Financial Stability Standards for Securities Settlement Facilities – June 2024 Standard 11: Participant Default Rules and Procedures

Guidance

Participant default rules and procedures facilitate the continued functioning of a securities settlement facility in the event that a participant fails to meet its obligations. Such rules and procedures help limit the potential for the effects of a participant's failure to spread to other participants and possibly undermine the viability of the securities settlement facility. Key objectives of default rules and procedures should, where relevant, include: ensuring timely completion of settlement, even in extreme but plausible market conditions; minimising losses for the securities settlement facility and for non-defaulting participants; limiting disruptions to the market; providing a clear framework for accessing securities settlement facility liquidity facilities as needed; and managing and closing out the defaulting participant's positions and liquidating any applicable collateral in a prudent and orderly manner. To the extent consistent with these objectives, a securities settlement facility should allow non-defaulting participants to continue to manage their positions and transactions as normal.

Rules and procedures

11.1.1 A securities settlement facility should have default rules and procedures that enable the securities settlement facility to continue to meet any obligations to non-defaulting participants in the event of a participant default. A securities settlement facility should explain clearly in its rules and procedures what circumstances constitute a participant default, addressing both financial and operational defaults.^[30] A securities settlement facility should describe the method for identifying a default. In particular, a securities settlement facility should specify whether a declaration of default is automatic or discretionary, and if discretionary, which person or group shall exercise that discretion. Key aspects to be considered in designing the rules and procedures include: the actions that a securities settlement facility can take when a default is declared; the extent to which such actions are automatic or discretionary; potential changes to the normal settlement practices, should these changes be necessary in extreme circumstances, to ensure timely settlement; the management of transactions at different stages of processing; the expected treatment of proprietary and customer transactions and accounts; the probable sequencing of actions; the roles, obligations and responsibilities of the various parties, including non-defaulting participants; and the existence of other mechanisms that may be activated to contain the impact of a default. A securities settlement facility should involve its participants, the Reserve Bank and other relevant authorities, and other relevant stakeholders in developing its default rules and procedures (see SSF Standard 2 on governance).

11.1.2 In the event of a participant default, financial and other obligations created for non-defaulting participants should be proportional to the scale and nature of participants' activities. Disproportionate obligations may place undue demands on participants at a time of wider market distress.

Use and sequencing of financial resources

11.1.3 A securities settlement facility's default rules and procedures should enable the securities settlement facility to take timely action to contain losses and liquidity pressures, before, at and after the point of participant default (see also SSF Standard 4 on credit risk and SSF Standard 6 on liquidity risk). Where relevant, a securities settlement facility's rules and procedures should allow the securities settlement facility to use promptly any financial resources that it maintains for covering losses and containing liquidity pressures arising from default, including liquidity facilities. The rules of the securities settlement facility should specify the order in which different types of resources will be used. This information would enable participants to assess their potential future exposures from using the securities settlement facility's services. Typically, a securities settlement facility should first use assets provided by the defaulting participant, such as collateral, to provide incentives for participants to manage prudently the risks, particularly credit risk, they pose to a securities settlement facility. The application of previously provided collateral should not be subject to prevention, stay or reversal under applicable law and the rules of the securities settlement facility. A securities settlement facility should also have a credible and explicit plan for replenishing its resources over an appropriate time horizon following a participant default so that it can continue to operate in a safe and sound manner. In particular, the securities settlement facility's rules and procedures should define any obligations of the non-defaulting participants to replenish the financial resources depleted during a default so that the time horizon of such replenishment is anticipated by non-defaulting participants.

11.2.1 This Standard is aimed at ensuring the timely settlement of obligations in the event that a participant or commercial settlement bank goes into external administration. The securities settlement facility should have a legally binding requirement for participants to notify it should they be in default or reasonably suspect that this is the case. Similar notification should be made in the event of a breach or likely breach of any risk control requirement of the securities settlement facility. Any communication should be at an appropriately high level both within the participant organisation and the securities settlement facility. The impact that a participant or commercial settlement bank in external administration may have on other participants should be minimised through the existence of legally binding arrangements, the timely flow of information, and the institution of appropriate controls and procedures. For a commercial settlement bank, this should include rules and procedures allowing its participant users to quickly nominate a new provider in the event that it enters external administration or is reasonably likely to do so. There is a difference between external administration and cases where a participant may have sufficient assets to meet its obligations, yet be unable to complete settlement of its obligations due to operational failure or liquidity pressures. This distinction should be recognised in the rules of the securities settlement facility.

11.2.2 A securities settlement facility should be well prepared to implement its default rules and procedures, including any appropriate discretionary procedures provided for in the rules. Management should ensure that the securities settlement facility has the operational capacity, including sufficient well-trained personnel, to implement its procedures in a timely manner. A securities settlement facility's rules and procedures should outline examples of when management discretion may be appropriate and should include arrangements to minimise any potential conflicts of interests. Management should also have internal plans that clearly delineate the roles and responsibilities for addressing a default and provide training and guidance to its personnel on how the procedures should be implemented. These plans should address documentation, information needs and coordination when more than one securities settlement facility or authority is involved. In addition, timely communication with stakeholders, in particular with the Reserve Bank and other relevant authorities, is of critical importance (see also SSF Standard 19 on regulatory reporting). The securities settlement facility, to the extent permitted, should clearly convey to affected stakeholders information that would help them to manage their own risks. The internal plan should be reviewed by management and the relevant board committees at least annually or after any significant changes to the securities settlement facility's arrangements.

11.3.1 To provide certainty and predictability regarding the measures that a securities settlement facility may take in a default event, a securities settlement facility should publicly disclose key aspects of its default rules and procedures, including: the circumstances in which action may be taken; who may take those actions; the scope of the actions which may be taken, including the treatment of both proprietary and customer positions, funds and other assets; the mechanisms to address any obligations of a securities settlement facility to non-defaulting participants; and, where direct relationships exist with participants' customers, the mechanisms to help address the defaulting participant's obligations to its customers. Such transparency should facilitate the orderly handling of defaults, enable participants to understand their obligations to the securities settlement facility and to their customers, and provide for informed decisions by market participants about their activities in the market. A securities settlement facility should ensure that its participants and their customers, as well as the public, have appropriate access to the securities settlement facility's default rules and procedures and should promote their understanding of those procedures in order to foster confidence in the market in the event of a participant default.

11.3.2 Any arrangements for dealing with the unsettled trades of a defaulting participant should be clear to all securities settlement facility participants and capable of being executed in a timely manner. For example, in the case of a securities settlement facility that settles via a multilateral net batch, rules for any reconstitution of a multilateral net batch excluding any settlement obligations of a defaulting participant that have not been guaranteed by a central counterparty should be clearly stated and disclosed to participants. Sufficient information and tools should be made available to participants to assist, as far as possible, in quantifying the potential magnitude of liquidity demands in the event of any such reconstitution of the batch, and taking appropriate steps to accommodate these demands (see SSF Standard 6.2). Reconstitution of the batch should provide for any requirements arising from a central counterparty's rules for dealing with the inability of a clearing participant to settle arising from its own failure or that of a commercial settlement bank.

11.4.1 A securities settlement facility should involve relevant participants and other stakeholders in the testing and review of its default procedures. Such testing and review should be conducted at least annually and following material changes to the rules and procedures to ensure that they are practical and effective. The periodic testing and review of default procedures is important to help the securities settlement facility and its participants understand fully the procedures and to identify any lack of clarity in, or discretion allowed by, the rules and procedures. Such tests should include all relevant parties, or an appropriate subset, that would likely be involved in the default procedures, such as members of the appropriate board committees, participants, linked or interdependent FMIs, the Reserve Bank and other relevant authorities, and any related service providers. This is particularly important where a securities settlement facility relies on non-defaulting participants or third parties to assist in the close out process and where the default procedures have never been tested by an actual default. The results of these tests and reviews should be shared with the securities settlement facility's board of directors, risk committee, and the Reserve Bank and other relevant authorities.

11.4.2 Furthermore, part of a securities settlement facility's participant default testing should include the implementation of the resolution regime for a securities settlement facility's participants, as relevant. A securities settlement facility should be able to take all appropriate steps to address the resolution of a participant. Specifically, the securities settlement facility, or if applicable a resolution authority, should be able to transfer a defaulting participant's open positions and customer accounts to a receiver, third party or bridge financial company.

11.5.1 A securities settlement facility should ensure that its default management procedures take appropriate account of the interests of all relevant stakeholders across the jurisdictions in which it operates, including those of its direct and indirect participants. A securities settlement facility's governance arrangements should ensure that these interests are taken into account (see SSF Standard 2 on governance). The actions that a securities settlement facility takes in the event of a default, such as any reconstitution of a multilateral net batch, could, through the impact on participants, potentially impact on pricing, liquidity and stability in certain financial markets. A securities settlement facility should consider these wider market impacts of its default management actions, and take mitigating action to minimise market impacts as appropriate.