Financial Stability Standards for Securities Settlement Facilities – June 2024 Standard 4: Credit Risk

Guidance

This Standard applies only to a securities settlement facility that assumes credit risk as principal. In general, a securities settlement facility operating in Australia would not be expected to assume credit risk as principal. The design of the securities settlement facility and the scope of its activities should minimise the potential for such risk to arise. In the event that it did assume credit risk as principal, the facility should consult with the Reserve Bank to identify clearly the circumstances in which such risk was assumed.

Credit risk is broadly defined as the risk that a counterparty will be unable to meet fully its financial obligations when due or at any time in the future. The default of a participant (and its affiliates) has the potential to cause severe disruption to a securities settlement facility, its other participants and the financial markets more broadly. Therefore, a securities settlement facility should establish a robust framework to manage its credit exposures to its participants and the credit risks arising from its settlement processes (see also SSF Standard 3 on the framework for the comprehensive management of risks, SSF Standard 8 on money settlements, SSF Standard 10 on exchange-of-value settlement systems and SSF Standard 13 on custody and investment risks). Credit exposures may arise in the form of current exposures, potential future exposures, or both. Current exposure, in this context, is defined as the loss that a securities settlement facility would face immediately if a participant were to default.^[11] Potential future exposure is broadly defined as any potential credit exposure that a securities settlement facility could face at a future point in time.^[12] The type and level of credit exposure faced by a securities settlement facility will vary based on its design and the credit risk of the counterparties concerned.^[13]

4.1.1 A securities settlement facility may face a number of credit risks from its participants or its settlement processes. A securities settlement facility may face counterparty credit risk from the extension of credit to participants. This extension of credit creates current exposures and can lead to potential future exposures, even when the securities settlement facility accepts collateral to secure the credit. A securities settlement facility would face potential future exposure if the value of collateral posted by a participant could fall below the amount of credit extended to the participant by the securities settlement facility, leaving a residual uncovered exposure. In addition, a securities settlement facility that explicitly guarantees settlement would face current exposures arising from any failure of a participant to fund its net debit position or meet its obligations to deliver financial instruments.

4.2.1 A securities settlement facility should frequently and regularly measure and monitor its credit risks throughout the day using timely information. A securities settlement facility should ensure it has access to adequate information, such as appropriate collateral valuations, to allow it to measure and monitor its current exposures and degree of collateral coverage. If credit risk exists between participants, the securities settlement facility should provide the capacity to participants to measure and monitor their current exposures to each other in the system or adopt rules that require participants to provide relevant exposure information. Current exposure should be relatively straightforward to measure and monitor; however, potential future exposure may require modelling or estimation. In order to monitor its risks associated with current exposure, a securities settlement facility should monitor market conditions for developments that could affect these risks, such as collateral values. In order to estimate its potential future exposure and associated risk, a securities settlement facility should model possible changes in collateral values and market conditions over an appropriate liquidation period. A securities settlement facility should regularly monitor the existence of large exposures to its participants and, where appropriate, their customers. A securities settlement facility's systems should be capable of calculating exposures to participants intraday and at short notice.

4.2.2 Additionally, a securities settlement facility should have the capacity to monitor any changes in the creditworthiness of its participants through the systematic review of timely information on financial standing, business activities and profile, and potential interdependencies. The securities settlement facility should use this capacity to conduct periodic reviews of its participants' credit standing, and to conduct ad hoc reviews where the securities settlement facility has reason to believe that a participant's credit standing may deteriorate.

4.2.3 A securities settlement facility should mitigate its credit risks to the extent possible. A securities settlement facility should, for example, eliminate its or its participants' principal risk associated with the settlement process by employing an exchange-of-value settlement system (see SSF Standard 10 on exchange-of-value settlement systems). The use of a system that settles securities and funds on a gross, obligation-by-obligation basis (DvP model 1) would further reduce potential liquidity exposures among participants. In addition, a securities settlement facility should limit its current exposures by strictly limiting the extension of credit.

4.3.1 If a securities settlement facility determines that a participant's credit standing may be in doubt, it should have the authority, under its rules and procedures, to impose additional credit risk controls on the participant. These may include placing restrictions on the level or types of activities that the participant can undertake, or calling for additional collateral from the participant. In extreme cases, the securities settlement facility may need to consider suspending the participant (see SSF Standard 11 on participant default rules and procedures and SSF Standard 15 on access and participation requirements).

4.4.1 A securities settlement facility may settle securities on a gross basis and funds on a net basis (DvP model 2) or settle both securities and funds on a net basis (DvP model 3). Further, a securities settlement facility that uses a DvP model 2 or 3 settlement mechanism may explicitly guarantee settlement, whether the guarantee is by the securities settlement facility itself or by its participants. In such systems, this guarantee represents an extension of intraday credit from the guarantor. In a securities settlement facility that does not provide an explicit settlement guarantee, participants may face settlement risk vis-à-vis each other if a participant defaults on its obligations. Whether this settlement risk involves credit exposures, liquidity exposures or a combination of both will depend on the type and scope of the obligations, including any contingent obligations, the participants bear. The type of obligations will, in turn, depend on factors such as the securities settlement facility's design, rules and legal framework.

4.4.2 In order to manage the risk from a participant default, a securities settlement facility should consider the impact of participant defaults and use robust techniques for managing collateral. A securities settlement facility should cover its current and, where they exist, potential future exposures to each participant fully with a high degree of confidence using collateral and other equivalent financial resources (equity can be used after deduction of the amount dedicated to cover general business risk) (see SSF Standard 5 on collateral and SSF Standard 12 on general business risk).^[14] By requiring collateral to cover credit exposures, a securities settlement facility mitigates, and in some cases eliminates, its current exposures and may provide participants with an incentive to manage the credit risks they pose to the securities settlement facility or other participants. Further, this collateralisation allows a securities settlement facility that employs a DvP model 2 or 3 mechanism to avoid unwinding transactions or to mitigate the effect of an unwind should a participant default on its obligations. Collateral and other equivalent financial resources can fluctuate in value, however, so the securities settlement facility needs to establish prudent haircuts to mitigate the resulting potential future exposures.

4.4.3 A securities settlement facility that uses a DvP model 2 or 3 mechanism and explicitly guarantees settlement, whether the guarantee is from the securities settlement facility itself or from its participants, should maintain sufficient financial resources to cover fully, with a high degree of confidence, all current and potential future exposures using collateral and other equivalent financial resources. A securities settlement facility that uses a DvP model 2 mechanism and does not explicitly guarantee settlement, but where its participants face credit exposures arising from its settlement processes, should maintain, at a minimum, sufficient resources to cover the exposures of the two participants and their affiliates that would create the largest aggregate credit exposure in the system. DvP model 3 mechanisms do not create credit exposures for participants due to the contemporaneous settlement of linked obligations. A higher level of coverage should be considered for a securities settlement facility that has large exposures or that could have a significant systemic impact if more than two participants and their affiliates were to default.

Use of financial resources

4.5.1 The rules of a securities settlement facility should expressly set out the order and circumstances in which specific resources of the securities settlement facility can be used in a participant default (see SSF Standard 11 on participant default rules and procedures and SSF Standard 18 on disclosure of rules, key policies and procedures, and market data). For the purposes of this Standard, a securities settlement facility should not include as ‘available’ to cover credit losses from participant defaults those resources that are needed to cover current operating expenses, potential general business losses or other losses from ancillary activities in which the securities settlement facility is engaged (see SSF Standard 1 on legal basis and SSF Standard 12 on general business risk). In addition, if a securities settlement facility serves multiple markets (either in the same jurisdiction or multiple jurisdictions), its ability to use resources supplied by participants in one market to cover losses from a participant default in another market should have a sound legal basis, be clear to all participants, and avoid significant levels of contagion risk between markets and participants. The design of a securities settlement facility's stress tests should take into account the extent to which resources are pooled across markets in scenarios involving one or more participant defaults across several markets.

Contingency planning for uncovered credit losses

4.5.2 In certain extreme circumstances, the post-liquidation value of the collateral and other financial resources that secure a securities settlement facility's credit exposures may not be sufficient to cover fully credit losses resulting from those exposures. A securities settlement facility should analyse and plan for how it would address any uncovered credit losses. A securities settlement facility should establish explicit rules and procedures that address fully any credit losses it may face as a result of any individual or combined default among its participants with respect to any of their obligations to the securities settlement facility. These rules and procedures should address how potentially uncovered credit losses would be allocated, including the repayment of any funds a securities settlement facility may borrow from liquidity providers.^[15] A securities settlement facility's rules and procedures should also indicate its process to replenish any financial resources it may employ during a stress event, so that it can continue to operate in a safe and sound manner.