Financial Stability Standards for Central Counterparties – December 2012 Standard 7: Liquidity Risk

Note: The headline standard and numbered ‘sub’-standards determined under section 827D(1) of the Corporations Act 2001 have been formatted in bold text while the guidance to these standards has been formatted as plain text. For more information see the Introduction for Standards and Introduction for Guidance. Although the Reserve Bank has taken due care in compiling this page, the published version of the Standards and Guidance should be used in the case of any differences between the two.

A central counterparty should effectively measure, monitor and manage its liquidity risk. A central counterparty should maintain sufficient liquid resources in all relevant currencies to effect same-day and, where appropriate, intraday and multiday settlement of payment obligations with a high degree of confidence under a wide range of potential stress scenarios that should include, but not be limited to, the default of the participant and its affiliates that would generate the largest aggregate liquidity obligation for the central counterparty in extreme but plausible market conditions.

Guidance

Liquidity risk arises in a central counterparty when it, its participants, or other entities cannot settle their payment obligations when due as part of the clearing or settlement process. Depending on the design of a central counterparty, liquidity risk can arise between the central counterparty and its participants, or between the central counterparty and other entities (such as commercial bank money settlement agents, nostro agents, custodian banks and liquidity providers). It is particularly important for a central counterparty to manage carefully its liquidity risk if, as is typical in many systems, the central counterparty relies on incoming payments from participants or other entities during the settlement process in order to make payments to other participants. If a participant or another entity fails to pay the central counterparty, the central counterparty may not have sufficient funds to meet its payment obligations to other participants. In such an event, the central counterparty would need to rely on its own liquid resources (that is, liquid assets and prearranged funding arrangements, including any arrangements with its participants) to cover the funds shortfall and complete settlement. A central counterparty should have a robust framework to manage its liquidity risks from the full range of participants and other entities. In some cases, a participant may play other roles within the central counterparty, such as a settlement or custodian bank or liquidity provider. These other roles should be considered in determining a central counterparty's liquidity needs.

7.1 A central counterparty should have a robust framework to manage its liquidity risks from its participants, commercial bank money settlement agents, nostro agents, custodians, liquidity providers and other entities.

Sources of liquidity risk

7.1.1 A central counterparty should clearly identify its sources of liquidity risk and assess its current and potential future liquidity needs on a daily basis. A central counterparty can face liquidity risk from the default of a participant. For example, a central counterparty might not be able to convert a defaulting participant's collateral into cash at short notice. A central counterparty can also face liquidity risk from any commercial bank money settlement agents, nostro agents, custodians and liquidity providers, as well as linked FMIs and service providers, if they fail to perform as expected. Moreover, as noted above, a central counterparty may face additional risk from entities that have multiple roles within the central counterparty (for example, a participant that also serves as the central counterparty's money settlement agent or liquidity provider). These interdependencies and the multiple roles that an entity may assume within a central counterparty should be taken into account by the central counterparty.

Managing liquidity risk

7.1.2 A central counterparty should regularly assess its design and operations to manage liquidity risk in the system. It could reduce the liquidity demands of its participants by providing participants with sufficient information or control systems to help them manage their liquidity needs and risks. Furthermore, a central counterparty should ensure that it is operationally ready to manage the liquidity risk caused by participants' or other entities' financial or operational problems. Among other things, a central counterparty that does not settle its funds obligations directly in central bank money (see CCP Standard 9 on money settlements) should have the operational capacity to reroute payments, where feasible, on a timely basis in case of problems with a correspondent bank.

7.1.3 A central counterparty may use other risk management tools to manage its liquidity risk. To mitigate and manage liquidity risk stemming from a participant default, a central counterparty could use, either individually or in combination, exposure limits, collateral requirements and prefunded default resources. To mitigate and manage liquidity risk stemming from a service provider or a linked FMI, a central counterparty could use, individually or in combination, selection criteria, concentration or exposure limits, and collateral requirements. For example, a central counterparty should seek to manage or diversify its liquid resources to avoid excessive intraday or overnight exposure to one entity. This, however, may involve trade-offs between the efficiency of relying on an entity and the risks of being overly dependent on that entity.

7.2 A central counterparty should have effective operational and analytical tools to identify, measure and monitor its settlement and funding flows on an ongoing and timely basis, including its use of intraday liquidity.

7.2.1 A central counterparty should have effective operational and analytical tools to identify, measure and monitor its settlement and funding flows on an ongoing and timely basis, including its use of intraday liquidity. In particular, a central counterparty should understand and assess the value and concentration of its daily settlement and funding flows through any commercial bank money settlement agents, nostro agents and other intermediaries. A central counterparty also should be able to monitor on a daily basis the level of liquid assets (such as cash, securities, other assets held in custody and investments) that it holds. A central counterparty should be able to determine the value of its available liquid assets, taking into account the appropriate haircuts on those assets (see CCP Standard 5 on collateral and CCP Standard 6 on margin).

7.2.2 If a central counterparty maintains prearranged funding arrangements, the central counterparty should also identify, measure and monitor its liquidity risk from the liquidity providers of those arrangements. A central counterparty should obtain a high degree of confidence through rigorous due diligence that each liquidity provider, whether or not it is a participant in the central counterparty, would have the capacity to perform as required under the liquidity arrangement and is subject to commensurate regulation, supervision or oversight of its liquidity risk management requirements. Where relevant to assessing a liquidity provider's performance reliability with respect to a particular currency, the liquidity provider's potential access to credit from the relevant central bank may be taken into account.

7.3 A central counterparty should maintain sufficient liquid resources in all relevant currencies to settle securities-related payments, make required variation margin payments and meet other payment obligations on time with a high degree of confidence under a wide range of potential stress scenarios that should include, but not be limited to, the default of the participant and its affiliates that would generate the largest aggregate payment obligation to the central counterparty in extreme but plausible market conditions. In addition, a central counterparty that is involved in activities with a more complex risk profile or that is systemically important in multiple jurisdictions should consider maintaining additional liquidity resources sufficient to cover a wider range of potential stress scenarios that should include, but not be limited to, the default of the two participants and their affiliates that would generate the largest aggregate payment obligation to the central counterparty in extreme but plausible market conditions.

7.3.1 A central counterparty should carefully analyse its projected liquidity needs under a range of stress scenarios, and subject this analysis to review by the Reserve Bank and other relevant authorities. In many cases, a central counterparty will need to maintain sufficient liquid resources to meet payments to settle required margin and other payment obligations over multiple days to accommodate multiday hedging and close out activities as directed by the central counterparty's participant default procedures (see CCP Standard 7.8 on liquidity stress testing).

7.4 For the purpose of meeting its minimum liquid resource requirement, a central counterparty's qualifying liquid resources in each currency include cash at the central bank of issue and at creditworthy commercial banks, committed lines of credit, committed foreign exchange swaps and committed repos, as well as highly marketable collateral held in custody and investments that are readily available and convertible into cash with prearranged and highly reliable funding arrangements, even in extreme but plausible market conditions. If a central counterparty has access to routine credit at the central bank of issue, the central counterparty may count such access as part of the minimum requirement to the extent it has collateral that is eligible for pledging to (or for conducting other appropriate forms of transactions with) the relevant central bank. All such resources should be available when needed.

7.4.1 A central counterparty's outright holdings of qualifying instruments, such as cash and assets eligible for pledging as collateral to (or for conducting other collateralised transactions with) the central bank of issue, are generally the most reliable source of liquidity and should form a substantial part of a central counterparty's qualifying liquid resources (see CCP Standard 7.7).

7.4.2 In addition to outright holdings of qualifying instruments, a central counterparty may negotiate committed lines of credit and repos on commercial terms with external third parties. A central counterparty may also conclude contractual agreements with its participants to provide additional qualifying liquid resources in specified circumstances. Such resources may, for example, be provided under committed lines of credit or committed repos. Any such arrangements should be highly reliable and explicitly included in the central counterparty's rules and procedures, ensuring that they have at least as robust a contractual basis as any equivalent commercial arrangement that might be reached with non-participant counterparties.

7.5 A central counterparty may supplement its qualifying liquid resources with other forms of liquid resources. If the central counterparty does so, these liquid resources should be in the form of assets that are likely to be saleable or acceptable as collateral for lines of credit, swaps or repos on an ad hoc basis following a default, even if this cannot be reliably prearranged or guaranteed in extreme market conditions. Even if a central counterparty does not have access to routine central bank credit, it should still take account of what collateral is typically accepted by the relevant central bank, as such assets may be more likely to be liquid in stressed circumstances. A central counterparty should not assume the availability of emergency central bank credit as part of its liquidity plan.

7.5.1 A central counterparty may consider using non-qualifying liquid resources within its liquidity risk management framework in advance of, or in addition to, using its qualifying liquid resources. This may be particularly beneficial where liquidity needs exceed qualifying liquid resources, where qualifying liquid resources can be preserved to cover a future default, or where using other liquid resources would cause less liquidity dislocation to the central counterparty's participants and the financial system as a whole.

7.6 A central counterparty should obtain a high degree of confidence, through rigorous due diligence, that each provider of its minimum required qualifying liquid resources, whether a participant of the central counterparty or an external party, has sufficient information to understand and to manage its associated liquidity risks, and that it has the capacity to perform as required under its commitment. Where relevant to assessing a liquidity provider's performance reliability with respect to a particular currency, a liquidity provider's potential access to credit from the central bank of issue may be taken into account. A central counterparty should regularly test its procedures for accessing its liquid resources at a liquidity provider.

7.6.1 A central counterparty should have detailed procedures for using its liquid resources to complete settlement during a liquidity shortfall. A central counterparty's procedures should clearly document the sequence in which each type of liquid resource would be expected to be used (for example, the use of certain assets before prearranged funding arrangements). These procedures may include instructions for accessing cash deposits or overnight investments of cash deposits, executing same-day market transactions, or drawing on prearranged liquidity lines, including any pre-committed liquidity allocation mechanisms involving participants established under the central counterparty's rules. In addition, a central counterparty should regularly test its procedures for accessing its liquid resources at a liquidity provider, including by activating and drawing down test amounts from committed credit facilities and by testing operational procedures for conducting same-day repos. A central counterparty should also adequately plan for the renewal of prearranged funding arrangements with liquidity providers in advance of their expiration.

7.7 A central counterparty with access to central bank accounts, payment services or securities services should use these services, where practical, to enhance its management of liquidity risk. A central counterparty that the Reserve Bank determines to be systemically important in Australia and has obligations in Australian dollars should operate its own Exchange Settlement Account, in its own name or that of a related body corporate acceptable to the Reserve Bank, to enhance its management of Australian dollar liquidity risk.

7.7.1 If a central counterparty has access to central bank accounts, payment services, securities services or collateral management services, it should use these services, where practical, to enhance its management of liquidity risk. Cash balances at the central bank of issue, for example, offer the highest liquidity (see CCP Standard 9 on money settlements).

7.7.2 A central counterparty that the Reserve Bank determines to be systemically important in Australia and has obligations in Australian dollars should operate its own Exchange Settlement Account at the Reserve Bank to enhance its management of Australian dollar liquidity risk.[1] This account may be held in the central counterparty's own name or, if approved by the Reserve Bank, in the name of a related body corporate. A holder of an Exchange Settlement Account may access the Reserve Bank's overnight and intraday liquidity facilities, provided it meets the Reserve Bank's other requirements for access to these facilities, including that it can deliver securities eligible as collateral to the Reserve Bank under a repo agreement. In assessing the systemic importance of a central counterparty, the Reserve Bank will consider factors such as:

  • the size of the central counterparty in Australia (for example, the value of transactions processed by the central counterparty in Australian dollar-denominated products, or its market share; or the total amount of initial margin held in respect of Australian dollar-denominated products)
  • the availability of substitutes for the central counterparty's services in Australia
  • the nature and complexity of the products cleared by the central counterparty
  • the degree of interconnectedness with other parts of the Australian financial system.

7.8 A central counterparty should determine the amount and regularly test the sufficiency of its liquid resources through rigorous stress testing. A central counterparty should have clear procedures to report the results of its stress tests to appropriate decision-makers at the central counterparty and to use these results to evaluate the adequacy of, and adjust, its liquidity risk management framework. In conducting stress testing, a central counterparty should consider a wide range of relevant scenarios. Scenarios should include relevant peak historic price volatilities, shifts in other market factors such as price determinants and yield curves, multiple defaults over various time horizons, simultaneous pressures in funding and asset markets, and a spectrum of forward-looking stress scenarios in a variety of extreme but plausible market conditions. Scenarios should also take into account the design and operation of the central counterparty, include all entities that might pose material liquidity risks to the central counterparty (such as commercial bank money settlement agents, nostro agents, custodians, liquidity providers and linked FMIs) and, where appropriate, cover a multiday period. In all cases, a central counterparty should document its supporting rationale for, and should have appropriate governance arrangements relating to, the amount and form of total liquid resources it maintains.

7.8.1 As part of a central counterparty's assessment of the sufficiency of its liquid resources through stress testing, it should consider any strong interlinkages or similar exposures between its participants, as well as the multiple roles that participants may play with respect to the risk management of the central counterparty, and assess the probability of multiple failures and the contagion effect among its participants that such failures may cause.

7.8.2 Liquidity stress testing should be performed on a daily basis using standard and predetermined parameters and assumptions. In addition, on at least a monthly basis, a central counterparty should perform a comprehensive and thorough analysis of stress-testing scenarios, models and underlying parameters and assumptions used to ensure they are appropriate for achieving the central counterparty's identified liquidity needs and resources in light of current and evolving market conditions. A central counterparty should perform stress testing more frequently when markets are unusually volatile, when they are less liquid, or when the size or concentration of positions held by its participants increases significantly. A full validation of a central counterparty's liquidity risk management model should be performed at least annually.

7.8.3 A central counterparty should conduct, as appropriate, reverse stress tests aimed at identifying the extreme default scenarios and extreme market conditions for which the central counterparty's liquid resources would be insufficient. In other words, these tests identify how severe stress conditions would be covered by the central counterparty's liquid resources. A central counterparty should judge whether it would be prudent to prepare for these severe conditions and various combinations of factors influencing these conditions. Reverse stress tests require a central counterparty to model extreme market conditions that may go beyond what are considered extreme but plausible market conditions in order to help understand the sufficiency of liquid resources given the underlying assumptions modelled. Modelling very extreme market conditions can help a central counterparty determine the limits of its current model and resources; however, it requires the central counterparty to exercise judgement when modelling different markets and products. A central counterparty should develop hypothetical very extreme scenarios and market conditions tailored to the specific risks of the markets and of the products it serves. Reverse stress tests should be considered a helpful risk management tool but they need not, necessarily, drive a central counterparty's determination of the appropriate level of liquid resources.

7.9 A central counterparty should establish explicit rules and procedures that enable the central counterparty to effect same-day and, where appropriate, intraday and multiday settlement of payment obligations on time following any individual or combined default among its participants. These rules and procedures should address unforeseen and potentially uncovered liquidity shortfalls and should aim to avoid unwinding, revoking or delaying the same-day settlement of payment obligations. These rules and procedures should also indicate the central counterparty's process to replenish any liquidity resources it may employ during a stress event, so that it can continue to operate in a safe and sound manner.

7.9.1 In certain extreme circumstances, the liquid resources of a central counterparty or its participants required under CCP Standard 7.3 may not be sufficient to meet the payment obligations of the central counterparty to its participants.[2] In a stressed environment, for example, normally liquid assets held by a central counterparty may prove not to be sufficiently liquid to obtain same-day funding, or the liquidation period may be longer than expected. A central counterparty should establish explicit rules and procedures that enable the central counterparty to effect same-day and, where appropriate, intraday and multiday settlement of payment obligations on time following any individual or combined default among its participants. These rules and procedures should address unforeseen and potentially uncovered liquidity shortfalls and should aim to avoid unwinding, revoking or delaying the same-day settlement of payment obligations. These rules and procedures should also indicate the central counterparty's process to replenish any liquidity resources it may employ during a stress event, so that it can continue to operate in a safe and sound manner.

7.9.2 If a central counterparty allocates potentially uncovered liquidity shortfalls to its participants, the central counterparty should have clear and transparent rules and procedures for the allocation of shortfalls. These procedures could involve a funding arrangement between the central counterparty and its participants, the mutualisation of shortfalls among participants according to a clear and transparent formula, or the use of liquidity rationing (for example, reductions in payouts to participants). Any allocation rule or procedure must be discussed thoroughly with and communicated clearly to participants, as well as be consistent with participants' respective regulatory liquidity risk management requirements. Furthermore, a central counterparty should consider and validate, through simulations and other techniques and through discussions with each participant, the potential impact on each participant of any such same-day allocation of liquidity risk and each participant's ability to bear proposed liquidity allocations.

Footnotes

The Reserve Bank has established a specific category of Exchange Settlement Account for central counterparties available at <https://www.rba.gov.au/media-releases/2012/mr-12-17.html>. [1]

These exceptional circumstances could arise from unforeseen operational problems or unanticipated rapid changes in market conditions. [2]