Assessment of ASX Clearing and Settlement Facilities – September 2019 Appendix C1. Financial Stability Standards for Central Counterparties

Standard 3: Framework for the comprehensive management of risks

A central counterparty should have a sound risk management framework for comprehensively managing legal, credit, liquidity, operational and other risks.

3.1 A central counterparty should have risk management policies, procedures and systems that enable it to identify, measure, monitor and manage the range of risks that arise in or are borne by the central counterparty. This risk management framework should be subject to periodic review.

Identification of risk

ASX's high-level framework for risk management is described in its Enterprise Risk Management Policy. Specific risks are identified and assessed based on their likelihood and potential impact. The risk categories considered are: reputational, counterparty, strategic, financial, operational, technology, and regulatory and legal risks.

Comprehensive risk policies, procedures and controls

ASX's Enterprise Risk Management Policy has been developed with reference to the international standard ISO 31000 Risk Management – Principles and Guidelines.^[13] The policy is reviewed by the Audit and Risk Committee every two years, with the most recent review taking place in November 2018. As part of this review, ASX updated its Enterprise Risk Management policy to reflect an increase in the number of risk categories from two to seven, and the adoption of a more granular five-point scale for assessing the likelihood and impact of risks. ASX has also separated out its updated Risk Appetite Statement (RAS) into a standalone document owned by the ASX Limited Board (see CCP Standard 2.6). At a high level, the ASX Enterprise Risk Management Policy outlines: the overall risk environment in the ASX Group; the objectives of risk management policies; the process by which risks are identified and assessed; the controls in place to detect and mitigate risks; and how risks are monitored and communicated. The Enterprise Risk Management Policy takes into account the risk tolerances established by ASX's RAS: ASX's tolerance for financial, operational, technology, counterparty, reputational, and regulatory and legal risks is ‘very low’; ASX's tolerance for strategic risks is ‘medium’.

ASX uses key risk indicators to measure levels of risk in the organisation and categorise risk levels according to a ‘red-amber-green’ scale.

The Enterprise Risk Management Policy also sets out how specific risk responsibilities across the ASX Group are assigned, including to the ASX Limited Board of Directors, the Audit and Risk Committee, the CS Boards, the Risk Committee, the General Managers of Enterprise Risk and Enterprise Compliance, and managers of individual functions. Managers of relevant functions are responsible for identifying and monitoring risks relevant to their function's activities, as well as for designing and implementing risk management controls to manage identified risks. As part of the risk profiling and assessment process, management assesses the appropriateness and operational effectiveness of these controls twice a year; these assessments are reviewed by the Risk Committee.

ASX's Clearing Risk Policy Framework sets out a comprehensive set of clearing and treasury risk policies to support the risk management approach of ASX's CCPs. These policies govern more granular internal standards, which in turn govern detailed procedures for the management of clearing and treasury risk. The structure of policies, standards and procedures reflects the requirements of the FSS.

A number of boards and internal committees oversee clearing risk management policy, including:

• The CS Boards. Each CS facility has a board (see CCP Standard 2.3 and ‘ASX Group Structure’ in Appendix B.1), which shares members with the other ASX CS facilities. The Clearing Boards have oversight of the Clearing Risk Policy Framework, and are responsible for any significant amendments. Policies and designated key standards under the Framework are also governed by the Clearing Boards.
• Risk Committee. The Risk Committee is constituted to ensure the adequacy and appropriateness of the risk management frameworks, policies, processes and activities of the ASX Group. This includes overseeing the implementation and adequacy of the Enterprise Risk Management Policy, and reviewing and approving key risk management policies, standards and procedures. It is chaired by the CRO and comprises the CEO, Deputy CEO, Chief Financial Officer (CFO), COO and Group General Counsel and Company Secretary. The Risk Committee meets at least on a quarterly basis.
• Regulatory Committee. The Regulatory Committee is chaired by the ASX Group General Counsel and Company Secretary and is made up of the CEO, Deputy CEO, Chief Compliance Officer, COO and CRO. The committee manages the processes associated with the development and execution of policy in relation to the operation and conduct of the ASX CS facilities, and ASX's licences, markets and other operations. It also oversees regulatory and legal management processes across ASX, amongst other responsibilities. The Regulatory Committee meets on a quarterly basis.
• RQWG. The RQWG is chaired by the General Manager, CRQD (or the CRO as alternate) and is made up of key staff from ASX's CRQD and CRPM functions who are most familiar with ASX's margin and other risk management models. The focus of the group is the review and application of quantitative risk policies and the Model Validation Framework, including oversight of model governance and the outcomes and recommendations of regular reviews of margining and stress test models. The group meets at least on a monthly basis or more frequently as required.
• DMRWG. The DMRWG is chaired by the CRO and comprises key representatives from ASX Legal, Compliance, Operations and Risk. The DMRWG provides oversight of the CCPs' DMRF. The DMRWG currently meets at least on a six weekly basis or more frequently as required.

Each CCP also maintains a participant RCC, which is consulted on material changes to default management processes, the margin methodology, the default fund, position or liquidity limits, participation criteria, new products, and other changes affecting the risk model or related rules (see CCP Standard 2.8). The RCCs' proposals and recommendations are presented to the respective CCP's board for consideration. Each committee meets three times per year.

Information and control systems

The ASX CCPs use information systems that are designed to provide timely and accurate information relevant to its risk policies, procedures and controls. This includes information on risk exposures to individual participants, as well as aggregated information on risk exposures across the CCPs. Key information systems include:

• Margining. ASX Clear uses the CME SPAN system for margining of derivatives, and CMM for the daily margining of cash equity transactions using a mixture of historical simulation of value at risk (HSVaR) and flat rates for less liquid securities. ASX Clear (Futures) uses the CME SPAN system for margining of exchange-traded derivatives and the FHSVaR-based Calypso margin system for OTC derivatives (see CCP Standard 6).
• Credit and liquidity stress testing. Stress testing is carried out daily to gauge the adequacy of each CCP's financial resources and to monitor the risks associated with individual participants' positions. Credit stress tests estimate the loss that would result from the default of two participants and their affiliates in extreme but plausible market conditions (see CCP Standard 4). Liquidity stress tests estimate the liquidity exposures that would arise under such circumstances, or under other extreme circumstances (see CCP Standard 7).
• Real-time risk monitoring. ASX Clear (Futures) uses a system that supports near real-time monitoring of participant exposures and margin erosion (see CCP Standard 6.4). ASX plans to extend this system to cover ASX Clear by June 2020.

Senior management of the ASX CCPs monitor daily risk management reports produced by their information management systems to identify changes in positions that may require mitigating action. The CCPs' information systems also provide information to participants about positions and margin requirements, which assists in their management of credit and liquidity exposures. ASX publishes detailed margining information on its website, including descriptions of the margining methodology, schedules of margin rates, and daily CME SPAN margin parameter files. This information is sufficient for participants to perform their own margin calculations on hypothetical or actual portfolios. To facilitate this, a number of third-party vendors use this information to provide margin estimation software to participants.

Internal controls

ASX's documented risk management policies and standards specify requirements for periodic formal review, although more frequent reviews may occur depending on changes to technology, business drivers or legal requirements. Reviews are conducted by specific working groups and committees as required. Clearing risk policies and standards are reviewed on an annual basis by the Clearing Risk Policy function within CRPM, the RQWG and the Risk Committee; material changes to clearing risk policies and standards are approved by the CS Boards. Under the Enterprise Risk Management Policy, ASX updates its risk profile every six months at a functional level, identifying relevant risks and setting out planned actions to respond to those risks.

Risk management arrangements are also subject to periodic review by Internal Audit. Such audits aim to provide assurance that the risk management framework continues to be effective. Risk management arrangements may also be subject to review by external experts from time to time.

3.2 A central counterparty should ensure that financial and other obligations imposed on participants under its risk management framework are proportional to the scale and nature of individual participants' activities.

Financial obligations are imposed upon participants through the ASX CCPs' ex ante and ex post risk controls. These are position-based controls.

Both CCPs collect initial margin from participants based on actual positions. The CCPs will also collect additional initial margin (AIM) where positions produce stress test losses beyond a predetermined threshold (see CCP Standards 4.2 and 4.4). AIM is also collected where stress test losses are high compared with the participant's underlying capital.^[14] Since margin is proportional to the size and volatility of a participant's positions, it is proportional to the scale and nature of the individual participant's activities.

The CCPs have different risk management arrangements if losses exceed margin held.

ASX Clear

All of ASX Clear's prefunded pooled financial resources or ‘default fund’ consists of own capital. Under ASX Clear's Operating Rules, if this default fund is exhausted, participants may be required to meet a ‘Recovery Assessment’ (see CCP Standard 4.8). Such an assessment is capped at $300 million in aggregate. The value of assessment obligations would be proportional to participants' quarterly average daily initial margin in the quarter preceding the default, subject to a variable cap. This cap is also based on participants' quarterly average daily initial margin in the three months preceding the default, but is calculated relative to the total pool of initial margin excluding the two participants and their affiliates with the highest quarterly initial margin.

Participants may also be required to contribute to the replenishment of ASX Clear's default fund if this is drawn upon in a default scenario. Individual participants' replenishment contributions would be determined in proportion to the risk associated with positions held by the participant prior to the default. The aggregate value of participant replenishment contributions is capped at $75 million; however, ASX retains the capacity to call additional clearing participant and ASX's own contributions in equal proportion to restore the default fund to pre-recovery levels, should stress tests reveal that post-recovery exposures were not being adequately covered. This would occur as part of a recalibration at the end of the quarter following a default.

Participants may also be required to provide liquidity under OTAs to support the timely settlement of ASX Clear's cash equity settlement obligations in the event that a participant default was to create significant payment obligations for the CCP (see CCP Standards 7.3 and 7.9). Participants' obligations under OTAs are linked to their positions due to settle in the relevant settlement batch.

ASX Clear's Operating Rules also set out non-financial participation requirements, such as operational requirements. These requirements are not prescriptive, and take into account the size and nature of a participant's business.

ASX Clear (Futures)

ASX Clear (Futures)' default fund is comprised of both own capital and participant contributions. Futures participants' contributions to the default fund are currently $100 million in aggregate (see CCP Standard 4.4), with each participant contributing a fixed component of $2 million and a variable component that is recalculated quarterly based on each participant's share of average initial margin over the previous quarter. OTC derivatives participants' prefunded contributions to the default fund are also $100 million in aggregate. Each OTC derivatives participant's contribution is currently fixed at $12.5 million. However, once aggregate initial margin in the OTC derivatives clearing services exceeds $500 million and at least four participants each contribute 15 per cent of initial margin, each participant's contributions will instead comprise a fixed component of $5 million and a variable component that is recalculated quarterly based on each participant's share of average initial margin over the previous quarter. At the end of June 2019, aggregate initial margin from OTC derivatives participants totalled $176 million.

Furthermore, the order in which survivors' default fund contributions would be used (i.e. the default waterfall) is proportional to the profile of the defaulter's activities. The proportion of futures and OTC derivatives participant contributions that would be used after each tranche of ASX Clear (Futures) capital is based on the defaulter's share of initial margin for exchange-traded compared with OTC derivatives products (including portfolio-margined futures) over the previous 90 days (see CCP Standard 12). ASX reviews at least annually the appropriateness of supporting both exchange-traded and OTC derivatives products with a single default fund. OTC participants are also required to bid competitively in any auction of a defaulted participant's OTC derivatives portfolio; otherwise, their default fund contributions may be used ahead of the contributions of other non-defaulting participants (see CCP Standard 12.1).

Under ASX Clear (Futures)' recovery arrangements, participants may be required to meet a Recovery Assessment should a loss caused by a participant default exhaust ASX Clear (Futures)' default fund (see CCP Standard 4.8). The value of an assessment would be capped at the level of each participant's default fund contribution for a single default, ensuring that any amount called would be proportional to the scale and nature of each participant's activities, with the cap rising to three times this amount if multiple defaults occur within 22 business days of completion of the default management process in relation to a default. Should ASX Clear (Futures) suffer losses estimated to exceed even the loss absorbing capacity of its recovery assessment powers, participants may be required to absorb further losses via payment haircutting (pro rata reductions to expected payment receipts; see CCP Standard 4.8). This is a position-based tool.

Participants may also be required to contribute to replenishment of ASX Clear (Futures)' default fund if this were drawn upon in a default scenario. Individual participants' replenishment contributions would be determined in proportion to the risk associated with positions held by the participant prior to the default. The aggregate value of participant replenishment contributions is capped at $200 million, but ASX would retain the capacity to call additional clearing participant contributions and increase its own contributions in equal proportion, to restore the default fund to pre-recovery levels as part of a recalibration at the end of the quarter following a default, should stress tests reveal that post-recovery exposures were not being adequately covered.

ASX Clear (Futures)' Operating Rules also set out non-financial participation requirements, such as operational requirements. These requirements are not prescriptive, and take into account the size and nature of a participant's business.

3.3 A central counterparty should provide incentives to participants and, where relevant, their customers to manage and contain the risks they pose to the central counterparty.

The use of margin and AIM at ASX Clear and ASX Clear (Futures) creates an incentive for participants to manage the exposures that they bring to the CCP, as does the requirement to contribute to the default fund in proportion to initial margin obligations at ASX Clear (Futures). Participants are also typically required to post additional collateral or increase their capital levels if they create exposures that are large relative to the size of their capital (see CCP Standard 3.2). ASX is proactive in monitoring participant exposures and utilises conservatively set triggers for additional monitoring or action, such as requiring participants to actively manage down exposures (see CCP Standard 4.2).

The ASX CCPs may also apply sanctions to, or place additional requirements or restrictions on, participants as it deems appropriate (including where participants fail to comply with the CCPs' Operating Rules).

3.4 A central counterparty should regularly review the material risks it bears from and poses to other entities (such as other FMIs, money settlement agents, liquidity providers and service providers) as a result of interdependencies, and develop appropriate risk management tools to address these risks.

ASX Clear and ASX Clear (Futures) review the material risks that they bear from and pose to other entities in the context of their ongoing review of enterprise risks (such as the six-monthly update of risk profiles; see CCP Standard 3.1), and their processes for identifying risks associated with new activities. In the case of new products and services, ASX carries out risk assessments when undertaking an expansion of its activities or in the event of material changes to its business. Risk assessments are built into ASX's project management framework (see CCP Standards 14.1, 16.4). ASX identifies potential sources of liquidity risk for the CCPs via review of its Liquidity Stress Testing and Liquidity Requirements Standard (see CCP Standard 7.8). ASX also reviews potential sources of credit risk arising from its non-clearing exposures to banks via review of ASXCC's investment mandate.

The interdependency between ASX Clear and ASX Settlement for the settlement of securities transactions, and both CCPs' interdependencies with Austraclear for the settlement of margin obligations are managed within the context of ASX Group's broader risk management framework (see CCP Standard 19).

3.5 A central counterparty should identify scenarios that may potentially prevent it from being able to provide its critical operations and services as a going concern and assess the effectiveness of a full range of options for recovery or orderly wind-down. A central counterparty should prepare appropriate plans for its recovery or orderly wind-down based on the results of that assessment. Where applicable, a central counterparty should also provide relevant authorities with the information needed for purposes of resolution planning.

ASX Clear and ASX Clear (Futures) have established a recovery plan that identifies scenarios that could threaten the ASX CCPs' ongoing provision of critical services, describes events that would trigger the activation of the recovery plan, and sets out how ASX would respond to such scenarios. It also describes the suite of tools available to the CCPs in recovery and details the governance arrangements both for the use of these tools and for review of the recovery planning framework. Under their respective operating rules, the ASX CCPs have the power to:

• address uncovered credit losses and liquidity shortfalls via Recovery Assessments and variation margin gains haircutting (at ASX Clear (Futures) only). ASX Clear also has the power to address a liquidity shortfall associated with cash equity settlement via OTAs (CCP Standard 7.9). If these tools fail to comprehensively address uncovered credit and liquidity shortfalls, both CCPs have the option – in the context of complete termination of all open contracts – of applying a haircut to any settlement payments to participants (see CCP Standards 4.8 and 7.9).
• restore a matched book via partial or complete termination of contracts if normal close-out processes cannot be carried out (see CCP Standard 12.1)
• replenish their default funds via a combination of ASX and participant replenishment contributions (see CCP Standards 4.8 and 12.1)
• address investment losses via investment risk capital and the allocation of certain investment losses in excess of $75 million to participants (see CCP Standard 14.3)
• address other non default-related losses via business risk capital (see CCP Standard 14.3).

In developing its recovery tools, ASX has performed an assessment in an attempt to ensure the tools: are comprehensive, effective and transparent; provide appropriate incentives; and minimise negative impacts on participants and markets.

To complement the recovery plan, ASX has information management tools to support decision-making in a recovery scenario. ASX has integrated the testing and review of the recovery plan into its broader framework for testing and review of risk and default management policies and processes.

Footnotes

International Organization for Standardization (ISO) is an international standard-setting body and ISO 31000 is considered to be relevant guidance for enterprise risk management. The ISO 31000 standard has been reproduced by Standards Australia and Standards New Zealand as AS/NZS 31000. [13]

A participant of ASX Clear (Futures) that is a bank or, in certain circumstances, a subsidiary of a bank or bank-holding company supervised in ASX-approved jurisdictions, is exempt from this requirement. [14]