Assessment of ASX Clearing and Settlement Facilities – September 2019 Appendix C1. Financial Stability Standards for Central Counterparties
Standard 1: Legal basis
A central counterparty should have a well-founded, clear, transparent and enforceable legal basis for each material aspect of its activities in all relevant jurisdictions.
ASX Clear | ASX Clear (Futures) |
Observed | Observed |
1.1 A central counterparty should be a legal entity which is separate from other entities that may expose it to risks unrelated to those arising from its function as a central counterparty.
ASX Clear and ASX Clear (Futures) are wholly-owned subsidiaries of ASX Clearing Corporation Limited (ASXCC), which is itself a wholly-owned subsidiary of ASX Limited (together referred to as the ASX Group). As separate legal entities, each of the ASX central counterparties' (CCPs) central clearing activities are separate from the activities conducted by each of the other ASX clearing and settlement (CS) facilities and the rest of the ASX Group, notwithstanding the sharing of operational resources across multiple entities within the group. Potential risks arising from the CCPs' reliance on financial resources held at the group level to cover general business risks are discussed under CCP Standard 14.2.
ASX Clear's services are limited to CCP clearing of ASX-quoted cash securities and derivatives transactions executed on the ASX markets, as well as ASX- and non-ASX-quoted cash market securities transacted on Approved Market Operator (AMO) platforms under the Trade Acceptance Service (TAS), in accordance with the ASX Clear Operating Rules and Procedures. Accordingly, ASX Clear does not provide any services that have a distinct profile from, or pose additional risks to, its activity of operating a CCP.
ASX Clear (Futures)' services are limited to CCP clearing of futures and options products that are traded on the ASX 24 market and certain over-the-counter (OTC) derivatives, in accordance with the ASX Clear (Futures) Operating Rules and Procedures, the OTC Rules and the OTC Handbook. Accordingly, ASX Clear (Futures) does not provide any services that have a distinct profile from, or pose additional risks to, its activity of operating a CCP.
1.2 The legal basis should provide a high degree of certainty for each material aspect of a central counterparty's activities in all relevant jurisdictions.
Legal basis
ASX Clear and ASX Clear (Futures) novate and net transactions submitted for clearing by their respective participants. Novation (where matched trades between participants are replaced by separate contracts between the buyer and the CCP, and the seller and the CCP) and netting both require a high degree of legal certainty. Key components of the legal framework under which the CCPs operate are listed below.
- The ASX CCPs each hold a CS facility licence under Part 7.3 of the Corporations Act 2001 (Corporations Act). These licences are administered by the Australian Securities and Investments Commission (ASIC) in consultation with the Bank. The Minister is the ultimate decision-maker on licensing matters, although this responsibility has been delegated to authorised ASIC officers since April 2016.[3]
- The ASX CCPs have defined Operating Rules and Procedures. Under section 822B of the Corporations Act, these Rules have effect as a contract under seal between: the relevant ASX CCP and each of its respective participants; each participant and each other participant; and each participant and each issuer. The Operating Rules and Procedures set out the rights and obligations of participants and the relevant CCP, including in the event of default or suspension.
- ASX Clear and ASX Clear (Futures) are approved as ‘netting markets’ under Part 5 of the Payment Systems and Netting Act 1998 (PSNA), which provides certain legal protections (see CCP Standard 1.5).
While both CCPs are recognised in the EU and ASX Clear (Futures) is recognised in Switzerland and exempt from registration in the US, the Operating Rules of both CCPs are governed by Australian law.[4] ASX Clear (Futures) is applying for designation by the Reserve Bank of New Zealand (RBNZ) in order to benefit from additional settlement finality protections under the Reserve Bank of New Zealand Act 1989 (RBNZ Act). ASX is developing a procedure that would allow it to repatriate NZD collateral to Australia upon a participant default, since some protections under the RBNZ Act are effective only for 24 hours following a default. ASX has not identified any legal risks arising from the CCPs' recognition or exemption in other jurisdictions.
The legal basis of the ASX CCPs' activities is reviewed by ASX Legal as part of business-as-usual processes, including contract execution and admission of participants domiciled in foreign jurisdictions, and change management processes, such as considering the impact of the introduction of new legislation or launch of new products. Input from ASX Legal is sought as part of internal processes for rule amendments and changes to procedures and guidance notes. ASX also undertakes either a general or targeted consultation with market participants when considering rule amendments. Through these processes, ASX seeks to maintain clear and understandable rules, procedures and contracts that are consistent with relevant industry standards and market protocols. However, ASX Legal does not periodically conduct general reviews to assess whether incremental changes to rules and procedures over time might reduce their clarity and understandability.
Rights and interests
The rights and interests of each CCP, its participants and, where relevant, its participants' customers in cleared positions and collateral, are defined in their respective Operating Rules and Procedures. ASX Clear (Futures) has further established the OTC Rules and Handbook, which sets out the rights and interests associated with participation in its OTC derivatives clearing service.
The capacity to deal with cash or non-cash collateral held by the ASX CCPs in the event of a participant default is an important risk protection. The Operating Rules of each CCP provide the CCPs with the right to deal with collateral of a participant in default to address losses or costs, or to meet other obligations arising from the default management process. Part 5 of the PSNA provides certain legal protections to the enforcement of security interests held by the CCPs in the event of a participant default (see also CCP Standard 1.5).
1.3 A central counterparty should have rules, procedures and contracts that are clear, understandable and consistent with relevant laws and regulations.
Section 822A of the Corporations Act establishes a framework to prescribe the matters that must be dealt with in the Operating Rules and those that may instead be considered under the Procedures. Operating Rule changes are subject to a Ministerial disallowance process, although the Minister's role in this process is delegated to authorised ASIC officers. The Corporations Act also establishes how any inconsistency between the licensed facility's rules and applicable laws and regulations (in particular, derivative transaction rules and derivative trade repository rules) would be resolved.
The Operating Rules and Procedures of each CCP are published on the ASX public website and the Customer Portal, ASX's restricted participant website. These documents are supplemented with explanatory material to support participants' (and prospective participants') understanding of the risks they face through participation in the system. In addition to the Operating Rules and Procedures, publicly available material includes high-level descriptions of both CCPs' risk management framework, the Cash Market Margining (CMM) and CME Standard Portfolio Analysis of Risk (SPAN) margining methodologies, business continuity arrangements and the CCPs' Default Management and Recovery Framework (DMRF). Participants have access to additional manuals, reports and explanatory notes covering such topics as the application process for new participants, compliance, technical and operational details, counterparty risk assessment, and fees.
There is a clear process for changing the ASX CCPs' Operating Rules and Procedures. In practice, proposed Operating Rule changes are submitted informally to ASIC. In consultation with the Bank, ASIC considers the changes and advises ASX of any regulatory concerns. Once such concerns are satisfactorily addressed, ASIC invites formal submission of the proposed Operating Rule changes, which triggers a 28-day disallowance period (referred to above), during which the Minister or delegate may choose to disallow the Operating Rule changes. The Minister or delegate must consider a number of factors when deciding whether to disallow Operating Rule changes, including whether the proposed changes are consistent with the public interest.[5] In addition, the Minister or delegate must ensure that there has been adequate consultation with the Bank when deciding whether to disallow Operating Rule changes, and consider any advice and recommendations from the Bank and ASIC staff.[6] If changes to the Operating Rules are not disallowed by the Minister or delegate, they are notified to participants via the ASX website.
1.4 A central counterparty should be able to articulate the legal basis for its activities to the Reserve Bank and other relevant authorities, participants and, where relevant, participants' customers, in a clear and understandable way.
The legal basis for the activities of the ASX CCPs and the protection of each facility as an approved netting market under the PSNA (see also CCP Standard 1.5) are in the Disclosure Framework document available on ASX's public website. This document sets out in detail how each CS facility meets the requirements of each Principle within the Principles for Financial Market Infrastructures (PFMI) developed by Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) (see CCP Standard 20.5).[7]
On behalf of each licensed entity within the ASX Group, including all ASX CS facilities, ASX Limited submits an annual report to ASIC under section 792F of the Corporations Act that is shared with the Bank. This report sets out the extent to which each licensee has complied with its obligations under Chapter 7 of the Corporations Act.
The ASX CCPs may seek independent legal opinions on relevant legal matters relating to significant new services, including any implications that their introduction may have for the legal basis of existing functionality. These opinions may, in some circumstances, be shared with participants or other stakeholders for their information, particularly to demonstrate that new Operating Rules will have the intended legal effect.
1.5 A central counterparty should have rules, procedures and contracts that are enforceable in all relevant jurisdictions. There should be a high degree of certainty that actions taken by the central counterparty under such rules and procedures will not be voided, reversed or subject to stays, including in the event that the central counterparty enters into external administration or that one or more of its participants defaults or is suspended.
The respective rules and procedures of ASX Clear and ASX Clear (Futures) set out how each CCP assumes risk in relation to its participants, arrangements for netting offsetting exposures and obligations of participants, and the risk controls that apply in respect of participants' net exposures. Measures that contribute to ensuring a high degree of certainty in respect of the ASX CCPs' activities are detailed below. Measures in respect to settlement finality are not covered below, but are detailed in CCP Standard 8.2.
Assumption of risk
The ASX CCPs assume risk on cleared trades through the process of novation, whereby matched trades between participants are replaced by separate contracts between the buyer and the CCP, and the seller and the CCP. Through novation, the obligations of the ASX CCPs are to each participant as principal. Equally, participants' obligations are to the relevant ASX CCP for all transactions that have been novated. For all client accounts in ASX Clear (Futures), the CCP also has a direct legal relationship with the client holding the account, but the clearing participant remains fully liable for any open positions associated with that account.
The point of novation is established by the relevant ASX CCP's Operating Rules:
- ASX Clear. For cash market securities, the ASX Clear Operating Rules specify that, in the normal course of business, a transaction executed on the ASX market or an AMO platform is novated with effect from the matching of a bid and offer (subject to notification to ASX Clear of the transaction). For exchange-traded and OTC equity derivatives, novation occurs in ASX Clear upon acceptance and registration of that transaction within the clearing system.
- ASX Clear (Futures). For exchange-traded derivatives in ASX Clear (Futures), the CCP's Operating Rules specify that a transaction on the ASX 24 market is novated upon the recording of a matched trade by the market, which occurs in ASX 24's trading system. Non-market trades are novated once their details have been approved and registered by ASX Clear (Futures). Acceptance rules for registration of OTC derivatives trades are set out in the OTC Rules. Requirements include, for example, that the OTC transaction has been submitted in accordance with procedures and eligibility criteria in the OTC Handbook, that participants are authorised and not in default, and that the transaction passes limit checks. If an OTC transaction satisfies the requirements and is accepted by ASX Clear (Futures) for registration, the transaction is novated with effect from the time at which the transaction details were received by ASX Clear (Futures).
Part 5 of the PSNA provides certain legal protections to the effectiveness of the process of novation outlined in the ASX Clear and ASX Clear (Futures) Operating Rules, by virtue of the ASX CCPs' status as approved netting markets.
Netting
Part 5 of the PSNA also provides certain legal protections to several aspects of the netting of exposures and payments entered into in accordance with the ASX Clear and ASX Clear (Futures) Operating Rules:
- the process of reducing each participant's contracts to a net exposure (reflecting the relevant CCP's exposure to the participant's portfolio of contracts)
- the relevant CCP's rules covering default, such that future exposures may be terminated and a net payout obligation calculated
- payments made on a net basis, by protecting against the voiding of net payments in the event of insolvency of a participant.
Enforceability of rules under external administration, recovery or participant default
The enforceability of the ASX CCPs' rules in circumstances when a participant has entered external administration is provided certain legal protections by Part 5 of the PSNA. The definition of external administration in Part 5 of the PSNA includes resolution measures for bank and non-bank financial institutions. These protections help ensure that the ASX CCPs can enforce key rights under their Operating Rules (including netting or termination of obligations and enforcement of security) in relation to a participant in external administration, despite any provision of insolvency law that might otherwise interfere with such rights.
ASX's processes for review of legal risk have not identified any material legal risk to the enforceability of the ASX CCPs' respective Operating Rules upon a CCP's entry into external administration. The ASX CCPs' rules give participants the right to close out future obligations (i.e. terminate novated contracts) in the event that the relevant CCP defaulted on its obligations as established by the rules. The rules do not interfere with the ASX CCPs' existing liquidity management arrangements. The continued appropriateness of these close-out netting rights will need to be assessed in light of future developments in financial market infrastructure (FMI) resolution.
ASX has carried out analysis on the legal basis of tools available under each of the ASX CCPs' recovery plans (see CCP Standards 3.5, 4.8, 7.9 and 14.3). This analysis has not identified any material legal risk to enforceability of these tools or the application of protections under Part 5 of the PSNA to payment haircutting, termination powers, offsetting transaction arrangements (OTAs) or the allocation of investment losses.
The Operating Rules of each CCP set out the rules that apply in the event of default or suspension of a clearing participant (see CCP Standard 12.1). ASX has satisfied itself on the enforceability of these rules.
1.6 A central counterparty conducting business in multiple jurisdictions should identify and mitigate the risks arising from any potential conflicts of law across jurisdictions. A central counterparty should provide the Reserve Bank with a legal opinion that demonstrates the enforceability of its rules and addresses relevant conflicts of law across the jurisdictions in which it operates. This should be reviewed on a periodic basis or when material changes occur that may have an impact on the opinion, and updated where appropriate.
Participants of ASX Clear and ASX Clear (Futures) include Australian-based subsidiaries and branches of entities that are domiciled in foreign countries (including Canada, France, Germany, Hong Kong, Switzerland, United Kingdom and United States); in addition, one ASX Clear (Futures) participant clears remotely from the United Kingdom. For both CCPs, however, their respective operating rules are governed by Australian law and require that all participants submit to the jurisdiction of New South Wales courts.
During the assessment period, each of the ASX CCPs took steps consistent with this Standard to satisfy itself that the laws of jurisdictions outside Australia do not impact its analysis of core legal risks, including matters covered under CCP Standards 1.2 and 1.5, other than the laws of New Zealand and the United States in respect of ASX Clear (Futures). ASX Clear (Futures) assessed relevant legal risks including the enforceability of rights over New Zealand and United States collateral in those jurisdictions. The legal analysis of potential conflicts of law across jurisdictions identified no material legal risks.
ASX Legal reviews existing legal opinions on a case-by-case basis when there are changes to legislation covered by the opinions, material changes to the Operating Rules of the ASX CCPs or new business initiatives that may impact the scope of the opinions. In addition, senior staff in ASX Legal periodically meet to assess whether any changes in law or business activities mean that existing legal opinions should be updated.
Footnotes
While the Minister has delegated responsibility for certain decisions under Chapter 7 of the Corporations Act to authorised ASIC officers, the Minister may still exercise the powers delegated by ‘calling up’ the matter. [3]
ASX Clear (Futures) has been recognised as a third-country CCP by the European Securities and Markets Authority (ESMA) and has been exempted from registration as a Derivatives Clearing Organisation (DCO) by the Commodity Futures Trading Commission (CFTC) in the US. ASX Clear has been recognised as a third-country CCP by ESMA. [4]
Section 827A of the Corporations Act sets out the matters the Minister must have regard to, available at <http://www.austlii.edu.au/au/legis/cth/consol_act/ca2001172/s827a.html>. [5]
For more information see ‘Guidelines for the Exercise of Powers Delegated to ASIC under Chapter 7 of the Corporations Act 2001’, available at <https://treasury.gov.au/publication/guidelines-for-the-exercise-of-powers-delegated-to-asic-2016/>. [6]
Available at <http://www.asx.com.au/documents/asx-compliance/pfmi-disclosure-framework.pdf>. Before 1 September 2014, CPMI was known as the Committee on Payment and Settlement Systems (CPSS). [7]