Clearing (Netting) & Settlement: the devil always lurks in the detail

The recent ASX CHESS consultation paper on netting and settlement caught my attention. Why? Well, because it raised some very important changes and raised a few fundamental questions. 

Introduction

Issued on February, 21st, the paper describes the new netting and settlement confirmation workflows. Elements of the paper captured my attention (the ‘geek-in-me’), so I thought I’d share some thoughts and some of the key themes that jumped out at me as I read the paper.  

Comments are due to be submitted to ASX this week, by Thursday March 18th. I hope some of these comments may be of use to those of you whose job it is to comment on such policy papers, and to those of you who are following this project or just have a curious mind.

Key Points

• Maximizing settlement efficiency is vitally important (YES, obviously)
• Ensuring there are legally enforceable default arrangements in place in a netting market is critically important (YES, without doubt)
• Is ASX creating an international precedent in the distributed ledger space? If so, will the proposed new netting and settlement workflows be robust enough to withstand pressure from a motivated administrator or liquidator, whose priorities may be diametrically opposed to those of a settlement system operator and market counterparties (Ugh? Don’t know)
• Why make the change in direction now? (Not sure, the timing is surprising, but it clearly relates to volume processing considerations).

Background

Netting by novation, with proper set-off (of broker/broker contracts) has been a key feature of the Australian settlement system for a very long time. Netting by novation pre-dates CHESS, launched in 1994.

Giving effect to ‘set-off’ of open settlement obligations, by electronically netting each broker’s net securities and net money position against the central counter party (originally called TNSC) was generally understood to be a critical risk management feature of the settlement system. Offsetting legally novated contracts is, as I understand it, important to prevent a liquidator or administrator from cherry picking (favorble) open trades in the event of a broker default. There is important case law that deals with this type of issue. It isn't unique to Australia. ASX will likely be aware of these.

What's incredibly interesting from my perspective about ASX’s consultation document, is it explains how ASX initially designed and built netting by novation with contractual offset into the new CHESS Replacement platform (as one might expect following three decades of legal and operational practice) yet ASX is now in the process of re-calibrating (“unpicking”) the design to remove this set-off feature. Why?

Instead, as I read it, ASX proposes to leave gross, or line-by-line, broker/broker settlement obligations in new CHESS (acknowledging they will be novated under the new, yet-to-be-published settlement rules), relying only on ‘reporting’ to convey the net settlement positions. Without a clear understanding of the new rules that will govern these new workflow processes, it is very hard for anyone to truly comment on the veracity of this new netting proposal. From the outside looking in, this new workflow feels like it might be no more effective than simple administrative netting. This is something expert legal advisors will need to take look at ‘early on’. 

My 'quick and dirty' analysis – and a few questions

Putting the timing of this change aside (remember, less than 12 months ago, the new CHESS platform was due to go live in just 3 or 4 weeks time, in April, 2021), meaning participants and systems providers will likely now need to do-over core parts of their back-office settlement workflows, and their upgraded interfaces to new CHESS.

The proposal raises a number of fundamental questions (for others to answer, in particular the securities, exchange and insolvency legal experts):  

1. What's the core driver forcing this change in systems design of the netting and pre-settlement process (especially this very late stage in the overall design of the CHESS replacement system)?  
2. The consultation document notes there is no international precedent for this specific new approach to netting, though it follows the general themes of netting systems (See s5.3, page 27). Why exactly is that the case? Stakeholders should surely seek to better understand why?
3. Is this new process legally robust enough to withstand challenges and claims from a highly motivated administrator or liquidator? This is, after all, the overarching rationale for ensuring netting is legally enforceable, sound and robust. Plenty has been written about the need for legal certainty in netting systems; e.g. by central banks, the G30, BIS and IOSCO etc..
4. Could ASX revert to its original netting design, should legal ‘set-off’ become necessary to protect the integrity of the new settlement system? It may not be necessary, as ASX appears to be signaling through this consultation, but it is hard to get comfortable looking at the overall system, its design and operation, without a very clear understanding of the overall legal framework that will govern ASX’s proposed netting and the settlement workflows, and its effectiveness to withstand challenge.
5. Is the new system also morphing into a continuous netting system? And if so, is this a progressive step to modernize the settlement process? And might other issues flow from such a change?  For example, what impact will it have on failed transactions and short positions in the market, if any?  

Summary

It’s very hard to form a clear view of ASX’s proposed new netting solution without a deep understanding of the proposed operating rules. These won’t follow for some months. 

I am not a lawyer, but it seems to me this new proposal, on the surface, represents a significant departure from the accepted norm (in Australia) of over three decades. Why that’s the case is not completely clear. Will the proposed new workflow create a global precedent for netting pre-settlement obligations on a ‘distributed ledger’? Or might it be a consequence of a technology that may not readily scale up to ‘net’ peak trade volumes (and with sufficient headroom to further scale up to a multiple of the March '20 peak), noting that the '20 peak was itself a significant multiple of the prior peaks when 'distributed ledger' technology was first considered and commissioned for the CHESS Replacement Project in 2016/17?

Whether the netting proposal will deliver both the efficiency and integrity needs of the Australian market remains to be seen. Without the proposed rules it is hard for anyone (even ASX) to deliver certainty, at this stage. As such, this seems like an important area where all key stakeholders, including securities and insolvency lawyers, and indeed ASX's regulators may need to dig deeper to test the robustness of the new system from a legal as well as an operational perspective --- assuming it isn't already obvious how it'll work under pressure from a motivated administrator. In any event, its best for some of us to ask the questions now, just in case. 

I trust these comments are helpful to that group of people across the market whose job it is to comment on market structure change, regulatory proposals, new technology, new workflows and / or new operating rules.

Feel free to reach out to me by direct message if you'd like to discuss any of the points above.

Thanks for reading, if you got this far...

Paul Conn