Assessment of ASX Clearing and Settlement Facilities – September 2019 3. Special Topic – Legal Basis

3.1 Introduction

A CS facility's legal basis defines the rights and obligations of the facility, its participants, and other parties (e.g. clients or service providers), and underpins assumptions made in risk management systems about the manner and time at which these rights and obligations arise. If the legal basis is inadequate, uncertain or unclear then the facility may face unintended, uncertain or unmanageable credit, liquidity or operational risks, which may create or amplify systemic risk.

This section provides an overview of the Bank's assessment of the ASX CS facilities against the standard relating to the Legal Basis (CCP and SSF Standard 1). ASIC staff also contributed to this review. In addition to reviewing potential sources of legal risk at the CS facilities, the assessment examined the controls ASX has in place to mitigate legal risk. The Bank also reviewed two secondary topics that are related to ASX's legal basis:

  • settlement finality (CCP Standard 8 and SSF Standard 7), which depends on the legal certainty that settlement cannot be subsequently unwound
  • segregation and portability of client positions and collateral (CCP Standard 13), which depends on the legal effectiveness of segregation arrangements and the identification of potential legal obstacles to timely transfer.

The Bank has also reviewed ASX against aspects of the General Business Risk Standard (CCP Standard 14 and SSF Standard 12), where this was relevant to a particular legal risk identified by the review.

The Bank's review of the ASX CS facilities' legal basis was supported by the provision of extensive legal analysis by ASX, including a number of external legal opinions. The Bank also conducted a desk-based review of relevant ASX procedures and policies and engaged with ASX on a number of follow-up questions.

The remainder of this section provides an overview of the key elements of the standards on Legal Basis, Settlement Finality, and Segregation and Portability. It describes the key legal risks identified via the review, how these are mitigated and recommended actions to address remaining gaps. It also outlines ASX's control framework for legal risks and describes how the framework operates in practice.

3.2 Legal Basis

The foundational nature of a CS facility's legal basis is reflected in the broad range of requirements set out in the CCP and SSF Standards and associated guidance related to the identification and management of legal risks. These requirements are summarised in the standard on Legal Basis (CCP and SSF Standard 1) as being that a CS facility ‘should have a well-founded, clear, transparent and enforceable legal basis for each material aspect of its activities in all relevant jurisdictions.’ Implicit in this overarching requirement is the need for the facility to appropriately manage its legal risks in order to achieve a sound legal basis. The key elements of the legal basis and associated requirements to manage legal risks that form the basis of the Bank's assessment are set out in Table 5.

Table 5: Key Elements of the Legal Basis
Requirement Standard(s) Key elements
Segregation from risks of affiliated entities CCP and SSF Standard 1.1; CCP Standards 14.2 and 14.3; SSF Standards 12.2 and 12.3

The CS facility should be in a legal entity that is not exposed to risks unrelated to those that arise from clearing or settlement.

If assets held to cover the CS facility's general business risks are not held by the facility itself, the facility should have legally certain arrangements in place that guarantee access to liquid net assets held by a related entity.

Protection of rights and interests CCP and SSF Standard 1.2; CCP Standards 5.6, 13.1, 13.3, 13.4 and 15; SSF Standards 5.6, 9.1, 9.5 and 13

The legal basis of a CS facility should clearly define the rights and interests of a CS facility, its participants and, where relevant, its participants' customers in the assets held in custody, directly or indirectly, by the CS facility, including:

  • interests in, and rights to use and dispose of, collateral (including cross-border collateral)
  • authority to transfer ownership rights or property interests
  • rights to make and receive payments, in all cases, notwithstanding the bankruptcy or insolvency of its participants, participants' customers, or a custodian bank
  • establishing that 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.

A CCP should have segregation and portability arrangements that effectively protect a participant's customers' positions and collateral from the default or insolvency of that participant, and disclose any legal or operational constraints that may impair such arrangements.

An SSF operating a central securities depository should have appropriate rules, procedures and controls to safeguard the rights of securities issuers and holders and ensure that, to the extent permissible by law, the creditors of the SSF have no claim over securities deposited or registered by participants.

Clear and understandable rules, procedures and contracts CCP and SSF Standard 1.3 A CS facility's rules and procedures should clearly set out the procedures that will be followed in certain circumstances, the degree of discretion that can be exercised, the processes for changing rules and procedures, and any notification period for unilateral changes to rules or procedures.
Clear articulation of the legal basis CCP and SSF Standard 1.4 A CS facility should be able to articulate the legal basis for its activities to the Bank and other relevant parties; one recommended approach to articulating the legal basis for each material aspect of a CS facility's business is to obtain well-reasoned and independent legal opinions or analyses.
Clear and certain final settlement, netting and novation arrangements CCP and SSF Standard 1.5; CCP Standards 8.1, 9.5 and 20.2; SSF Standards 7.1 and 8.5

There should be a clear legal basis regarding the timing of final settlement of a CS facility's obligations, including the point at which transactions are irrevocable. Similarly, netting arrangements and, for CCPs, novation arrangements should be legally certain.

A CCP's rules, policies and procedures should clearly identify the point in the clearing process at which the CCP assumes the risk exposure and the nature and scope of that exposure.

Enforceability CCP and SSF Standard 1.5; CCP Standard 19.2; SSF Standard 17.2 The rules, procedures and contracts of a CS facility should be enforceable in all relevant jurisdictions and in the event of recovery or orderly wind-down. The legal basis should protect the CS facility and any linked FMIs. A CS facility should obtain a written and reasoned independent legal opinion as to the enforceability of the CS facility's arrangements under the laws of each relevant jurisdiction.
Conflicts of law CCP and SSF Standard 1.6 A CS facility operating in multiple jurisdictions should obtain well-reasoned, independent legal opinions that identify and analyse potential conflicts of law, as well as the enforceability of its rules and its ability to satisfy its regulatory obligations in all relevant jurisdictions. A CS facility should develop rules and procedures to mitigate identified risks. The legal opinion should be reviewed whenever there is a material change to the CS facility's operational, governance or risk management arrangements or to the legal or regulatory framework governing its activities.

3.2.1 Identification of legal risks

Operating Rules

The Bank's review of the elements of the legal basis set out in Table 5 has confirmed that the ASX CS facilities are exposed to only a limited range of legal risks that affect its core clearing and settlement activities in Australia. This is in part due to the strong protections that the Payment Systems and Netting Act 1998 (PSNA) provides in relation to provisions of the CS facilities' operating rules. These protections include:

  • Protection of the finality of Austraclear's settlement process by its approval as RTGS system under Part 2 of the PSNA. With this approval, a transaction settled in Austraclear at any time on the day on which a participant enters external administration has the same effect as if the participant had gone into external administration on the next day (in the case of a winding-up) or as if the participant had not gone into external administration (in the case of other forms of external administration). Accordingly, in the event of insolvency all transactions settled on the day of the insolvency are irrevocable and cannot be unwound simply because of the event of external administration.[13]
  • Protection of the netting arrangements of ASX Settlement by its approval under Part 3 of the PSNA. This approval ensures that netting in accordance with ASX Settlement's Rules and Procedures is legally certain, and that any payment or transfer made in order to discharge the net obligation under the netting arrangements is not to be void or voidable in the event of a participant entering external administration.[14]
  • Protection of the legal certainty of the Operating Rules of both ASX Clear and ASX Clear (Futures) as netting markets under Part 5 of the PSNA. This includes the effectiveness of the process of novation, by which the CCPs assume obligations to their participants for each cleared transaction, protections for the netting of exposures and payments with participants (including in the event of a participant default), and protection for the enforceability of the CCPs' Operating Rules (including default management and recovery rules) in the event of a participant's external administration.

ASX has, however, identified that the CCPs' Operating Rules do not explicitly authorise the offsetting of opposing positions held by two or more participants that have defaulted at the same time, which may be a preferred default management strategy in an extreme event such as this. ASX plans to remove this uncertainty as part of a broader set of default management rule changes that have been developed in response to lessons learned in the 2015 default of BBY, expected to be implemented in the second half of 2019.

Recommendation. The ASX CCPs should implement changes to their operating rules to enhance the legal certainty of default management actions.

Intragroup capital arrangements

The standards on General Business Risk (CCP Standard 14 and SSF Standard 12) require the ASX CS facilities to hold capital against operational, business and investment risks, but allow this capital to be held by a related entity if there are legally certain arrangements guaranteeing the facility's access to this capital when required. [15] ASX maintains an intragroup agreement (the ASX Group Support Agreement) between the CS facilities, ASX Limited, ASX Operations Limited (ASX Operations) and other group entities, which covers arrangements for the holding of CS facility operational, business and investment risk capital by ASX Limited or another group entity (in practice the capital is invested in liquid assets by ASX Operations).

The Bank's review revealed four key gaps in the arrangements for holding operational, business and investment risk capital under the ASX Group Support Agreement, two of which had been addressed by 30 June, and another which had been partly addressed.

  • Access to capital in the event that the CS facility's financial standing is in doubt. The agreement originally allowed a broad range of termination rights against the CS facilities, including that ASX Limited or ASX Operations could immediately terminate the agreement with respect to a CS facility if the facility was insolvent or was entering external administration. Access to capital under the agreement in such circumstances is essential since it is required to fund the facility's recovery or wind-down plan. ASX has since made amendments to the agreement that restrict the right of ASX Limited or ASX Operations to terminate the agreement for reasons of a CS facility's insolvency or external administration, unless the relevant capital has already been transferred to the facility, addressing the most potentially serious gap associated with termination rights under the agreement. However, there remain a number of material gaps, including certain non-insolvency circumstances in which ASX Limited could terminate the agreement without transferring the capital.
  • Access to capital in the event that ASX Limited's or ASX Operations' financial standing is in doubt. The agreement includes no provision that safeguards the CS facilities' access to capital if ASX Limited or ASX Operations was to become insolvent. This gap is potentially of serious concern if not addressed promptly since, in extreme circumstances, it could mean that the facilities have no access to business, operational or investment risk capital. Addressing this gap is not straightforward since any solution will need to avoid the possibility that the transfer of capital by ASX Limited or ASX Operations could be characterised as an unfair preference in insolvency. ASX has developed a proposed solution involving granting the CS facilities security over the assets in which their capital has been invested. Execution of this arrangement is expected to occur later in 2019.
  • Investment risk capital. Since July 2018, capital to cover potential losses on the CCPs' investment portfolio (i.e. investment of participant cash collateral and ASX's contribution to the CCPs' default funds) has been calculated as a separate capital requirement from operational and business risks. The agreement did not make reference to this separate pool of investment risk capital, but the recent amendments to the agreement have addressed this gap.
  • Restrictions on investment of capital. The agreement placed no restriction on how capital held at the group level should be invested. In practice, the capital is invested in liquid assets under the terms of the ASX Limited and ASX Operations Investment Mandate, consistent with the requirements of the FSS. ASX's recent amendments have introduced this requirement into the agreement.

The ASX Group Support Agreement also covers a range of matters relevant to the CS facilities that were not within the scope of the current review, including arrangements for intragroup provision of operational and human resources relied on by the facilities. The Bank plans to review these aspects of the agreement in greater detail over the coming assessment period.

Recommendation. The ASX CS facilities should implement changes to the ASX Group Support Agreement to ensure that business, operational and investment risk capital is available to the CS facilities when required, including in circumstances where the financial standing of the CS facilities or the ASX Group entities holding the capital is in doubt.

Cross-border legal risks

ASX has identified that there are only three countries that are relevant to the analysis of core legal risks for the ASX CS facilities: Australia, New Zealand and the United States. Although the facilities have participants based in other jurisdictions, the analysis provided by ASX has concluded that the PSNA will validate actions taken under the Operating Rules within Australia, even if these actions are contrary to the laws of overseas jurisdictions (such as the insolvency law governing foreign participants). The one exception identified is for offshore collateral or other settlements that take place overseas, where a foreign court may be able to enforce decisions that give precedence to foreign law. This is currently only an issue for collateral held in New Zealand and the United States by ASX Clear (Futures). The conclusion also relies on the understanding that the ASX CS facilities do not need to pursue action to recover debts from a defaulting (foreign) participant where these exceed the level of collateral posted by that participant in order to manage a default. This is consistent with the risk management framework of the ASX CCPs, which assumes that any uncollateralised losses will be allocated to the default fund (and then, if needed, to loss allocation tools that are part of the recovery plan). However, it does mean that, in some circumstances, participants (and the ASX CCPs) will suffer larger losses than they would have if ASX had successfully recovered funds from the estate of the defaulting participant. The Bank has discussed with ASX that it should document its policy on debt recovery and disclose its approach to its participants.

The Bank's review resulted in ASX identifying an additional legal risk affecting NZD collateral and margin payments in ASX Clear (Futures). The risk relates to a small number of participants that participate in ASX Clear (Futures) via an Australian branch, but also have a branch in New Zealand. If one of these participants was to enter insolvency, then it is possible that a New Zealand court could take action that interferes with ASX Clear (Futures)' rights over any NZD collateral posted by the participant. In order to mitigate this risk, ASX Clear (Futures) has applied for designation as a settlement system by the RBNZ, which would provide it with additional settlement finality protections under the Reserve Bank of New Zealand Act 1989 (RBNZ Act). ASX is also developing a procedure that would allow it to repatriate NZD collateral to Australia upon a participant default, where the stronger protections of the PSNA would apply.

The analysis of the New Zealand legal basis has also identified that settlement finality protections under the RBNZ Act are only valid for the first 24 hours following a default, although this time limit applies only to the application of collateral within New Zealand and does not limit the repatriation of NZD collateral to Australia. This would be most likely to affect a New Zealand-based direct OTC participant lodging NZD collateral, which has prompted ASX to defer plans to admit New Zealand-based participants unless and until there is legislative change that results in longer-lasting protections for settlement finality.

The analysis of the United States legal basis provided by ASX has not identified any additional material gaps. However, the scope of this analysis excludes any analysis of participants that are neither an Australian corporation nor an Australian branch of a foreign bank. Currently there is one such ‘wholly remote’ participant that does not post any USD collateral, and ASX has introduced a series of measures to prevent the participant from posting USD collateral in the future.[16]

Recommendation. ASX Clear (Futures) should take all possible steps to achieve designation as a settlement system in New Zealand and develop a procedure supporting the repatriation of NZD collateral.

3.2.2 Control framework for legal risks

The ASX Legal department consists of 26 staff, led by the Group General Counsel and Company Secretary. ASX's preference has been to develop its own in-house legal expertise rather than rely on input from external counsel on routine matters.

There are two main elements of ASX's control framework for legal risks:

  • Business-as-usual (BAU) controls primarily involve ASX business areas seeking support from ASX Legal on matters that raise potential legal risks. Input from ASX Legal is sought as part of business processes such as contract execution, admission of participants domiciled in a foreign jurisdiction and changes to margining processes. ASX Legal may seek external legal opinions in certain circumstances, such as issues involving highly specialised areas of law or advice on foreign law. ASX Legal also works with the business to develop and assist with the implementation of procedures to control for legal risks (e.g. improvements to contract review processes and controls).
  • Change management controls seek to address legal risks that arise from both external and internal changes, such as the introduction of new legislation or ASX seeking to launch a new service or product. ASX Legal monitors for changes that may impact the operating rules of the CS facilities (which set out the rights and obligations of participants and the relevant facility) or the conclusions of external legal opinions. To support early engagement of ASX Legal with business initiatives or other changes that may require legal input, ASX Legal participates in a number of organisation-wide committees and groups. These include executive-level management groups (such as the Group General Counsel's membership of the Executive Committee), the Default Management and Recovery Working Group, ASX CCP Risk Consultative Committees, and business-level team meetings.

The Bank judges that ASX's overall control framework for legal risks is consistent with FSS requirements, but that there are some areas where enhancements could be made to improve the overall effectiveness of the framework.

BAU controls

The effectiveness of ASX's BAU controls relies on business units understanding when to seek legal input. Consultation and engagement with ASX Legal is embedded in internal processes for amending operating rules, procedures, and guidance notes. However, ASX has not conducted an exercise to comprehensively identify areas where legal input is required and embedded these requirements in documented procedures, meaning that the requirement to engage with ASX Legal is missing from, for example, procedures relating to the introduction of new products or services. ASX had self-identified a number of such gaps in its documented controls before the Bank's review and has commenced work to address them. In particular, ASX is developing a list of areas where legal input must be sought by the business and is taking steps to ensure that these requirements are embedded in business-level processes and procedures. Work is also underway to review processes for contract review and execution, and to finalise a set of guidelines for the engagement of external counsel. The Bank will monitor ASX's completion of work to enhance, formalise and document BAU controls for legal risks.

External legal opinions

It is critical that the ASX CS facilities identify the range of legal risks that could materially affect their ability to perform obligations or provide services as intended. Before the Bank's review, ASX had relied primarily on its own internal legal analysis to identify these risks, supplemented by advice from external counsel and occasional external legal opinions that were typically targeted at highly specialised questions. While this approach has the benefit of deepening ASX's internal knowledge of its legal basis, it creates the risk that the analysis of legal risks is not sufficiently objective or has been carried out by a generalist rather than specialist in the relevant areas of law. CCP and SSF Standards 1.4 and 1.6 highlight the use of well-reasoned and independent legal opinions as a means of identifying and articulating any risks to the legal basis of a CS facility. During the assessment period, ASX Legal formalised and documented a set of guidelines for seeking external legal advice to complement its internal legal expertise in a more systematic manner. 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, ASX Legal management have recently instituted periodic meetings to discuss whether any changes to law or business activities mean that existing legal opinions should be revisited.

The Bank does not consider that these processes are sufficiently comprehensive. For example, the procedures do not capture the requirement in CCP and SSF Standard 1.6 to review, and update where appropriate, independent legal opinions covering potential conflict of laws at least every two years. The Bank also identified the potential for other enhancements, such as the adoption of a risk-based approach to prioritise obtaining independent opinions in areas of high legal risk or systemic importance. To address the Bank's concerns, it is expected that ASX will review and update its processes for commissioning, reviewing and updating legal opinions on operating rules and key contractual arrangements.

Recommendation. The ASX CS facilities should review and update processes and procedures governing the commissioning, reviewing and updating of legal opinions.

Review of rules and procedures

CCP and SSF Standard 1.3 requires that a CS facility establish rules and procedures that are clear and understandable and are consistent with industry standards and market protocols. ASX engages with participants and monitors market developments to identify changes to industry standards and market protocols and may consider rule changes to maintain consistency with these. Drafting and consultation processes for rule changes aim to ensure drafting is clear and understandable. However, ASX does not conduct periodic general reviews to assess the risk that incremental changes to rules and procedures over time might reduce their clarity and understandability.

Recommendation. The ASX CS facilities should establish a periodic review, to be carried out at least every five years, of operating rules and procedures for all CS facilities to ensure they are clear and understandable and are consistent with industry standards and market protocols

3.3 Settlement Finality

The standards on Settlement Finality (CCP Standard 8 and SSF Standard 7) require that a CS facility's rules and procedures should clearly define the point at which settlement of payments, transfer instructions or other obligations is final. Finality means that the transfer of an asset is irrevocable and unconditional, or that other obligations have been discharged in line with the terms of the underlying contract.

The ASX CS facilities' approach is consistent with the Settlement Finality standards and associated guidance, with one minor gap identified. The gap relates to a requirement in the Settlement Finality standards that a CS facility complete final settlement on the intended date of settlement, other than allowing for a small amount of failed security settlements in the normal course of business. Reflecting this, the guidance to the relevant standard sets out that a facility's rules should make clear that changes to operating hours should not be made for routine reasons (e.g. to accommodate an idiosyncratic and low-impact participant issue) but should be justified on an exceptional basis (e.g. in order to avoid a broader disruption). This is ASX's practice, but it is not set out in the Operating Rules of the CS facilities. ASX plans to amend the rules of each facility to address this gap and the Bank will monitor this work.

3.4 Segregation and Portability

The standard on Segregation and Portability (CCP Standard 13) sets out that a CCP should have rules and procedures that enable the segregation of positions and collateral of a participant's customers (clients). In the event of a participant's insolvency, such arrangements protect clients' collateral from claims by a participant's other creditors and can improve a client's ability to identify and recover its collateral. Segregation also facilitates the transfer of clients' positions and collateral to another participant. The standard requires that, to the extent reasonably practicable under prevailing law, a CCP should put in place portability arrangements that make it highly likely that a client's positions and collateral can be transferred to another participant if the client's participant defaults.

To enable a CCP to readily identify positions of a participant's clients and to segregate related collateral, the Segregation and Portability standard requires that a CCP should maintain client positions and collateral in individually segregated accounts or in omnibus client accounts, or equivalent. Under an individually segregated account structure, each client's positions and collateral are held in a separate account at the CCP, segregated from the positions and collateral of the participant and each other client. Under an omnibus account structure, all positions and collateral belonging to omnibus segregated clients of a particular participant are held together in a single account segregated from the positions and collateral of that participant.

The ASX CCPs take different approaches to client segregation. ASX Clear (Futures) offers individually segregated accounts and client omnibus accounts for both OTC and exchange-traded futures. ASX Clear offers individually segregated accounts for options but does not offer individually segregated accounts or client omnibus accounts for cash market transactions. Instead, ASX Clear relies on an exception in the FSS guidance that permits the use of alternative means to provide protection for clients' assets if this protection is materially equivalent to full segregation of client and house positions and collateral. This exception is limited to cash markets and subject to the CCP demonstrating to the Bank that the alternative protections are materially equivalent to full segregation.

ASX Clear's arrangements for cash market transactions utilise a structure that commingles house and client positions and collateral. To attempt to achieve protections materially equivalent to full segregation, ASX Clear has put in place arrangements that involve the strict segregation of client cash and securities during the period between trade and settlement, and there is a requirement that cash received from the settlement process is placed in trust for the client until it can be disbursed. This is designed to ensure that the client is not exposed to the loss of its cash or securities other than for a matter of minutes during the processing of settlements. However, it does not provide any compensation to the client for the opportunity cost of a failed settlement if its participant was to default (known as replacement cost), for example if the client was forced to re-sell its securities for a lower price. While the current arrangements do provide margin reductions for participants from netting across house and client positions, they also require participants to fund the entire margin requirement since client collateral cannot be passed through to ASX Clear if accounts are not segregated.

The Bank has concluded that ASX Clear's current arrangements for cash market transactions are acceptable given the complexity and limited lifespan of introducing material changes to the account structure used by CHESS. The CHESS replacement system is expected to have functionality that can be configured to support segregation of a participant's clients' positions and collateral from those of the participant during the pre-settlement period. Once the new system is able to support either client omnibus or individually segregated accounts, the Bank would place greater weight on the additional protections that implementation of a segregated account structure would deliver in assessing whether existing arrangements remain consistent with the Segregation and Portability standard. To facilitate the Bank's review of existing arrangements, ASX should conduct an assessment of the case for introducing segregation, including whether the protections remain materially equivalent, and consult with the Bank on the outcome.

Recommendation. ASX Clear should conduct an assessment of whether the protections from arrangements utilising a commingled house/client account structure remain materially equivalent to those provided by omnibus or individual client segregation. ASX should consult with the Bank on the outcome of this assessment within 12 months of the CHESS replacement system going live.

During the assessment period, ASX Legal took steps to address legal impediments to the adoption of portability as a default management strategy for ASX Clear and ASX Clear (Futures). The requirements of the Anti-Money Laundering and Counter-Terrorism Financing Act 2006 (AML/CTF Act) to perform a know-your-customer (KYC) procedure before accepting ported customers may mean that participants are unable to accept the transfer of customers following a default within an acceptable timeframe in a way that is consistent with the AML/CTF Act. ASX has applied to AUSTRAC for relief allowing participants to accept the transfer of customer positions before carrying out the applicable customer identification procedure, on the condition that they would subsequently close out any positions of transferring customers found to pose an unacceptable risk.

Footnotes

A similar protection is provided to the CHESS RTGS service in ASX Settlement; however, this service is not currently active. [13]

A similar protection is provided to Austraclear's Assured Mode, which is used as a contingency arrangement settling on a deferred net basis if RTGS settlement is unavailable. [14]

The standards do not require that capital for operational and business risks is held in separate pools. However, the CCP Resilience Guidance requires investment risk capital to be held separately. [15]

In this context, USD collateral means collateral denominated in USD and located in the United States. It does not include, for example, USD-denominated collateral that is posted to an Australian bank via arrangements wholly within Australia. [16]