Clearing and Settlement Systems
37. Clearing and settlement systems manage the risk of non-delivery of the commodity or security traded once the market has determined the price of the thing being traded. Clearing and settlement systems are an integral component of a safe, sound and efficient market.
Current status and issues in New Zealand
38. The New Zealand regulatory framework for the purposes of securities and futures clearing and settlement systems does not currently conform to the BIS-IOSCO recommendations. Legislation on securities transfer, enforceability of netting arrangements in winding up, bankruptcy and statutory management and clearing houses does currently exist and is robust for the purposes of government, semi-government and private sector debt and equity securities, however this legislation is neither comprehensive nor organised in a coherent manner for the purposes of a securities and futures clearing system.
39. The relevant provisions address payments systems rather than securities settlement systems. The subject of clearing houses appears in the Companies Act with Section 310K empowering the Reserve Bank to declare any person as a 'recognised clearing house' for the purposes of the provisions of the Companies Act that ensure the enforceability of multilateral netting arrangements. The Reserve Bank is also empowered under Reserve Bank Act to recommend that a payment system be declared a 'designated payment system'.
40. There are currently two designated payments systems in New Zealand: the Reserve Bank's Austraclear, a real time settlement system (used for debt and equity securities) and ESAS an Exchange Settlement Account System providing settlement accounts for the settlement of all real time payments. Austraclear and ESAS are designated payment systems under Part 5C of the Reserve Bank Act.
41. Notably New Zealand's legislation does not adequately address clearing and settlement for securities markets when measured against the BIS-IOSCO recommendations. Specifically the Companies Act and the Reserve Bank Act provisions were designed in a different context and before the BIS-IOSCO recommendations for central counterparties were finalised in March 2004. For example, there is no formal monitoring and enforcement role for the securities market regulator (the Securities Commission) in relation to clearing and settlement systems. Rather the Reserve Bank has some regulatory responsibility but its focus in the existing legislation is directed to the financial system of New Zealand as a whole, rather than the specifics of the securities and futures markets.
42. The Companies Act focuses on the event of company liquidation and the transactional aspect of clearing and settlement rather than the underlying financial system. It applies to settlement of payment obligations and does not apply to underlying commodity and security delivery obligations. This leaves uncertainty as to enforcement of transactions in, and delivery of, the underlying product.
Approval and monitoring of a clearing and settlement system
43. I propose to create a new "opt-in" regime for clearing and settlement systems. Note that, following the establishment of the new regime, Ministry of Economic Development officials will undertake scoping and report back to me on further work required in the 2008/9 year in relation to whether the new regime should remain opt-in or become mandatory for trading in emissions units and whether the new regime should be opened to clearing and settlement in relation to products other than securities and emissions units.
44. It is proposed to insert new provisions in the Securities Markets Act which will allow the regulation of clearing and settlement in a similar manner to provisions relating to registration of securities exchanges (including in relation to application procedures, assessment criteria and rule approval). The new regime will run on an "opt-in" basis in parallel to the existing Companies Act regime for clearing and settlement systems. This will ensure that existing clearing houses which operate in relation to payment systems can continue to operate in accordance with the Companies Act under the supervision of the Reserve Bank.
45. The Securities Markets Act provides for registration of securities exchanges and the regulation of conduct rules that relate to trading on securities exchanges. Clearing and settlement, while not limited to securities, is nonetheless an integral process that occurs post-trading of the securities on the exchange. For these reasons there are several advantages in including provisions relating to regulation of clearing and settlement of securities and futures contracts in the same legislative context as provisions dealing with the trading of securities and the exchanges on which they are traded. Use of similar application procedures and rule approval criteria will contribute to efficient application processes, both for simplification of legislation and for persons most likely to "opt-in". While NZX is the only exchange that has indicated it wishes to operate a clearing and settlement system, other clearing and settlement systems owned independently from the NZX may also opt-in to avail themselves of this enhanced official recognition. The regulatory framework and regulator's powers already in the Securities Markets Act are necessary to meet monitoring, inspection, etc requirements of the IOSCO principles.
46. Locating rules on clearing houses associated with exchanges in the same piece of legislation as the requirements for exchanges is adopted in many overseas jurisdictions and is familiar to international market participants. Transparency and accessibility are enhanced.
47. This maintains the use of the existing procedures, which apply to a registered exchange and which are equally appropriate for clearing and settlement system, and it will also allow for ease of administration and oversight by regulators where a registered exchange, such as NZX, will also operate a registered clearing and settlement system.
48. Note that the proposal will mean that there are parallel regimes under the Securities Markets Act and the Reserve Bank Act for approving and regulating clearing and settlement systems. However, this will allow potential operators of a clearing and settlement system to opt-in to the most appropriate regime. The Securities Commission and the Reserve Bank would each have responsibility for monitoring and enforcing the activities of the clearing and settlement system which are relevant to each agency's area of responsibility.
49. Ministry of Economic Development officials, in conjunction with the Reserve Bank and Securities Commission will undertake a review of the regime once it is operating in relation to systemic stability implications and the interface between the clearing and settlement system and the payments system and I will report back if further changes are necessary.
Clearing house rules and approval criteria
50. An approved clearing and settlement system will be required to meet the relevant IOSCO recommendations on securities settlement systems and central counterparties. This will include developing rules governing:
- criteria for membership;
- the conduct of clearing and settlement activities within the clearing and settlement system, including collateral and clearing fund requirements;
- the basis upon which delivery and payment instructions are given;
- the basis on which delivery and payment obligations are calculated and effect (either on a gross basis or using netting); and
- default procedures, including any action to be taken if a participant in the system is unable, or likely to become unable, to meet the participant's obligations to any or all of the following:
- the operator of the system;
- another participant in the system;
- any other party to the operating rules.
51. The rules of the clearing and settlement system would have effect despite any other law to the contrary. These requirements are consistent with the IOSCO Recommendations for clearing and settlement systems.
52. In considering an application for designation by a clearing and settlement system, the Minister must have regard to:
- The purpose and scope of the clearing and settlement system, including the importance of the clearing and settlement system to the integrity and effectiveness of the markets for which it clears and settles trades;
- The financial resources of the clearing and settlement system and its proposed governance arrangements;
- The proposed operating rules of the clearing and settlement system, and whether they are adequate for the purpose and scope of the clearing and settlement system, including their ability to manage risks that the clearing and settlement system is exposed to (including risks in linkages with other clearing and settlement systems);
- Any laws or regulatory requirements relating to the operation of the clearing and settlement system and the extent to which the system complies (or would comply) with those laws or regulatory requirements; and
- Whether it is in the public interest to approve the application.
53. The proposed new regime enables the Minister of Commerce to assess the appropriateness of the operating rules in light of the purpose and scope of the particular system. The proposed assessment criteria are partly derived from the Securities Markets Act and the Reserve Bank of New Zealand Act and allow the Minister to utilise the existing processes and expertise of the Securities Commission and the Reserve Bank in assessing an application.
Primacy of the interests of the clearing and settlement system
54. In addition to changes in relation to the establishment of a clearing and settlement system, it is also proposed to make changes to facilitate the operation of the clearing and settlement system which will provide greater certainty to market participants that multilateral netting arrangements are enforceable, trades cleared through a clearing and settlement system are final, and insolvency rules applying to the transaction are appropriate.
Validation of operating rules
55. It is proposed that certain aspects of the operating rules of the system be valid and enforceable despite any law or agreement to the contrary. This is equivalent to what section 156O(1) of the RBNZ Act provides in relation to designated payment systems.
56. Note that this is not a blanket validation of the operating rules in their entirety. Rather (as with designated payment systems), the validation will only cover certain aspects of the rules that deal with matters specifically addressed in the IOSCO Recommendations (for example, netting, defaulting participants, and the finality of settlements).
Netting
57. Netting is a fundamental feature of a clearing and settlement system and is specifically addressed in the IOSCO Recommendations. It is proposed that any netting under the rules of a clearing and settlement system will be valid and enforceable despite any law to the contrary. The equivalent designated payment system rule is contained in section 156R of the RBNZ Act.
Default of participants and finality of settlements
58. Without further protection, a clearing house is exposed to risk that, if a market participant becomes insolvent, the liquidator may be able to wind back a transaction which has been conducted on the exchange. This could have a flow-on effect on other transactions and threaten the stability of the clearing and settlement system and the market.
59. It is proposed to give primacy to the interests of the clearing and settlement system in the event of insolvency of a market participant. It should be noted that NZX's proposal stated that it would be desirable for there to be a blanket priority for all aspects of a transaction involving a clearing house. However, this could raise the potential for "gaming", ie two parties using a clearing house in a non-arms length transaction to avoid a liquidator. This situation is unlikely to arise where the transaction occurs on a market such as NZX, however the reforms in this paper are more generic and would not prevent a clearing house taking transactions other than those on the market, such as over the counter transaction.
60. In order to address this, I propose that the primacy apply only in so far as it is necessary to protect the integrity of the clearing system (i.e., the ability of the clearing house to finalise and settle the transaction). While this primacy will give the clearing house protection against clawback of the transaction by a liquidator of a market participant, it will not affect the liquidator's right to pursue the original parties to the underlying transaction. The underlying trades themselves do not threaten the integrity of the clearing system and should continue to be vulnerable to challenge by a liquidator of a clearing participant.
61. It is also proposed to give priority to the clearing house in relation to any collateral posted by a clearing participant, in so far as necessary to settle any transaction relating to that participant. This ensures that any transactions conducted through the clearing and settlement system can be completed providing certainty for other participants. To get this priority, the clearing house will need to have operating rules that contain mechanisms by which the interests of existing security holders in the collateral are taken into account before collateral is lodged in the system. The intention is to balance the interests of the clearing house against the interests of existing security holders as fairly as possible.
Priority under the Personal Property Securities Act in relation to the underlying transaction
62. It is also proposed to extend the priority provided by section 97 of the Personal Property Securities Act ("PPSA") in respect of shares and other securities to emissions units. This will have the effect that a purchaser who gave value for an emissions unit, acquired it without notice of a security interest, and takes possession (by recording their interest in the register of emissions units), will have priority over the holder of a security interest in the emissions unit.
63. Note that commodities other than securities and emissions units will not be able to take advantage of this special priority rule under the PPSA.
64. NZX's original proposal was put forward before the finalisation of the ETS, and therefore NZX envisaged that a regulated clearing house would be responsible for running a private register of emissions units, rather than there being a government register. A private register could have a wider range of types of emissions units, including voluntary units.
65. Following establishment of the ETS, it could be appropriate to limit the protections available through clearing and settlement to NZ ETS units only. However, such limitation could have the practical effect of making a clearing house commercially unviable. Officials believe therefore that it is not appropriate to limit the scope of emissions units that may be cleared and settled through a regulated clearing and settlement system.
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