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• 7. Providing Certainty

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7.1 The risk management practices within settlement systems are an integral component of an efficient and robust financial system. There is a range of risk management mechanisms available to clearing houses and settlement systems to mitigate the fulfilment risk facing participants in that system, which generally arises because of non-performance by other clearing participants (i.e., their counterparty to the transaction). These include the participation requirements (e.g., capital adequacy) on clearing participants, requiring margin to be posted by participants to underwrite their obligations, and access to and adequacy of the clearing house's capital reserves.

7.2 There are a number of models under which the clearing house may operate, some of which involve the clearing house bearing some degree of the risk of non-performance by the participants in the system. In the case of the central clearing party model[1], the clearing house assumes the settlement risks through the process of novation, thereby becoming the seller to all clearing participant buyers and the buyer to all clearing participant sellers.

7.3 In situations where the clearing house is directly bearing the risk, to a significant degree, of a default by a clearing participant it is typical for the clearing house to require participants to post collateral in the form of margin to mitigate this exposure. In the event of default this margin plays a very important role in meeting the central clearing house's obligations to other participants who were pre-novation counterparties to the defaulting clearing participant. The effectiveness of this collateral to address risks in the event of default will be a function of, among other things, the ability for the designated settlement system to have a timely claim to the defaulting party's collateral. If the clearing house cannot secure the collateral in a timely manner then the entire settlement system may be put at risk.

7.4 Any uncertainty over the designated clearing house's ability to realise collateral in a timely manner, in the event of a default, will increase the operating costs and capital requirements for the designated clearing house, thereby weakening the designated clearing house's international competitiveness. International participants will in some cases refuse to rely on settlement systems which cannot provide credible assurances that access to that collateral is assured to a very high degree. Finally, the failure of the operator of a designated settlement system has the potential to have a contagion effect, thereby threatening New Zealand's wider financial system.

Problem Definition

Uncertain legal position of designated clearing houses' interests in collateral

7.5 Under the current law a designated settlement system could conceivably require clearing participants to provide them with a first-ranking priority for their interest in collateral. This would require the clearing participants to negotiate subordinations from (multiple) secured parties, in favour of the security interest of the designated clearing house.

7.6 The difficulties with this approach, beyond the practicalities of identifying existing security interest holders and negotiating effective subordinations with them, are largely concerned with the certainty and speed with which the designated clearing house will be in a position to deploy the collateral to mitigate liquidity risks in the event of a default. Potential delays arise due to:

• requirements to comply with the provisions in the Personal Property Securities Act 1999 (PPSA), pertaining to notification periods prior to disposal of the collateral and other procedural issues; and
• the risk that a receiver appointed to represent other creditors' interests challenges, and delays or frustrates the operator of the designated system's claim.

7.7 There may be further problems in that many large international participants, such as global investment banks, would have to breach the terms of their financing agreements (e.g., due to the existence of negative pledge clauses) if they were to grant a first ranking priority to a clearing house. This, coupled with different legal requirements that differ from those that are typically found in major international markets, would be sufficient to deter their involvement in New Zealand markets both as clearing participants and more generally.

Uncertainty as to effect of sections 95 and 97 of the PPSA

7.8 An alternative approach under the existing law might be for the designated clearing house to rely upon the provisions in the PPSA which effectively provide an overriding priority in specific circumstances. However, there is uncertainty as to whether the PPSA currently provides clearing houses with sufficient certainty that they will be able to realise, in a timely manner, collateral provided in a settlement system by defaulting clearing participants.

7.9 Sections 95 and 97 of the PPSA[2] provide persons receiving money or purchasing investment securities with a priority over third party security interests for cash and investment securities, provided certain conditions are met. As these are far and away the two most common forms of collateral that are provided in settlement systems, it is conceivable that a clearing house could be expected to rely on these provisions for securing its interest in collateral.

7.10 However, there is debate and a degree of doubt within the legal profession concerning the extent to which a clearing house can rely on these provisions to provide assurance that the clearing house will be able to realise collateral. This legal uncertainty arises because:

• the interpretation of these provisions of the PPSA has yet to be tested in the courts with respect to collateral used to assure settlement. For example there is debate as to whether a clearing house that received "cash" collateral posted as margin is a "creditor", and to whether it has received payment of "a debt owing", under section 95. Therefore the PPSA provisions do not provide clearing houses and international participants the assurances they require;
• there is a risk that a clearing house's claim to investment securities under section 97 could be frustrated if the clearing house is found to have knowledge of prior security interests; and
• the right of a clearing house to collateral under sections 95 and 97 could be challenged by a third party, requiring the clearing house to establish that the sections apply under the specific circumstances of the case, thereby at a minimum delaying the clearing house's ability to realise the collateral in the required timeframe to meet liquidity pressures.

7.11 Some of these concerns may be able to be dealt with by designing the rules and procedures of the designated settlement system specifically to ensure the requirements of sections 95 and 97 are met. However, we believe there are real benefits in removing any residual doubt and specifically providing for the priority in legislation.

7.12 Further, it is critical that the affected clearing house is able to realise the collateral quickly enough to address liquidity concerns. Even if the right of the clearing house to the collateral were not challenged, there is a concern that the process in Part 9 of the PPSA would not permit the timely realisation of the collateral.

IOSCO recommendations

7.13 The current situation falls short of the International Organisation of Securities Commissions ("IOSCO") recommendations (a current, relevant international standard) with respect to a clearing house's priority in collateral, which call for a "high degree of assurance" that collateral can be accessed quickly.

7.14 Where the clearing house bears some of the risk in the event of a clearing participant defaulting, there is a requirement for a high degree of assurance to:

• ensure the efficiency and robustness of the clearing system: lack of certainty increases the costs of operating a clearing house (e.g., by requiring additional capital) and reduces the confidence that potential clearing participants and their customers have in the settlement system; and
• mitigate systemic risk to the wider financial system: failure of a clearing house which is bearing risks during the settlement process has potentially wider impacts on the financial system (for example, where the clearing house novates during the settlement process).

Approach to the issue abroad

7.15 The European Union, the UK, the USA, and Canada have all provided statutory priority to clearing houses over collateral posted as margin. International participants will therefore be looking for a clear, unambiguous priority in relation to a clearing house's interest in posted collateral when deciding whether or not to participate in the New Zealand market.

Conclusion on problem definition

7.16 For these reasons, the current law does not provide the necessary degree of assurance that clearing houses, which use participants' collateral to give greater assurance of settlement, can in the event of a default by a clearing party rely on this collateral to satisfy obligations to its participants or to satisfy the level of assurance recommended under the IOSCO principles and required by many international participants. While there may be a high degree of certainty in the ability of the clearing house to secure a priority in the collateral under the current law, it is doubtful that the clearing house will be able to realise that claim quickly enough to address liquidity concerns. Liquidity is paramount in mitigating credit and systemic risks in the event of a significant default, particularly when a default occurs in volatile markets, where in a matter of minutes prices can move significantly against the clearing house's open position due to the default.

Change Proposed in Draft Bill

7.17 The Draft Bill provides that the PPSA be amended so that certain operators of designated settlement systems have priority in relation to any collateral provided in the settlement system by a clearing participant in the event of default by that participant and the process for realising that collateral will be simplified to enable immediate realisation of the collateral (see clause 12 of the Draft Bill, which inserts a new section 103A into the PPSA). The designation will provide for this and it is intended that only collateral used by designated clearing houses for the purposes of effecting the settlement will have the benefit of these protections.

7.18 Although the discussion of this issue above considers the position where the collateral provided to the clearing house is either investment securities or money, this is because these are the forms of collateral that are most commonly provided to clearing houses as they are highly liquid with observable market prices. Notwithstanding this, the amendment to the PPSA will apply the statutory priority to all types of collateral. The Ministry is interested in submitters' views on whether it is necessary or desirable to limit this provision to collateral in the form of investment securities and money.

Impacts of Change Proposed in Draft Bill

7.19 The impacts of this change are anticipated as being as follows:

• Wider financial system: Confidence in settlement systems is a foundation of an efficient and robust financial system, and the statutory priority has the potential to strengthen this confidence. The likelihood of settlement failures, or default by a designated clearing house, due to inability to access collateral, will be reduced by improving the certainty and timeliness with which the clearing house can access this collateral in the event of a clearing participant default. The amendment may assist in attracting international market participants, clearing participants, and providers of capital. This provision might also encourage the use of central counterparty structures which could serve to concentrate risks within our financial systems. However, this risk is mitigated by the approval and ongoing regulation of designated settlement systems, a process involving dual regulators and subject to international best practice.
• Designated clearing houses: Whilst the designated clearing house is an obvious beneficiary of the statutory priority, the policy rationales for the priority are to strengthen clearing participants' and their customers' confidence in our financial systems, and mitigate financial system systematic risk which might otherwise arise. Any financial benefit to the clearing house arises as a consequence of the realisation of these policy objectives. Clearing houses will benefit from the creation of the statutory priority in their favour through increased certainty in their ability to realise collateral posted by a clearing participant in the event of default by that participant. This will be financially beneficial to clearing houses in a number of ways, including lower expected costs and greater certainty of outcome than is currently the case under the PPSA. The reduced risk profile and greater transparency, in keeping with international best practice, will result in New Zealand clearing houses being more attractive to third parties to rely on for their clearing and settlment activities. In these ways, the amendment will contribute to New Zealand clearing houses being commercially viable and being able to leverage off their investments in clearing house technology.
• Clearing participants: Clearing participants in designated settlement systems, which enjoy the statutory priority, will have greater certainty of settlement as a consequence of the statutory priority. In the event that another participant defaults, the clearing house will have certainty of priority over collateral and the ability to liquidate the collateral immediately if required.
• Parties with security interests in the collateral of clearing participants: Parties with security interests in the collateral of clearing participants are generally sophisticated institutions (such as major banks) with expertise in financial markets and personal property securities law. It is expected that these institutions will be able to provide for the new risk profile of their debtors by re-pricing and/or restructuring the relevant debt. We understand that these changes may happen over time and are not likely to occur immediately. Assuming sections 95 and 97 of the PPSA would apply to collateral posted with a designated clearing house in any event, it is unlikely that the statutory priority granted in favour of a designated clearing house will impact on the secured party's ability to access collateral in the absence of this amendment. However, as referred to above, the statutory priority in favour of designated clearing houses applies in respect of all types of collateral. Accordingly, if collateral other than investment securities or money was posted as collateral with the designed clearing house (which the Ministry understands would be unlikely in practice), the secured party would not have priority to that collateral in circumstances where they may otherwise have expected to have priority. These possible impacts would also arise where a customer of a clearing participant delivers collateral in a form other than cash or investment securities to the participant for the participant to post as collateral with the designated clearing house.