Review of Settlement Practices for Australian Equities 4. Issues Arising from these Events

Although these events have raised some issues about the settlement process, at no stage has there been any doubt about the stability of the central counterparty, ACH. The Bank's assessment of ACH against the Financial Stability Standard for Central Counterparties in 2007 concluded that ACH has adequate resources and risk management procedures to withstand the failure of a large participant during a period of financial turbulence. There was never any suggestion during the recent episode that ACH would be unable to settle the trades novated to it.

Furthermore, although the settlement delays were in part related to settlement difficulties arising from securities lending transactions, this does not mean that securities lending itself is problematic. Indeed, securities lending and associated short selling add to market liquidity and to the efficiency of pricing. They contribute to lower bid-offer spreads and help ensure that prices reflect the views of both bullish and bearish investors. Securities lending also plays an important role in ensuring that most trades settle on time, even when market participants experience operational problems. While recent events have raised a number of issues around the transparency of short selling which deserve attention, both short selling and securities lending are critical to the efficient functioning of the equity market.

Notwithstanding this assessment, the delays have highlighted a number of issues related to settlement arrangements that are worthy of further examination. These include the following:

(i) Timelines and decision points

While settlement normally takes place by around noon each day, there is no fixed time by which settlement must be completed. Similarly, there is no irrevocable time by which settlement banks need to authorise their clients' payments. While this flexibility has some advantages, it means that decisions can be delayed, creating uncertainty about what is going on in the market and when settlement will be completed.

(ii) The joint settlement of on-market and off-market transactions

The recent events demonstrate that the inability of a settlement participant to meet its settlement obligations arising from off-market transactions can have implications for the settlement of trades novated to the central counterparty. While novated trades do not carry any guarantee that settlement will occur according to the T+3 schedule, the market rightly has a strong expectation that transactions novated to the central counterparty will settle on time.

(iii) Concentration of pre-settlement activity

There is considerable activity in the couple of hours prior to the 10.30 am cut-off for settlement instructions as participants arrange to lend and transfer securities. In many cases, settlement participants wait until the morning of T+3 to complete the priming of their accounts, partly due to the need to wait for final matched settlement instructions from offshore clients. This concentration of activity can lead to significant swings in participants' settlement obligations on the morning of T+3. As a result, the smooth functioning of the system is reliant on the willingness of participants' settlement banks to accommodate late swings in net cash payment obligations.^[9]

(iv) Lack of transparency of off-market transactions

The events of January also highlight a lack of transparency in off-market transactions. These transactions are bilaterally agreed and the terms and conditions associated with them are known only to the direct counterparties to the transaction. At present, securities lending transactions, in particular, are not separately identified within CHESS and hence contractual and contingent obligations in respect of such transactions – for example, the scheduled return or the lender's right to recall within three days – cannot be factored into an analysis of settlement failure risks.

Footnote

Similarly, there is a dependence on settlement banks' willingness to accommodate swings in funding obligations in the event that back-out procedures are triggered and settlements have to be rescheduled. [9]