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Bills Digest No. 196 1997-98
Payment Systems and Netting Bill 1998

WARNING:
This Digest was prepared for debate. It reflects the legislation as introduced and does not canvass subsequent amendments. This Digest does not have any official legal status. Other sources should be consulted to determine the subsequent official status of the Bill.

Passage History

Date Introduced: 1 April 1998

House: House of Representatives

Portfolio: Treasury

Commencement: This Act commences on the day on which it receives the Royal Assent

To create certainty in the Australian financial payments system by deeming certain transactions valid which might otherwise be declared void in the event of a party to the transaction entering into external administration on the same day as the transaction.

The Bill addresses the lacuna in the law resulting from rapid advances in technology. Telecommunications and computers now enable financial institutions to embrace the age of electronic commerce as it becomes available to them.

The Bill specifically provides certainty for the following transactions:

• Multilateral netting payments or transfers (multilateral netting);
• Netting arrangements in connection with trading of derivatives (close-out netting);
• Netting arrangements in connection with the rules of a stock market or futures exchange or an associated clearing house (market netting); and
• Transactions undertaken through the soon to be implemented "Real Time Gross Settlement" system (RTGS).

Netting

Mutual parties to a transaction may set-off their debts and credits at the time of the transaction so that a net balance can be determined at that point in time (bilateral netting).

The main object is for each party to reduce its exposure on open contracts if its counter-party becomes insolvent before the date for performance(1).

The law allows the net amount (rather than the gross amount) to become payable or provable in the event of liquidation, provided a party claiming the benefit of a set-off is without notice of the liquidation at the time of the transaction.(2)

Multiparty netting

With the advance of technology, financial institutions are now able to involve themselves in a web of multiple and complex transactions with customers on a very large scale. Accordingly, the participants have in place a system of multiparty set-off (multiparty netting).

However, unlike bilateral netting arrangements, uncertainty currently exists where multiparty netting transactions occur on the day a participant enters into external administration.

At common law, the zero hour rule applies to transactions from the beginning of the day (midnight or zero hour) on which the external administration is declared. This Bill displaces the zero hour rule and brings multiparty netting transactions into line with the certainty created by the legislative regime of bilateral netting transactions.

Close-out netting

This is used in financial markets transactions such as currency (foreign exchange) and interest rate swaps. It is a process which permits a party to a financial contract to terminate the contract if the counter-party becomes insolvent and;

• To calculate the termination value of the obligations of the parties; and
• To set-off the termination value so calculated to arrive at a net amount payable by one party to the other.

Market netting

This typically arises under the rules of a stock exchange, futures exchange or a clearing house.

The rules commonly provide for the novation (an agreement discharging a contract and entering into a new one) to a clearing house of contracts entered into by exchange members, and the setting-off obligations under those contracts in the event of default by a member and for the purpose of settlement.

The Draft Report of the Companies and Securities Advisory Committee (CASAC) Netting Sub-Committee of November 1996, Netting in Financial Markets Transactions, states that some experienced lawyers believe that there is no basis for doubting that current close-out netting and market netting arrangements are effective.(3) However, in the Final Report of June 1997, the Sub-Committee held the view that it would be very desirable that the legal position be clarified beyond doubt. It argues that if, for example, the law were to allow a liquidator of an insolvent party to "cherry-pick" by disclaiming unfavourable contracts and holding the other party to contracts which are favourable, the outcome could be disastrous to the other party. If there is any risk that this outcome could occur, the risk must be taken into account as part of the credit risk process when a financial institution considers whether to enter into financial contracts. The result could be to inhibit contracting and consequently deny counter-parties the benefits which can flow from financial contracts such as financial derivatives, even if the apprehended disaster never occurs.(4)

The Bill creates certainty in that current close-out and market netting arrangements would be allowed to stand notwithstanding the insolvency of a party to the netting contract.

Real Time Gross Settlement Systems (RTGS)

The Reserve Bank and the Australian Payments Clearing Association (APCA) have initiated this system. The basis of RTGS is the development of a sound framework and related infrastructure to settle high-value payments and to enhance clearing and settlement systems between participants in the payment system.

Effectively, the processing of payments only occurs if the paying institution has funds available in its settlement account with the Reserve Bank. If such funds are available, the following occurs simultaneously;

• The funds are debited to the paying customer's account,
• The funds are credited to the payee's account, and
• Corresponding entries are entered to their respective institution's accounts with the Reserve Bank.

The result is that the settlement of the transaction takes place immediately and irrevocable.

The Bill displaces the zero hour rule so that the integrity of the RTGS system is upheld in the event of a paying party entering into external administration on the day of the transaction. This will prevent the "undoing" of the transaction and in doing so, maintains its simultaneous and irrevocable nature.

Clause 5 provides for definitions and in addition refers to particular legislation for clarity.

Clause 6 upholds the integrity of the RTGS payment system by deeming payments (made in accordance with the system) to be made on the day after the paying participant goes into external liquidation. This displaces the common law zero hour rule.

Clause 7 obliges participant parties to notify the RTGS system administrator of the external administration as soon as practicable. This section is important. Failure to comply carries a penalty of imprisonment for 5 years.

Clause 10 upholds the integrity of approved multilateral netting arrangements. If a party to such an arrangement goes into external administration the external administrator can recover from the other an amount equal to the amount of the net obligation.

Clause 14 upholds the effectiveness of close-out netting contracts. If a party to such a contract goes into external administration the obligations may be terminated, termination values may be calculated and the net amount shall become payable in accordance with the contract. The provisions of this clause are qualified by the requirement that the parties must act in good faith and without notice.

Clause 15 gives the Reserve Bank the power to declare that Clause 14 shall not apply to a close-out netting contract if it is satisfied that systemic disruption in the financial system could result if it were to apply. The extent of the discretion conferred on the Reserve Bank is unclear.

Clause 16 upholds the effectiveness of market netting contracts. If a party to such a contract goes into external administration the obligations may be terminated, termination values may be calculated and the net amount shall become payable in accordance with the contract.

The Bill insulates Australian financial payments and netting systems from the application of insolvency laws.

Participants in the system are guaranteed the integrity of their transactions at the expense of creditors of a failed participant. Creditors, of course, include day-to-day depositors.

Although the Bill creates stability in the Australian financial system to which it relates, it does so at the expense of those creditors outside the system who would otherwise have a legitimate right to stand in line with all others under the current insolvency law regime.

The balance favours the system. The system follows that of other OECD countries who have already addressed, or are presently addressing, the legal uncertainties which attach.(5)

In essence, the Bill answers the call of technology. As technology and the age of electronic commerce continue to move forward, the law consistently limps in the background. The Bill addresses the legal uncertainty under which the system is currently operating and places the onus upon the participants to consider their respective credit risks.

One issue, which may become legally troublesome, is the nature of the entities entering into transactions addressed by this Bill. Consider the following:

• What particular entities have the capacity to contract under the system? Should they be clearly defined so that participants can be certain that any issues of ultra vires do not arise?
• Should there be special provisions in place to safeguard against trust entities where trust deeds do not entitle the trustee to enter into contracts under the system?

As a final point, the Bill will uphold the integrity and stability of the Australian financial system. As a result, a heavy onus must be placed upon the integrity and stability of the technological infrastructure under which the system operates. In 1998, the legal uncertainty of the zero hour rule may well be dealt with by this Bill, but will its technological cousin be dealt with as effectively by the communications and computer systems yet to face the zero hour of the year 2000?

Endnotes

1. Butterworths Australian Legal Dictionary 1997 at .785.
2. Australian Corporations Law section 553C.
3. Page 3 at 5.2.
4. Page 3 at 5.2.
5. Includes the United Kingdom, Canada and New Zealand.

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ISSN 1328-8091
© Commonwealth of Australia 1998

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