Financial Stability Standards for Securities Settlement Facilities – December 2012 Standard 1: Legal Basis

Guidance

A robust legal basis for a securities settlement facility's activities in all relevant jurisdictions is critical to a securities settlement facility's overall soundness. The legal basis defines, or provides the foundation for relevant parties to define, the rights and obligations of the securities settlement facility, its participants and other relevant parties, such as its participants' customers, custodians, money settlement agents and service providers. Most risk management mechanisms are based on assumptions about the manner and time at which these rights and obligations arise through the securities settlement facility. Therefore, if risk management is to be sound and effective, the enforceability of rights and obligations relating to a securities settlement facility and its risk management should be established with a high degree of certainty. If the legal basis for a securities settlement facility's activities and operations is inadequate, uncertain or opaque, then the securities settlement facility, its participants and their customers may face unintended, uncertain or unmanageable credit or liquidity risks, which may also create or amplify systemic risks.

1.1.1 In general, a securities settlement facility should not provide services that have a distinct risk profile from, and potentially pose material additional risks to, its activity of operating the securities settlement facility. This may require that the securities settlement facility provide any such services in a legally and financially separate entity, or take other equivalent action. Where a securities settlement facility performs, or wishes to perform, functions that, while having a distinct risk profile, are complementary or necessarily ancillary to its activity as a securities settlement facility, it should consult the Reserve Bank and demonstrate that any potential risks posed to its activity as a securities settlement facility are appropriately and effectively managed.

1.1.2 The identification of the securities settlement facility as a separate legal entity is of particular importance in circumstances in which an entity related to the securities settlement facility is experiencing operational or financial difficulties, including external administration. Related activities that may expose the securities settlement facility to additional financial risks unrelated to those arising from its function as a securities settlement facility include banking-like activities or investment management.

1.1.3 The legal separation of the securities settlement facility may also provide protection to those other activities should the securities settlement facility itself experience operational or financial difficulties. This Standard does not assume or suggest, however, that legal separation will remove all risks that may arise as a result of operational or financial difficulties faced by a securities settlement facility or a related entity.

Legal basis

1.2.1 The legal basis should provide a high degree of certainty for each material aspect of a securities settlement facility's activities in all relevant jurisdictions.^[3] The legal basis consists of the legal framework and the securities settlement facility's rules, procedures and contracts. The legal framework includes general laws and regulations that govern, among other things, property, contracts, insolvency, corporations, securities, banking, secured interests and liability. In some cases, the legal framework that governs competition and consumer and investor protection may also be relevant. Laws and regulations specific to a securities settlement facility's activities include those governing its authorisation, regulation, supervision and oversight; rights and interests in financial instruments; settlement finality; netting; immobilisation and dematerialisation of securities; arrangements for delivery versus payment (DvP), payment versus payment (PvP) or delivery versus delivery (DvD); collateral arrangements; default procedures; and the resolution of a securities settlement facility. A securities settlement facility should establish rules, procedures and contracts that are clear, understandable and consistent with the legal framework and provide a high degree of legal certainty. A securities settlement facility also should consider whether the rights and obligations of the securities settlement facility, its participants and, as appropriate, other parties, as set forth in its rules, procedures and contracts are consistent with relevant industry standards and market protocols.

Rights and interests

1.2.2 The legal basis should clearly define the rights and interests of a securities settlement facility, its participants and, where relevant, its participants' customers in the financial instruments, such as cash and securities, or other relevant assets held in custody, directly or indirectly, by the securities settlement facility. It is not sufficient for key rights and obligations to be implied. The legal basis should fully protect both a participant's assets held in custody by the securities settlement facility and, where appropriate, a participant's customer's assets held by or through the securities settlement facility, from the insolvency of relevant parties and other relevant risks. It should also protect these assets when held at a custodian or linked FMI. In particular, consistent with SSF Standard 9 on central securities depositories, the legal basis should protect the assets and positions of a participant's customers. Where applicable, the legal basis should provide certainty with respect to: a securities settlement facility's interests in, and rights to use and dispose of, collateral; a securities settlement facility's authority to transfer ownership rights or property interests; and a securities settlement facility's rights to make and receive payments, in all cases, notwithstanding the bankruptcy or insolvency of its participants, participants' customers or a custodian bank.^[4] Also, the securities settlement facility should structure its operations so that its claims against collateral provided to it by a participant should have priority over all other claims, and the claims of the participant to that same collateral should have priority over the claims of third-party creditors.

Mitigating legal risk

1.2.3 In general, there is no substitute for full legal certainty supported by applicable legislation in all jurisdictions relevant to a securities settlement facility's activities. However, in some practical situations, such as might arise where a securities settlement facility offers services outside its home jurisdiction, or where participants are located in another jurisdiction to that of the securities settlement facility, it may not be possible, notwithstanding an independent legal opinion, to be confident of full legal certainty for all aspects of a securities settlement facility's operations. In this case, a securities settlement facility should investigate steps to mitigate its legal risk through the selective use of alternative risk management tools that do not suffer from the legal uncertainty identified. These could include, in appropriate circumstances, participant requirements, exposure limits, collateral requirements and prefunded default arrangements. If such controls are insufficient or not feasible, a securities settlement facility could, as appropriate, apply activity limits, restrict access or not perform the problematic activity until the legal situation is addressed.

1.3.1 The operating rules and procedures of a securities settlement facility play a key role in enabling participants to understand the risks they incur. The rules need to be clear, comprehensive and up to date to facilitate understanding by participants and prospective participants of the risks they can face through participation in the system. Explanatory material written in plain language can aid understanding of the facility's design and processes, thus improving understanding of risks that may arise through participation.

1.3.2 The rules and procedures should describe the roles of participants and the securities settlement facility and the procedures that will be followed in various circumstances (for example, which parties are to be notified of specific events and the timetables for decision-making and notification). They should make clear the degree of discretion parties are able to exercise in taking decisions that can have a direct effect on the operation of the system. There should be clear processes for changing rules and procedures. The degree of discretion the securities settlement facility can exercise to make unilateral changes to the rules or procedures, and any period of notice it must give to participants, should be clear.

1.4.1 One recommended approach to articulating the legal basis for each material aspect of a securities settlement facility's activities is to obtain well-reasoned and independent legal opinions or analyses. A securities settlement facility should consider, subject to any restrictions, sharing these legal opinions and analyses with its participants in an effort to promote confidence among participants and transparency in the system. In addition, a securities settlement facility should seek to ensure that its activities are consistent with the legal basis in all relevant jurisdictions. These jurisdictions could include: those where a securities settlement facility is conducting business (including through linked FMIs); those where its participants are incorporated, located or otherwise conducting business for the purposes of participation; those where collateral is located or held; and those indicated in relevant contracts.

Settlement finality

1.5.1 There should be a clear legal basis regarding when settlement finality occurs in a securities settlement facility in order to define when key financial risks are transferred in the system, including the point at which transactions are irrevocable. Settlement finality is an important building block for risk management systems (see also SSF Standard 7 on settlement finality). A securities settlement facility should consider, in particular, the actions that would need to be taken in the event of a participant's insolvency. A key question is whether transactions of an insolvent participant would be honoured as final, or could be considered void or voidable by liquidators and relevant authorities. In some countries, for example, so-called ‘zero-hour rules’ in insolvency law can have the effect of reversing a payment, notwithstanding that it has successfully been processed by a payment system. Because this possibility can lead to credit and liquidity risks, the securities settlement facility should ensure that the finality of settlement is not affected by the operation of zero-hour rules in any relevant jurisdiction. If the securities settlement facility offers real-time gross settlement, or has arrangements that involve the netting of transactions, it should seek the benefit of the relevant sections of the Payment Systems and Netting Act 1998 (if operating in Australia), or equivalent legislation in other jurisdictions. A securities settlement facility also should consider the legal basis for the external settlement mechanisms it uses, such as funds transfer or securities transfer systems. The laws of the relevant jurisdictions should support the provisions of the securities settlement facility's legal agreements with its participants and money settlement agents relating to finality.

Netting arrangements

1.5.2 If a securities settlement facility has a netting arrangement, the enforceability of the netting arrangement should have a sound and transparent legal basis. In general, netting offsets obligations between or among participants in the netting arrangement, thereby reducing the number and value of payments or deliveries needed to settle a set of transactions. Netting can reduce potential losses in the event of a participant default and may reduce the probability of a default. Netting arrangements should be designed to be explicitly recognised and supported under the law and enforceable against a securities settlement facility and a securities settlement facility's failed participants in bankruptcy. In particular, the securities settlement facility should seek the benefit of the relevant sections of the Payment Systems and Netting Act (if operating in Australia), or equivalent legislation in another jurisdiction, with respect to any netting arrangements. Without such legal underpinnings, net obligations may be challenged in judicial or administrative insolvency proceedings. If these challenges were successful, the securities settlement facility and its participants could face gross exposures and settlement obligations, which in some circumstances could be many multiples of net obligations.

Enforceability

1.5.3 The rules, procedures and contracts related to a securities settlement facility's operation should be enforceable in all relevant jurisdictions. In particular, the legal basis should support the enforceability of the participant default rules and procedures that a securities settlement facility would use to handle a defaulting or insolvent participant, especially any transfers of a direct or indirect participant's assets or positions (see also SSF Standard 11 on participant default rules and procedures). A securities settlement facility should have a high degree of certainty that actions taken under such rules and procedures will not be voided, reversed or subject to stays, including with respect to the resolution regimes applicable to its participants.^[5] Ambiguity about the enforceability of procedures could delay and possibly prevent a securities settlement facility from taking actions to fulfil its obligations to non-defaulting participants or to minimise its potential losses. The securities settlement facility should obtain a written and reasoned legal opinion as to the enforceability of the securities settlement facility's arrangements under the laws of each relevant jurisdiction.

1.5.4 A securities settlement facility should also establish rules, procedures and contracts related to its operations that would be enforceable in the event that the securities settlement facility had to implement its plans for recovery or orderly wind-down, and in the event of external administration. Where relevant, these should adequately address issues and associated risks resulting from foreign and cross-border participation and interoperability of FMIs. There should be a high degree of certainty that any actions taken by the securities settlement facility under such rules and procedures would not be voided, reversed or subject to stays. Ambiguity about the enforceability of procedures that facilitate the implementation of the securities settlement facility's plans for recovery or orderly wind-down, or the resolution of the securities settlement facility, could delay and possibly prevent the securities settlement facility or the Reserve Bank and other relevant authorities from taking appropriate actions and hence increase the risk of a disruption to its critical services or a disorderly wind-down of the securities settlement facility.

Default or suspension of participants

1.5.5 The rules applying in the event of the default or suspension of a participant should be set out in advance: this enhances the certainty of obligations placed on participants and thus minimises the opportunity for surviving participants to challenge any liability; in a default situation, there are likely to be strong incentives to undertake behaviour to minimise any contribution, and this could amplify systemic risks (see SSF Standard 11 on participant default rules and procedures).

External administration

1.5.6 Where a securities settlement facility is in external administration or is otherwise facing difficulties, there is scope for instability in the broader financial system. A high degree of certainty in the legal framework concerning such events can help to limit the capacity for such instability.

Conflicts of law

1.6.1 Legal risk due to conflicts of law may arise if a securities settlement facility is, or reasonably may become, subject to the laws of various other jurisdictions (for example, when it accepts participants established in those jurisdictions, when assets are held in multiple jurisdictions, or when business is conducted in multiple jurisdictions). In such cases, a securities settlement facility should identify and analyse potential conflicts of law and develop rules and procedures to mitigate associated risks (see paragraph 1.6.2 on obtaining a legal opinion). For example, the rules governing a securities settlement facility's activities should clearly indicate the law that is intended to apply to each aspect of its operations. The securities settlement facility and its participants should be aware of applicable constraints on their abilities to choose the law that will govern the securities settlement facility's activities when there is a difference in the substantive laws of relevant jurisdictions. For example, such constraints may exist because of jurisdictions' differing laws on insolvency and irrevocability.

Legal opinion

1.6.2 A securities settlement facility operating in multiple jurisdictions should obtain a well-reasoned, independent legal opinion(s) covering potential conflicts of law, as well as the enforceability of its rules and its ability to satisfy its regulatory obligations in all relevant jurisdictions. Any opinion relevant to the securities settlement facility's operations in Australia should be shared with the Reserve Bank. At least every two years, the legal opinion obtained under this Standard should be reviewed, updated where appropriate, and where relevant provided to the Reserve Bank. Between periodic reviews, the legal opinion should be reviewed whenever there is a material change to the securities settlement facility's operational, governance or risk management arrangements or to the legal or regulatory framework governing its activities that may impact on the opinion. Further to such a review, the opinion should be updated where appropriate and provided to the Reserve Bank. Material changes triggering a review of the legal opinion may include changes to: the nature and composition of the securities settlement facility's membership; its internal organisation or structure; product offerings; or applicable laws or regulations.