Review of Settlement Practices for Australian Equities 2. Background

The Reserve Bank's responsibilities

The Reserve Bank has oversight responsibility for financial stability and risk issues arising from clearing and settlement arrangements in the Australian equity market. Specifically, under Section 827D of the Corporations Act 2001, the Reserve Bank ‘may determine standards for the purposes of ensuring that clearing and settlement (CS) facility licensees conduct their affairs in a way that causes or promotes overall stability in the Australian financial system'. Reflecting this responsibility, the Reserve Bank determined the Financial Stability Standards for central counterparties and securities settlement facilities in 2003, with the standards applying to the facilities operated by ASX. The Standards require that:

A CS facility licensee must conduct its affairs in a prudent manner, in accordance with the standards of a reasonable CS facility licensee in contributing to the overall stability of the Australian financial system, to the extent that it is reasonably practicable to do so.[1]

The standards are supplemented by a number of minimum measures which are relevant in determining whether the licensed facilities meet the standards. Amongst other things, the facilities are required to have in place arrangements to ensure that settlement is timely, irrevocable and on an appropriate delivery-versus-payment basis.

The Reserve Bank conducts annual assessments of compliance against these standards. The latest assessments were conducted over the nine months to June 2007 and the Bank found that all of ASX's licensed CS facilities complied with the relevant standards.[2] The settlement delays in January 2008, however, prompted the Bank to examine whether some changes to the settlement procedures in the Australian equity market could make the settlement process more robust. This Review therefore focuses on changes relating to the settlement of equities and the factors that affect settlement, including the securities lending market and the fails regime. It does not cover the issues of short-selling, margin lending and the supervisory framework for brokers, which fall outside the Reserve Bank's regulatory responsibilities.

Settlement of equities transactions in Australia

There are two broad classes of transactions that are settled through ASX's equities settlement facility: ‘on-market’ transactions and ‘off-market’ transactions.

On-market transactions are executed on ASX's trading platform and are ‘novated’ to a central counterparty, the Australian Clearing House (ACH). As a result of novation, ACH becomes the buyer to every seller, and the seller to every buyer, facilitating trading by ensuring that each trader ultimately has a known and highly credit-worthy counterparty.

In contrast, off-market transactions are negotiated bilaterally and are not novated to the central counterparty. The vast majority of these transactions are undertaken to ensure that securities are in position to meet settlement obligations arising from novated market transactions. These can be thought of as ‘settlement priming’ transactions.

There are two principal types of such transactions.

The first is a securities loan either to cover a short sale, or to cover an anticipated shortfall in a participant's securities account for other reasons. Such transactions are agreed through bilateral negotiation between the counterparties (Attachment 1 provides some background on the securities lending market in Australia).

The second type is a pre-positioning transfer of securities across accounts at ASX Settlement and Transfer Corporation Pty Limited (ASTC). Such transfers are required because institutional investors often hold securities accounts directly at ASTC, but use the services of a general clearing member to clear trades through ACH.[3] As a result, these parties need to transfer securities or funds to the clearing member acting on their behalf to ensure that scheduled novated trades are able to settle. These are not ‘trades’ in the normal sense, but rather transfers that need to take place for settlement to occur as intended.

The Bank is not aware of any reliable data on the relative importance of these two types of ‘settlement priming’ transactions, although it is highly likely that the latter is much more significant.

The remaining off-market settlements comprise a variety of transaction types, including: some securities loan returns, refinancing of margin loans, and transfers related to initial public offerings.

Another important category of equity transactions is ‘crossings’. These transactions, which account for more than one quarter of turnover in ASX-listed securities, are struck off-exchange between two parties across the books of a broker. In the case of a crossing, no novation takes place and, crucially, no direct settlement obligations arise in the securities settlement system. If the broker holds the stock in its client sub-account at ASTC, there is merely a transfer of title in its own books. If, on the other hand, a party to the crossing holds its securities elsewhere (either in its own account at ASTC or via another broker/custodian), that party must separately agree with the broker an ancillary off-market transfer of securities. Such a transfer would occur exactly as described in the case of an institutional investor pre-positioning securities or cash for its general clearing member.

On-market transactions are settled on the third business day after trade (T+3), while offmarket transactions are settled at a time agreed between the two parties to the transactions. Many, but not all, securities loans are settled on the day that they are arranged, while some other off-market trades settle with a considerably longer lag.

Settlement of on-market and most off-market transactions takes place in a daily ‘batch’ run by CHESS. All scheduled securities transfers are reduced to a single net transfer per line of stock for each participant. Payments associated with these transactions are similarly settled on a net basis and occur in the Reserve Bank Information and Transfer System (RITS), passing across the Exchange Settlement accounts of a number of ‘settlement banks’.[4] This method of settlement is known as Delivery-versus-Payment (DvP) Model 3.[5] Settlement typically takes place at around noon each day. The deadline for new batch settlement instructions is 10.30 am (Attachment 2 provides additional details on settlement arrangements).

The netting process significantly reduces the amount of equities and funds required to change hands at the time of settlement. Since July 2007, the average daily value of gross equities settled has been in excess of $17 billion[6], split almost equally between novated and non-novated transactions. After netting, however, the average daily settlement value has been less than $2 billion although, over recent years, it has been as high as $7.6 billion (Graph 1).

Graph 1
Graph 1: Value of CHESS Batch Settlements


See Financial Stability Standards for Central Counterparties and Securities Settlement Facilities, Reserve Bank of Australia, June 2005. [1]

See 2006/07 Assessment of Clearing and Settlement Facilities in Australia, <>. [2]

ASX has three categories of direct participation: market participant; clearing participant; and settlement participant. Institutional investors are often direct settlement participants, but not direct clearing participants. [3]

In the context of settlement in CHESS, these are known as Payment Providers. [4]

There is also a facility to transfer securities free of payment outside of the batch settlement. [5]

This figure is based on data sourced from CHESS. The values of both the buy and sell legs of all novated transaction vis-à-vis the central counterparty are included alongside the value of all market-related non-novated transactions. [6]