Financial Stability Standards for Central Counterparties – December 2012 Standard 9: Money Settlements

Guidance

A central counterparty typically needs to conduct money settlements with or between its participants for a variety of purposes, such as the settlement of individual payment obligations, funding and defunding activities, and the collection and distribution of margin payments. To conduct such money settlements, a central counterparty can use central bank money, commercial bank money or a combination of the two. Where individual payment obligations are settled in commercial bank money, exposures are typically created between commercial banks, which are ultimately settled in central bank money. A central counterparty may not specify how participants fund their obligations. However, the central counterparty, its participants, any commercial settlement banks and any commercial bank money settlement agents should take into account the risks associated with alternative money settlement arrangements.

Settlement in central bank money typically involves the central bank of issue assuming the role of money settlement agent, with final money settlement occurring across accounts held by participants or their commercial settlement banks with the central bank. Typically, this sort of arrangement for the settlement of individual transactions minimises the accrual of exposures between commercial settlement banks.

Settlement in commercial bank money typically occurs on the books of a commercial bank money settlement agent. In this model, a central counterparty typically establishes an account with one or more commercial bank(s) and requires each of its participants to establish an account with one of them. In some cases, the central counterparty itself can serve as the money settlement agent, in which case money settlements are effected through accounts on the books of the central counterparty. A central counterparty may also use a combination of central bank and commercial bank monies to conduct settlements, for example, by using central bank money for funding accounts at commercial banks, prior to settlement of individual payment obligations in commercial bank money across those accounts.

A central counterparty and its participants may face credit and liquidity risks from money settlements. Credit risk may arise when participants use commercial settlement banks to effect money settlements, or when the central counterparty uses a commercial bank money settlement agent. Liquidity risk may arise in money settlements if, after a payment obligation has been settled, participants or the central counterparty itself are unable to transfer readily their assets at the commercial settlement bank, or money settlement agent, into other liquid assets, such as claims on a central bank.

9.1.1 With the use of central bank money, a payment obligation is typically discharged by providing the central counterparty, its participants or its participants' commercial settlement banks with a direct claim on the central bank; that is, the relevant central bank is the money settlement agent, and the settlement asset is central bank money. Central banks have the lowest credit risk and are the source of liquidity with regard to their currency of issue. However, the use of central bank money may not always be practical or available. For example, a central counterparty or its participants may not have direct access to central bank accounts and payment services in all relevant jurisdictions.

9.1.2 In Australia, a central counterparty may apply to hold an Exchange Settlement Account at the Reserve Bank, in its own name or that of a related body corporate acceptable to the Reserve Bank, provided that it meets any associated financial, operational and legal requirements.^[1] Further, 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 settle its Australian dollar obligations. In determining whether a central counterparty is systemically important in Australia the Reserve Bank will have regard to relevant factors, including those listed in paragraph 7.7.2.

9.2.1 An alternative to the use of central bank money is commercial bank money. When settling in commercial bank money, a payment obligation is typically discharged by providing the central counterparty or its participants with a direct claim on a commercial bank money settlement agent. To conduct settlements in commercial bank money, a central counterparty and its participants need to establish accounts with at least one commercial bank, and likely hold intraday or overnight balances, or both. The use of commercial bank money to settle payment obligations, however, can create additional credit and liquidity risks for the central counterparty and its participants. For example, if a commercial bank money settlement agent became insolvent, the central counterparty and its participants might not have immediate access to their settlement funds or ultimately receive the full value of their funds. It also creates operational dependencies on the relevant commercial bank(s).

9.3.1 If a central counterparty uses a commercial bank money settlement agent (or a non-bank deposit-taking institution) for its money settlements, it should monitor, manage and limit its credit and liquidity risks arising from this arrangement. For example, a central counterparty should limit both the probability of being exposed to the bank's failure and limit the potential losses and liquidity pressures to which it would be exposed in the event of such a failure. A central counterparty should establish and monitor adherence to strict criteria for its commercial bank money settlement agents that take into account, among other things, their regulation and supervision, creditworthiness, capitalisation, access to liquidity and operational reliability. Under these criteria, a commercial bank money settlement agent should be subject to effective banking regulation and supervision. It should also be creditworthy, be well capitalised and have ample liquidity from the marketplace or the central bank of issue. Where money settlements take place in Australian dollars, a central counterparty should only utilise an authorised deposit-taking institution (ADI) that holds an Exchange Settlement Account at the Reserve Bank and has been approved to act as an agent for RTGS payments by the Australian Prudential Regulation Authority.

9.3.2 Even where ultimate settlement occurs in central bank money, many participants in a central counterparty may not have direct access to accounts with the relevant central bank. They will therefore typically use the services of commercial settlement banks to effect money settlements or carry out funding and defunding activities. These commercial settlement banks play an important role in the settlement of payment obligations (including margin payments) and therefore the central counterparty should establish appropriate criteria around their financial and operational capacity to fulfil this role, which may include similar criteria to those described in paragraph 9.3.1 (see also CCP Standard 12 on participant default rules and procedures).

9.3.3 In addition, a central counterparty should monitor and manage the concentration of its and, to the extent reasonably practicable, its participants' credit and liquidity exposures to commercial bank money settlement agents and commercial settlement banks. The central counterparty should consider the diversification of its and its participants' exposures to commercial banks in the settlement process and assess its potential losses and liquidity pressures as well as those of its participants in the event of the failure of a commercial bank money settlement agent or commercial settlement bank (see also CCP Standard 18 on tiered participation arrangements).

9.4.1 Where a central counterparty conducts money settlements on its own books, it offers cash accounts to its participants, and a payment or settlement obligation is discharged by providing the central counterparty's participants with a direct claim on the central counterparty itself. The credit and liquidity risks associated with a claim on a central counterparty are therefore directly related to the central counterparty's overall credit and liquidity risks. A central counterparty should look to minimise these risks by limiting its activities and operations to clearing and closely related processes (see CCP Standard 1.1). Further, to settle payment obligations, the central counterparty could be established as a supervised special purpose financial institution and limit the provision of cash accounts to participants. In some cases, a central counterparty can further mitigate risk by having participants fund and defund their cash accounts at the central counterparty using central bank money. In such an arrangement, a central counterparty is able to back the settlements conducted on its own books with balances that it holds in its account at the central bank.

9.5.1 In settlements involving either central bank or commercial bank money, a critical issue is the timing of the finality of funds transfers. These transfers should be final when effected (see also CCP Standard 1 on legal basis and CCP Standard 8 on settlement finality). To this end, a central counterparty's legal agreements with any commercial bank money settlement agent should contain clear provisions regarding the finality of funds transfers. The central counterparty should communicate the effect of these provisions to participants. Participants' legal agreements with commercial settlement banks should similarly provide clarity in relation to these matters, although in some cases a central counterparty may not have access to these agreements. If a central counterparty conducts intraday money settlements (for example, to collect intraday margin), the arrangement should provide real-time finality or intraday finality at the times when a central counterparty wishes to effect money settlement.