Payments System Board Annual Report – 2006 Safety and Stability

The Reserve Bank has a general responsibility for the safety and stability of the payments system and clearing and settlement facilities in Australia. The Reserve Bank Act 1959 requires the Payments System Board to have regard to ‘risk in the financial system’ in the exercise of the Bank's payments system powers and ‘stability of the financial system’ in its oversight of clearing and settlement facilities. The acts providing specific powers in these areas – the Payment Systems (Regulation) Act 1998, the Payment Systems and Netting Act 1998 and the Corporations Act 2001 – also emphasise these responsibilities.

Central to the oversight of payment systems from a stability perspective is the assessment of systemically important systems against recognised international standards. The Bank conducted such an assessment of Australia's real-time gross settlement system – known as the Reserve Bank Information and Transfer System (RITS) – during 2004/05. This assessment has been followed up over the past year with an independent external assessment by the International Monetary Fund (IMF) as part of the Financial Sector Assessment Program (FSAP).

In the case of clearing and settlement facilities, licensees must comply with financial stability standards developed by the Bank. Each year, the Bank conducts a formal assessment of each licensee's compliance with the relevant standard, with the assessment provided to the Minister with portfolio responsibility for the Corporations Act.

The RTGS System

On average, 25,000 transactions, with a value of around $145 billion, are currently settled through Australia's real-time gross settlement (RTGS) system each day. This compares with around 15,000 transactions, with a value of around $100 billion, during 1998/99, the system's first year of operation. The average transaction size is currently around $5.8 million, down from around $6.6 million in 1998/99.

Transactions processed through the RTGS system come from three main sources: the settlement of debt securities trades and other transactions from the Austraclear feeder system; interbank lending; and other interbank transactions, predominantly related to foreign exchange settlement and high-value corporate payments. In 2005/06, the value of transactions through the Austraclear feeder system averaged around $38 billion per day, while interbank lending averaged $19 billion, and other interbank transactions averaged around $98 billion.

The Board's 2000 Annual Report included an assessment of RITS against the then draft Core Principles for Systemically Important Payment Systems (published in final form by the Bank for International Settlements in 2001). In 2004/05 the Bank undertook a second, more detailed, self-assessment of RITS against the Core Principles. As mentioned in last year's Annual Report, the Bank concluded that RITS complied with all of the Core Principles and that the Bank's oversight arrangements complied with the ‘Responsibilities of the Central Bank in Applying the Core Principles’.

During the past year, the Bank's self-assessment provided input to an independent external assessment of RITS by the IMF as part of its FSAP. The preliminary conclusion of this external assessment – which took place over a two-week period in December 2005 – is that RITS complies with the Core Principles. According to the preliminary findings, RITS is a sound and efficient payment system, with a solid legal basis, well developed functionality, adequate risk management, and effective and transparent governance. As part of its findings, the IMF has also made a number of recommendations, which the Bank and the Payments System Board are currently considering. The results of the FSAP will be published later in 2006.

Clearing and Settlement Facilities

The Corporations Act requires that clearing and settlement facility licensees comply with financial stability standards determined by the Reserve Bank. The Bank has determined two such standards – the Financial Stability Standard for Central Counterparties and the Financial Stability Standard for Securities Settlement Facilities. These standards have been outlined in previous Annual Reports.

The standard applying to central counterparties applies to two facilities: the Australian Clearing House (ACH) and SFE Clearing Corporation (SFECC), the former of which is owned by the Australian Stock Exchange (ASX) and the latter by SFE Corporation. The standard relating to securities settlement facilities also applies to two facilities: ASX Settlement and Transfer Corporation (ASTC) and Austraclear. Since the merger of the ASX and the Sydney Futures Exchange (SFE) in July 2006, all these facilities are under common ownership although to date the securities settlement and central counterparty arrangements have remained unchanged. A fifth licensed facility operated by IMB Limited falls outside the application of the Financial Stability Standards as a result of its small size.

The ACH provides central counterparty services for a range of mainly equity related products – including physical equities, warrants and equity derivatives – traded on the ASX, while ASTC provides the corresponding settlement facility. SFECC provides central counterparty services for derivatives contracts traded on the SFE, but does not provide central counterparty services for debt securities. The Austraclear settlement system is first and foremost a system for settling over-the-counter debt securities trades, although settlement of obligations from derivatives contracts also occurs through the system.

As the central counterparty for the ASX, the ACH becomes the seller to every buyer and buyer to every seller (through the process of ‘novation’) for transactions on ASX markets. The value of physical equities and warrants traded on the ASX market and novated to the ACH averaged around $4 billion per day in 2005/06, while the notional value of futures and options contracts novated averaged close to $2 billion per day (Table 8). At the end of each day, the net amounts owed to the ACH by each participant as a result of trading in equities and warrants are calculated. The total owed to and by the ACH from each day's trading averaged $360 million in 2005/06, but because several days' trading is awaiting settlement at any time, aggregate amounts owed to and by the ACH averaged $735 million. There are no equivalent figures for derivatives, but the value of margins held by the ACH against its obligations averaged $940 million in 2005/06.

The notional value of derivatives contracts traded on the SFE market and novated to SFECC is considerably higher than for the ACH, reflecting the higher level of turnover in debt futures markets than the equities market. During 2005/06, the value of margins held by SFECC against its obligations averaged $1.7 billion.

In terms of value, the Austraclear system is the larger of the two securities settlement systems, handling debt securities settlements of $26 billion per day. Equities and warrants traded on the ASX market and settled by ASTC average around $4 billion per day. In addition, ‘off-market’ settlements by ASTC, which predominantly result from securities lending, are estimated to amount to around $1 billion per day.

Turnover in both securities and exchange traded derivatives increased significantly in 2005/06. In the equities and derivatives markets, the value of turnover was up by around 25 per cent from 2004/05, while the value of debt securities settled through Austraclear was up 13 per cent.

The Reserve Bank is required to assess how well each clearing and settlement facility licensee has met its obligation to comply with the Financial Stability Standards at least once a year. It is required to report the results to the responsible Minister.

In its most recent assessment the Bank determined that each of the licensees had satisfied its obligations with respect to the relevant standard. In reaching this conclusion, the Bank undertook an extensive information gathering exercise, as well as drawing upon information provided by licensees as part of their quarterly reporting obligations and regular face-to-face discussions between the Bank and key personnel of the licensees.

In its assessments, the Bank has focused particularly on the risk management practices of ACH and SFECC. As providers of central counterparty services, these facilities simplify counterparty risk management by replacing exposures to a variety of other participants with an exposure to a central counterparty. This arrangement also allows more robust risk controls to be placed on participants and provides additional scope for netting of obligations. Central counterparties, however, also result in a significant concentration of risk. This risk can crystallise if a participant defaults on its obligations to the central counterparty, which is required to meet all its obligations to other participants. This concentration of risk means that it is important that measures are in place to provide confidence that, in all but the most extreme circumstances, a central counterparty can accommodate a default without threatening its solvency, or causing significant disruption to financial markets or the financial system more generally.

Clearing and settlement facilities are responsible for determining their own risk management arrangements, consistent with the Financial Stability Standards. These arrangements typically operate at a number of levels.

Firstly, criteria for participation in each system are used to ensure that only participants that will not adversely affect the safety and stability of the system are admitted. These criteria cover areas such as the financial strength and operational capacity of the participants.

Secondly, margining is used to limit risk to the central counterparty from a participant defaulting on its derivatives obligations. Participants must post cash or other collateral with the central counterparty when contracts are initiated and pay in additional funds if the market moves against them. SFECC can also impose ‘additional initial margins’ in response to a variety of triggers, including stress tests, and places position limits on participants, based on net tangible assets. There is no margining of physical equities by ACH, but unlike most futures and options, equities exposures are short-lived, usually three days.

Thirdly, the financial resources available to the central counterparty are an important protection to the system. These can be drawn on in the event that losses exceed margins and other assets of a defaulting participant held by the central counterparty. This situation could arise if a default by a participant coincided with a very large market movement.

In the case of the ACH, a minimum amount of $110 million is set aside to meet the central counterparty's obligations in the event of a default. This amount includes capital and funds paid into a restricted reserve from the National Guarantee Fund in 2005. In addition, insurance of $100 million was obtained in late 2005, which can be drawn upon if losses exceed $110 million. The ACH also has the capacity to require non-defaulting participants to contribute up to a total amount of $220 million to meet clearing losses not covered by those other resources, and has access to a line of credit that can be drawn down at short notice to facilitate settlement.

SFECC holds capital of $30 million and participant contributions of $60 million. It can call for additional participant contributions if required. Insurance of a further $60 million to cover a range of risks, including default, is also in place.

Finally, central counterparties are expected to have systems that allow them to monitor the exposures of individual participants, the level of risk faced by the system as a whole, and the adequacy of financial resources and margins on an ongoing basis. Stress testing is central to these arrangements, enabling the central counterparty to evaluate potential losses under extreme but plausible circumstances. Stress tests provide a means of evaluating whether a particular combination of risk management arrangements and resources is adequate. Models for determining margins must also be adequate and their validity assessed on a regular basis.

The Bank emphasised in its assessments of central counterparties that, while the facilities are considered to have satisfied the Financial Stability Standards, work currently being undertaken to improve some elements of risk management should continue to be given a high priority. The Bank also believes that, given the rapid increases in market activity over recent years, licensees should continue to monitor closely the adequacy of their financial resources to deal with a default.

At the time of last year's Annual Report, it was anticipated that Australia's main clearing and settlement facilities would be subject to informal (rather than full) assessments against international standards as part of the IMF FSAP. In the event, the Australian authorities and the IMF agreed that informal assessment of these systems would be of limited benefit. As a consequence, it was decided that they would not be assessed as part of the FSAP, but that a full assessment should be undertaken at a later stage. The timing is yet to be decided, and will in part depend on the effect the merger of the ASX and the SFE has on the operations of their clearing and settlement facilities.

Foreign Exchange Settlement Risk

Another focus of the Bank's work continues to be foreign exchange settlement risk; that is the risk that one party to a foreign exchange transaction will pay the currency it sold but not receive the currency it bought. Policymakers, both in Australia and internationally, have sought to ensure that this risk is understood and measured. The BIS Committee on Payment and Settlement Systems has established a Foreign Exchange Settlement Risk Sub-group to assess strategies for reducing the risks associated with the settlement of foreign exchange transactions. The Reserve Bank of Australia is a member of this group.

A major part of the Sub-group's work in the past year has been to conduct a survey of the way in which banks manage the settlement of their foreign exchange transactions. Most countries participating in this survey have conducted similar surveys previously, but there has been significant change to settlement options in recent years, including the establishment of the CLS Bank (CLS), which began operation in 2002. Since CLS commenced operations, the number of transactions settled has grown strongly (Graph 6 and 7). In recent months, around 250,000 transactions in all eligible currencies have been settled each day, with an average daily value of over US$2.5 trillion. Settlement of the Australian dollar leg of transactions accounts for around 3.5 per cent of all transactions settled in CLS, valued at around A$130 billion.

The current survey of settlement practices is expected to give an indication of the extent to which the focus on foreign exchange settlement risk has been accompanied by a reduction in settlement risk. The participation of a number of Australian banks in the survey is being coordinated by the Bank. The results will be published in 2007.