Assessment of ASX Clearing and Settlement Facilities Appendix C1. Financial Stability Standards for Central Counterparties

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.

ASX Clear ASX Clear (Futures)
Observed Observed

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.

The respective Operating Rules and Procedures of ASX Clear and ASX Clear (Futures) provide each CCP with the authority and flexibility to deal with a participant default using a range of methods. The powers available to each CCP to close-out or otherwise manage the positions of a defaulted participant vary based on product type.

Cash equities – ASX Clear

For cash market transactions, ASX Clear has the power to:

  • carry the defaulted participant's outstanding cash equity transactions through to settlement
  • enter into market transactions to sell or purchase securities to facilitate the settlement of novated transactions
  • enter into an OTA in respect of any settlements involving the failed participant or those affected by its failure (see CCP Standard 7.3).

If standard close-out processes could not be successfully carried out, ASX's recovery arrangements would allow ASX Clear to apply partial or (as a last resort) complete termination powers in order to restore its matched book.

Exchange-traded derivatives – ASX Clear and ASX Clear (Futures)

For exchange-traded derivatives, ASX Clear and ASX Clear (Futures) may employ a variety of methods to close out or otherwise manage the positions of the defaulted participant. These may include:

  • transfer or port some or all of the defaulted participant's clients to another participant if certain conditions are met
  • on- or off-market liquidation or close-out by entering into equal-but-opposite transactions
  • exercise or expiry of contracts
  • hedging of contracts.

As above, if standard close-out processes could not be successfully carried out, ASX's recovery arrangements would allow the ASX CCPs to apply partial or (as a last resort) complete termination powers in order to restore its matched book.

OTC derivatives – ASX Clear (Futures)

In the event of default of an OTC participant, ASX Clear (Futures) may first suspend the defaulted participant and would then look to hedge its exposure arising from the defaulting participant's portfolio. ASX Clear (Futures) may engage the relevant DMG to assist in this process (see ‘Documentation and governance’ below). To close-out the defaulter's portfolio, ASX Clear (Futures) may then conduct one or more auctions of the portfolio (including the hedges) to non-defaulted participants. 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. ASX utilises a ‘juniorisation’ mechanism that is designed to ensure that non-defaulting participants bid competitively in the auction of a defaulter's portfolio. For the participants obliged to take part in the auction, the juniorisation mechanism determines the order in which their contributions to the OTC-only part of the ASX Clear (Futures) default fund would be applied to losses on the default in the event that the auction crystallises losses beyond the defaulter's margin and the first tranche of ASX capital (see below).

ASX Clear (Futures), in consultation with the DMG, could conduct the auction in one of the following forms:

  • The defaulted participant's portfolio could be auctioned in a single pool to the single highest bidder, or split into multiple identical units auctioned off to several bidders. In the latter case, the order of application of participant contributions to losses would be based on the lowest bid for any unit within the pool.
  • Alternatively, the defaulted participant's portfolio could be broken up into separate pools with shared characteristics (for example currency, product, tenor, carry or trade volume), with separate auctions in respect of each pool. Each of these pools could be auctioned off in a single unit or multiple identical units. The application of bidding participants' contributions to losses would be based on the ranking of bids in each of these pools, weighted according to the relative risk of each pool.

As an alternative to an auction, ASX Clear (Futures) could agree the transfer of equivalent contracts with a non-defaulting participant, but in doing so would seek to avoid crystallising losses that would require the application of non-defaulting participants' commitments. If neither an auction nor transfer could be successfully carried out, ASX's recovery arrangements would allow ASX Clear (Futures) to apply partial or (as a last resort) complete termination powers in order to restore its matched book.

Use and sequencing of financial resources

Following a declaration of default, ASX Clear and ASX Clear (Futures) may, among other things, suspend the defaulted participant's authority to clear some or all market transactions. In circumstances where all clearing activities were suspended, there would be no further payments or collateral movements to the participant. This enables the CCPs to ‘crystallise’ the defaulted participant's position and generate detailed account and position data (including collateral held). This establishes the basis for the close-out of exposures to the defaulted participant.

In the first instance, ASX Clear and 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). In the event that the defaulted participant's contributions were insufficient, ASX Clear and ASX Clear (Futures) could draw upon their respective default fund (see CCP Standard 4).

ASX Clear's $250 million default fund is fully funded by the CCP's equity.

ASX Clear (Futures)' $650 million default fund is fully prefunded with contributions from both ASX and clearing participants. The default fund comprises $450 million in ASX capital (across three tranches), and $200 million in participant contributions (across two tranches). The order in which losses would be applied to the default fund (i.e. the default waterfall) is as follows:

  1. First tranche of ASX capital ($120 million)
  2. Futures and/or OTC participant contributions ($100 million)
  3. Second tranche of ASX capital ($150 million)
  4. Futures and/or OTC participant contributions ($100 million)
  5. Third tranche ASX capital ($180 million).

The two tranches of participant contributions are commingled across futures and OTC products. While not essential, 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 commingled default fund adopted by ASX Clear (Futures) simplifies the default management process when the defaulter's portfolio contains both OTC derivatives and portfolio-margined futures positions. The order and proportion in which participants' futures and OTC contributions would be used is based on the scope of the defaulter's activities, i.e. the defaulter's level of initial margin for exchange-traded and OTC derivatives products (including portfolio-margined futures) over the previous 90 days. For example, if the defaulter cleared only futures products, losses would first be applied to futures participant contributions.

The method of allocating losses across participants' contributions, which are proportional to the scale and nature of individual participants' activities (see CCP Standard 3.2), depends on the product. For futures products, losses would be applied to individual participant contributions on a pro-rata basis. For OTC products, losses would be applied according to a juniorisation mechanism. Under this mechanism, the allocation would be related to the size of participants' bids in the auction of the defaulter's portfolio, so that the winner of the auction has its contribution applied last and the participant with the lowest bid has its contribution applied first, subject to bids exceeding a minimum threshold determined by ASX. Participants that are not required to take part in an auction (for example, participants that lack the capacity to manage particular product types within an auction pool) would have their contributions applied at the same point as the winner of the auction.

In the event that a CCP's prefunded resources were exhausted, each of ASX Clear and ASX Clear (Futures) have the power to call Recovery Assessments from participants (see CCP Standard 4.8). Recovery Assessments at ASX Clear are capped at $300 million, while at ASX Clear (Futures) a call could be made of up to a further $200 million in Recovery Assessments from participants for a single default, or up to $600 million if multiple participants were to default. The allocation of Recovery Assessments across individual participants is proportional to the risk associated with positions held by participants prior to the default. Beyond this, ASX Clear (Futures) would be able to reduce (haircut) a range of its outgoing payment obligations to participants to allocate remaining financial exposures stemming from the default. The allocation of payment haircuts is linked to the positions held by participants. As a last resort, the CCPs would have the power in recovery to allocate losses by reducing settlement payments in the context of complete termination of all open contracts.

Replenishment of financial resources

ASX has established a staged process for replenishment of the CCP default funds in the event that these were partially drawn down or exhausted following a participant default. At the end of a 22-business-day cooling-off period, the ASX Clear and ASX Clear (Futures) default funds would be fully replenished up to $150 million and $400 million, respectively. Participants' contributions are capped at half of the amount needed to replenish the CCPs' default funds to those levels. Individual participants' replenishment contributions would be determined in proportion to the risk associated with positions held by the participant prior to the default. A participant's replenishment contribution is independent of its Recovery Assessment. If further increases to the default fund were required following full replenishment, these would be met 50/50 by the ASX CCPs and participant contributions as part of the quarterly recalibration of the default fund. Participant contributions arising from this quarterly recalibration would also be broadly proportional to the risk associated with positions held by that participant (see CCP Standard 3.2).

Documentation and governance

The CCPs' Rules and Procedures form part of ASX's CCP Default Management and Recovery Framework (DMRF), a collection of internal and public documents that set out the guiding principles and procedures for managing a clearing participant default. An important part of the DMRF is the Default Management Policy and Default Management Standard, applicable to both ASX Clear and ASX Clear (Futures), which assist in the management of a clearing participant default. These new documents, together with updates to the existing DMRF documentation, were finalised in the assessment period.

The DMRF 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 ASX, its participants and the broader market. The DMRWG provides oversight and review of the DMRF, including discussion of proposed changes prior to submission to the CS Boards.

The Default Management Standard and accompanying procedures provide guidance on 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. The standard is intended to be flexible, rather than prescriptive, allowing ASX to adapt its default management approach to the specific circumstances as appropriate.

The DMRF outlines the key roles and responsibilities in managing a clearing participant default. The ASX Group has established a DMC, comprising senior management from relevant areas within ASX, to be the primary 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 the event of the default of an OTC participant, ASX Clear (Futures) would convene the relevant DMG, which comprises non-defaulting clearing participants invited or nominated to participate by ASX Clear (Futures). Currently there is only one DMG: while ASX Clear (Futures) clears two categories of OTC derivatives (AUD IRD and NZD IRD), members of the DMG are considered to have expertise in both product types. The DMG comprises representatives of at least six and a maximum of ten OTC participants. The DMG would advise and be consulted by ASX Clear (Futures) on the management of an OTC participant default. ASX Clear (Futures) is not obliged to follow the recommendations of the DMG, but would be required to provide reasoning where it did not accept the DMG's advice. DMG representatives are also tasked with periodically convening to review the default management process and recommend amendments. Each OTC derivatives clearing member is involved directly in simulations of the hedging and auction stages of the default management process (see CCP Standard 12.4).

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.

Each CCP's Operating Rules set out the circumstances in which it may declare a participant to be in default, or when it may otherwise impose restrictions on a participant's rights and activities. In the case of clearing participants, these include scenarios in which a participant becomes subject to external administration, is unable to fulfil the obligations arising from its open contracts, defaults at another exchange or CS facility, or breaches the CCP's risk-control requirements. An event of default may also arise where the CCP suspects that a participant would not be able to fulfil its obligations or otherwise comply with the CCP's rules. The CCPs' participants are obliged to inform ASX immediately if an event of default has occurred or may reasonably be suspected to occur.

ASX's response to a potential clearing participant default would depend on whether the incident was a financial, operational or other compliance breach. This differentiation is intended to reflect the severity of the breach and potential consequences of declaring an event of default.

  • A financial breach arises when a participant is unable to meet its existing financial obligations, or there is considerable uncertainty about the participant's ongoing ability to meet such obligations
  • An operational breach occurs when a participant has sufficient assets to meet its obligations but is unable to settle these obligations due to a technical or operational failure
  • Other compliance breaches may result from a participant's failure to otherwise comply with the CCP's Operating Rules.

Although the ASX Clear and ASX Clear (Futures) Operating Rules set out specific events of default, declaration of a default would never be automatic. Instead, the ASX CCPs maintain 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 would generally depend on its nature. Specifically, ASX distinguishes between ‘financial’, ‘operational’ and other ‘compliance’ defaults. This differentiation is intended to reflect the severity of the breach and potential ramifications of a declaration of default. The Participant Incident Response Group (PIRG), which is chaired by the Executive General Manager, Operations and made up of senior staff from operational, risk management, compliance and legal functions, is responsible for monitoring and managing clearing participant incidents and the escalation of potential default events to the DMC (see Appendix C.2, SSF Standard 3.1 for further detail on the PIRG). Ultimately, the declaration of any default is the responsibility of the Managing Director and CEO of ASX (or relevant delegates), under delegated responsibility from the CS Boards.

The Operating Rules and Procedures allow ASX Clear and ASX Clear (Futures) to employ a variety of methods to close out or otherwise manage the positions of a defaulted participant, including one that has been subject to external administration or breached a risk control requirement (see CCP Standard 12.1).

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

ASX Clear's Operating Rules and Procedures, ASX Clear (Futures)' Operating Rules and Procedures and the OTC Rules and OTC Handbook are available on the ASX public website. These rules outline when the CCPs may take action against a participant and the powers of the CCPs in the event of a default, including the ability of ASX to transfer client derivative positions to other participants. The CCPs' Operating Rules set out the treatment of proprietary and customer positions. In addition, ASX has published on its website a high-level overview of each CCPs' approach to managing a clearing participant default, a guidance note on each CCPs' approach to the suspension and termination of participants, as well as a client fact sheet that outlines the segregation and portability arrangements in ASX Clear (Futures) and the rights of clients in the event of their clearing participant's default. The OTC Handbook provides a description of the default management auction process for OTC derivatives, including numerical examples of the juniorisation process.

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

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 DMRF is reviewed on an annual basis, or more frequently as needed, and is regularly tested by in-house default management fire drills. The fire drills assist in ensuring that relevant ASX personnel are familiar with the default management process and identify areas where the DMRF should be updated. Findings, including any recommended enhancements to the DMRF, are reported to the DMRWG after each fire drill. ASX conducted three fire drills during the assessment period, one focused on ASX Clear, one on OTC derivatives (see below) and one on settlement failures (see SSF Standard 11.4). The Bank was invited to the first two of these fire drill exercises and will continue to observe future fire drills. In recent years, the DMRF has been updated on several occasions to reflect experiences gained from managing defaults and learnings from fire drills. The DMRF is expected to be further updated once the proposed FMI resolution regime has been finalised.

Currently, participants are not directly involved in default management fire drills for ASX Clear and those that test ASX Clear (Futures)' default management procedures for exchange-traded products. 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. Nevertheless, after each fire drill ASX engages its default brokers to test their operational capability to execute the close-out trades as well as to consider the process that the brokers would use to close out, how long it would take and what price the broker would expect in the fire drill scenario. During the assessment period, ASX continued engagement with its default brokers to improve the operational efficiency of the default process, while ASX Clear implemented a change to its Operating Rules that allows it to require any clearing participant to act as a default broker. ASX Clear (Futures) engaged an additional default broker during the assessment period, taking its total number to three; ASX Clear has four active default brokers and anticipates appointing additional default brokers during the next assessment period.

Separate fire drills for ASX Clear (Futures)' OTC clearing service are conducted by the DMG, the most recent of which took place in September 2017. This fire drill assessed the effectiveness of changes to ASX's OTC default management processes introduced in June 2017. These amendments included changes to simulate the pricing of hedging trades by obtaining hypothetical quotes from participants, and to strengthen the governance of hedging decisions made by the DMG by referring these to the DMC for approval.

The ASX CCPs' default arrangements take into account, as far as possible, the implementation of any resolution regime that governs the CCPs' participants. ASX has undertaken analysis on the impact of resolution proceedings for ADIs and banks in several other jurisdictions on a CCP's default management processes. This analysis was most recently updated in May 2018. While acknowledging that bank resolution authorities may have broad powers to intervene in the arrangements of an insolvent bank 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 FMI resolution once the proposed framework for FMI resolution has been finalised.

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 DMRF identifies that the key aim in handling a default is to minimise the impact of the event on the ASX CCPs, their participants and the market. Since close-out decisions by the DMC are complex and involve careful consideration of the specific circumstances surrounding the default, documented default management procedures are not prescriptive. Rather, the CCPs 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.

ASX Clear's participants include both Australian and overseas brokers with a significant domestic presence, including subsidiaries of Australian and overseas banks. Products cleared by ASX Clear are traded on Australian markets and denominated in AUD. Accordingly, default management actions would be taken during the local time zone for all participants.

At ASX Clear (Futures), futures participants are predominantly large foreign banks or subsidiaries of these banks that have a significant domestic presence. However, one futures participant clears remotely from the United Kingdom. All OTC participants are 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 (which make up around 2 per cent of initial margin requirements). Accordingly, default management actions would be taken during the local time zone for all but one participant (taking into consideration the extended trading hours of the ASX 24 market). ASX has not identified any impediments to carrying out its default management processes in the event of the default of a remote clearing participant, although ASX would consider additional factors such as the potential impact of time zone differences, as well as interactions with foreign CCPs and external administrators.