Payments System Board Annual Report – 2009 Oversight of Clearing and Settlement Facilities

The Reserve Bank Act assigns responsibility to the Payments System Board for ensuring that the powers and functions of the Reserve Bank relating to the oversight of clearing and settlement (CS) facilities under the Corporations Act are exercised in a way that ‘will best contribute to the overall stability of the financial system’.

Under the Corporations Act, CS facilities licensed to operate in Australia are required to comply with financial stability standards set by the Reserve Bank.[7] Four licensed CS facilities, all owned by the Australian Securities Exchange (ASX), are currently required to meet the Financial Stability Standards:[8]

  • Australian Clearing House (ACH) – the central counterparty for cash equities and equity-related derivatives traded on the ASX market;
  • SFE Clearing Corporation (SFECC) – the central counterparty for derivatives traded on the Sydney Futures Exchange (SFE);
  • ASX Settlement and Transfer Corporation (ASTC) – the settlement facility for cash equities and warrants traded on the ASX market; and
  • Austraclear – the settlement facility for fixed-income securities traded in over-the-counter markets.

While assessment is ongoing throughout the year, the Board conducts a formal assessment of each facility's compliance with the standards once a year. The assessments covering the 2007/08 financial year were published in October 2008.

Other work of the Board in relation to its oversight of CS facilities during 2008/09 included: variation to the Financial Stability Standard for Central Counterparties, to give effect to a regime for oversight of overseas facilities; and variation to the Financial Stability Standard for Securities Settlement Facilities, to require the collection and publication of data on equities securities lending.

In addition, the Board had oversight of two pieces of work undertaken by the Reserve Bank: the review of participation requirements in central counterparties, carried out jointly with ASIC in early 2009; and a survey of the over-the-counter (OTC) derivatives market in Australia carried out by the Reserve Bank jointly with ASIC and APRA.

The Board's work in these areas is summarised below.

Developments in Clearing and Settlement over 2008/09

Volatility in financial markets rose to extremely high levels over 2008/09, reflecting strains throughout the global financial system. In response, traded volumes and values in a number of the markets served by Australia's CS facilities declined, in some cases substantially. The turbulence in financial markets and associated concerns with some firms' financial positions also resulted in an increase in the risks faced by the central counterparties. While Lehman Brothers was not a direct participant in either central counterparty or ASTC, the investment bank's failure did pose some challenges. Nevertheless, as discussed above in ‘Performance of Australia's Payments Infrastructure during the Market Turbulence’, all four licensed CS facilities were resilient to the turbulent conditions during this period.

The value of equities and derivatives transactions processed by the licensed CS facilities declined in 2008/09. While average daily trading volumes increased by around 16 per cent in the cash equities market, the average daily value fell by 30 per cent, reflecting the substantial decline in share prices during the year (Graph 23). Combined with the longer term trend towards breaking up large orders for gradual release into the market, this resulted in a continuing fall in the average transaction size. The fall in average settlement value on each side of the daily net Clearing House Electronic Sub-register System (CHESS) settlement batch was more moderate than the fall in the value of cash equities trades, as a result of the netting of obligations in the batch. The average settlement value on each side of the daily net CHESS settlement batch fell by 2 per cent to about $620 million in 2008/09.

The slower growth in trading activity in 2008/09 reflected an increase in risk aversion among market participants in the face of the financial market turbulence. Market volatility had been elevated since September 2007 when financial market strains first emerged, but was particularly high in late 2008 following the bankruptcy of Lehman Brothers (Graph 24). The ban on covered short selling imposed by ASIC in September 2008 – due to concerns about its potential to contribute to unwarranted price fluctuations in an already volatile market – may also have limited trading activity to some extent. The ban was subsequently removed in November 2008 for non-financial stocks and in May 2009 for financial stocks.

Activity in the ASX and SFE derivatives markets declined substantially during the year in response to the turbulent market conditions, with only a modest recovery late in 2008/09, at least for the major interest rate contracts. Volumes traded on the SFE market fell by 28 per cent in 2008/09, with average open interest in the government bond contracts declining by around a third, and open interest in the 90-day bank accepted bill futures contract declining by 5 per cent. Volumes traded on the smaller ASX derivatives market fell by 18 per cent in 2008/09.

Trading in debt securities was also relatively subdued, after strong growth in recent years. The value of debt securities settled through Austraclear (comprising outright purchases and sales, as well as repos of debt securities) averaged around $42 billion in 2008/09, broadly flat, compared with growth of around 30 per cent in each of the previous two financial years. There was, however, some variability within the year, including a sharp increase in repo activity in September and October 2008 as market participants' demand for liquidity rose during the financial market turbulence (Graph 25).

Notwithstanding the decline in trading activity, the risks faced by the central counterparties – as measured by the value of margin collected from participants – increased during 2008/09 as market volatility rose. The central counterparties' participant monitoring also intensified as strains in the financial system threatened the financial standing of some clearing participants. More details on the central counterparties' risk-management activities, including additional steps taken in response to the market turbulence, are discussed above in ‘Performance of Australia's Payments Infrastructure during the Market Turbulence’.

In the case of ACH, average daily exposure to participants' settlement obligations arising from cash equities trades on the ASX market (almost three-quarters of which are novated to ACH) was $993 million in 2008/09.[9] This was a 23 per cent fall from the exposure faced in 2007/08 due to the decline in traded values. However, taking into account the increased market volatility, the risks faced by ACH in relation to these exposures increased. ACH does not routinely collect margins in respect of participants' cash equity positions, but does calculate a notional margin amount for ASX 200 stocks. Average daily notional initial margin rose by 10 per cent to $175 million, with average mark-to-market margin little changed at $41 million.

Similarly, while derivatives traded volumes and open interest declined, the risk associated with the remaining positions rose as market volatility increased. Both ACH and SFECC raised initial margin levels sharply in late 2008. For ASX-traded derivatives, the daily average of initial (risk) and mark-to-market margins required by ACH was broadly constant at around $1.6 billion in 2008/09, despite the decline in positions (Graph 26). Initial margins collected in respect of trades on the SFE market increased by 26 per cent to a daily average of $3.6 billion in 2008/09.

Consistent with international developments, the Australian cash equities market faces the prospect of competition in trading. Three applications for market licences to provide trading platforms for ASX-listed equities to compete with the ASX market are currently awaiting a decision by the Minister for Financial Services, Superannuation and Corporate Law.[10] If these licences are granted, arrangements would need to be made to enable the new trading platforms to clear and settle trades. ASX has consulted with industry and market licence applicants on how these platforms might connect to ACH and ASTC and in December 2008 published draft high-level business requirements for the provision of these services to non-ASX trading platforms. The Reserve Bank has been in regular dialogue with ASX and ASIC on this matter.

2007/08 Assessment

In October 2008, the Reserve Bank published its Assessment of the four licensed CS facilities against the relevant Financial Stability Standards, covering the year to end-June 2008. The Reserve Bank concluded that all four facilities met the relevant standard over this period.

The period covered by the Assessment was a challenging one in many respects. Volatility, particularly in the equities market, increased significantly, as did traded volumes and values in a range of markets. There were also some highly publicised financial difficulties at a number of brokers. Given these developments, the Assessment paid particular attention to the adequacy of the facilities' risk controls, both in terms of ongoing monitoring of participants and management of financial risks.

The Assessment drew out a number of important developments during the period under review, particularly in respect of risk-management practices at ACH and SFECC. These included:

  • Enhancements to stress-testing capabilities: Both ACH and SFECC continued to enhance their stress-testing arrangements, with SFECC implementing a new stress-testing framework during the assessment period. The Assessment concluded that the introduction of these arrangements provided a useful way to gauge the adequacy of the central counterparties' risk resources, particularly as the value of novated trades increases over time.
  • The mapping of stress-test outcomes to risk resources: ACH completed the phased implementation of a regime whereby additional collateral is called from participants when large exposures are identified by daily stress tests. This was seen as particularly important in respect of the cash equities market, where the absence of routine margining left ACH reliant entirely on pooled risk resources to cover exposures. A similar arrangement had been in place at SFECC for some time.
  • The introduction of greater flexibility to treasury investments and the management of risk resources: During the 2007/08 assessment period, ASX created a new corporate entity, ASX Clearing Corporation (ASXCC), to manage the investment of all assets held by ACH and SFECC as well as raise market-based funding for these entities. The Assessment concluded that this new structure would add flexibility to the treasury function and the management of the central counterparties' resources.[11]

The Assessment also highlighted a number of areas in respect of which further consideration by ASX was encouraged.[12] These included:

(i) The need for enhancements to existing arrangements for the settlement of cash equities

In the Review of Settlement Practices for Australian Equities (the Review), published in May 2008, the Board recommended changes to existing settlement processes to address the risks revealed by a disruption to equity settlement in late January. The Assessment of ASTC encouraged ASX to give further consideration to the recommendations in the Review, and in particular modifying the batch-settlement process by introducing a firm deadline for the back out of the settlement obligations of a participant that is unable to meet its payment obligations. In response, ASX released a consultation document in December 2008, seeking views on a range of possible amendments to existing processes. These included: establishing a firm deadline for the back out of settlement obligations; requiring that participants connect to CHESS RTGS, an existing, but currently unused, mechanism for delivery-versus-payment (DVP) settlement outside of the single daily net batch process; and removing ACH derivatives margins from the daily equity settlement batch (so as to ensure that timely settlement of payments integral to central counterparty risk management were not dependent on completion of the equity settlement process).[13]

At the time of publication of the Assessment, ASX had already made progress in respect of the Board's recommendation that arrangements for dealing with settlement fails be enhanced. These included the announcement of:

  • an increase in the minimum and maximum penalty fees applied in respect of failed trades – an increase in the minimum from $50 to $100, and an increase in the maximum from $2,000 to $5,000; and
  • a regime whereby if a trade remained unsettled on the fifth day after trade date (ie, two days after the intended settlement date), the party failing to deliver would be required to close out the position in the market.

Both changes were ultimately implemented after the assessment period – on 1 September 2008 and 30 March 2009, respectively.

In addition, as suggested in the Review, the Reserve Bank opened a dialogue with ASX, other regulators, and market participants around a framework for disclosure of equities securities lending activity. This was progressed after the assessment period and is discussed further in ‘Disclosure of Equities Securities Lending’, below.

(ii) The arrangements for monitoring participants

In light of the financial difficulties experienced by several brokers in early 2008, considerable attention was paid in the 2007/08 Assessment to the facilities' monitoring of their participants. These problems highlighted that risks to clearing and settlement processes arising from participants' off-market activities were not adequately captured by existing monitoring arrangements. The Assessment noted the Reserve Bank's interest in the outcome of further review of these arrangements by ASX Markets Supervision. There was also seen to be a case for continuing dialogue on these matters during the 2008/09 assessment period.

In a related development, ACH and SFECC both announced their intention to raise minimum capital requirements for participants. This triggered an adverse reaction, particularly among smaller ACH clearing participants. The Reserve Bank indicated its broad support for efforts to raise the average financial standing of clearing participants, but noted the importance of a risk-based approach to setting participation requirements. In the event, the Minister for Superannuation and Corporate Law asked the Reserve Bank and ASIC to conduct a review of the central counterparties' participation requirements, with particular reference to the prospective increase in minimum capital requirements at ACH. This review was carried out in early 2009, with a joint report published in April 2009.[14] This is discussed further in ‘Review of Participation Requirements in Central Counterparties’, below.

(iii) Treasury investment policy

A new harmonised treasury investment policy was established during the 2007/08 assessment period. The new policy restricted investment to high-quality liquid assets and applied new ratings-dependent limits for unsecured issuer exposures. One issue identified, however, was that the policy still left open the potential for large concentrated exposures to the four largest domestic banks. While recognising difficulties in achieving adequate diversification in suitably high quality and liquid Australian dollar assets, the Assessment noted that the Reserve Bank would be continuing a dialogue with ASX on this matter, in the context of establishment of the new treasury arrangements in ASXCC.

Oversight of Overseas Central Counterparties

In 2008/09, the Board finalised its policy on the application of the Financial Stability Standard for Central Counterparties to overseas central counterparties licensed to operate in Australia.

To date, all licensed central counterparties have been required to comply in full with the Financial Stability Standard for Central Counterparties, irrespective of any other regulatory obligations they are required to meet. With a trend emerging internationally towards cross-border provision of clearing services, the Board endorsed the publication of a consultation paper in October 2008 which set out a proposed regime for the oversight of overseas central counterparties.[15] Following a review of submissions, the regime was finalised by the Board and the Financial Stability Standard for Central Counterparties was varied in February 2009 to give effect to the new arrangements.[16] Under the regime, any overseas central counterparty licensed under Section 824B(2) of the Corporations Act would be exempt from full assessment against the Standard as long as it was able to provide documentary evidence from the overseas regulator that it met all relevant requirements.

A licence may be granted under Section 824B(2) at the Minister's discretion, and only where the applicant is deemed to operate under a ‘sufficiently equivalent’ regulatory regime in its home jurisdiction.[17] While the concept of sufficient equivalence is explicitly recognised in the Corporations Act, the Act provides no detail on how it is to be assessed. Therefore, guidance was also developed on how the Reserve Bank would approach the assessment of sufficient equivalence in relation to the degree of protection from systemic risk. Following a further round of consultation, the Board finalised a three-step approach to this assessment in July 2009, considering: the clarity and coverage of the overseas regime; the oversight process of the overseas regulator; and observed outcomes.[18]

Disclosure of Equities Securities Lending

An important conclusion from the Review of Settlement Practices for Australian Equities was that improved disclosure of securities lending activity in the Australian equities market could help to enhance the robustness of the settlement process and the functioning of the market. During 2008/09, the Reserve Bank worked closely with ASX and others on developing new disclosure arrangements.

In October 2008, the Board endorsed the release of a consultation document setting out a proposed variation to one of the measures underpinning the Financial Stability Standard for Securities Settlement Facilities that would have the effect of requiring ASX to collect and publish relevant information on securities lending activity.[19] Following consultation, a number of practical issues related to how the new arrangements might be implemented were discussed with industry participants, and the regime was finalised in February 2009.[20] Under the regime, settlement participants in ASTC will be required to provide data to ASX on both securities lending transactions and outstanding positions. The key features are:

  • Real-time tagging of all securities loan-related settlement instructions submitted to CHESS. These data will be particularly useful for ASTC as operator of the securities settlement facility, to give visibility of loan-related transactions submitted for settlement and allow settlement performance of such trades to be monitored effectively.
  • Daily reporting to ASX by settlement participants of their outstanding on-loan and borrowed positions, by security. These data will provide a gauge of outstanding loans which might be subject to recall, and allow for separate identification of chains of loans. The Reserve Bank will also work with ASX and others to encourage non-settlement participants to provide similar data on a voluntary basis.
  • Quarterly reporting of the aggregate number of shares committed to lending programs by settlement participants. The Reserve Bank will also work with ASX and the industry to obtain these data from non-settlement participants on a voluntary basis.
  • Daily publication by ASX of the number and value of tagged transactions and the aggregate on-loan position for settlement participants in each security. These will be published alongside relevant comparative statistics and explanatory notes.

ASX is working towards full implementation of the regime by end-December 2009. In the meantime, a pilot phase for the direct positional reporting began in late May 2009, during which the Reserve Bank has been working with ASX and reporting parties to refine the requirements, test systems and processes, and ensure data quality.

Review of Participation Requirements in Central Counterparties

In December 2008 the Reserve Bank and ASIC were asked by the Minister for Superannuation and Corporate Law to provide advice on what is an appropriate ‘core liquid capital’ requirement for participants in Australia's licensed clearing facilities. This followed the implementation of a rule change at ACH whereby the minimum ‘core liquid capital’ requirement for participants was to be increased from $100,000 to $2 million with effect from 1 January 2009, and further to $10 million with effect from 1 January 2010.

Following consultation with ACH participants, the Reserve Bank and ASIC produced a report, which was published in April 2009. The report concluded that there was a strong in-principle case for ACH to set a minimum level of capital for its clearing participants, and that an increase from the previous level of $100,000 was appropriate. Given developments in financial markets over late 2008 and early 2009, however, and uncertainties in the market for third-party clearing, the report recommended a more gradual implementation of the increase in minimum capital requirements. This would allow additional time for the third-party clearing market to deepen and provide further scope for smaller brokers to examine various alternative business strategies.

The Minister accepted these recommendations. ACH also expressed broad agreement with the conclusions of the report and announced an extension to its timetable for increasing minimum capital requirements. The revised timetable is:

  • an increase to $5 million effective 1 July 2010 (and to $10 million for third-party clearers); and
  • a further increase to $10 million, effective 1 January 2012 (with a further increase for third-party clearers to be confirmed).

ASX also announced its intention to consult on possible additional enhancements to its risk framework, with routine margining of cash equities explicitly mentioned.

Survey of the OTC Derivatives Market in Australia

In April 2008, the Financial Stability Forum (FSF) released a report analysing the sources of the emerging turbulence in financial markets and making recommendations to increase the resilience of the financial system.[21] One of the recommendations was to ensure a robust legal and operational infrastructure for the OTC derivatives market.

Following the publication of the FSF report, APRA, ASIC and the Reserve Bank formed a working group to monitor international developments in the OTC derivatives market and assess the conduct of business in the Australian market in the context of the FSF recommendations. The first step was to carry out a survey of OTC derivative market participants in Australia, with an important focus being on risk-management and post-trade processing practices.

The survey was circulated in two phases, in December 2008 and March 2009, with a number of face-to-face meetings also held with respondents. A report detailing the key findings was issued in May 2009. Survey responses confirmed that the scale of activity in the Australian OTC derivatives market is relatively low by international standards and, with the possible exception of the interest rate and foreign exchange segments of the market, also low in absolute terms. Furthermore, Australian market practices have accommodated increasing volumes in recent years, and have also proved resilient to shocks, such as the bankruptcy of Lehman Brothers in September 2008. Perhaps reflecting these factors, improvements to risk-management and operational practices in Australia appear to have been pursued with less urgency than has been the case internationally.

Nevertheless, the survey revealed a number of important developments and enhancements in these areas over time, reflecting general industry-wide improvements in risk management, in part driven by international regulatory initiatives. For instance, there was evidence of increasing acceptance of the importance of timely execution of industry-standard documentation, a continuing trend towards collateralisation of exposures, and a gradual shift towards increased automation and use of third-party platforms for key post-trade processing functions.

While acknowledging these developments, the working group reached the conclusion that there remained room for further enhancement to operational and risk-management practices in the Australian OTC derivatives market. The report on the survey listed a number of areas in which industry was encouraged to work with the authorities to strengthen market practices. In particular, the report encouraged industry to take steps to:

  • promote market transparency;
  • ensure continued progress in the timely negotiation of industry standard legal documentation;
  • expand the use of collateral to manage counterparty credit risks;
  • promote Australian access to central counterparties for OTC derivatives products;
  • expand the use of automated facilities for confirmations processing;
  • expand the use of multilateral ‘portfolio compression’ and reconciliation tools; and
  • increase Australian influence in international industry fora.

Following publication of the report, an industry forum was held to present the findings and elicit feedback from industry participants. Through June 2009, a number of bilateral meetings were also held with relevant industry associations and other stakeholders. The three financial authorities will continue to work collaboratively with industry through 2009/10 to promote the enhancements set out in the report.

Footnotes

These standards, along with minimum measures relevant to meeting the standards and guidance on their interpretation, are available at <http://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/standards/financial-stability-standards.html> [7]

An additional licensed facility, IMB Limited, falls outside the scope of the Financial Stability Standard for Securities Settlement Facilities due to its small size and the limited nature of its operations. [8]

The daily exposure faced by ACH arises from unsettled trades through the three-day settlement cycle. ACH's average total settlement exposure from a single day's trades was $466 million in 2008/09, down by 24 per cent from the previous year. [9]

The Minister has indicated that the applications will be dealt with in conjunction with the implementation of new arrangements for market supervision. This is scheduled for the third-quarter of 2010. Under the new arrangements, supervision of market participants will transfer from ASX Markets Supervision to ASIC. Should competition be permitted, these arrangements will facilitate the monitoring of participants' activities across market venues. [10]

ASX had planned to raise funds for the central counterparties' pooled risk resources by issuing principal-reducing notes via ASXCC. Given turbulent conditions in financial markets, plans to issue these notes were placed on hold until late in the 2008/09 assessment period and have since been postponed indefinitely. [11]

Dialogue continued with ASX through 2008/09 on several of the matters raised in the 2007/08 Assessment, with further developments summarised and discussed in the 2008/09 Assessment of the four licensed facilities, published in September 2009: <http://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/pdf/report-2008-2009.pdf> [12]

ASX has since announced its conclusions and will proceed with a number of enhancements during 2009/10. These include a firm deadline for the back out of settlement obligations and removal of ACH derivatives margins from the daily settlement batch (requiring instead that these be settled via Austraclear). [13]

The joint ASIC/RBA Review of Participation Requirements in Central Counterparties is available at: <http://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/consultations/review-requirements/rprcc-032009.pdf> [14]

The document Consultation on Variation of the Financial Stability Standard for Central Counterparties: Oversight of Overseas Facilities is available at: <http://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/pdf/oversight-overseas-oct08.pdf> [15]

The Notice of Variation is available at: <http://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/pdf/variation-counterparties-feb09.pdf> [16]

The guidance associated with the varied Standard stresses that an overseas central counterparty subject to this regime will retain direct obligations to the Reserve Bank. These obligations might be more onerous where the central counterparty provides services for a particularly large or systemically important market. Indeed, in some circumstances, the Reserve Bank could advise the Minister that licensing under the alternate regime for overseas facilities was not appropriate and that the applicant should operate under a full domestic licence (and hence be subject to full assessment against the Financial Stability Standard for Central Counterparties). [17]

The consultation document Consultation on Assessing Sufficient Equivalence is available at: <http://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/consultations/assess-suff-equiv/ase-052009.pdf> and the final guidance is available at: <http://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/standards/overseas-equivalence.html> [18]

The document Consultation on Disclosure of Equities Securities Lending is available at: <http://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/pdf/disclosure-equities-oct08.pdf> [19]

The document Disclosure of Equities Securities Lending is available at: <http://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/consultations/disclosure-equities-0209/desl-022009.pdf> [20]

The Financial Stability Forum was re-established in April 2009 as the Financial Stability Board (FSB). The FSB has an expanded membership and a strengthened mandate. [21]