cost of maintaining client accounts limits the availability of such services for retail clients. Furthermore, even where a client has established back-up clearing arrangements, the back-up participant may be unwilling or unable to take on the positions in the specific circumstances. Another issue that may arise is an absence of suitable transferee participants.

Accordingly, ASX has begun to consider how transfer arrangements could be enhanced to assist in the efficient porting of clients in an event of default. This includes examining ways to improve the operational efficiency of the portability process. ASX also plans to examine how the CHESS replacement system and the new Customer Portal could be used to facilitate portability.

Operational efficiencies

The BBY default highlighted some of the operational difficulties that can arise in the default management process, particularly where there are a large number of individual accounts or ETO positions that need to be closed out. While default brokers are able to close out many futures and cash equity positions via algorithmic trading strategies, ETO positions are generally closed out manually. In light of the BBY experience, ASX has indicated that it would be likely to use both of its default brokers to expedite the close-out process. ASX also plans to appoint a third default broker for the major markets that it clears to provide extra protection against the risk that one of the default brokers was itself the defaulting participant. ASX is also examining the possibility of auctioning large or complex ETO portfolios, particularly where a portfolio might otherwise take an unreasonably long time to close out.

ASX is also examining ways in which its new risk management system could be used to facilitate, and mitigate risks arising in, its default management processes, as well as considering developing guidelines for the treatment of specific cover positions for incorporation into the DMF.^[48]

Legal impediments

The two ASX participant defaults have drawn attention to the legal restrictions on dealing with the assets and liabilities of an entity under external administration. These restrictions could limit the options available to ASX in managing a participant default. There was also a concern that the PSNA, which protects the finality of cash equity settlements in ASX Settlement (see Appendix A2.1, SSF Standard 1.2), did not extend to the settlement of outstanding obligations by a participant under administration. Without the consent of the participant's administrator, such settlements could potentially therefore have been challenged and unwound, which would have been highly disruptive to the market.

In order to mitigate such legal risks, ASX proposed that the PSNA be amended to provide CS facilities that operate approved netting arrangements, such as ASX Settlement, with the legal basis to proceed with the settlement of outstanding netted obligations by a participant under external administration without the administrator's consent. This proposal was taken forward by the government as part of the Resilience Act, which was passed by Parliament in May 2016. ASX is also considering engagement with professional associations to educate insolvency practitioners about the default management processes of CCPs and SSFs, in an attempt to assist their decision-making on such matters in the event of a participant default.

4.7.2 Revision of DMF documentation

In 2015/16, ASX undertook a wide-ranging review of the DMF documentation related to its CCPs. The review was intended to enhance the accessibility of the DMF and align it with ASX's broader risk management framework, taking into account ASX's new suite of recovery tools and learnings from the BBY default and recent fire drills. The new and updated documents are due to be finalised in 2016/17, following the incorporation of any learnings from the 2016 fire drills and approval by the CS Boards.

ASX also carried out its annual review of the SSFs' overarching Default Management Policy and Standards in early 2016. ASX has indicated its intention to carry out further work on updating the SSF default management procedures documentation and enhancing its public disclosures on the SSF default management process during the coming Assessment period. This will include publishing a Guidance Note on the suspension and termination of an Austraclear participant.

4.7.3 Participant education and disclosures

As part of its broader review of the DMF, ASX is enhancing its published information on default management. The BBY default highlighted the potential benefit of increasing clients' awareness of both their exposure to their clearing participant and the actions that could be taken by ASX in the event of that participant's default. Greater awareness could support default management processes, since certain actions may require client consent (including the transfer of positions and collateral to another participant). Accordingly, ASX plans to update and expand the suite of disclosures published on its website. ASX has also launched a public education initiative, which is aimed at promoting a deeper understanding among market participants about the role of the CCPs and their risk and default management arrangements. Consistent with recommendations in the Bank's 2014/15 Assessment, ASX has also developed participant disclosures on the potential liquidity impact from the use of OTAs and the back-out algorithm (see Section 3.5.1).

4.7.4 New risk management system

In 2014/15, ASX commenced the development of a new risk management system (see Section 3.5.1). The first phase of this project centred on facilitating the OTC default management process; this functionality was implemented in October 2015. The new system is able to provide ASX with near real-time information on the defaulter's outstanding exposures, track profits and losses, perform ‘what-if’ analysis, and recommend hedging transactions. The system also automates the auction process and facilitates the tracking and reporting of actions taken throughout the default management process. The new system was used to support ASX's OTC default management fire drill in July. A future phase of the project will deliver enhanced default management capabilities for cash equities and exchange-traded derivatives.

The system's functionality will continue to be developed over time, integrating learnings from upcoming fire drills and other enhancements identified by the DMSG. As part of this project, ASX is also developing an enhanced reporting system. This is expected to assist ASX's close-out process by enabling the identification of option strategies and the use of specific cover within individual portfolios.

4.8 Conclusions and Recommendations

ASX has a well-established framework for managing the default of a participant, which it has continued to enhance over recent years through its testing and review process. The Bank's assessment is that the facilities have observed all of the relevant requirements in the FSS. The Bank has nonetheless made a number of recommendations outlining steps required for the facilities to continue to observe these requirements. The Bank has also identified some additional areas in which ASX could usefully enhance its default management approach in the spirit of continuous improvement.

Many of the Bank's recommendations are consistent with ASX's plans to implement further enhancements to its DMF, and ASX has already undertaken to carry out work in a number of these areas. The Bank therefore expects ASX's DMF to continue to evolve over the coming period, largely to incorporate the refinements identified during ASX's review of experiences gained from the BBY default. The key conclusions drawn by the Bank in performing its assessment are set out below.

• Rules and procedures. ASX's DMF documentation for its CCPs provides clear and comprehensive guidance on the CCPs' default management arrangements. In order to ensure that this guidance remains effective, ASX is encouraged to complete its review of the DMF documentation and finalise the planned revisions to the relevant documents.

  ASX should carry out further work to enhance its SSF default procedures in order to ensure an effective response in an event of default. At a minimum, these documents could usefully elaborate on any discretionary decisions that the SSF can make and the factors that need to be considered in making these decisions, such as known interdependencies with other ASX CS facilities and market participants. Furthermore, the SSF procedures documents should be reviewed on a regular basis to ensure that they remain practical and appropriate.

• Governance and processes. ASX has practical and effective rules and procedures for managing the default of a participant. Consistent with recommendations in the Bank's 2014/15 Assessment, ASX has carried out a comprehensive review of experiences gained from the BBY default and set out a plan for further refining its default management processes accordingly. The Bank encourages ASX to implement these refinements, and to continue seeking ways of enhancing the effectiveness of the DMF through its ongoing testing and review process.

  The Bank also encourages ASX to continue examining ways in which its new risk management system could be used to facilitate, and mitigate any risks arising in, the default management process. This system functionality should continue to be developed over time as further enhancements are identified by the DMSG. Until the new risk system is developed, there may also be some benefit in exploring further options for improving the effectiveness of the default management process within ASX's existing systems.

  Relatedly, ASX should ensure that any default management procedures (along the lines of the back-out algorithm) built into its new system for clearing and settlement of cash equities are clearly documented, and that the effectiveness of these procedures can be tested and reviewed on an ongoing basis.

• Testing and review. ASX has appropriate processes and governance in place for the ongoing testing and review of its DMF. ASX has continued to enhance this testing and review framework, with further plans to increase the complexity and scope of its default management fire drills over the coming years. As part of its future refinements, ASX should extend the participation in its default management fire drills to involve all relevant internal and external stakeholders. This will aim to ensure that all relevant stakeholders are familiar with the default management processes, and allow ASX to test the interaction between the different stakeholders. In particular, the Bank recommends that:

  – ASX seek more substantial feedback from its default brokers during the fire drills for exchange-traded products; at a minimum, ASX should engage with its default brokers on an appropriate close-out strategy for the hypothetical defaulter's portfolio and ensure that there are no impediments to the default brokers' ability to carry out its responsibilities

  – ASX involve its Risk Consultative Committees and all other clearing participants in fire drills that test ASX's recovery arrangements; in particular, ASX should test its participants' capacity to receive instructions or notifications regarding the use of recovery tools and carry out any necessary internal processes to receive approval for meeting their obligations

  – ASX test the interaction between the DMC and the DMG in its OTC fire drills, and between the DMC and the PIRC in fire drills that simulate the default of a clearing and settlement participant.

  As part of the fire drills, ASX should also ensure that it gives due consideration to the known interdependencies between market participants and linked FMI. In particular, where the fire drill scenario involves the default of an SSF participant, ASX should explicitly consider the potential implications of the default of for any dependent participants or linked FMI.

• Public disclosure. The information disclosed by the ASX CCPs is sufficient to provide guidance to the market about the actions that ASX may take in an event of default. ASX is nevertheless encouraged to continue promoting participants' understanding of its DMF by completing its review of participant disclosures and carrying out its plans to enhance public education on this matter.

  The ASX SSFs should carry out further work to meet the minimum required standard of disclosures that promote participants' understanding of their default rules and procedures. At a minimum, ASX should release its planned Guidance Note on the suspension and termination of Austraclear participants, and develop an information note that provides an overview of the back-out algorithm and the potential flow-on effects of a settlement participant or Payment Provider default on other market participants. ASX should ensure that all disclosures related to its default management arrangements are easily accessible.

• Market impact. The overarching objective of ASX's default management arrangements is to minimise the impact of a participant default on ASX, its participants and the broader market. As part of its default management fire drills, ASX should nevertheless validate its expectation that its default management arrangements take appropriate account of stability interests in other jurisdictions in which it has material activity, most notably in New Zealand.

Tables 9 and 10 summarise the Bank's assessment of the ASX CCPs and SSFs, respectively, against the specific sub-standards of the FSS that address matters related to default management, applying the rating system described in Section 2.2. Tables 9 and 10 include the Bank's recommendations and identify areas in which the Bank will continue to monitor developments during the 2016/17 Assessment period.

Footnotes

The steps taken by ASX to manage the BBY default and the experiences gained from the event are discussed in Section 4 of the Bank's 2014/15 ASX Assessment, available at <http://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/assessments/2014-2015/>. [32]

Default management was previously included as a special topic in the Bank's 2010/11 ASX Assessment. [33]

Available at <http://www.asx.com.au/documents/clearing/131001_Default_Management_-_Public_Information_Document_v2.pdf>. [34]

Available at <http://www.asx.com.au/documents/rules/asx_otc_handbook.pdf>. [35]

Available at <http://www.asx.com.au/documents/clearing/ASXClientClearingClientFactSheet22January2016.pdf>. [36]

Available at <http://www.asx.com.au/documents/rules/asx_settlement_guidance_note_05.pdf>. [37]

See Section 9 of the ASX Settlement Procedure Guidelines. [38]

Reviews of the SSF default management documents are carried out by the Settlement Risk Policy Committee. [39]

In relation to cash market transactions, ASX Clear uses commingled house and client omnibus accounts, which means that house and client positions are therefore not separately identified. In any case, however, a transfer of cash market client positions is unlikely to be feasible due to the short (two-day) settlement cycle. [40]

For further information on ASX's recovery tools, see Section 6 of the 2014/15 ASX Assessment. [41]

In October 2015, ASX implemented enhanced recovery plans, which include tools to fully address any uncovered credit losses and replenish financial resources following a participant default, as well as arrangements to meet any liquidity shortfall. See Section 6 of the 2014/15 ASX Assessment. [42]

The defaulting participant (or its external administrator) would use this information as one of the inputs to the process of closing the positions of clients on the participant's books. This is a separate process which is outside the scope of ASX's default management process. [43]

A client's HIN identifies their holdings of securities in CHESS. [44]

ASX Clear can address a liquidity shortfall in the settlement batch via the use of OTAs with participants due to receive funds. Under the OTA, ASX Clear would re-deliver the stock to the relevant non-defaulting participant in return for an amount equal to ASX Clear's payment obligation to that participant. ASX Clear would agree to repurchase the stock the next business day. [45]

ASX's management of the BBY default is discussed in Section 4 of the Bank's 2014/15 ASX Assessment. [46]

ASX's management of the MF Global default is discussed in Box B of the Bank's 2011/12 ASX Assessment, available at <http://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/assessments/2011-2012/>. [47]

ASX Clear participants are able to lodge stocks as ‘specific cover’ collateral for call options written on that stock. All other collateral (including cash and eligible securities) posted by the participant to cover its margin requirement is treated as ‘general cover’. [48]