CS facilities may differ significantly in the nature of their activities, their scale, the products and participants, and their importance to the Australian financial system. In recognition of this, it is proposed that specific requirements for cross-border CS facilities be applied in a graduated and proportional manner.
Under this approach, there would be some basic requirements imposed on all cross-border CS facility licensees, both domestic and overseas, which largely clarify, elaborate and interpret general licence obligations under Part 7.3 of the Act, including under the FSSs. While in principle it would be expected that these requirements would be met by all licensees, some specific measures may not in practice apply unless a facility had material Australian-based participation or provided services in Australian-related products (e.g. Australian dollar-denominated products, or securities issued by Australian-domiciled issuers).
Other requirements would apply only if the licensee was deemed to be, or over time became, systemically important in Australia, and/or exhibited a particularly strong connection with the Australian financial system and real economy. Determination of which specific measures should apply to a given facility would reflect a case-by-case assessment of the benefits from enhanced influence for the Regulators, relative to the costs of imposing additional requirements.
The benefits are likely to be greatest where the underlying market is systemically important to Australia, particularly where the facility also has a strong connection to the domestic economy (perhaps by virtue of its participation base or its product mix), such that a disruption could give rise to instability and reputational, confidence or integrity concerns. In such circumstances, a key consideration for the Regulators would be whether adequate channels existed whereby the services of the facility to the Australian market could continue uninterrupted in the event of distress to the facility. This might imply tighter influence through primary regulation8 and restrictions on offshore outsourcing of critical operational functions, such that appropriate resolution actions could readily be applied.9
Potential costs, on the other hand, may extend to unintended changes in the market structure, including potential fragmentation, or a disproportionate increase in costs for some participants relative to others. The proposed framework therefore spans the following:
- Foundational requirements
- for all CS facilities licensed in Australia: legal compatibility of the facility's rules with Australian regulatory objectives; adequate channels to demonstrate compliance with FSSs and other obligations as CS facility licensees under Part 7.3 of the Act;
- for CS facilities licensed in Australia that have material Australian-based participation and/or provide services in Australian-related products: governance and operational arrangements that promote stability in the Australian financial system.
- Additional requirements for systemically important CS facilities: holding an Exchange Settlement Account (ESA) with the RBA; strengthened influence for the Regulators.
- Additional requirements for CS facilities that have a strong domestic connection: holding a domestic CS facility licence (and hence submitting to primary regulation by the Regulators), which may also require a domestic legal presence; and controlling the degree of offshore outsourcing of critical functions, including systems, data and staffing.10
At least in theory, a CS facility could have a strong domestic connection without also being systemically important. An example might be a CCP serving an alternative trading platform for ASX securities that commanded only a small share of the market. Even though such a facility might be integrated with the Australian financial system and real economy, its small scale might limit the potential for reputational or system-wide confidence concerns to arise. From a stability perspective, therefore, only the foundational requirements would apply. However, in some circumstances, for instance if a trading platform served by an offshore CS facility had a high degree of retail participation, retail consumer protection concerns or market integrity considerations might nevertheless lead ASIC to recommend that the facility apply for a domestic licence and thereby submit to primary regulation by the Regulators.11
More generally, even if a facility initially entered the Australian market with a small operation, the requirements for both systemically important facilities and those for facilities with a strong domestic connection would be expected to apply should its market share grow substantially or the nature of its operations or participants change.
3.1 Foundational Requirements
In principle, the class of foundational requirements should not generate substantial incremental costs for CS facilities, particularly since they generally clarify or make explicit requirements already contemplated within the Act. Of the measures considered here, some will be more relevant to CCPs, and others more relevant to SSFs. Furthermore, the requirements may be applied differently, and indeed may not apply at all, depending on the characteristics of a facility, and in particular whether the facility has material Australian-based participation or provides services in Australian-related products.
3.1.1 Foundational requirements for all CS facilities licensed in Australia
Some requirements should apply to all licensed CS facilities, irrespective of the nature and scope of their activities in Australia. These include requirements that underpin both the legal status of the facility's activities within the Australian jurisdiction, and the exercise of the Regulators' responsibilities under the Act. These are discussed below.
Legal compatibility of rules with Australian regulatory objectives
As already acknowledged in the Act, and elaborated in ASIC's RG 211 and the FSSs, it is essential that any CS facility operating in Australia can enforce its rules, procedures and contracts, and that the application of overseas laws does not deliver outcomes that are incompatible with Australian regulatory objectives.
Facilities are already required under the current FSSs to have rules that are clear and legally enforceable in all relevant jurisdictions. It is additionally proposed that under the revised FSSs, any offshore-based CS facility intending to operate in Australia obtain (and make available to the Regulators) an independent legal opinion stating that rules relevant to its activities in Australia are enforceable, and identifying any conflicts of law between Australia and the facility's home jurisdiction that may be relevant to Australian regulatory objectives.12 This should enable the Regulators to determine the potential for outcomes that may be incompatible with Australian regulatory objectives. The facility would be required to refresh the opinion periodically and submit a revised opinion in the event of a material legislative change in either jurisdiction. The Regulators would seek, as appropriate, their own independent legal advice on the soundness of opinions submitted by facilities.
Channels to demonstrate compliance with Australian regulatory requirements
All CS facility licensees must comply with their obligations under the Act, even where a level of reliance is placed on an overseas facility's home regulator. Facilities should therefore provide for adequate channels to demonstrate to the Regulators their compliance with these requirements. Th
e appropriate form of this demonstration may, again, depend on the type of facility and the nature of its activities. In the case of an overseas licensee, for the Regulators to conduct their respective annual assessments as required under Part 7.3 of the Act, there should be adequate information-sharing arrangements between the Regulators and the licensee's home regulator. These arrangements should clarify procedures for sharing and requesting relevant information.13
Where a facility holds a domestic licence, it is important that the Regulators have adequate channels to execute their responsibilities as primary regulators. In particular, the Regulators are obliged to conduct direct assessments of facilities' compliance with their obligations under the Act and therefore, irrespective of a facility's systemic importance or the strength of its domestic connection, its operations must be organised in such a way that the Regulators' capacity to carry out direct oversight is not impeded.
Such capacity could be compromised where a domestic CS facility licensee outsourced management capacity or critical operations to offshore entities (including related entities). Similar issues could arise in the event that arrangements were established for outsourcing or the sharing of functions with an offshore CS facility in the context of a merger, joint venture or other form of cooperation. Indeed, such concerns were raised in the context of the proposed ASX-SGX merger. It would therefore be appropriate for Australian regulators to vet arrangements for the offshore outsourcing of critical functions by domestic CS facility licensees to ensure adequate access to information and effective oversight.
There is precedent for such a policy in banking regulation. The Australian Prudential Regulation Authority (APRA) has developed a Prudential Standard on outsourcing under which authorised deposit-taking institutions (ADIs) must consult with APRA prior to any offshore outsourcing of material business activities, and include in any outsourcing agreement an explicit right for APRA to gain access to information and conduct on-site visits.14 The Regulators could adopt a similar approach to vetting arrangements for the offshore outsourcing of important functions of domestic CS facility licensees.
Under section 825A(3) of the Act, the Minister can impose or vary conditions if deemed appropriate, having regard to the licensee's obligations under Part 7.3 and any change in the facility's operations or the conditions under which the facility is operating. Were a CS facility to seek to outsource some or all of its material business activities offshore, in a way that could compromise its capacity to demonstrate compliance with its obligations under the Act, ASIC or the RBA may advise the Minister that a condition be imposed to restrict or prohibit such outsourcing.
3.1.2 Foundational requirements for CS facilities licensed in Australia that have material Australian-based participation and/or provide services in Australian-related products
In respect of those facilities that have material Australian-based participation and/or provide services in Australian-related products, a particular concern of the Regulators will be whether the facility's governance and operational arrangements support stability and effective provision of services in the Australian financial system.
In the absence of effective competition between CS facilities operating in Australia, commercial considerations alone may not be sufficient to ensure that the interests of smaller markets such as Australia are adequately reflected in a CS facility's governance and operational arrangements. The failure of a facility to consider these interests could have implications for both the RBA's responsibility to promote stability in the financial system and ASIC's responsibility to assess whether CS facility licensees provide their services in a fair and effective way.
With respect to the RBA's responsibilities, governance arrangements that did not adequately consider Australian interests could in some circumstances introduce additional risks to the Australian financial system. For example, failure to account for Australian interests in a CCP's governance of risk and default management arrangements could give rise to stability risks by creating disproportionate obligations for surviving Australian-based participants in the event of a default, or generating other spillovers to the Australian financial system via the close-out process. Similarly, failure to provide adequate operational support or money settlement arrangements to Australian-based participants could lead to undue disruption in the event of a crisis or operational incident. Equally, the fair and effective delivery of services to Australian-based participants and their clients could be compromised if governance and operational arrangements did not adequately consider Australian interests.
Consistent with the objectives of minimising disruption and ensuring effective oversight, it is therefore proposed that a cross-border CS facility be required to demonstrate that its governance and operational arrangements take appropriate account of stakeholder interests in all relevant markets and jurisdictions, including in Australia. Specific measures may, for instance, encompass the following:
- In respect of governance of a CCP's risk and default management arrangements, Australian interests could be accommodated in a variety of ways. For example, a CCP may offer Australian-based participants representation on its counterparty credit risk management committee; or it may consult bilaterally, or via a more focused forum. The appropriate degree of representation would depend at least in part on the relative importance of Australian-based participants to the CCP's overall activities.
- A CS facility should ensure that any obligations created for surviving participants in the event of a participant default – such as responsibilities under a CCP's default management arrangements – are commensurate with the scale and nature of individual participants' activities. Furthermore, in the case of a CCP, consideration of the effectiveness of arrangements for the close-out of a defaulter's positions should take into account the potential for spillovers in all relevant markets, including in Australia.
- A CS facility should provide adequate operational support to Australian-based participants during Australian market hours. This would mitigate operational risk arising from participation in a CS facility with operations based in another time zone.
- To the extent reasonably practicable, a CS facility should support effective access by accommodating local market practices. This would reduce operational risk and compliance costs. For a CCP, this might imply the need to review its arrangements for marking Australian-related positions to market, its approach to making and settling margin calls, and its collateral eligibility criteria. A CS facility should provide for appropriate channels by which participants can communicate their views, influence operational arrangements, and offer participant feedback on operational matters. In the case of Australian-based participants, this might take the form of a seat on a user group, should one exist, or perhaps a dedicated participant forum to reflect Australian interests.
3.2 Requirements for Systemically Important CS Facilities
Where a CS facility is, or is likely to become, systemically important in Australia, additional measures may be necessary to manage the systemic risk implications of the facility's activities. The determination of systemic importance will be made by the Regulators, as appropriate, and may require a degree of judgement in some cases. Consistent with the indicators considered by the Basel Committee on Banking Supervision (BCBS), and those outlined in the Principles, relevant
factors in assessing the systemic importance of a facility in Australia would ordinarily include:15
- the size of the facility in Australia (for example, the absolute number and value of transactions processed by the facility in Australian dollar-denominated products, or its market share; or, for CCPs, the total amount of initial margin held in respect of Australian dollar-denominated products)
- the availability of substitutes for the facility's services in Australia
- the nature and complexity of the products cleared or settled by the facility
- the degree of interconnectedness with other parts of the Australian financial system.
An approach to determining systemic importance that aligned with that in the Principles was also recommended by the Council in its conclusions on reform of FMI regulation.
Additional measures that might be considered where a CS facility was deemed to be systemically important are elaborated below.
3.2.1 Holding an Exchange Settlement Account with the RBA
In the case of a systemically important CCP, it is essential that the facility has sufficient access to Australian dollar liquidity to ensure that it can meet its settlement obligations in a timely manner. This accords with the objective of minimising disruption and is firmly enshrined in the new Principles.
To reflect this, the RBA is updating its policy on access to ESAs. In particular the revised policy introduces a specific 'CCP' category of ESA holder, and requires that any licensed CCP deemed to be systemically important operate its own ESA for settlement of its Australian dollar obligations.16 In accordance with the policy, a CCP would have access to Australian dollar liquidity under the RBA's overnight and intraday liquidity facilities (against eligible collateral) to support settlement of its Australian dollar obligations, including in times of market stress. Subject to the RBA's reaching agreement with the relevant central banks, Australian dollar liquidity extended against eligible Australian dollar collateral could potentially be supplemented by arrangements whereby the CCP posted eligible securities to its home (or another) central bank and the RBA then provided Australian dollars to that central bank under a swap agreement. Furthermore, settlement across an ESA rather than the books of a commercial bank would mitigate any settlement and operational risks arising from the use of an agent – either for the CCP or its participants.
Operating an ESA brings with it certain ancillary financial, operational and legal requirements (which in the context of an overseas CS facility provide comfort that the facility has the capacity to operate effectively in Australia), including the following:
- a CCP would be expected to hold a specified quantum of RBA-eligible collateral in an Austraclear account in its own name;
- at a minimum, sufficient management resources should be located in Australia, with the ability to make timely decisions, operate the ESA account, and liaise with the RBA as appropriate. Day-to-day operation of the account could, however, be carried out remotely;
- the CCP would be required to obtain (for the benefit of the RBA) a legal opinion confirming that it can comply with the Reserve Bank Information and Transfer System (RITS) Regulations.17
3.2.2 Strengthened influence for Australian regulators
To achieve adequate influence in the supervision of a systemically important overseas CS facility licensee, the Regulators would seek membership of any multilateral cooperative oversight group. The Regulators would also seek participation in any crisis management groups or other such arrangements to provide for representation of Australian financial stability or other regulatory interests in the event of the actual or potential default of a major clearing participant, disruption to relevant markets, or financial stress to the CS facility itself.
'Responsibility E: Cooperation with Other Authorities', included in the Principles, underpins the establishment of such arrangements for FMIs operating in multiple jurisdictions. The level of Australian regulatory representation would need to be commensurate with the nature of the facility's activities in Australia. For a systemically important overseas CS facility licensee, this would imply representation sufficient to ensure that the Regulators were party to key strategic decisions concerning the facility and had an opportunity to raise any issues or concerns regarding the facility's risk management, default procedures, and operational arrangements. It is recognised that each Regulator's role in cooperative oversight or crisis-management arrangements may differ, depending on the particular circumstances.18
3.3 Requirements for CS Facilities with a Strong Domestic Connection
All CS facilities that are licensed to operate in Australia will have some domestic connection.19 The strength of this connection will, however, differ among facilities. For some CS facilities, the connection may be relatively weak; for instance, the facility may serve a market that is inherently highly international, or it may have only a small number of Australian participants. For others, the mix of products or participants will imply a strong domestic connection, which may be evident in a predominantly domestic focus or a strong link to the Australian economy. A CS facility that is both systemically important and has a strong domestic connection is likely to be regarded as critical to overall confidence in the Australian financial system. In such cases, it is especially important that regulatory requirements promote financial stability, minimise reputational risks and underpin confidence and integrity.
In particular, where an overseas CS facility licensee has a strong domestic connection, the Regulators may in some circumstances seek to further strengthen their influence by assuming a primary regulatory role. This would imply requiring that the facility apply for a domestic licence, which in turn might require that it establish a domestic legal presence. Furthermore, as recommended by the Council, the Regulators would also wish to have the capacity to 'step-in' in certain defined circumstances, such as a threat of insolvency, significant operational outage or distress, or a significant and persistent failure to comply with licence obligations or directions. It is anticipated that this capacity would be available only in the case of a domestic CS facility licensee, and that to be effective it may imply additional restrictions on outsourcing.20
The strength of a facility's domestic connection will reflect the characteristics of the markets it serves, including the nature of its products and participants, and any Australian clients of those participants, as well as any links and dependencies with other domestic FMIs or the domestic legal framework. Determining whether a facility's domestic connection is sufficiently strong to warrant the imposition of these more stringent requirements will entail consideration of a number of factors relevant to an assessment of the costs and benefits. Factors relevant to this assessment include, but are not limited to, the following:
- Whether the CS facility offers services in a domestic or international market. A facility's domestic connection is likely to be stronger where it serves a domestic, as opposed to international, market. In this case, the benefits from strengthening influence are likely to be higher, and the costs of doing so lower. By contrast, where a market is by its nature international (e.g. the markets for interest rate swaps or cross-currency swaps), imp
osing costly additional requirements could lead to fragmentation. This may outweigh the benefits of additional influence.
- The mix of domestic and international participants in the facility. Similarly, a systemically important facility with primarily Australian-based participants is likely to have a strong connection with the domestic financial system. In this case, any disruption would be likely to have widespread and prominent confidence and reputational effects. The benefits of greater influence would therefore probably also be high in this case. Furthermore, these benefits might come at a relatively low cost, since fewer participants may be seeking the netting and liquidity pooling benefits associated with participating in an internationally integrated facility.
- The potential for market disruption to affect the real economy. Where disruption to a CS facility has the potential to affect transactions or confidence in the real economy, perhaps via its effect on securities-issuing firms or its effect on the confidence of Australian retail investors, the benefits of enhanced influence for Australian regulators are likely to be high.
- Whether the market serviced by the facility is retail or wholesale. Disruption to a CS facility serving a market with a high level of retail participation may have a disproportionate impact on confidence, and may carry greater reputational risks for the Regulators due to the reliance placed on them by retail investors. The benefits of increased regulatory influence may therefore be greater than in a wholesale market of comparable size and complexity.21
- Whether the facility clears or settles a domestic securities market. A CS facility that clears or settles domestic securities traded on an Australian licensed market is likely to have strong links to other FMIs and the domestic legal framework. For instance, a CCP that clears domestic equities or fixed-income securities will typically have links to a domestic SSF, which in turn will be subject to Australian laws underpinning securities transfers. These factors imply a strong domestic connection and a more substantial benefit from enhanced influence.
- Links that the facility has with other FMIs. More generally, a facility may have links to other FMIs through the clearing and settlement process or through interoperability arrangements. Where a facility has links to other FMIs overseen by the Regulators (e.g. Australian domestic markets), the resulting interconnections with the Australian financial system and other Australian regulatory activities may strengthen the case for greater influence.
Applying this framework, a SSF that settles Australian securities would almost certainly have a strong domestic connection under this test. Such a facility would operate in a primarily domestic market, perhaps with a high level of domestic retail participation. It would also have a nexus with real economy issuers, and most likely have links to other Australian-based FMIs. In the case of a CCP, quantifying the costs and benefits of greater influence might not be so straightforward, and a degree of judgement may be necessary in determining whether the costs of imposing additional measures outweigh the benefits.
The specific additional requirements proposed for the case where a facility is not only systemically important but also has a strong domestic connection are elaborated below. As previously acknowledged, there may also be some circumstances in which similar requirements would be considered by ASIC in the case of a CS facility that had a strong domestic connection but was not deemed to be systemically important.
3.3.1 Holding a domestic CS facility licence
To meet the objectives of minimising disruption and providing for effective oversight, it is proposed that a systemically important CS facility deemed to have a sufficiently strong domestic connection be required to hold a domestic CS facility licence. The facility would then be directly assessed by the RBA against the applicable FSSs on an annual and ongoing basis, and also by ASIC against the licensee's other obligations under Chapter 7 of the Act.22 A primary regulatory role for the Regulators would provide for an enhanced role in influencing the activities of the facility, proportional to the potential impact of those activities on stability, confidence and integrity in the Australian financial system, or indeed the real economy.
At present, the Act allows a registered foreign company with a principal place of business outside of Australia to apply for a domestic CS facility licence. This could reduce the benefits of a primary regulatory role, particularly to the extent that conflicts in insolvency laws remained. One area in which existing powers could therefore usefully be strengthened through legislative change would be to provide for an ancillary requirement that a systemically important facility with a strong domestic connection also establish an Australian subsidiary, subject to Australian insolvency law and other obligations under the Act. While this would create additional costs and obligations for an overseas facility, these costs may be justified where the connection of the facility with the domestic financial system was sufficiently strong.
3.3.2 Overseeing the outsourcing of critical functions
Consistent with the Regulators' continuity of services objective, controls around the offshore outsourcing of critical functions may enhance the effectiveness of step-in powers, should these be granted.23 To the extent that the critical functions of a CS facility were outsourced (and in particular if they were outsourced to an independent third party), any statutory manager appointed by the Regulators to step in to operate the facility in the event of acute financial or operational stress might not be able to assume direct control. Indeed, the manager might be unable to maintain continuity of operations if the outsourcing provider repudiated the original outsourcing agreement.
The limitations on offshore outsourcing for a systemically important facility with a strong domestic connection might therefore be stronger than the vetting of outsourcing arrangements for domestic licensees set out in Section 3.1. The additional controls envisaged for systemically important facilities with a strong domestic connection would seek to ensure that the Regulators were able to step in to operate the facility in stressed circumstances. The facility's critical operations should therefore be organised so as to facilitate such actions. This could include a requirement that any offshore outsourcing agreement provide for contractual rights of access for the Regulators' appointed manager in a step-in scenario, and that such rights of access survive termination of the agreement.
8 Primary regulation may be defined for the present purposes as regulatory oversight by the regulator in a licensee's principal place of business. Where a CS facility was domestically incorporated and had a domestic licence, Australia would be deemed to be its principal place of business. ASIC and the RBA would therefore be primary regulators, since they would conduct their regulatory oversight with no routine reliance on assessments or reports from a regulator of the facility in another place of business.
9 The capacity to take appropriate actions could equally be undermined by the outsourcing of critical functions to another domestically located entity. This issue is, however, out of the scope of the framework articulated in this paper and will be addressed separately in the planned revisions to the FSSs.
10 The framework as articulated
in this paper does not incorporate any requirements in relation to how the assets (e.g. posted margin or default fund contributions) of a CCP's clearing participants or its clients should be held. However, the Regulators will continue to monitor the case for such requirements and may consult on proposals in this area in the future.
11 If such a judgement were made prior to the facility obtaining a licence, the Minister could reject any application for an overseas licence and insist that the facility applied for a domestic licence. If this judgment occurred subsequent to the facility obtaining an overseas licence, perhaps in response to a change in the nature and scope of the facility's business, the facility might be requested to reapply for a domestic licence. As will be discussed in Section 4, amendments to the Act are under consideration which would enhance the legal certainty around any such request.
12 Guidance to Principle 1 (Legal Basis) of the Principles envisages that an FMI obtain a legal opinion for such purposes. Explanatory note 3.1.3 states that 'one recommended approach to articulating the legal basis for each material aspect of an FMI's activities is to obtain well-reasoned and independent legal opinions or analyses'.
13 In accordance with the Act, the Minister must have regard to the adequacy of arrangements for cooperation between ASIC, the RBA and an overseas licensee's home regulator when making a decision as to whether to grant, revoke or suspend an overseas licence.
14 This is set out in Prudential Standard CPS 231 (replacing the previous standard APS 231 from 1 July 2012).
16 Any non-systemically important CCP licensed to operate in Australia would also be entitled to hold an ESA, but would not be required to do so.
17 RITS, Australia's high-value payments system, is used by banks and other approved institutions to settle their payment obligations on a real-time gross settlement (RTGS) basis. Final and irrevocable settlement is achieved by the simultaneous crediting and debiting of ESAs held at the RBA. Payments are entered into RITS directly, or delivered via the external feeder systems, SWIFT and Austraclear. RITS is the means by which ESAs are accessed. Membership of RITS is compulsory for all ESA holders, which mainly comprise Australian-licensed banks.
18 In some cases, representation by just one of the Regulators would be sufficient to ensure that Australia's interests were adequately represented. As is currently the case, ASIC and the RBA anticipate sharing information wherever it is legally permitted and practically possible to do so.
19 In establishing whether a CS facility is operating in Australia and requires a domestic licence, ASIC will establish whether there is a 'sufficient nexus between the facility's operations and Australia'. See ASIC's RG 211, p 9.
20 In the case of a systemically important overseas facility that did not have a strong domestic connection, the Regulators would assess the adequacy of the arrangements for recovery and resolution in the facility's principal place of business – including actions that might be taken to ensure the continuity of critical services – as part of its assessment of sufficient equivalence of the overseas regime, and on an ongoing basis.
21 The typically greater size and complexity of wholesale markets is, however, relevant in determining systemic importance.
22 It is noted that a facility with an overseas licence would also be assessed on an annual basis. In practice, however, the Regulators would place at least some reliance on information provided by, and assessments carried out by, the home regulator in conducting its assessment in those circumstances.
23 As in Section 3.1, references to 'outsourcing' here encompass other arrangements involving the sharing of facilities or services with an offshore FMI as a result of a merger, joint venture or other cooperative agreement.