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

Standard 14: General business risk

A central counterparty should identify, monitor and manage its general business risk and hold, or demonstrate that it has legally certain access to, sufficient liquid net assets funded by equity to cover potential general business losses so that it can continue operations and services as a going concern if those losses materialise. Further, liquid net assets should at all times be sufficient to ensure a recovery or orderly wind-down of critical operations and services.

14.1 A central counterparty should have robust management and control systems to identify, monitor and manage general business risks, including losses from poor execution of business strategy, negative cash flows or unexpected and excessively large operating expenses.

ASX's approach to business risk is consistent with its overall Enterprise Risk Management Policy and Framework (see CCP Standard 3). Under the framework, formal policies are in place for individual risk categories such as accounting, authorisations, business continuity, technology, fraud control and procurement.

ASX monitors a variety of financial business risks, including market risk, credit risk, liquidity risk and capital risk.

• Group funds (as distinct from collateral lodged by participants) may be exposed to market risk arising from changes in market variables such as interest rates and foreign exchange rates. Mitigants for market risk include hedging of foreign exchange and limits with respect to weighted average maturity of investments, with appropriate capital allocation.
• Credit risk for the group's general business activities arises in the collection of receivables, which principally comprise fees from market participants, issuers, users of market data and other customers. Mitigants include active collection procedures on trade receivables and review of the ‘ageing’ of receivable amounts, as well as ceasing to provide services where receivables remain unpaid. The ASX CCPs novate the income from receivables to a related entity that bears the responsibility for collecting receivables.
• Liquidity risk arises from the group's time-critical payables. This is mitigated by ASX's liquidity management arrangements, including forward planning and forecasting of liquidity requirements and holding sufficient liquid assets to meet payment obligations.
• ASX may be exposed to capital risk if equity in its group entities falls below prudent or regulatory minimum levels. ASX manages its capital at a group level, with an objective of maintaining a prudent level of surplus net tangible equity above its capital allocation. Ongoing monitoring of cash flows and capital adequacy is conducted via quarterly meetings of the Risk Committee.

ASX undertakes periodic strategic risk assessments in the context of its overall business plans. Through this process, ASX identifies new strategic business initiatives. These are subject to financial analysis, including sensitivity analysis on cash flows. Impacts on capital are also determined and analysed.

ASX conducts risk assessments when undertaking any 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 Standard 16.2). Under this framework, an initial high-level complexity indication is defined at the project concept stage. This is followed by a formal project risk assessment covering both project delivery risks and impacts to business activities. ASX typically conducts a series of workshops involving a range of stakeholders to discuss risks associated with any planned new service. Prior to the approval of a project for launch/production, ASX prepares an operational readiness summary and conducts a final workshop to discuss possible risks associated with initial launch. This includes consideration of potential failure scenarios and workarounds, procedures for escalation of issues, customer readiness, and help desk and key staff availability.

Following launch, the risks of a new activity are captured in risk profiles that are prepared by relevant management every six months. The Risk Committee also monitors actual and forecast capital and liquidity requirements on a quarterly basis, including requirements related to new projects.

During the assessment period, ASX established KRIs for each of the risk categories set out in its revised Risk Appetite Statement, including for financial and strategic risks (see CCP Standard 2.6). These indicators are reported to the ASX's Audit and Risk Committee on a quarterly basis.

14.2 A central counterparty should hold, or demonstrate that it has legally certain access to, liquid net assets funded by equity (such as common stock, disclosed reserves or other retained earnings) so that it can continue operations and services as a going concern if it incurs general business losses. The amount of liquid net assets funded by equity a central counterparty should hold, or have access to, should be determined by its general business risk profile and the length of time required to achieve a recovery or orderly wind-down, as appropriate, of its critical operations and services if such action is taken.

As at 30 June 2019, ASX set aside $31 million for ASX Clear and $40 million for ASX Clear (Futures), to cover the CCPs' operational and business risks. In determining the sufficiency of these capital levels, ASX has estimated the capital required to cover: six months of current operating expenses (see CCP Standard 14.3); operational and legal risk; non-covered credit and counterparty credit risk; non-covered market risk; and business risk.

ASX Clear and ASX Clear (Futures) also undertake periodic loss scenario analysis in order to validate whether the operational and business risk capital is sufficient to meet the potential single largest uninsured business loss event for the CCPs. ASX has in place a number of insurance policies to reduce its exposure to a broad range of risks, including professional indemnity, fraud, and operational risks such as computer manipulation and equipment failure. However, this insurance provides limited direct cover for the CCPs due to the nature of ASX's intragroup arrangements and the type of losses that the CCPs could be directly exposed to. The other factors driving ASX's operational and business risk capital calculation limit the extent to which the level of ASX's insurance cover could reduce the level of capital that it holds.

In July 2018, ASX set aside a separate pool of capital of $75 million to cover losses arising from custody and investment risks across both CCPs. Prior to this, a common pool of capital was held to cover custody and investment risks as well as other general business risks.

Since ASX has identified constraints to making business risk capital bankruptcy remote within the CCP, this capital is held at the ASX Group level to ensure that it cannot be applied to meet losses caused by a participant default. Each CS facility has a separate allocation for business risk capital that is explicitly recognised within group-wide capital holdings. These holdings include an additional buffer against potential losses sustained elsewhere in the group. The ASX Group Support Agreement places an obligation on ASX to maintain sufficient capital to support ASX Clear's and ASX Clear (Futures)' continued operations in the event of general business losses, supporting the legal certainty of the CCPs' access to business risk capital as required. However, the agreement does not guarantee CCP access to business or investment risk capital if the ASX Group entity holding the capital is nearing insolvency or external administration, and in certain non-insolvency circumstances the agreement provides ASX Limited with the right to terminate the agreement without transferring this capital to the CCP. ASX plans to address these gaps later in 2019.

14.3 A central counterparty should maintain a viable recovery or orderly wind-down plan and should hold, or have legally certain access to, sufficient liquid net assets funded by equity to implement this plan. At a minimum, a central counterparty should hold, or have legally certain access to, liquid net assets funded by equity equal to at least six months of current operating expenses. These assets are in addition to resources held to cover participant defaults or other risks covered under CCP Standard 4 on credit risk and CCP Standard 7 on liquidity risk. However, equity held under international risk-based capital standards can be included where relevant and appropriate to avoid duplicate capital requirements.

ASX Clear and ASX Clear (Futures)' recovery planning arrangements have been developed with reference to the CPMI-IOSCO guidance on recovery planning (see CCP Standard 3.5). In calculating the levels of business risk capital described under CCP Standard 14.2, ASX has sought to ensure access to sufficient liquid net assets to fund operations during the execution of the CCPs' recovery plan or to cover a minimum of six months of current operating expenses.

The ASX CCPs' recovery approach establishes arrangements such that non-default losses arising from a range of general business risks would be absorbed by ASX through application of operational and business risk capital held for the CCPs at the ASX Group level. Unlike investment losses (referred to below), general business losses from causes such as a decline in revenues or an increase in operating expenses are likely to be relatively slow-moving in nature. This recovery approach takes into account that ASX has in place a number of insurance policies to reduce its exposure to a broad range of risks (see CCP Standard 14.2). ASX Limited has also committed to maintaining adequate levels of business risk capital for the CCPs and securities settlement facilities (SSFs), recapitalising these funds as required (see CCP Standard 14.5).

In the case of investment losses (other than those resulting from fraud of, or material non-compliance with the investment policy of, the ASX CCPs; see CCP Standard 15), ASX would apportion any losses in excess of $75 million (an amount equal to the ASX CCPs' total custody and investment risk capital) between participants (see CCP Standard 14.5).

14.4 Assets held to cover general business risk should be of high quality and sufficiently liquid in order to allow the central counterparty to meet its current and projected operating expenses under a range of scenarios, including in adverse market conditions.

The risk capital for ASX's CS facilities is invested in accordance with the ASX Limited and ASX Operations Pty Limited Investment Mandate. The Investment Mandate specifies investment objectives, responsibilities, approved products and counterparties, and audit and maintenance of the mandate. Approved products are generally highly rated and liquid products such as: cash deposits; bank bills, negotiable certificates of deposit and floating rate notes issued by Australian Prudential Regulation Authority (APRA) approved ADIs; foreign exchange in specified currencies; Australian Government securities; and selected semi-government securities. Limits are applied against counterparty, liquidity and market risks. Liquidity limits are specified for maximum instrument maturity and weighted average maturity.

14.5 A central counterparty should maintain a viable plan for raising additional equity should its equity fall close to or below the amount needed. This plan should be approved by the board of directors and updated regularly.

As noted, ASX Limited manages its operational and business risk capital at the group level. The ASX Limited Board monitors the ongoing capital adequacy of the ASX Group as part of its regular capital planning activities. The Board determines the most appropriate means of raising additional capital when needed, giving due consideration to prevailing market conditions and available alternative financing mechanisms. This was most recently reviewed and approved by the Board in June 2018.

The ASX CCPs' recovery approach depends on timely and reliable recapitalisation processes to address general business losses. Accordingly, the CCPs have established an intragroup service agreement which commits ASX Limited to maintaining adequate levels of business risk capital for the CCPs, recapitalising these funds as required. ASX Limited maintains a plan that sets out how it would fulfil its obligations to recapitalise ASX Clear and ASX Clear (Futures). The elements of this plan include the use of existing group cash reserves and raising additional capital through an equity issuance by ASX Limited.

In the case of investment losses, reliance on recapitalisation alone is unlikely to be sufficiently timely to address losses in excess of custody and investment risk capital. ASX would apportion any losses (other than those resulting from fraud of, or material non-compliance with the investment policy of, the ASX CCPs; see CCP Standard 15) in excess of $75 million (an amount equal to the ASX CCPs' custody and investment risk capital) between participants. This would be done in proportion to the amount of cash each participant has provided to the CCPs (including margin, default fund contributions and excess cash).