2007/08 Assessment of Clearing and Settlement Facilities in Australia 5.2 SFE Clearing Corporation (SFECC)

Background

SFECC provides central counterparty services for derivatives traded on the SFE market.

SFECC operates within a sound legal framework, based on its Clearing Rules. Under Section 822B of the Corporations Act, these rules constitute a contract under seal between SFECC and each of its participants, and between participants. Among other things, the rules set out the rights and obligations of SFECC and each of its participants in respect of SFECC's provision of central counterparty services. The netting arrangements contained in SFECC's Clearing Rules are further protected under Part 5 of the Payment Systems and Netting Act.

Given the concentration of counterparty risk in a central counterparty, effective risk-management processes are crucial. SFECC manages the risk associated with the potential for a participant default through a range of measures: threshold participation requirements and ongoing monitoring; daily stress testing of exposures; collateralisation of exposures by participants; and the maintenance of a buffer of risk resources, including own capital.

SFECC levies margins on all derivative products. It also levies Additional Initial Margins (AIMs), which can be called when large exposures are identified by capital stress testing. SFECC has access to additional risk resources – the Clearing Guarantee Fund (CGF) – on which it can draw in the event of a participant failure. The aggregate value of the CGF is currently $400 million, comprising $100 million in SFECC's own capital (including a subordinated loan provided by SFE Corporation); participant commitments of $150 million (of which $120 million is paid up in advance and $30 million is contingent); and default insurance of $150 million.

At the end of June 2008, SFECC had 15 participants, predominantly large foreign banks and their subsidiaries. Two participants resigned during the assessment period and one joined.

Assessment of Developments in 2007/08

Since the merger of ASX and SFE in September 2006, a number of steps have been taken to enhance risk-management capabilities and harmonise practices across SFECC and ACH. In particular, during the assessment period, SFECC has made improvements to its capital stress-testing arrangements and added significantly to its risk resources. Another important focus in this assessment has been SFECC's participant-monitoring processes. While the financial difficulties experienced by a number of ASX brokers during the first half of 2008 did not have a direct impact on the SFE market, or the capacity of SFECC participants to meet their obligations to the central counterparty, the Reserve Bank has sought to establish that risks identified by the episode are effectively managed by SFECC. Changes to SFECC's margin-setting and treasury-investment arrangements are also described, as well as SFECC's operational performance.

Capital stress testing and risk resources

The Reserve Bank's assessment report for the 2006/07 period noted that SFECC had been engaged for some time in developing a new capital stress-testing framework. Stress tests are applied to participants' end-of-day positions, enabling SFECC to gauge the adequacy of its pooled risk resources to meet any projected stress-test losses beyond the value of a participant's margins posted. SFECC is thereby able to identify occasions when additional collateral should be sought from participants in respect of exceptionally large positions.

A new suite of stress tests was ultimately implemented in two phases during the 2007/08 assessment period – in November 2007 and March 2008. SFECC now runs 30 stress-test scenarios daily, based on a range of individual and composite percentage price changes for the four largest contracts (SPI 200 futures; 90-day bank accepted bill futures; three-year Commonwealth Treasury Bond futures; and ten-year Commonwealth Treasury Bond futures). Activity on the SFE market is highly concentrated in these four contracts, with SPI 200 futures alone accounting for around 60 per cent of total initial margins posted to SFECC. For individual contract scenarios, stress tests aim to capture price moves with a once-in-30-years probability of occurring; multi-contract scenarios aim to capture price moves with a once-in-100-years probability.

Should stress testing reveal exceptionally large exposures, SFECC has the capacity to call for AIMs. Participants are subject to AIMs calls in the event that their positions trigger projected stress losses in excess of a pre-defined threshold – the Stress-test Exposure Limit (STEL) – which varies according to the credit standing of the participant. Highly rated participants' STELs are set at the level of the CGF; lower-rated participants' STELs are set at a level somewhat below the CGF. Participants are informed of obligations under the AIMs regime by 7am and must post additional collateral by 11am.

Upon implementation of the first phase of the new stress-testing regime in November 2007, there was a sharp increase in the number and size of projected stress-test losses in excess of the value of the CGF (Graph 7, upper panel). This reflected the increased strength of the stress scenarios, combined with a high level of concentration in clearing participants' open positions. In all, there were 35 occasions during the last quarter of 2007 on which projected stress-test losses exceeded the value of the CGF. These triggered a significant number of, often sizeable, AIMs calls, which peaked at $224 million on 29 November 2007 (Graph 7, lower panel).

In conjunction with the second phase of implementation of the new stress-testing framework, SFECC also reviewed the split between the variable, participant-specific component of its additional risk resources – AIMs – and the fixed, mutualised component – the CGF. As a result of this review, in March 2008, SFECC increased the value of the CGF from $200 million to $400 million (Graph 8). This was achieved via an increase in the value of the subordinated loan from SFE Corporation (from $50 million to $70 million); a doubling of paid-up participant commitments (from $60 million to $120 million); and an increase in default insurance coverage from $60 million to $150 million. The pre-existing capacity to call contingent participant commitments, of up to $30 million, in the event of a participant default was also brought into the CGF.

It is the Reserve Bank's assessment that the new stress-testing framework represents a significant improvement over previous arrangements. Taken together with the increase in risk resources and the close link to the AIMs regime, SFECC's capacity to withstand the default of a large participant in extreme market circumstances has been strengthened.

The Reserve Bank welcomes, in particular, the increase in the level of the CGF, which has reduced SFECC's reliance on AIMs calls. Indeed, since early March, there have been no calls under the AIMs regime, although this also in part reflects the scaling back of clearing participants' open positions on the SFE market. While the capacity to call additional collateral from participants to cover extraordinarily large projected stress losses is a key element of SFECC's risk-management processes, it is important that an appropriate balance be achieved between variable collateral calls and fixed, mutualised risk resources.

One limitation of the AIMs regime is that, should collateral be called under stressed market conditions, the participant may face difficulties in meeting its obligation to SFECC. This could, in extreme circumstances, precipitate a default. Furthermore, stress testing is conducted daily on the basis of positions at the end of the day-time trading session, which may have been established up to almost 24 hours earlier during the previous night-time trading session. With settlement of AIMs calls then not completed until 11am the following day, SFECC can retain uncovered exposure to extreme price moves on new large positions for up to 42 hours (and longer at weekends). Routine initial margin calls are similarly made on the basis of positions at the end of the day-time trading session – consistent with margining practices internationally – but SFECC does have the capacity to call for variation margin intraday in the event that sizeable price movements erode initial margin cover, or in response to significant changes in clearing participants' positions. Clearing participants also often keep excess collateral with SFECC. These elements of SFECC's risk-management framework therefore allow for some amelioration of the risk associated with new positions until the point at which both routine initial margin and AIMs calls are settled, although SFECC currently has no means of calculating and covering projected stress exposures during this period. The Reserve Bank therefore sees a case for giving further consideration to whether the regime might be enhanced so as to allow for AIMs calls to be made sooner after a large position is established, while acknowledging both the potential technological challenges associated with implementation of such enhancements and that the regime already compares favourably with international best practice.

In March 2008, some refinements to the AIMs regime were implemented. First, new STELs became effective, reflecting participants' internal credit ratings.[1] Second, a new discounting policy was introduced within the AIMs regime, whereby highly rated participants became eligible for discounts on their AIMs calls of up to 50 per cent of the projected excess stress loss (up to a maximum discount of $500 million). SFECC applies this discounting system only under normal market conditions. In extreme market conditions – as defined by a stated measure of market volatility – discounting would be suspended and SFECC would require full collateralisation of AIMs.[2] While the introduction of a discounting regime for AIMs reduces the level of cover provided by some participants in normal conditions, the Reserve Bank acknowledges the rationale for recognising participant credit quality in SFECC's risk-management processes.

Margin setting

Margin-setting arrangements at both SFECC and ACH have recently been reviewed and a common approach has been established. Initial margins for SFE futures positions are now set on the basis of a three-standard-deviation (99.73 per cent) confidence interval for price movements, with an assumed close-out period of the higher of one or two days. This compares with the previous methodology of a 99 per cent confidence interval and a one-day close-out assumption for all but the four major contracts (for which the higher of one-day or two-day close-out was applied). All margin rates are to be reviewed on a quarterly cycle, with ad hoc reviews to take place in response to market developments.[3][4]

Treasury investments

As discussed in the assessment of ACH (Section 5.1), an important development during the assessment period has been the creation of a new corporate entity, ASXCC, to manage the treasury function for the two central counterparties in the future. The Reserve Bank has reviewed the prospective new arrangements and accepts that they add flexibility to both SFECC's treasury investment function and the management of its risk resources. The Reserve Bank is currently reviewing the legal robustness of the terms and conditions associated with potential market-based funding of the central counterparties' risk resources via ASXCC.

Also, as noted in the ACH assessment, ASX has recently introduced a harmonised treasury investment policy for the two central counterparties, which will form the basis for the investment mandate to be applied by the new ASXCC entity. In the case of SFECC, the maximum exposure to any issuer, other than the four largest domestic banks, is $120 million, reflecting the level of capital allocated to SFECC's treasury investment activities. The Reserve Bank will continue to discuss the new arrangements with ASX during the period ahead as the new treasury arrangements via ASXCC are finalised.

Participant monitoring and participation requirements

The financial difficulties experienced by several ASX brokers during early 2008 did not directly impact upon the SFE market and the ability of SFECC clearing participants to meet their obligations to the central counterparty. Nevertheless, these events did reveal some potential gaps both in the current industry-wide regulatory framework and in the scope of ASX's existing participant capital- and liquidity-monitoring arrangements. These are being considered by ASX in the context of a review of ASX Markets Supervision's monitoring processes. The episode also provided SFECC with some operational and legal clarity in respect of default-management procedures. The Reserve Bank will pay close attention to developments in this area over the coming year.

Although not directly related to these events, some changes were made during the period to SFECC's participant monitoring and participation requirements; others are planned in the near future.

One notable change during the year was the introduction of a new harmonised internal credit-rating framework for ACH and SFECC in January 2008. At SFECC, the internal model had previously rated participants according to the value of net tangible assets, with a distinction made between ADIs and non-ADIs. Within the new framework, participants are assigned internal ratings of ‘A’ through to ‘E’. These ratings are based on the external rating of the clearing participant (where available) or its parent if that parent provides a guarantee to the clearing participant. Otherwise, credit ratings are based on net tangible assets adjusted for subordinated debt. A participant's credit quality, as reflected in its internal credit rating, determines its STEL and its eligibility for discounts on AIMs calls. Prior to implementation of the new regime, each participant had its own STEL, based on its net tangible assets.

At the end of the assessment period, six of SFECC's 15 participants were rated A; a further seven were rated B; and two were rated D. Six SFECC participants are ADIs. In common with plans at ACH, SFECC is planning to take steps to further improve the average financial standing of its participants. Currently, SFECC participants are required to maintain minimum net tangible assets of $5 million. SFECC recently announced that it intends to increase the minimum requirement for non-bank ADI clearing participants to $10 million, and to $20 million for those clearing for third parties. The timing of this change has not yet been finalised. It is also proposed that bank ADIs will be granted an exemption from these net tangible asset requirements, with reliance placed upon the participant's compliance with the Australian Prudential Regulation¬† Authority's (APRA) prudential regime. While the Reserve Bank supports SFECC's efforts to further enhance the average financial standing of its participants, it is important both that the approach to setting access criteria continues to be risk based and that higher threshold participation criteria complement and do not substitute for close ongoing monitoring of participants. This is acknowledged by ASX.

New products

ASX introduced a new type of derivative contract, known as a contract for difference (CFD), in November 2007. Until then, CFDs had only been available in Australia in the OTC market. ASX CFDs are traded on the SFE market and novated to SFECC. CFD positions are subject to the same risk-management framework as other derivatives traded through SFE. At present, participants' positions in CFDs constitute a very small proportion of SFECC's aggregate risk exposure – on average, initial margins levied on CFD positions account for less than half of one per cent of aggregate initial margins. Should this segment of the market grow substantially, it may become appropriate to submit CFD positions to stress testing.

Operational performance

In April 2008, SFECC brought in-house some of the operational support for its key SECUR system, which had previously been provided by OMX.[5] SFECC is now responsible for all first- and second-level computer system support and business-continuity arrangements. First-level support provides users with a first point of contact; someone with a general working knowledge of the relevant computer systems. Second level support offers more specific expert assistance to users. OMX will continue to provide third-level support; this is the support provided by the product's suppliers (manufacturers, software developers etc).

SECUR achieved a very high level of operational reliability during the period with no reported outages. Capacity utilisation averaged 27 per cent during the assessment period, peaking at 42 per cent. SFECC carried out regular connectivity and procedural tests throughout the period, with satisfactory results. A major business-continuity test simulating loss of the primary Sydney site was carried out for SECUR in November 2007. Other enhancements to operational risk-management policies were implemented during the period, including in respect of pandemic response planning, fraud control and incident management.

Summary

It is the Reserve Bank's assessment that SFECC has complied with the Financial Stability Standard for Central Counterparties during the assessment period.

The assessment highlights a number of important developments in respect of SFECC's risk-management practices:

  • enhancements to the stress-testing framework: The new stress-testing framework, which was introduced in two phases during the period – in November 2007 and March 2008 – has significantly improved SFECC's capacity to gauge the adequacy of its risk resources.
  • an increase in risk resources: SFECC doubled the size of its risk resources – the CGF – from $200 million to $400 million, reducing its reliance on collateral calls on participants under the AIMs regime.
  • enhancements to margin-setting processes: A new harmonised margining process was introduced late in the assessment period at ACH and SFECC. For SFECC, the new regime aims to capture three standard deviations (99.73 per cent) of price moves, up from 99 per cent, and amends the assumed close-out period to be the higher of one or two days.
  • new arrangements for the management of treasury investments and funding of risk resources: A new corporate entity, ASXCC, has been created, which will be used in the future to manage the treasury function for ACH and SFECC. The new structure will also add flexibility to the central counterparties' funding and capital-management processes.

Notwithstanding the improvements to SFECC's risk-management practices over the past year, the environment in which SFECC operates continues to evolve. Accordingly, the assessment identifies a number of areas for further consideration by SFECC during the forthcoming period. These include:

  • the arrangements for the ongoing monitoring of participants: The financial difficulties experienced by a small number of ASX brokers during the first half of 2008 did not have a direct impact on SFECC. Nevertheless, the Reserve Bank welcomes the ongoing review of capital- and liquidity-monitoring policies by ASX Markets Supervision, which should further strengthen arrangements. The Reserve Bank will continue to pay close attention to developments in this area over the coming year.
  • participation requirements: SFECC recently announced its intention to raise minimum capital requirements for participants. The Reserve Bank supports efforts to raise the average financial standing of clearing participants, but notes the importance of continued detailed monitoring of participants and a risk-based approach to setting access criteria. This is acknowledged by ASX.
  • the timing of collateral calls on participants with very large positions: The AIMs regime is an important component of SFECC's risk-management processes, which compares favourably with international best practice in this area. However, under this regime, calls can only be made in respect of participants' positions at the close of the previous day-time trading session, leaving a window of uncovered exposure. While acknowledging the likely technological challenges, and other protections afforded by SFECC's risk-management processes, the Reserve Bank sees a case for ASX to give further consideration to how the regime might be enhanced to allow for the calling of AIMs sooner after a trade giving rise to a large exposure is established.
  • treasury investment policies: A new harmonised treasury investment policy was established for ACH and SFECC during the assessment period. It is intended that this harmonised policy will form the basis for the investment mandate to be applied by the new ASXCC entity. The policy restricts investments to high-quality, liquid assets and, except in the case of the four largest domestic banks, sets counterparty limits within the value of capital allocated to treasury investment. The Reserve Bank acknowledges the improvement over the previous regime, but notes that it still leaves open the potential for large and concentrated investment exposures to the four largest domestic banks. The Reserve Bank will discuss the policy further with ASX during the forthcoming period.

Footnotes

Previously, STELs had been based on a participant's external credit rating or its net tangible asset position. [1]

SFECC would suspend discounting – thereby reverting to full collateralisation of AIMs – if exponentially-weighted moving average (EWMA) SPI volatility was 30 per cent higher than historical volatility. [2]

With the exception of electricity contracts which will be subject to a monthly review. [3]

Participants can satisfy their margin and AIMs obligations using cash and certain categories of high-quality, liquid non-cash collateral. Typically cash is used. SFECC previously imposed a $700 million limit on the aggregate value of non-cash collateral posted across all participants. This limit was removed in April 2008, but participants are now required to give two days' notice if they intend to swap cash for non-cash collateral in excess of $50 million. [4]

Similar new ‘in-sourcing' arrangements were introduced for Austraclear's principal system, EXIGO. [5]