Central Counterparties and Settlement Systems

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1 Central Counterparties and Settlement Systems Greg Johnston Reserve Bank of Australia Workshop On Developing Government Bond Market in APEC Economies Shanghai National Accounting Institute, P.R. China November 12-15, 2002

2 Outline The role of central counterparties and settlement systems Australian examples Key standards Regulation

3 Trading, Clearing and Settlement Market Trade Counterparty Counterparty Novation Central Counterparty Clearing Settlement System Settlement Instructions

4 Central Counterparties Central counterparties provide three core services: - standard clearing services (including calculation of net obligations) - a financial guarantee that trade obligations will be settled - associated risk management services These services commence from the point of novation

5 Central Counterparties As a result, central counterparties take on risks associated with trading: - credit risk (including replacement cost and principal risks) - liquidity risk - market risk These risks need to be carefully managed Central counterparty insolvency is possible

6 Settlement Systems Provide the legal, technical and other infrastructure to transfer title to securities As part of this service, they also act as a central depository for securities Registry services may also be provided

7 Settlement Systems Do not, as a result of their core function, take on trading-related risks Settlement systems for Gov t securities often relied upon: - to implement monetary policy - as a source of intraday liquidity in RTGS cash transfer systems

8 Developing a Securities Market Trading, clearing and settlement are essential functions Central counterparty clearing may be desirable, but benefits and risks need to be carefully assessed

9 Current Arrangements in Australia Australian Stock Exchange Sydney Futures Exchange Instruments Equities (Exchange traded) Futures, Options (Exchange traded) Debt (OTC Market) Futures, Options (Exchange traded) Central Counterparties TNS Clearing Options Clearing House SFE Clearing Securities Settlement Systems CHESS Austraclear

10 Settlement System Standards

11 Legal Framework Settlement systems should: - have legally enforceable regulations - not act as a central counterparty (or otherwise take on trading-related risks) - ensure members rights and obligations are clearly defined - have necessary status under relevant legislation to ensure finality of completed transactions netting & zero hour rule

12 Membership Requirements Membership requirements should: - be based on objective and publicly disclosed criteria - require operational capacity to settled in timely manner - allow system operator to suspend a member which breaches its rules or is insolvent

13 Certainty of Title Members must, in all circumstances, have clear and unambiguous title - including where solvency of system operator is in doubt The type of title must be clear (eg legal, beneficial) Method for lending, pledging and transfer of title must be clear

14 Settlement Process Book entry settlement - requires that securities be immobilised or dematerialised Delivery versus payment Finality clearly defined Cash settlement assets must carry little or no credit risk - requires central bank or commercial bank funds

15 Settlement Process No buildup of settlement exposures between commercial banks as providers of cash settlement asset (ie no model 2 DvP) Net versus RTGS settlement should take into account role of Government securities in relevant jurisdiction

16 Risk Management Insolvent member or commercial bank - immediate suspension - where relevant, members must be able to quickly nominate a new commercial bank as provider of cash assets Insolvency of a related party - access to staff, buildings, technical systems and support must be assured

17 Contingency Arrangements Contingency arrangements must include: - detailed plans and back-up systems - regular internal and external testing - regular review of arrangements

18 Technical Systems Computer systems must have: - sufficient capacity to process transaction volumes which are significantly larger than average - regular planning for future processing requirements - a change management regime - backup copies of data

19 Outsourcing Board approved policy must be in place before arrangement is in place - risks must be identified - management must be able to be adequately monitored and controlled Outsourcing must be established in a legally binding contract Board must approve arrangement and be kept informed of service provider s performance

20 Central Counterparty Standards

21 Legal Framework The central counterparty must: - be a separate legal entity from a settlement system - ensure that the point of novation is clearly defined - define the nature and scope of any financial guarantee - define the rights and obligations of members - ensure that any netting used in the arrangement is legally certain

22 Membership Requirements Requirements must: - be based on objective and publicly disclosed criteria - be aimed at ensuring that central counterparty is not exposed to unacceptable credit risks - require members to provide reports relevant to assessing their credit worthiness - allow facility to suspend a member which breaches its rules or is insolvent

23 Settlement of Obligations Payment of standalone cash obligations must be made using an RTGS (or equivalent) payment mechanism Settlement of securities must be done on a DvP basis

24 Default Procedures A central counterparty must have specific default procedures These procedures must require its members to: - inform it if they are insolvent - notify it if they have, or are likely to breach, a risk control requirement Central counterparty must also be able to close out a defaulting member s open contracts

25 Risk Controls A central counterparty must have in place measures which would allow it to meet its obligations even if its largest member defaults These measures would typically include: - margining arrangements - settlement guarantee funds which can readily be turned into cash; and - loss-sharing rules.

26 Stress Testing Regular stress testing must be done to review the adequacy of margin and settlement guarantee funds Scenarios reflect extreme, but possible, changes in market prices Note that members may not have paid all their margins at the time of a failure

27 Separation of Management Risk control section must separate from marketing and business development sections Central counterparty boards should establish a risk committee - should receive independent audit advice on risk controls Risk management staff should report directly to CEO and be under oversight of board s risk committee

28 Other Standards Settlement system standards for contingency arrangements and outsourcing also apply to central counterparties

29 Regulation Roles and responsibilities of central banks and securities regulators should be clearly defined Standards should be publicly disclosed Regulators should have the ability to ensure compliance

30

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