Financial Stability Standards for Securities Settlement Facilities – June 2024 Standard 6: 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 securities settlement facility should effectively measure, monitor and manage its liquidity risk. A securities settlement facility 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 securities settlement facility in extreme but plausible market conditions.
Guidance
This Standard applies primarily to a securities settlement facility that assumes liquidity risk as principal, although it also places some obligations where the design of a securities settlement facility generates liquidity risk exposures for its participants. In general, a securities settlement facility operating in Australia would not be expected to assume liquidity 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 liquidity risk as principal, the facility should consult with the Reserve Bank to identify clearly the circumstances in which such risk was assumed.
Liquidity risk arises in a securities settlement facility when it, its participants or other entities cannot settle their payment obligations when due as part of the settlement process. Depending on the design of a securities settlement facility, liquidity risk can arise between the securities settlement facility and its participants, between the securities settlement facility and other entities (such as commercial bank money settlement agents, nostro agents, custodian banks and liquidity providers), or between participants in a securities settlement facility. It is particularly important for a securities settlement facility to manage carefully its liquidity risk if the securities settlement facility 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 securities settlement facility, the securities settlement facility may not have sufficient funds to meet its payment obligations to other participants. In such an event, the securities settlement facility would need to rely on its own liquid resources (that is, liquid assets and prearranged funding arrangements) to cover the funds shortfall and complete settlement. A securities settlement facility 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 securities settlement facility, such as a settlement or custodian bank or liquidity provider. These other roles should be considered in determining a securities settlement facility's liquidity needs.
6.1 A securities settlement facility 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
6.1.1 A securities settlement facility should clearly identify its sources of liquidity risk and assess its current and potential future liquidity needs on a daily basis. A securities settlement facility can face liquidity risk from the default of a participant. For example, a securities settlement facility might not be able to convert a defaulting participant's collateral into cash at short notice. A securities settlement facility 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 securities settlement facility may face additional risk from entities that have multiple roles within the securities settlement facility (for example, a participant that also serves as the securities settlement facility's money settlement agent or liquidity provider). These interdependencies and the multiple roles that an entity may assume within a securities settlement facility should be taken into account by the securities settlement facility. A securities settlement facility that employs a DNS mechanism may also create direct liquidity exposures between participants. In a securities settlement facility that uses a DvP model 2 or 3 settlement mechanism and does not guarantee settlement, participants may face liquidity exposures to each other if one of the participants fails to meet its obligations (see SSF Standard 10 on exchange-of-value settlement systems).
Managing liquidity risk
6.1.2 A securities settlement facility should regularly assess its design and operations to manage, and where possible reduce, liquidity risk in the system. A securities settlement facility that employs a DNS mechanism may be able to reduce its participants' liquidity risk by using alternative settlement designs, such as real-time gross settlement (RTGS) designs with liquidity saving features or a continuous or extremely frequent batch settlement system (see SSF Standard 10 on exchange-of-value systems). In addition, 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 securities settlement facility 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 securities settlement facility that does not settle its funds obligations directly in central bank money (see SSF 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.
6.1.3 A securities settlement facility may use other risk management tools to manage its liquidity risk. For instance, to mitigate and manage liquidity risks from the late-day submission of payments or other transactions, a securities settlement facility could adopt rules or financial incentives for timely submission. And to mitigate and manage liquidity risk stemming from a service provider or a linked FMI, a securities settlement facility could use, individually or in combination, selection criteria, concentration or exposure limits, and collateral requirements. For example, a securities settlement facility should seek to manage or diversify its settlement flows and 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.
6.2 A securities settlement facility 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.
6.2.1 A securities settlement facility should have effective operational and analytical tools to identify, measure and monitor its settlement and funding flows on an ongoing and timely basis, including any use of intraday liquidity. In particular, a securities settlement facility should understand and assess the value and concentration of its daily settlement and funding flows through any money settlement agents, nostro agents and other intermediaries. A securities settlement facility 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 securities settlement facility should be able to determine the value of its available liquid assets, taking into account the appropriate haircuts on those assets (see SSF Standard 5 on collateral).
6.2.2 In a DNS system, a securities settlement facility should provide sufficient information and analytical tools to help its participants measure and monitor their liquidity risks in the securities settlement facility. As part of this, the securities settlement facility should ensure that all participants understand that their settlement obligations might change, and to the extent possible, how they might change, in the event that a participant (or its settlement bank) failed to meet its obligations and the securities settlement facility had to recalculate other participants' obligations in a multilateral net settlement batch.
6.2.3 If a securities settlement facility maintains prearranged funding arrangements, the securities settlement facility should also identify, measure and monitor its liquidity risk from the liquidity providers of those arrangements. A securities settlement facility should obtain a high degree of confidence through rigorous due diligence that each liquidity provider, whether or not it is a participant in the securities settlement facility, 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.
6.3 A securities settlement facility should maintain sufficient liquid resources in all relevant currencies to effect same-day settlement and, where appropriate, intraday or 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 payment obligation in extreme but plausible market conditions.
6.3.1 A securities settlement facility should ensure that it has sufficient liquid resources, as determined by regular and rigorous stress testing, to effect settlement of any payment obligations that it faces as principal with a high degree of confidence under a wide range of potential stress scenarios. In some instances, a securities settlement facility may need to have access to sufficient liquid resources to effect settlement of payment obligations over multiple days to account for any potential liquidation of collateral that is outlined in the securities settlement facility's participant default procedures (see SSF Standard 6.8 on liquidity stress testing).
6.4 For the purpose of meeting its minimum liquid resource requirement, a securities settlement facility'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 securities settlement facility has access to routine credit at the central bank of issue, the securities settlement facility 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.
6.4.1 A securities settlement facility'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 securities settlement facility's qualifying liquid resources (see SSF Standard 6.7).
6.5 A securities settlement facility may supplement its qualifying liquid resources with other forms of liquid resources. If the securities settlement facility 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 securities settlement facility 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 securities settlement facility should not assume the availability of emergency central bank credit as part of its liquidity plan.
6.5.1 A securities settlement facility 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 securities settlement facility's participants and the financial system as a whole.
6.6 A securities settlement facility 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 securities settlement facility 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 securities settlement facility should regularly test its procedures for accessing its liquid resources at a liquidity provider.
6.6.1 A securities settlement facility should have detailed procedures for using its liquid resources to complete settlement during a liquidity shortfall. A securities settlement facility'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 securities settlement facility's rules. In addition, a securities settlement facility 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 securities settlement facility should also adequately plan for the renewal of prearranged funding arrangements with liquidity providers in advance of their expiration.
6.7 A securities settlement facility with access to central bank accounts, payment services or securities services should use these services, where practical, to enhance its management of liquidity risk.
6.7.1 If a securities settlement facility 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 SSF Standard 8 on money settlements).
6.8 A securities settlement facility should determine the amount and regularly test the sufficiency of its liquid resources through rigorous stress testing. A securities settlement facility should have clear procedures to report the results of its stress tests to appropriate decision-makers at the securities settlement facility and to use these results to evaluate the adequacy of, and adjust, its liquidity risk management framework. In conducting stress testing, a securities settlement facility 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 securities settlement facility, include all entities that might pose material liquidity risks to the securities settlement facility (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 securities settlement facility should document its supporting rationale for, and should have appropriate governance arrangements relating to, the amount and form of total liquid resources it maintains.
6.8.1 As part of a securities settlement facility's assessment of the sufficiency of its liquid resources through stress testing, it should also 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 securities settlement facility, and assess the probability of multiple failures and the contagion effect among its participants that such failures may cause.
6.8.2 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 securities settlement facility 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 securities settlement facility's identified liquidity needs and resources in light of current and evolving market conditions. A securities settlement facility 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 securities settlement facility's liquidity risk management model should be performed at least annually.
6.8.3 A securities settlement facility should also conduct, as appropriate, reverse stress tests aimed at identifying the extreme default scenarios and extreme market conditions for which the securities settlement facility's liquid resources would be insufficient. In other words, these tests identify how severe stress conditions would be covered by the securities settlement facility's liquid resources. A securities settlement facility 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 securities settlement facility 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 securities settlement facility determine the limits of its current model and resources; however, it requires the securities settlement facility to exercise judgement when modelling different markets and products. A securities settlement facility 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 securities settlement facility's determination of the appropriate level of liquid resources.
6.9 A securities settlement facility should establish explicit rules and procedures that enable the securities settlement facility 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 securities settlement facility'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.
6.9.1 In certain extreme circumstances, the liquid resources of a securities settlement facility or its participants required under SSF Standard 6.3 may not be sufficient to meet the payment obligations of the securities settlement facility to its participants.[19] In a stressed environment, for example, normally liquid assets held by a securities settlement facility may prove not to be sufficiently liquid to obtain same-day funding, or the liquidation period may be longer than expected. A securities settlement facility should establish explicit rules and procedures that enable the securities settlement facility 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 securities settlement facility'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.
6.9.2 If a securities settlement facility allocates potentially uncovered liquidity shortfalls to its participants, the securities settlement facility should have clear and transparent rules and procedures for the allocation of shortfalls. These procedures could involve a funding arrangement between the securities settlement facility 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 securities settlement facility 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.
Footnote
These exceptional circumstances could arise from unforeseen operational problems or unanticipated rapid changes in market conditions. [19]