ACH Clearing Rules. Guidance Note No. 17 END-CLIENTS USING MARGINED FINANCIAL PRODUCTS RISKS FOR MARKET, CLEARING AND SETTLEMENT PARTICIPANTS.

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1 ACH Clearing Rules Guidance Note No. 17 KEY TOPICS 1. Potential settlement risks for Participants with end clients using margin lending accounts; 2. Arrangements to address potential settlement risks; 3. Obligations of Clearing Participant to ACH as principal; 4. Purpose and process for lodgement and release of Collateral for Options CCP Contracts; 5. Potential expectation gap for Participants when authorising release of Collateral. ASX Market Rules 5.1, 5.2, 5.3, 5.7.3, 7.1, 28.3, 28.4 ACH Clearing Rules , 7.1, 7.2, 9.1, 9.2, 10.1, 10.2, 12.1, 12.2,12.14, 13.2, 14.5, 14.6, 14.7, 15.1, 15.2, 19.3, 19.6, 20.1, Annexures 1 & 2 to ACH Clearing Rule Procedures ASTC Settlement Rules 4.3, 7.1, 7.2, 8.17, 9.4, 9.5, 12.4, 12.19, , 14.6, 14.8, 14.9 END-CLIENTS USING MARGINED FINANCIAL PRODUCTS RISKS FOR MARKET, CLEARING AND SETTLEMENT PARTICIPANTS Purpose This Guidance Note seeks to bring to the attention of ASX Market Participants ( Market Participants ), ACH Clearing Participants ( Clearing Participants ) and ASTC Settlement Participants ( Settlement Participants ) potential settlement risks when acting for end-clients using margin lending accounts. This Guidance Note also reflects specifically on the lodgement and release of Collateral for Options CCP Contracts in the context of such risks. Background Where a person acquires financial products using margin loans, the margin lender typically requires that such products or other financial products held by the person be provided as security for such loans in accordance with the margin lender s loan to valuation ratio ( LVR ) requirements. In circumstances of market volatility, there is a greater risk that the margin lender s LVR requirements will be breached, triggering a margin call and potential seizure of the secured financial products by the margin lender to cover its loan to that person. This risk is made more acute where the margin loan is secured against a single stock or stock in a single market sector. In certain circumstances a margin call could also be made if the LVR for that stock is sharply lowered or the relevant stock was removed from the margin lender s approved list (effectively reducing the LVR for that stock to zero). ASX, ACH and ASTC wish to highlight potential exposures that Participants may have (particularly in times of market volatility) when assuming trading, clearing and settlement obligations in respect of financial products of endclients that are used as security for margin loans to the end-client. Guidance Note History Introduced: 16 May May 2008 Page 1 of 7

2 Potential settlement risks when clients use margin lending accounts Potential exposure of Participants Participants with end-clients using financial products as security for margin loans made to that client by a third party margin lender need to be aware of the risk where a margin lender controls such financial products. If a margin lender refuses to make such products available for settlement (including where the margin lender seizes such financial products following an unmet margin call) the Participant may be unable to access the financial products for delivery at settlement. These circumstances could result in a breach of the Participant s obligations (in the case of Clearing Participants refer to section below under heading Obligations of Clearing Participant to ACH as Principal ). The risk is greater in a falling market than in a rising market: a falling market is more likely to result in a shortfall on the margin lender s security for that client s lending position pursuant to its LVR requirements, which may trigger (including in the circumstances of an unmet margin call) the margin lender to seize the secured financial products and refuse to make them available to the end-client or its Participant. If a Cash Market Transaction or Derivatives Market Contract has been entered into in respect of the affected financial products (and obligations assumed by relevant Market, Clearing and Settlement Participants) on the basis of the availability of such financial products, there may be a risk that the relevant financial products may be unable to be delivered at settlement resulting in settlement failure, where equivalent financial products are not able to be physically sourced from elsewhere. Settlement failure may have disciplinary consequences for the Participants concerned, and has the potential to adversely affect other Participants, the settlement facility and the wider financial system. Need for adequate arrangements to address potential exposure Accordingly, where Participants have end-clients using financial products as security for margin loans, it is important that they consider whether: they have in place adequate contractual arrangements with their clients, the margin lenders or other persons providing or controlling the relevant financial products, to enable the Participant to: o be aware of any security interest over any financial products for which it receives a sell Order (or otherwise assumes trading, clearing and settlement obligations) as well as the identity of the margin lender or its associate in favour of whom such security interest has been granted and which controls such financial products as a result 16 May 2008 Page 2 of 7

3 o secure the performance of the delivery obligation to the Participant; and o secure the performance of the Participant s obligations (including the Clearing Participant s settlement obligations to ACH under Cash CCP Transactions and Derivatives CCP Contracts); if the Clearing Participant provides third party clearing facilities, it has in place adequate arrangements with Market Participants to enable the Clearing Participant to secure the performance of its settlement obligations to ACH under Cash CCP Transactions and Derivatives CCP Contracts; and otherwise they have adequate risk management controls to address their potential exposure when their end-clients use financial products as security for margin loans. In the context of the third point above, Participants may also wish to give consideration to adopting procedures which seek to mitigate the risk of default in the performance of settlement obligations when end-clients use financial products as security for margin loans. Obligations of Clearing Participant to ACH as principal Under ACH Clearing Rule , Cash Market Transactions entered into on ASX are novated to ACH immediately following execution and Derivatives Market Contracts entered into on ASX are novated to ACH at the time of registration with ACH. Upon novation of a Cash Market Transaction or Derivatives Market Contract under ACH Clearing Rule , ACH is interposed between the Buyer and the Seller and becomes the counterparty for the payment and delivery obligations of the Buyer to the Seller and of the Seller to the Buyer respectively. As a result, the Cash Market Transaction or Derivatives Market Contract is discharged and replaced by two Cash CCP Transactions or two Derivatives CCP Contracts between the Buyer and ACH and between the Seller and ACH. Under Cash CCP Transactions and Derivatives CCP Contracts, the obligations and rights between the Seller (Clearing Participant for the seller under the relevant Cash Market Transaction or Derivatives Market Contract) and ACH and between the Buyer (Clearing Participant for the buyer under the relevant Cash Market Transaction or Derivatives Market Contract) and ACH are owed as principals to each other, notwithstanding that the relevant Clearing Participant may be acting on behalf of a Client. That is, regardless of a client s performance (or non-performance) of its obligations to its Clearing Participant, the Clearing Participant must perform its obligations to ACH as central counterparty. 16 May 2008 Page 3 of 7

4 Options CCP Contracts Collateral held by ACH In the context of the above potential exposure of Participants where end-clients use financial products as security for margin loans made to the client by a third party margin lender, ACH also wishes to draw attention to the lodgement and release of Collateral for Options CCP Contracts and the potential expectation gap of Clearing Participants when authorising the release of such Collateral, in situations where the Clearing Participant has obligations as Seller. Lodgement of Cover Under the ACH Clearing Rules, ACH may require that a Clearing Participant in whose name an Options Market Contract is registered provide Cover to ACH for its margin obligations in respect of the contract. Cover can be in the form of cash or Collateral (as set out in the Procedures to the ACH Clearing Rules). Where financial products are provided as Collateral it is not necessary that they be the same financial products as the underlying financial products for the relevant options contract (for example, NAB shares may lodged as Collateral for a CBA options contract). ACH will only accept lodgement of financial products which are controlled by a Settlement Participant. Clearing Participants are reminded that when seeking to replace Collateral covering a margin obligation, the lodged Collateral will not be released by ACH until after replacement Cover has been received by ACH. Collateral is held by ACH to secure the obligations of a Clearing Participant to ACH in respect of its Options CCP Contracts and not for the purpose of settling the resulting delivery obligation arising from the exercise of the Options CCP Contract (although ACH can use such Collateral to perform settlement obligations in the circumstances referred to below) nor for the purpose of performing the obligations of the client to its Clearing Participant in respect of any Options CCP Contract or resulting Cash CCP Transaction. Where the Clearing Participant commits an event of default (for example, if the Clearing Participant fails to pay an amount due to ACH), ACH has rights to deal with the Collateral, including to sell the Collateral and apply the proceeds from any sale towards satisfying any amount due by the Clearing Participant as principal to ACH. Where a client defaults in its obligations to a Clearing Participant (for example, if the client fails to deliver securities in satisfaction of an exercised options contract) the Clearing Participant s obligations owed as principal to ACH remain however Collateral lodged with ACH may not be available to the Clearing Participant for the purpose of performing such obligations to ACH (as referred to further below). 16 May 2008 Page 4 of 7

5 Where securities are lodged as Collateral they are reserved in an ACH subposition as Derivatives Cover. Whilst the Collateral is held in the ACH Subposition it is subject to a security interest in favour of ACH to secure the Clearing Participant s obligations to ACH in respect of the relevant derivatives account of the Participant with ACH 1. Where the financial products sought to be lodged as Collateral are also subject to a security interest provided to a margin lender, ACH requires that a Deed of Priority be in place between ACH and the relevant margin lender, which provides, amongst other things, that ACH s security interest in those products ranks in priority to the margin lender s security interest whilst the financial products are reserved in the ACH Subposition 2. Pursuant to the terms of the Deed of Priority, the margin lender is also required to obtain from the relevant client whose financial products are subject to a security interest in favour of the margin lender and from that client s Clearing Participant, an acknowledgment in relation to the operation of the Deed of Priority in respect of that client and its financial products sought to be lodged as Collateral. Release of Collateral upon discharge of Options CCP Contracts Upon allocation by ACH of an Exercise Notice submitted by the Buyer of an Options CCP Contract to a Seller of the contract, the relevant Options CCP Contract is discharged and a new Cash CCP Transaction arises in respect of the financial products underlying that options contract under which (in the case of a Call Option): the relevant Clearing Participant with obligations of the Seller under the Options CCP Contract agrees to deliver the underlying financial products; and the relevant Clearing Participant with obligations of the Buyer under the Options CCP Contract agrees to pay the exercise value. The discharge of the Options CCP Contract results in the termination of the relevant margin obligations in respect of the Options CCP Contract and the need for the Clearing Participant to provide Cover for those margin obligations. Accordingly, financial products provided as Collateral will ordinarily be released from the ACH Subposition upon request to ASTC from the controlling Settlement Participant for those financial products, provided that the relevant Clearing Participant requests 3 or authorises 4 the release and the Collateral is not otherwise required by ACH as security for the Clearing Participant s obligations in respect of the relevant derivatives account for which the Collateral was held. 1 E.g. refer to Registered Holder Collateral Cover Authorisation ( Authorisation ) contained in Annexure 2 to ACH Clearing Rule Procedures. 2 Refer to ASX Derivatives Notice 122 dated 10 November Where the Clearing Participant is also the Controlling Participant, pursuant to CHESS 029 Options Cover Removal Request message. Refer also to section 2.3 of Annexure 1 to ACH Clearing Rule Procedures. 4 Where the Clearing Participant is not the Controlling Participant, pursuant to CHESS 103 CP Collateral Removal Authorisation message. Refer also to section 2.3 of Annexure 1 to ACH Clearing Rule Procedures. 16 May 2008 Page 5 of 7

6 Potential expectation gap of Clearing Participants when authorising release of Collateral ACH has become aware that where financial products are lodged as specific Cover for Call Options, and a request is made by the Controlling Participant (being a person other than the Clearing Participant) 5 to release the financial products from the ACH Subposition following exercise of the option, the Clearing Participant may be authorising the release of the Collateral from the ACH Subposition on the expectation or assumption that the financial products will then be made available to the Clearing Participant to perform the Clearing Participant s settlement obligations to ACH under the resulting Cash CCP Transaction. Where however the Clearing Participant does not have adequate arrangements in place with its Client, the margin lender or other person providing or controlling the financial products that were provided as Collateral, the Clearing Participant may not be able to legally enforce the delivery of such financial products to it for settlement in accordance with that expectation. For example, a failure to have adequate arrangements in place may leave the Clearing Participant exposed where the margin lender seeks to utilise the released Collateral to satisfy the client s obligations to it, ahead of the client s obligations to the Clearing Participant. Need for adequate arrangements to address potential expectation gap Accordingly, in the context of the need referred to earlier in this Guidance Note for Participants to have adequate arrangements to address their potential exposures when acting for end clients using margin lending accounts, Clearing Participants should also consider whether they have appropriate contractual arrangements in place with their Clients, the margin lenders or other persons providing or controlling the financial products provided as Collateral. The arrangements should ensure that where the Clearing Participant authorises the release of the financial products provided as Collateral from the ACH Subposition on the expectation that they will be made available to the Clearing Participant to perform the Clearing Participant s settlement obligations, either: the Clearing Participant has access to those financial products for the purpose of satisfying its settlement obligations to ACH for the resultant Cash CCP Transactions; or the Clearing Participant will have access to other financial products which will enable it to satisfy those obligations. (Refer back to Need for adequate arrangements to address potential exposure.) 5 ACH understands that in respect of financial products provided as security for margin loans, the Controlling Participant will typically be the margin lender or an associated entity. 16 May 2008 Page 6 of 7

7 Qualification ASX, ACH and ASTC as licensees have published this note to promote commercial certainty, and assist Participants. Nothing in this note necessarily binds ASX, ACH and ASTC in the application of the Rules in a particular case. In issuing this note ASX, ACH and ASTC are not providing legal or financial advice and Participants should obtain their own advice from a qualified professional person in respect of their obligations, their potential exposures and steps to mitigate such exposure. ASX, ACH and ASTC may replace this Guidance Note at any time. Readers should contact ASX, ACH and ASTC to ensure they have the latest version. 16 May 2008 Page 7 of 7