Payments System Board Annual Report – 2007 Ongoing Regulatory Responsibilities
The Board has a number of ongoing regulatory responsibilities that require either regular review or periodic decisions. Over the past year, it has focused heavily on its oversight of licensed clearing and settlement facilities and, in particular, on understanding risks and risk mitigation in central counterparties. It has also granted one approval under the Payment Systems and Netting Act, and the Bank has granted three Exchange Settlement (ES) Accounts.
Oversight of Clearing and Settlement Facilities
The operators of clearing and settlement facilities that serve financial markets in Australia are required to be licensed under the Corporations Act. One of the key obligations of licensees is to meet Financial Stability Standards determined by the Bank. Two standards were determined by the Bank in 2003: the Financial Stability Standard for Central Counterparties and the Financial Stability Standard for Securities Settlement Facilities. The aim of these standards is to ensure that licensees operate their facilities in a way that promotes overall stability in the Australian financial system.
There are four main clearing and settlement facility licensees serving Australia's financial markets – Australian Clearing House (ACH), SFE Clearing Corporation (SFECC), ASX Settlement and Transfer Corporation (ASTC) and Austraclear.[19]
ACH provides central counterparty clearing services to a range of financial products traded on the ASX market, including equities, warrants and equity-related derivatives, while SFECC provides similar services for derivatives traded on the Sydney Futures Exchange (SFE) market. ASTC provides for the settlement of equities and warrants traded on the ASX market. Austraclear offers securities settlement services for over-the-counter trades in debt securities and also provides for cash settlements for derivatives contracts on the SFE market. Cash settlements in relation to derivatives traded on the ASX market can be settled either through ASTC or Austraclear. Following the merger of the Australian Stock Exchange Limited and Sydney Futures Exchange Limited in July 2006, these licenses are held within the one corporate group, now known as the Australian Securities Exchange (ASX) (Figure 1).
The continued rapid growth in trading in Australian financial markets in 2006/07 has seen the value of transactions processed by the four clearing and settlement facilities also expand rapidly. Trading in equities and warrants on the ASX market increased by 35 per cent over the past year to $5.3 billion per day, while the notional value of equity derivatives traded on that market grew by 7 per cent. The notional value of derivatives trading on the SFE market increased by 33 per cent in the year, to $148 billion per day. Since debt securities are traded in an over-the-counter market, trading values are not directly observable, but settlements of debt securities through Austraclear averaged $34 billion per day in 2006/07, an increase of 36 per cent from 2005/06.
Around 70 per cent of cash equities trades are novated to the equities central counterparty, ACH. Netting within ACH reduces the central counterparty's exposure from each day's novated equities trades to an average of $450 million. However, because equities typically settle three days after the trade date, ACH's cumulative exposures are higher, averaging $950 million during 2006/07, an increase of 30 per cent from the previous year.
Equities settlements through ASTC incorporate both trades novated to ACH and non-novated transactions. After netting, the average daily value of ASTC settlements was $525 million in 2006/07, an increase of 37 per cent from 2005/06.
Quantification of the derivatives exposures managed through central counterparties is more difficult. The average volume of open derivatives contracts increased by 7 per cent during the year for ACH and by 40 per cent for SFECC. A more complete measure of the exposures managed is initial margins held by the central counterparty, which reflect both open interest and the central counterparty's assessment of the riskiness of individual contracts, as embodied in margin requirements. Initial margins held by ACH for ASX derivatives increased by 45 per cent to average $503 million in 2005/06, while initial margins held by SFECC increased by 80 per cent to an average of $3 billion.
The Bank is required to assess each clearing and settlement facility licensee at least annually on how well it meets the applicable Financial Stability Standard. These assessments rely upon extensive information gathering from the licensees, quarterly reporting obligations, as well as regular liaison. In 2006/07, the Bank finalised its assessments of the four licensed clearing and settlement facilities for the year ended September 2006. The Bank determined that each of the licensees had satisfied its obligations with respect to the relevant standard.
In the most recent assessment, the Bank focused particularly on the risk management practices of ACH and SFECC. As providers of central counterparty services, these facilities simplify counterparty risk management by replacing exposures to a variety of participants with an exposure to the central counterparty. This arrangement also allows more robust risk controls to be placed on participants and provides additional scope for netting of obligations. Central counterparties, however, also result in a significant concentration of risk. This risk can crystallise if a participant defaults on its obligations to the central counterparty, which is nonetheless required to meet all its obligations to other participants. This concentration of risk means that it is important that measures are in place to provide confidence that, in all but the most extreme circumstances, a central counterparty can accommodate a default without threatening its solvency, or causing significant disruption to financial markets or the financial system more generally.
Clearing and settlement facilities are responsible for determining their own risk management arrangements, consistent with the Financial Stability Standards. These arrangements typically operate at a number of levels.
Firstly, criteria for participation in each facility are used to ensure that only participants that will not adversely affect the safety and stability of the facility are admitted. These criteria cover areas such as the financial strength and operational capacity of the participants.
Secondly, margining is used to limit risk to the central counterparty from a participant defaulting on its derivatives obligations. Participants must post cash or other collateral with the central counterparty when contracts are initiated and pay in additional funds if the market moves against them. SFECC can also impose ‘additional initial margins’ in response to stress tests, and places position limits on participants based on net tangible assets. There are currently no initial margins imposed on physical equities, but unlike most futures and options, equities exposures are short-lived, usually lasting three days.
Thirdly, the financial resources available to the central counterparty are an important protection to the facility. These can be drawn on in the event that losses exceed margins and other assets of a defaulting participant held by the central counterparty. This situation could arise if a default by a participant coincided with a very large market movement.
In the case of ACH, a minimum amount of $110 million was set aside over the assessment period to meet the central counterparty's obligations in the event of a default. This amount included capital and funds paid into a restricted reserve from the National Guarantee Fund in 2005. In addition, insurance of $100 million was obtained in late 2005, which could be drawn upon for losses exceeding $110 million. ACH also had the capacity, over the assessment period, to require non-defaulting participants to contribute up to a total amount of $220 million to meet clearing losses not covered by those other resources, and has access to a line of credit that can be drawn down at short notice to facilitate settlement.
Over the assessment period, SFECC's default fund was $90 million, comprised of capital of $30 million and participant contributions of $60 million. It could call for additional participant contributions if required. Insurance of a further $60 million to cover a range of risks, including default, was also in place.
Both ACH and SFECC have increased the financial resources they have on hand to deal with a participant default since the September 2006 assessment was finalised. In March 2007, ACH increased the minimum funds it holds to $150 million and the amount that ACH may call from non-defaulting participants should other financial resources be exhausted was increased to $300 million. In addition, ACH increased the value of the line of credit it holds to $150 million, enhancing its ability to meet its obligations in a timely manner. Similarly, SFECC increased the size of its default fund to $140 million. Both these changes are currently being assessed by the Bank in the context of the 2006/07 assessment period (see below).
Finally, central counterparties are expected to have systems that allow them to monitor the exposures of individual participants, the level of risk faced by the facility as a whole, and the adequacy of financial resources and margins on an ongoing basis. Stress testing is central to these arrangements, enabling the central counterparty to evaluate potential losses under extreme but plausible circumstances. Stress tests provide a means of evaluating whether a particular combination of risk management arrangements and resources is adequate. Models for determining margins must also be adequate and their validity assessed on a regular basis.
The Bank emphasised in its assessments of central counterparties that, while the facilities are considered to have satisfied the Financial Stability Standards, work being undertaken to improve some elements of risk management should continue to be given a high priority. The ACH assessment also drew attention to the large stress loss exposures faced by ACH from time to time. ACH has subsequently put in place a system of participant contributions that addresses these exposures for cash equities.
The Bank has decided, in consultation with ASX, to change the assessment timetable from 2006/07. Assessments will now be undertaken as at the end of June each year. The Bank is currently in the process of conducting an assessment of the licensed clearing and settlement facilities for the nine months to June 2007; from 2008, the assessments will relate to the full year to June.
Approvals under the Payment Systems and Netting Act 1998
Under Part 3 of the Payment Systems and Netting Act, the Bank has the power to approve a multilateral netting arrangement. An approval protects the net amounts calculated in a multilateral netting arrangement in the event of legal challenge should a party to the arrangement enter external administration. Without approval, there is some risk that surviving participants in the arrangement may be forced to pay their gross obligations to the defaulting institution with the prospect of receiving nothing in return.
ASTC operates the settlement system for the Australian equities market and for related markets, including some derivatives. As a part of this operation, each day ASTC calculates settlement obligations between its settlement participants arising from financial market transactions. This involves the calculation of net settlement positions in funds and equities for each participant.
The net payment positions between ASTC settlement participants give rise to interbank payment obligations. Therefore, ASTC also calculates net interbank obligations between holders of ES Accounts acting on behalf of ASTC settlement participants. These payment obligations are settled in RITS as a batch at around 12.30pm each day, with the settlement of related equities positions occurring in ASTC's clearing house electronic sub-register system (CHESS).
ASTC applied to the Bank for these netting procedures to be approved under Part 3 of the Payment Systems and Netting Act. Given the importance of legally robust clearing and settlement arrangements to the financial markets which ASTC serves, the risk of disruption to the banking system, and having regard to the criteria set out in the Payment Systems and Netting Act, the Board agreed that approval of the multilateral netting arrangement operated by ASTC was warranted. An approval was issued on 1 May 2007.
Exchange Settlement Accounts
When the Payments System Board was established in 1998, one of its first tasks was to determine the Bank's policy on access to ES Accounts. These accounts are important for providers of payment services because they provide a means for settlement obligations to be extinguished through the exchange of a settlement asset that carries no credit risk. Some payment systems specify settlement of obligations through ES Accounts.
In early 1999, the Board established a new policy liberalising access to ES Accounts as recommended by the Financial System Inquiry in 1997. Under the policy, providers of third-party payment services are eligible for an ES Account, with institutions supervised by APRA eligible for an account without special conditions.
In addition, in 2003, the Board agreed to relax the requirement that all banks settle RTGS transactions through their own ES Account. In particular, the Board agreed to allow banks with a small value of aggregate payments – less than 0.25 per cent of the value of all RTGS payments – to apply to the Bank to appoint another bank as agent to make payments on their behalf.
In 2006/07, the Bank granted ES Accounts to three applicants: the HongKong and Shanghai Banking Corporation Ltd; Sumitomo Mitsui Banking Corporation; and Allied Irish Banks PLC. The latter two applied for and were granted permission to appoint an agent to make payments on their behalf. A full list of ES Account holders is available on the Bank's website.
Foreign Exchange Settlement Risk
For a number of years the Bank has participated in a subgroup of the BIS Committee on Payment and Settlement Systems (CPSS) (the Foreign Exchange Settlement Risk (FXSR) Subgroup). The subgroup is responsible for assessing strategies for the reduction of foreign exchange settlement risk and, as part of that role, also undertakes, in conjunction with the US Federal Reserve, co‑operative oversight of Continuous Linked Settlement (CLS) Bank. These roles have involved the Bank in two major streams of work during the year – the process for approval of new business to be undertaken by CLS Bank and a survey of foreign exchange settlement risk.
CLS Bank
CLS Bank was established in 2002 as a response to the concern of many central banks and other regulators that no effective mechanism existed for the elimination of settlement risk associated with foreign exchange transactions. That risk is created when the settlement of the sale of one currency is completed before settlement of the currency bought. Because settlement occurs across different payment systems in different time zones (for example, RITS for the Australian dollar and Fedwire for the US dollar) there was no effective means of achieving payment-versus-payment (PvP) settlement (where both currencies are settled simultaneously) prior to the establishment of CLS Bank.
During 2006/07, the international community of central banks considered proposals by CLS Bank to expand its business beyond PvP foreign exchange settlements. One proposal, now approved, is to settle non-deliverable forward (NDF) foreign exchange contracts and foreign exchange option premiums. While these are foreign exchange related products, payments are one-sided; a participant settling an NDF or option premium will either pay or receive funds in CLS Bank rather than paying funds in one currency and receiving funds in another, as occurs with traditional CLS settlements. A second proposal is for CLS Bank to settle one-sided payments associated with over-the-counter credit derivatives housed in the Depository Trust & Clearing Corporation (DTCC) Deriv/SERV Trade Information Warehouse. This proposal has been subject to close scrutiny by central banks since it extends CLS Bank's settlement of one-sided payments beyond its core foreign exchange business. One concern, expressed by some central banks in the Asia Pacific region, is that the use of CLS Bank to settle a broader range of payments could lead to a further concentration of payments late in the day, increasing operational and other risks. The discussion of these issues was elevated from the FXSR Subgroup to a Senior Level Ad-Hoc Task Force convened specifically for the purpose. Following extensive discussion and consultation, the international community of central banks has approved this additional business subject to a set of conditions and a series of undertakings by CLS Bank.
Foreign exchange settlement risk survey
Also in 2006/07, the FXSR Subgroup continued work on a comprehensive survey of financial institutions in order to assess current foreign exchange (FX) settlement practices. This updates two earlier surveys conducted by the CPSS in 1996 and 1997 (and replicated by the Bank in 1997 and 1998). The current survey sought information on settlement practices for the month of April 2006, and aimed to cover at least 80 per cent of total FX settlements by involving 109 institutions. The Bank coordinated collection of data from Australian-based banks with significant FX operations, while data on the operations of foreign banks based in Australia were collected by the central banks in the countries where the banks' head offices are located. The report on the survey ‘Progress in reducing foreign exchange settlement risk’ was released by the Bank for International Settlements in July 2007 as a consultation document.
The survey collected data from institutions on the values settled through different settlement methods, by currency and by counterparty. It also incorporated a qualitative component, based on interviews, to assess institutions' management of FX settlement risk. Globally, the surveyed institutions reported average daily FX settlements equivalent to US$3.8 trillion in April 2006; Australian dollar settlements accounted for around 3 per cent of the total.
As part of the survey, settlements were classified into six settlement methods: CLS Bank; traditional correspondent banking; bilateral netting; ‘on us’ without settlement risk; ‘on us’ with settlement risk; and other PvP. The results show that settlement through CLS Bank has become the predominant method of settling FX transactions, accounting for 55 per cent of the value of global settlements (Table 11). The next most common method is through traditional correspondent relationships, with this method still accounting for around one-third of settlements. The only other method of settlement accounting for significant values is bilateral netting, which accounted for around 8 per cent of the total.
The pattern for the Australian-based banks is similar to that for banks in other countries, with around 60 per cent of settlements through CLS Bank and 35 per cent through traditional correspondent banking arrangements. Across currencies, the settlement methods used for the Australian dollar are similar to those used for other currencies (see Table 12).
Overall the development of the CLS service and its adoption means a large proportion of FX settlements are now undertaken on a PvP basis and generate little or no FX settlement risk.
Footnote
A fifth licensed facility operated by IMB Limited is not subject to the Financial Stability Standards due to its small size. [19]