Payments System Board Annual Report – 2005 Safety and Stability

The Reserve Bank has responsibility for the soundness of the systems through which financial institutions make payments and settle obligations of around $150 billion each business day. These responsibilities are set out in three pieces of legislation. The Reserve Bank Act 1959, sets out the Payments System Board's responsibilities for the payments system and clearing and settlement facilities. The Payment Systems (Regulation) Act 1998 gives the Bank powers to regulate the payments system. The Corporations Act 2001, gives the Bank responsibility for assessing clearing and settlement facilities' efforts to reduce systemic risk and to determine standards to ensure that these facilities conduct their affairs in a way that promotes financial stability.

Financial Stability Standards

The Bank issued Financial Stability Standards for Central Counterparties and Securities Settlement Facilities in 2003. The intent of the standards, as set out in the Corporations Act 2001, is to ensure that clearing and settlement facility licensees conduct their affairs in a way that causes or promotes the stability of the Australian financial system. Details of the standards have been discussed in previous Annual Reports.

The standards currently apply to four facilities; these are the central counterparties and securities settlement facilities operated by the Australian Stock Exchange (ASX) and the Sydney Futures Exchange (SFE). In the Bank's assessment, all four facilities now meet the relevant standards.

During the year, the Bank made a technical variation to the standard for securities settlement facilities in order to avoid unnecessary regulation of facilities which, due to their small size, are unlikely to have implications for the stability of the overall system. As a result of the variation, the standard only applies to licensees that settle transactions in financial products totalling more than $100 million in a financial year. The Board approved the variation at its May meeting and it came into force on 1 June 2005.

Split of the National Guarantee Fund

As noted in last year's Report, the ASX's central counterparty, Australian Clearing House (ACH) was not in full compliance with Measure 7 of the Financial Stability Standard for Central Counterparties when the standards came into effect. Under this measure, ACH must ensure that, in all but the most extreme circumstances, it has sufficient liquid funds to settle its obligations in the event of the default of a participant. There were, however, doubts about ACH's capacity to do so given its reliance on resources from the National Guarantee Fund (NGF), which could have been subject to competing claims from investors. These claims meant that the exact funding available to ACH for clearing support in the event of a default was uncertain, as was how quickly funds could be accessed.

The Bank's view was that, to the extent ACH needed to rely on funds from the NGF to settle its obligations in the event of a participant defaulting, it did not meet the requirements of Measure 7. The Bank, however, granted ACH transitional relief from the standard pending more appropriate arrangements being put in place. This was achieved in March 2005 following the splitting of the NGF. To achieve the split, the Parliamentary Secretary to the Treasurer directed, under section 891A of the Corporations Act 2001, the transfer of $71.5 million from the NGF to ACH. Under conditions attached to ACH's licence, these funds can only be used for clearing and settlement support and not for any other purpose without the consent of the Minister. ACH's claim on the NGF for clearing support funds was also removed.

This transfer of funds was effected at the end of March 2005, prior to the expiry of ACH's transitional relief from Measure 7 of the standard. At the same time, ASX provided additional funds to ACH in order to bring its available resources up to a level it considered consistent with the standard. It also put in place an emergency assessment power to allow participants to be levied when other resources are insufficient to cover a clearing loss.

Financial Sector Assessment Program

The Australian Government has volunteered to take part in the International Monetary Fund's (IMF) Financial Sector Assessment Program (FSAP), which aims to identify strengths and vulnerabilities in a country's financial system and to determine how key sources of risk are being managed. The IMF is aiming to complete Australia's FSAP by mid 2006, with visits by IMF staff and external experts in December 2005 and March/April 2006. Among other things, the assessment will focus on Australia's compliance with a range of international standards relating to the financial sector. These will include the Core Principles for Systemically Important Payment Systems, against which Australia's real-time gross settlement (RTGS) payment system will be assessed, the Recommendations for Central Counterparties and the Recommendations for Securities Settlement Systems (the Recommendations), against which the facilities operated by the ASX and SFE will be informally assessed.

As noted above, clearing and settlement facilities in Australia are subject to the Financial Stability Standards which came into force on 30 May 2003. While these standards address similar risks to those addressed in the Recommendations, there are variations in approach. The Recommendations, when read in conjunction with the relevant assessment methodology, are quite prescriptive and wide-ranging. They cover areas as disparate as communication procedures and efficiency – areas for which the Reserve Bank does not have responsibility under the Corporations Act 2001. The Financial Stability Standards, on the other hand, focus particularly on factors with potential to affect financial stability. Therefore, while it is likely that the IMF will assess some areas of the facilities' operations as not being in full observance of the Recommendations, this would not be inconsistent with them continuing to be in compliance with the Financial Stability Standards.

In preparation for the FSAP assessment, the Bank has undertaken a self-assessment of the RTGS system – the Reserve Bank Information and Transfer System (RITS) – against the Core Principles for Systemically Important Payment Systems.

The Core Principles were produced by the Bank for International Settlements' Committee on Payment and Settlement Systems (CPSS) in 2001. There are 10 core principles which cover a variety of elements contributing to the safety and efficiency of a system. Four responsibilities of the central bank in applying the Core Principles are also outlined. The Bank's assessment is that RITS performs well against the Core Principles, complying with all nine principles that are considered applicable, along with the four responsibilities of the central bank.^[8]

The positive assessment of RITS reflects two factors. The first is that Australia has established a very sound legal framework for payment systems, based on the 1998 amendments to the Reserve Bank Act 1959, the Payment Systems (Regulation) Act 1998 and the additional legal certainty provided by the Payment Systems and Netting Act 1998. The second is that when Australia developed its RTGS system, which was implemented in 1998, it was able to incorporate the best features of other systems that had been implemented in other countries throughout the 1990s. As a consequence, Australia's system is stable, sound and liquidity efficient.

Foreign Exchange Settlement Risk

Foreign exchange settlement risk is the risk that one party to a foreign exchange transaction will pay the currency it sold but not receive the currency it bought. Policymakers, both in Australia and internationally, have sought to ensure that these risks are understood and measured. The CPSS has established a Foreign Exchange Settlement Risk (FXSR) Sub-Group to assess strategies for reducing foreign exchange settlement risk. The Reserve Bank of Australia is a member of this group.

There are several methods by which foreign exchange settlement risk can be reduced. One solution is provided by Continuous Linked Settlement (CLS) Bank which is a special purpose bank with the aim of eliminating foreign exchange settlement risk in transactions between eligible currencies. The FXSR Sub-Group provides a forum through which co-operative oversight of CLS Bank is undertaken.

CLS eliminates foreign exchange settlement risk by participating in individual currencies' payment systems and linking both legs of a foreign currency transaction, which are settled simultaneously across its books. CLS has been described in more detail in previous Payments System Board Annual Reports.

The Australian dollar has been included in CLS since it began operations in September 2002. In December 2004, four additional currencies were included in CLS – the Hong Kong dollar, Korean won, New Zealand dollar and South African rand. This brings the number of currencies settling in CLS to fifteen (Table 8).

Since it commenced operations, transactions in CLS have grown strongly. In all eligible currencies in 2004/2005, there were around 162,000 transactions per day, with a total value of nearly US$1.8 trillion (Graph 7). There were almost 6,000 Australian dollar transactions per day in 2004/2005, with a value of around A$83 billion – up by around 60 per cent from 2003/2004 (Graph 8).

Operational Resilience of the Financial System

While each organisation in the financial system has responsibility for ensuring the resilience of its operations in the face of accidental or man-made disruption, there are a number of areas where a co-ordinated approach can be useful. To this end, the Bank has been working closely with the Banking and Financial Infrastructure Advisory Group (BFAG), which is one of a number of similar industry groups set up by the Attorney-General's Department. The Group is focusing its efforts on identifying common vulnerabilities – such as those to telecoms infrastructure, utilities and equipment vendors – and devising a means to mitigate the resulting risk. It is also working on ensuring the co-ordination of operational responses to a disruption and identifying industry benchmarks for resumption capabilities.

Footnote

Core Principle V – Settlement in Multilateral Netting Systems is not applicable since RITS is not a multilateral netting system. [8]