FINANCIAL STABILITY STANDARD FOR SECURITIES SETTLEMENT FACILITIES - GUIDANCE

May 2003

Introduction

This guidance is issued in relation to the financial stability standard determined under section 827D(1) of the Corporations Act 2001 (Cth) that applies to Australian clearing and settlement (CS) facility licensees, under Part 7.3 of the Act, that operate a securities settlement facility.

The objective of this guidance is to provide further information and detail on the measures that the Reserve Bank considers relevant for the meeting of the standard. It is intended to assist in the interpretation of those measures, but is not of itself a standard and is not intended to contain obligations that are binding on CS facility licensees.

1. Legal framework

A well-founded legal basis is critical for the safe and reliable operation of a securities settlement facility, and for minimising the potential for financial system instability to arise from its operation. The operator of the securities settlement facility is responsible for identifying and minimising legal risk.

The legal basis of a securities settlement facility includes its operating rules and written procedures, and contractual agreements between participants and service providers. These should be enforceable given the underlying legislative, regulatory and common law framework within which a securities settlement facility operates. [Back to Standard 1]

Measure 1(a) of the Standard

The identification of the operator of the securities settlement facility as a separate legal entity is of particular importance where an entity related to the operator of the securities settlement facility is experiencing operational or financial difficulties, including external administration. Related entities which may expose the operator of the securities settlement facility to risks unrelated to those arising from its function as a securities settlement facility may include a related central counterparty, a financial market, or technology or other service providers.

The legal separation of the operator of the securities settlement facility from other legal entities may also provide protection to those other legal entities should the securities settlement facility itself experience operational or financial difficulties.

The measure does not assume, however, that a legal separation will remove all risks that may arise as a result of operational or financial difficulties faced by a securities settlement facility or related entities. [Back to Standard 1(a)]

Measure 1(b) of the Standard

The contract (or contracts) arising from a securities settlement facility's legal framework must be enforceable, with a high degree of certainty, in the legal jurisdiction within which the securities settlement facility operates, is licensed or otherwise regulated. However, rights and obligations arising from a securities settlement facility's legal framework may also have a connection to other legal jurisdictions, such as where a securities settlement facility has participants that are established in another jurisdiction, or where the securities settlement facility offers services in relation to financial products that are issued in another jurisdiction. These other jurisdictions may be relevant to the securities settlement facility's activities such that the operator of the securities settlement facility would want to ensure that the relevant contracts were legally enforceable in those jurisdictions. However, a jurisdiction with a trivial or merely tangential connection to the securities settlement facility's activities would be unlikely to be relevant in this context.

The measure may be met by the operator obtaining a written and reasoned legal opinion as to the enforceability of the securities settlement facility's arrangements under the laws of each relevant jurisdiction. Such an opinion should include a discussion, to the extent that can be objectively determined, of whether the securities settlement facility's activities in the jurisdiction meet the measure in respect of control of legal risk. [Back to Standard 1(b)]

Measure 1(c) of the Standard

The legal framework of a securities settlement facility will necessarily impose certain rights and obligations upon the securities settlement facility and its participants. The operator of the securities settlement facility must ensure that any and all rights and obligations arising from participation in a securities settlement facility are clearly defined and set out in a securities settlement facility's legal framework. It is not sufficient for key rights and obligations to be implied.

Where a participant or the operator of the securities settlement facility is in external administration or is otherwise facing difficulties, there is scope for these events to cause instability in the broader financial system. A high degree of certainty in the legal framework concerning such events can help to limit the capacity for such instability.

It is important that the rules applying to a default situation are set out in advance: this minimises the opportunity for surviving participants to challenge their liability (in a default situation, there are likely to be strong incentives to undertake behaviour to minimise any contribution, and this could amplify systemic risks). A more detailed discussion is contained in the guidance on measure 6: External administration. [Back to Standard 1(c)]

Measure 1(e) of the Standard

The operator of a securities settlement facility should obtain its own legal advice on legislation that offers legal certainty. For example, if the securities settlement facility offers real-time gross settlement (RTGS), or has arrangements involving the netting of transactions, then its operator must seek the benefit of the relevant sections of the Payment Systems and Netting Act 1998 (Cth). Cross-jurisdictional issues may also be relevant. [Back to Standard 1(e)]

2. Participation requirements

A securities settlement facility's participation requirements must aim to ensure that all participants have sufficient resources, both financial and otherwise, to meet obligations arising from participation in the securities settlement facility. The goal of such requirements is to promote the safety and integrity of the securities settlement facility, and in doing so limit the potential for financial system instability. The operator of the securities settlement facility should, at the same time, ensure that access to the securities settlement facility is not restrictive beyond the need for ensuring financial system stability, and make certain that requirements are fair and are applied equitably across participants.

The reference to fair and open access is directed towards transparency and the reduction of systemic risk, rather than towards competition issues, which are dealt with in Australia under other legislation. [Back to Standard 2]

Measure 2(a) of the Standard

Participation requirements (particularly those relating to risk) should be set out in the securities settlement facility's rules. If tiering exists, each class of participation should be clearly defined and the participation requirements should be the same for all applicants of the same class.
If the securities settlement facility's rules require that key personnel be of good character, the operator of the securities settlement facility should ensure that the process of making this judgement is as objective as possible. [Back to Standard 2(a)]

Measure 2(b) of the Standard

Each participant should be required to have sufficient capacity to process the expected volumes and values of transactions with the required speed, particularly at peak times and on peak days.

The operator of the securities settlement facility must have procedures in place to ensure that its financial requirements are met on an ongoing basis.

Participation requirements must be ongoing. Any breach or potential breach should be required to be reported to the operator of the securities settlement facility. [Back to Standard 2(b)]

Measure 2(c) of the Standard

An appeals process should not detract from the operator's ability to suspend or cancel participation. For serious breaches, the preferable approach would provide for the suspension or cancellation to persist during an appeal, with reinstatement upon a successful appeal, rather than the suspension or cancellation being put on hold until an appeal were heard. [Back to Standard 2(c)]

3. Understanding risks

The operating rules and procedures of a securities settlement facility play a key role in enabling participants to understand the financial risks they incur. The rules should be clear, comprehensive and up-to-date to facilitate understanding by participants and prospective participants of the risks they can face through participation in the system. Explanatory material written in plain language, although not necessarily binding legally, can aid understanding of the facility's design and processes, thus improving understanding of risks that may arise through participation.

Participants and prospective participants should be able to understand the basic design of the system, as that will be an important determinant of their rights and obligations. Rules and procedures should be readily available to all participants and prospective participants and at least the key rules relating to financial risks should be publicly disclosed. Consideration should be given to publicly disclosing all rules.

The rules and procedures should describe the roles of participants and the system operator and the procedures that will be followed in various circumstances (for example, which parties are to be notified of specific events and the timetables for decision-making and notification). They should make clear the degree of discretion parties are able to exercise in taking decisions that can have a direct effect on the operation of the system. There should be clear processes for changing rules and procedures. The degree of discretion the CS facility licensee as operator of the securities settlement facility can exercise to make unilateral changes to the rules or procedures, and any period of notice it must give to participants, should be clear.

Where the operator of a securities settlement facility allows tiered participation (for example, different classes of participation have different rights and obligations in the facility), rules and procedures should cover the impact of tiering arrangements. [Back to Standard 3]

4. Certainty of title

To the extent that it is relevant in the context of a particular securities settlement facility, CS facility licensees should ensure that the facility's participants have proper title to securities held in the facility, as this can reduce a number of risks involved in the custody of securities. These include the risk of loss through the negligence, fraud or operational failure of the securities settlement facility. It can also help reduce the risk of loss upon the insolvency of the operator of the securities settlement facility. [Back to Standard 4]

Measure 4(a) of the Standard

The rules and contractual arrangements relating to title to securities should ensure that the operator of the securities settlement facility and its participants have a high degree of certainty regarding their rights and interests in securities held and recognised by the facility. The legal arrangements put in place by the facility should clearly state the title or interest held by participants. The measure does not require that the facility's rules address all forms of title, interest or dealing available, merely those it purports to recognise. [Back to Standard 4(a)]

Measure 4(b) of the Standard

The facility's procedures should address the legal and operational mechanisms governing the transfer of title or interests between participants. The mechanisms for transfer should ensure that participants know with a high degree of certainty the timing of transfers, and the role of encumbrances, where relevant. [Back to Standard 4(b)]

Measure 4(c) of the Standard

The rules and arrangements relating to title to securities should ensure an effective separation between the assets of the operator of the securities settlement facility and assets that the facility holds on behalf of its participants. In the event of an operator's insolvency, participants should have a high degree of certainty that securities held by the operator are immune from the claims of the operator's creditors. Furthermore, effective separation will allow the transfer of assets from the insolvent operator of the securities settlement facility to participants or to the operator of an alternative facility.

Custody records should not be affected by any operational failure. Sufficient back-up arrangements should be in place to ensure records are not lost even under extreme circumstances, and that they can be accessed in a reasonably timely fashion. [Back to Standard 4(c)]

5. Settlement

This measure is aimed at reducing the risk of systemic disturbance by eliminating principal risk in the settlement of transactions in a securities settlement facility. Primarily, this requires the delivery-versus-payment (DvP) settlement of obligations arising from a trade. By extinguishing payment and security obligations simultaneously, the risk that a party to a transaction will pay away without receiving consideration in kind is eliminated. [Back to Standard 5]

Section (i) of Measure 5: Principal risk and settlement finality

Measure 5(i)(a) of the Standard

Typically, DvP is achieved in one of three ways:

• where the final transfer of payment from buyer to seller and the final transfer of security from seller to buyer occur simultaneously and on a trade-by-trade basis;
• where final securities transfers are settled on a trade-by-trade basis, with final payment transfers settled on a net basis at the end of the processing cycle; or
• where both final securities transfers and final payment transfers occur on a net basis at the end of the processing cycle.

The timing of DvP settlement of trades is important. Where the final simultaneous transfer of securities and payment occurs continuously throughout the day, principal risk is eliminated. Where final transfer of securities occurs continuously, but final payment is deferred until some later time, sellers of securities are exposed to principal risk. Where both securities and payments are exchanged with finality at the end of the day there is a prospect that, even though principal risk is eliminated, net obligations may be sufficiently large that a participant default would cause survivors to face significant liquidity pressures, which could result in systemic disruption.

Only where settlement values are not large may the payment transfers and/or final securities transfers occur on a net basis. In those circumstances, both securities transfer and payment must occur contemporaneously unless this is precluded by operational requirements. Where netting is involved, the operator of the securities settlement facility should ensure that it has taken steps to ensure the certainty of netting arrangements. The operator of the securities settlement facility should, at a minimum, ensure that the final and irrevocable settlement of obligations is completed by the end of the settlement day. [Back to Standard 5(i)(a)]

Measure 5(i)(b) of the Standard

The rules and procedures should clearly set out the conditions that have to be met to ensure that final and irrevocable settlement has taken place. Settlement cannot be considered final until all conditions have been satisfied and there is no further possibility that it will be unwound. [Back to Standard 5(i)(b)]

Section (ii) of Measure 5: Cash settlement assets

Settlement of obligations between providers of cash settlement assets is often referred to as 'settlement of the interbank leg'. The term 'provider of cash settlement assets' is used in recognition that parties other than banks may be involved in this process.

In the case of a DvP transaction, it is the transfer of funds between the buyer's provider of cash settlement assets to the seller's provider that must be made by an irrevocable real-time payment method to meet the measure. [Back to Standard 5(ii)]

Section (iii) of Measure 5: Exposures between providers of cash settlement assets

Where settlement involves the exchange of one asset for another (a DvP transaction), the settlement of obligations requires up to three steps:

• the security (or title over the security) needs to be transferred from seller to buyer;
• payment must be transferred from the buyer's account at its provider of cash settlement assets to the seller's account at its provider; and
• where the buyer and seller have different providers of cash settlement assets, funds must be transferred from the buyer's provider to the seller's provider of cash settlement assets through Exchange Settlement Accounts held by the providers at the Reserve Bank.

Contemporaneous performance of the three steps involved in a DvP transaction requires that:

• the transfer of cash settlement assets is irrevocably linked with the DvP settlement of securities and payment obligations, such that one cannot occur without the other;
• where netting is used, securities blocked prior to transfer are not subject to claims by third parties; and
• final and irrevocable settlement of all obligations arising from a securities trade occurs either simultaneously or within such a very small period of time that the benefits of DvP are achieved. [Back to Standard 5(iii)]

Measure 5(iii)(c) of the Standard

Operational requirements refer to practical matters arising out of the nature of the security and payment being exchanged that preclude contemporaneous settlement. This includes where title must be exchanged by individual physical delivery and, as a practical matter, payment is by other than electronic transfer. [Back to Standard 5(iii)(c)]

6. External administration

This measure is aimed at ensuring the timely settlement of obligations in the event that a participant or cash settlement asset provider goes into external administration.

The impact that a participant in external administration may have on other participants should be minimised through the existence of legally binding arrangements, the timely flow of information, and the institution of appropriate controls and procedures.

There is a difference between external administration and cases where a participant may have sufficient assets to meet its obligations, yet be unable to complete settlement of its obligations due to operational failure or liquidity pressures. This distinction should be recognised in the rules of the securities settlement facility. [Back to Standard 6]

Measure 6(a) of the Standard

The operator of the securities settlement facility should have a legally binding requirement for participants to inform it should they go into external administration, or reasonably suspect that this will occur. Such communication should be at an appropriately high level both within the participant organisation and the operator of the securities settlement facility. [Back to Standard 6(a)]

7. Operational risk

The aim of this measure is to minimise the risk that deficiencies in information systems or internal controls, or a failure of personnel or management, will result in losses to participants of the securities settlement facility and potential systemic disturbance. [Back to Standard 7]

Section (i) of Measure 7: Security and operational reliability

Measure 7(i)(c) of the Standard

Operational and back-up computer systems, and links between systems, should have ample, scalable capacity for anticipated daily volumes, and be subject to stress testing. [Back to Standard 7(i)(c)]

Measure 7(i)(d) of the Standard

All procedures relating to change management should be thoroughly documented. Such procedures should include notification to participants where significant changes occur that may have an impact on the operations of the CS facility.

In the normal course, the operator should ensure that all changes to existing systems and supporting infrastructure are thoroughly tested outside of the production environment. [Back to Standard 7(i)(d)]

Section (ii) of Measure 7: Business continuity procedures

The operator of the securities settlement facility should have comprehensive arrangements in place to address a contingency, i.e. the failure of one or more components of the system. [Back to Standard 7(ii)]

Measure 7(ii)(a) of the Standard

Business continuity procedures should be available to participants. These procedures should in general seek to ensure that minimum service levels are maintained. In extreme circumstances, the procedures may allow for suspension of services.

The transition to back-up systems should be timely and reliable. In general, back-up systems should be capable of the timely completion of daily transactions. [Back to Standard 7(ii)(a)]

Measure 7(ii)(b) of the Standard

The participants of a securities settlement facility should have complementary business continuity arrangements that are appropriate to the nature and size of the business undertaken by that participant. Rules and procedures should clearly and fairly specify the requirements of participants in this regard. [Back to Standard 7(ii)(b)]

Measure 7(ii)(c) of the Standard

The degree of industry participation in the testing should be appropriate to the nature and size of the business undertaken by individual participants. [Back to Standard 7(ii)(c)]

Section (iii) of Measure 7: Outsourcing

The securities settlement facility should ensure that the risks associated with outsourcing key business functions are clearly identified and properly managed. The operator should have a formal policy, determined by its board, which sets out the process for entering into, maintaining and exiting key outsourcing arrangements.

Before an outsourcing arrangement is established, senior management should identify the business, operational and other risks involved and ensure that these risks can be adequately monitored and controlled by the facility.

The board should approve the establishment of any outsourcing arrangement for a key business activity and be informed on a regular basis of the performance of the service provider. [Back to Standard 7(iii)]

Section (iv) of Measure 7: External administration of a related body

Agreements between an operator and its related bodies should be in place to ensure that, to the extent permissible by law, the operator of a securities settlement facility is able to ensure that it continues to access key resources. [Back to Standard 7(iv)]

8. Regulatory reporting

The Corporations Act 2001 (Cth) imposes requirements for notification to regulators in certain circumstances. The measure imposes additional reporting requirements.

Oral notification to the Reserve Bank may be appropriate, particularly in circumstances where timely communication is needed. In practice, this should be followed by notification in writing.

To assist in meeting the measure, formal points of liaison will be agreed upon between the operator of the securities settlement facility and the Reserve Bank.

The Reserve Bank will review information contained in a CS facility licensee's annual report to the Australian Securities and Investments Commission. [Back to Standard 8]

Measure 8(a) of the Standard

This refers to a CS facility licensee's obligations under subsection 821A(aa) of the Corporations Act 2001 (Cth). [Back to Standard 8(a)]