2012/13 Assessment of ASX Clearing and Settlement Facilities B1.2 ASX Clear (Futures)

Standard 12: Participant Default Rules and Procedures

A central counterparty should have effective and clearly defined rules and procedures to manage a participant default. These rules and procedures should be designed to ensure that the central counterparty can take timely action to contain losses and liquidity pressures and continue to meet its obligations.

Rating: Observed

ASX Clear (Futures) has sufficient powers under its Operating Rules and Procedures to manage a participant default, and has documented an internal framework setting out its default management approach (CCP Standard 12.1). Powers available to ASX Clear (Futures) include powers to suspend a defaulting participant, apply margin and pooled financial resources to meet losses, and a range of close-out and hedging tools, including the auction of open OTC derivatives positions to surviving participants (CCP Standards 12.1, 12.2). Participants are also required to report default events or an expected default to the CCP. ASX Clear (Futures) has published its Operating Rules that set out its default management powers, and a high-level overview of its approach to default management (CCP Standard 12.3). Default management procedures are tested and reviewed on at least an annual basis, and future tests of OTC default management arrangements will involve participants, including to test the auction process (CCP Standard 12.4). ASX Clear (Futures)' default management arrangements are designed for the particular characteristics of its primarily Australian-based activities, and take into account potential impacts on relevant markets.

In order to continue to fully observe CCP Standard 12 following the launch of the new OTC derivatives clearing service, the Bank notes that ASX Clear (Futures) should take the following steps:

  • Further develop its default rules and procedures. In particular, in accordance with commitments made to the Bank prior to the launch of the OTC derivatives clearing service, ASX should develop an appropriate mechanism to encourage competitive bidding in any auction of a defaulted participant's positions, doing so within the context of a more fully articulated default management process.

In addition, given the role participants play in default management, the Bank will monitor closely the implementation of ASX Clear (Futures)' plans to test default arrangements for OTC derivatives clearing participants, including through participant involvement in testing (CCP Standard 12.4).

Based on this information, the Bank's assessment is that ASX Clear (Futures) has observed the requirements of CCP Standard 12 during the 2012/13 Assessment period. ASX Clear (Futures)' default management arrangements are discussed in further detail under the following sub-standards.

12.1 A central counterparty should have default rules and procedures that enable the central counterparty to continue to meet its obligations in the event of a participant default and that address the replenishment of resources following a default. A central counterparty should ensure that financial and other obligations created for non-defaulting participants in the event of a participant default are proportional to the scale and nature of individual participants' activities.

Rules and procedures

The Operating Rules and Procedures provide ASX Clear (Futures) with the authority and flexibility to deal with a participant default using a variety of methods to manage its exposure. ASX Clear (Futures) has the ability to close out any open contracts, to exercise or terminate open contracts, or to seek to transfer (port) client positions. The specific close-out method will depend on market conditions and the products in question.

The formal Rules and Procedures are supplemented by an internal Default Management Framework (DMF), applicable to both ASX Clear and ASX Clear (Futures), to assist in the management of a clearing participant default. The DMF is based on high-level principles regarding the management of a default that have been approved by the CS Boards. In particular, these principles specify that the key aim in handling a default is to minimise the impact of the event on the CCP, clearing participants and the market. The DMSG provides oversight and review of the DMF, including discussion of proposed changes prior to submission to the CS Boards.

The DMF covers each stage of a default, from the identification of a default event, to the management of the defaulter's position, real-time monitoring of financial solvency, and financial offset and reconciliation. It is intended to be flexible, rather than prescriptive, and may be developed and adapted as appropriate.

The DMF outlines the key roles and responsibilities in managing a clearing participant default. The ASX Group has established a Default Management Committee (DMC), comprising senior management from relevant policy and operational areas, to be the primary decision-making forum for the management of a default. The DMC's responsibilities range from recommending declarations of default and suspensions, to devising a risk neutralisation plan and overseeing its implementation.

In July 2013, ASX Clear (Futures) amended its default management arrangements for the introduction of its OTC derivatives clearing service. In the event of the default of an OTC participant, ASX Clear (Futures) will convene the relevant Default Management Group (DMG), which comprises non-defaulting clearing participants, seconded on a rotating basis. The DMG will advise and be consulted by ASX Clear (Futures) on each stage of the management of the default. ASX Clear (Futures) is not obliged to follow the recommendations of the DMG, but will provide reasoning where it does not accept the DMG's advice.

Use and sequencing of financial resources

Following a declaration of default, ASX Clear (Futures) will suspend the defaulting participant's authority to clear. Suspension, rather than termination, ensures that the participant remains bound by the central counterparty's rules. There are no further payments or collateral movements to the clearing participant following declaration of a default. This enables the central counterparty to ‘crystallise’ the defaulting participant's position and generate detailed account and position data (including collateral held). This establishes the basis for the close out of exposure to the defaulting participant.

In the first instance, ASX Clear (Futures) would meet obligations arising from a participant default using collateral lodged by that participant. Collateral may be in the form of cash or eligible securities (see CCP Standard 5.1). Where the defaulting participant's contributions are insufficient, ASX Clear (Futures) may draw upon pooled financial resources (see CCP Standard 4). Under the amended default arrangements introduced in July 2013, these resources are commingled across futures and OTC products. While not essential, the commingled default fund adopted by ASX Clear (Futures) simplifies the default management process when the defaulter's portfolio contains both OTC derivatives and cross-margined futures positions. ASX regards the commingling of financial resources as appropriate in light of the homogeneity of both the products to be cleared and the clearing participants. The order in which survivors' contributions to pooled financial resources will be used (i.e. the default waterfall) will, however, be proportional to the scope of the defaulter's activities. The proportion of futures and OTC participant contributions that would be used after each tranche of ASX capital will be based on the defaulter's share of initial margin for exchange-traded compared with OTC derivatives products (including cross-margined futures) over the previous 90 days.

ASX has withdrawn its power to call an additional $30 million in promissory commitments from futures participants in the event that paid-up resources are exhausted. Since these funds would only be available a significant time after a participant default, they were not taken into account by the Bank when assessing the adequacy of ASX Clear (Futures)' financial resources.

ASX has documented, in an internal paper provided to the ASX Limited Board, a process for making decisions regarding replenishment of ASX Clear (Futures)' financial resources following any draw down arising from a participant default. Responsibility for determining if financial resources will be replenished and, if so, how this should be achieved, ultimately lies with the ASX Limited Board, which would make this decision in consultation with the ASX Clear (Futures) Board. ASX's documented replenishment intentions canvass several options, including the injection of additional funds from within the ASX Group, from participants or from third-party institutions. The particular approach taken will depend on the specific circumstances, including the severity of the loss and the market environment (see also CCP Standard 4.8). ASX Limited has also committed to maintaining a certain level of equity capital in ASX Clear (Futures) (including via ASXCC) provided certain conditions are met, including that ASX Clear (Futures)' is solvent. For its part, the Bank would require that any potential new formulation of financial resources continued to meet the CCP Standards.

Default management – futures

The DMF and the Operating Rules and Procedures allow ASX Clear (Futures) to employ a variety of methods to close out or otherwise manage the positions of a defaulting participant. These include transfer, on- or off-market liquidation, expiry, exercise, compulsory settlement (generally considered to be a last-resort method of closing out, and not available in respect of OTC products) and hedging (see CCP Standard 12.2(b) for more information on close-out arrangements).

Default management – OTC derivatives

In addition, ASX Clear (Futures) has outlined its intended approach to the default of an OTC participant. ASX Clear (Futures) will first suspend the defaulting participant and terminate its open positions, then look to hedge its exposure to non-defaulting participants. ASX Clear (Futures) may engage one or more participating members of the relevant DMG to assist in this process. ASX Clear (Futures) then plans to conduct one or more auctions to establish new open contracts equivalent to those terminated (including hedges). ASX Clear (Futures) may set a reserve price on the default auction(s).

All OTC participants that have positions in the relevant products are required to bid in the auction of a defaulter's portfolio, or else the contributions to pooled financial resources by non-bidders will be used ahead of the contributions of other non-defaulting participants (so-called ‘juniorisation’). However, there is currently no incentive in the rules for non-defaulting participants to bid competitively. Absent a mechanism to allocate positions to restore its matched book, ASX Clear (Futures) would hold the hedged position until it could re-run the auction successfully or bilaterally negotiate a sale. ASX has committed to developing an effective mechanism for juniorising contributions over the next few months, and expects to be in a position to implement such a mechanism by December 2013. In the short term, uncompetitive bidding is less likely, since relatively low volumes in this initial period make it likely that a defaulter's portfolio would be relatively small and not complex. To limit the expansion of ASX's OTC derivatives clearing service before this occurs, ASX has committed to implementing a form of juniorisation approved by the Bank prior to any introduction of a client clearing service.

As an alternative to an auction, ASX Clear (Futures) may agree the transfer of equivalent contracts with a non-defaulting participant if this will not result in the application of non-defaulting participants' commitments.

12.2 A central counterparty should be well prepared to implement its default rules and procedures, including any appropriate discretionary procedures provided for in its rules. This requires that the central counterparty should:

  1. require its participants to inform it immediately if they:
    1. become subject to, or aware of the likelihood of external administration, or have reasonable grounds for suspecting that they will become subject to external administration; or
    2. have breached, or are likely to breach, a risk-control requirement of the central counterparty; and
  2. have the ability to close out, hedge or transfer, a participant's open contracts in order to appropriately control risk of a participant that:
    1. becomes subject to external administration; or
    2. breaches a risk-control requirement of the central counterparty.

To facilitate early identification of a default event, the ASX Clear (Futures)' Operating Rules and Procedures require that participants inform ASX Clear (Futures) immediately in the event of a default, or if there is a reasonable expectation of such an event. This requirement is legally binding and would continue to apply even in the event that an external administrator was appointed to the clearing participant. The Operating Rules and Procedures envisage a number of possible events of default. These include: becoming subject to external administration; being unable to meet obligations relating to open contracts; default of the clearing participant at another CCP or exchange; and being in breach of the CCP's risk-control requirements, such as failing to fulfil margin or other payment obligations to the CCP.

Although the ASX Clear (Futures) Operating Rules set out specific events of default, declaration of a default is never automatic. Instead, ASX Clear maintains the right to investigate a potential default fully, taking into account any extenuating circumstances. The process of investigating, and the subsequent handling of, a potential default depends on its nature. Specifically, the rules distinguish between ‘operational’, ‘compliance’ and ‘financial’ defaults. This differentiation appropriately reflects the gravity and potential ramifications of a declaration of default. Ultimately, the declaration of any default is the responsibility of the Managing Director and Chief Executive Officer of ASX, under delegated responsibility from the CS Boards.

The DMF and the Operating Rules and Procedures allow ASX Clear (Futures) to employ a variety of methods to close out or otherwise manage the positions of a defaulting participant. These include transfer, on- or off-market liquidation, expiry, exercise, compulsory settlement (generally considered to be a last-resort method of closing out) and hedging. In respect of the OTC derivatives clearing service, ASX Clear (Futures) may conduct an auction of the defaulting participant's OTC derivatives positions.

There are advantages and disadvantages to each close-out method and therefore the specific method used in practice will depend on market conditions and the products in question. For example, subject to other legal and practical impediments, the account structure used by the CCP is a factor in determining the ease with which client positions can be transferred following a default event. Since ASX Clear (Futures) offers omnibus client account with net margining, transfer of individual client positions in a default event may be difficult due to possible under collateralisation of individual positions (see CCP Standard 13). As described in CCP Standard 12.1, ASX policy establishes a preference for controlling the risk associated with a defaulted participant's OTC derivatives positions through a process of hedging then auction.

12.3 A central counterparty should publicly disclose key aspects of its default rules and procedures.

ASX Clear (Futures)' Operating Rules and the OTC Rules are available on ASX's public website. These rules outline when ASX Clear (Futures) can take action against a participant and the powers of ASX Clear (Futures) in the event of a default, including the ability of ASX to transfer clients' positions to other participants. ASX Clear (Futures)' Operating Rules set out the treatment of proprietary and customer positions. In addition, ASX has published a high-level overview of its approach to managing a participant default on its website.

12.4 A central counterparty should involve its participants and other stakeholders in the testing and review of the central counterparty's default procedures, including any close out procedures. Such testing and review should be conducted at least annually and following material changes to the rules and procedures to ensure that they are practical and effective.

The DMF is reviewed on an annual basis, or more frequently as needed, and is regularly tested by in-house default management ‘fire drills’. These tests ensure that relevant ASX personnel are familiar with the default management process and identify areas where the DMF should be updated. Findings, including any recommended enhancements to the DMF, are reported to the DMSG after each fire drill. The Bank observed the ASX fire drill exercise conducted at the end of 2012 and will continue to observe future fire drills. In the 2011/12 Assessment period the DMF was updated to incorporate lessons learnt from the default of MF Global. In the current Assessment period, ASX undertook a comprehensive review of the DMF in light of new requirements of the FSS and the introduction of clearing for OTC interest derivatives.

Currently, participants are not directly involved in default management fire drills for the ASX CCPs. This allows ASX to more freely incorporate scenarios based on actual participants and portfolios into its fire drills, involving the use of confidential information that cannot be shared with other participants. However, after each fire drill a sample order file is sent to each of the default brokers that would be used by ASX to execute close-out trades, in order to test the compatibility of the file with their systems. With the introduction of the OTC clearing service, the DMGs will include rotating participation from clearing participants and will convene at regular intervals to review the default management process and recommend amendments. Each OTC derivatives clearing member will be involved directly in regular default simulations, including testing of the auction process.

In addition to the default management information provided on its website, ASX provides detailed responses to any targeted requests for information made by clearing participants. Clearing participants have the ability to provide feedback and seek further information on default processes through this mechanism.

The default arrangements in ASX Clear (Futures) take into account, as far as possible, the implementation of any resolution regime governing the CCP's participants. ASX has undertaken analysis on the impact of ADI resolution proceedings on a CCP's default management processes. While acknowledging that ADI resolution authorities may have broad powers to intervene in the arrangements of an insolvent ADI participant, the analysis suggests that, in general, resolution proceedings should not impede a CCP's default management processes. ASX will be conducting further analysis on the interaction between ADI and financial market infrastructure (FMI) resolution once international work on FMI resolution and the proposed domestic framework for FMI resolution have been finalised. Additionally, ASX intends to address the management of an ADI participant default in its 2013 default management fire drill.

12.5 A central counterparty should demonstrate that its default management procedures take appropriate account of interests in relevant jurisdictions and, in particular, any implications for pricing, liquidity and stability in relevant financial markets.

The DMF identifies that the key aim in handling a default is to minimise the impact of the event on ASX Clear (Futures), its participants and the market. Since the decision in respect of close out by the DMC is complex and involves consideration of the specific circumstances surrounding the default, the default management procedures are not prescriptive. Rather, ASX Clear (Futures) would consider a range of high level factors in a default situation, including: any systemic risk implications; potential contagion and implications for wider market liquidity; interdependencies with other entities; the impact on the CCP's risk profile and financial standing; additional risks that could be incurred by participants; and market conditions and default portfolio complexity.

Futures participants are predominantly large foreign banks or their subsidiaries with a significant domestic presence. All OTC participants will be Australian banks, Australian branches of foreign banks or Australian incorporated subsidiaries of foreign banks. In addition, products cleared by ASX Clear (Futures) are AUD-denominated, with the exception of NZD contracts. Accordingly, default management actions would be taken during the local time zone for all participants (taking into consideration the extended trading hours of the ASX 24 market).