1998 

THE PARLIAMENT OF THE COMMONWEALTH OF AUSTRALIA 

HOUSE OF REPRESENTATIVES 

 
PAYMENT SYSTEMS AND NETTING BILL 1998 

 
EXPLANATORY MEMORANDUM 

(Circulated by authority of the 
Treasurer, the Hon Peter Costello, MP) 
 
13809

PAYMENT SYSTEMS AND NETTING BILL 1998
Overview and financial impact statement
General overview
The Payment Systems and Netting Bill 1998 will:
(a) overcome the effects of the Zero Hour Rule in relation to payment and settlement systems approved by the Reserve Bank of Australia (Part 2 of the Bill, Integrity of approved RTGS systems); and
(b) enhance legal certainty for multilateral netting in the payment system (Part 3 of the Bill, Integrity of approved netting arrangements); and
(c) enhance legal certainty for netting in financial market transactions (Part 4 of the Bill, Close-out netting contracts); and
(d) enhance legal certainty for netting undertaken in accordance with the rules governing stock and futures exchanges and the associated clearing houses (Part 5 of the Bill, Market netting contracts).
Financial impact statement
The Payment Systems and Netting Bill 1998 will not have any impact upon government expenditure.
 
Regulation impact statement
Nature and extent of the problem
Integrity of the financial payment system
Control of risk in the payment system is a worldwide policy concern of governments and central banks.  Risk in the payment system can be reduced by using legally sound netting systems which require participants in the system (eg banks) to meet their net (rather than gross) obligations to other participants (eg other banks).  Netting has been recognised as an effective strategy for reducing risk in the payment system for three reasons.
First, by replacing the need for meeting each obligation with the need to meet only net obligations, it significantly reduces the liquidity required to enable the financial system to operate efficiently.  The net obligations of an institution for the same day will, invariably, be considerably less than the sum of its gross exposures.  The total gross obligations for a particular day can easily exceed the capital and reserves of an institution.
Secondly, an institution need not wait until one transaction is settled in order to be in funds to meet another payment obligation. 
Thirdly, multilateral netting significantly lessens the risk of systemic failure.  Because an institution’s net obligation will, invariably, be considerably less than the sum of its gross obligations, the resulting shortfall to the system, should that institution fail, will be less than the sum of its bilateral shortfalls to other parties.
In November 1990 the Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries recommended that netting schemes for cross-border, multi-currency systems  “should have a well-founded legal basis under all relevant jurisdictions”.
The Australian payments system currently comprises a number of separate and distinct instruments and systems for transferring funds in Australia between payers and payees, between banks, and between banks and other financial institutions.  It links the Reserve Bank to the domestic banks and enables banks to settle for payments made to, and received from, other banks using accounts held with the Reserve Bank. 
The system of multilateral netting currently operating in the payment system produces a result reflecting a participant’s overall debit or credit position vis-a-vis all the other participants.  The system sums the exposures of each participant in the payment system and calculates its net position at the end of the day. 
In the present framework of banking and insolvency law some uncertainties attach to the effectiveness of the multi-lateral netting arrangements.  These uncertainties focus on the application of the law concerning unfair preferences in relation to multi-lateral netting arrangements.  While insolvency law confers a statutory right of set-off in certain circumstances, there is some uncertainty about whether multilateral netting arrangements are enforceable.  The Financial System Inquiry (“the Wallis Report”) recommended that preparation and consideration of netting legislation be expedited. 
Integrity of real time gross settlement systems 
The Wallis Report also noted that good progress world-wide is being made in reducing settlement risk in domestic high-value payments through the development of real time gross settlement (RTGS) systems, including in Australia, and has specifically recommended that the Reserve Bank give high priority to promoting cost-effective control of domestic and international settlement risks.
The Reserve Bank and the major national banks have participated actively in the establishment of Australian Payments Clearing Association Limited (APCA).  APCA is a non-profit company whose shareholders and directors represent the Reserve Bank, the four major national banks, State banks, other banks, building societies and credit unions.  The Reserve Bank, APCA and the major financial institutions are working to recast and develop the Australian payment system and its component parts.  The basis of this reform is the development of a sound framework and related infrastructure to support enhanced clearing and settlement systems between participants in the payment system.  
As part of this process, high-value payments (which account for more than two-thirds of the value of cleared payments in Australia) are to be settled on a RTGS basis.  Under RTGS, the processing of payments only occurs if the paying institution has funds available in its settlement account with the central bank.  At the same time as the funds are debited to the paying customer's account, and credited to the payee’s account, the corresponding entries are passed to their institutions' accounts with the central bank.  In this way the transaction is completed in all its elements - including settlement - immediately and irrevocably.  The Reserve Bank and APCA are working towards implementing RTGS at around mid 1998.
Multilateral netting will, however, continue for low-value payments, including cheques, whose paper origins do not lend themselves to settlement on the electronic RTGS system.  The multilateral net obligations determined at the end of trading each day will, in turn, be settled on the RTGS system.
In the present framework of banking and insolvency law, some uncertainties attach to the effectiveness of the RTGS arrangements.  These uncertainties focus on the application of the Zero Hour Rule to RTGS arrangements.
When a court-ordered liquidation commences, any payments or transfers of property made by the company thereafter are void, subject to certain exceptions such as payments made by the liquidator.  It has been suggested that a court-ordered liquidation may be taken to have commenced at the beginning of the day on which the order was made (“the Zero Hour Rule”).  Accordingly, any payments made by a bank between midnight and the time the order was made could be void, including RTGS payments and payments made to settle multi-lateral net positions.  Similar rules apply where a company enters a voluntary administration.  Such an outcome would undermine the irrevocability of those payments and create severe liquidity problems in the payment system.
Integrity of close-out and market netting contracts
In May 1994 the Companies and Securities Advisory Committee (CASAC) decided to undertake a review of over-the-counter (OTC) derivatives.  To assist its deliberations, it established an expert advisory committee which recommended that CASAC should establish a separate sub-committee to review and make recommendation on the law concerning the netting of transactions in financial markets.  In June 1997 the CASAC Netting Sub-Committee recommended in its Final Report , Netting in Financial Markets Transactions, the enactment of legislation to clarify a number of issues arising in netting in financial market transactions. 
CASAC, in its Final Report on Regulation of On-exchange and OTC Derivatives Markets also supported the enactment of facilitative netting legislation.  Likewise, the Wallis Report supported the introduction of legislation to give legal certainty to the netting of financial transactions.
The CASAC Netting Sub-Committee identified a number of legal issues, not yet clarified by case law, which have been the subject of some debate amongst lawyers.  Nevertheless, the Netting Sub-committee concluded that it would be desirable for the legal position to be clarified beyond doubt.  This is because of the high value of many of the transactions which are subject to netting arrangements, and the potentially disastrous consequences of adverse rulings by the courts.
In December 1997 the Treasurer released for public comment as part of the Corporate Law Economic Reform Program a discussion paper on Electronic Commerce.  The paper proposed the enactment of legislation, along the lines recommended by the CASAC Netting Sub-Committee, to provide a more certain and robust legal framework for close-out and market netting arrangements.
Objectives
Integrity of real time gross settlement
Cash transfers and securities settlements made in RTGS systems, and made prior to the exclusion of the failed institution from the RTGS system, should not be rendered void by the Zero Hour Rule as a disposition made after the commencement of the winding up.  
Integrity of the financial payments system, and close-out and market netting.
Further, legal certainty should be provided for netting arrangements for the settlement of low-value retail payments in the financial payment system, close-out netting in the financial markets and for netting undertaken in accordance with the rules governing stock and futures exchanges and the associated clearing houses. 
Identification of Options
Integrity of the financial payments system
The following options have been identified to improve the integrity the financial payments systems:
(a) the status quo (ie not address the uncertainties associated with multi-lateral netting); and
(b) bilateral netting; and
(c) novation to a central clearing house; and
(d) a legislative response.
Integrity of real time gross settlement systems 
The following options have been identified to improve the integrity of the financial payments system:
(a) the status quo (ie retention of the Zero Hour Rule); and
(b) a legislative response.
Integrity of close-out and market netting
The following options have been identified to improve the integrity of close-out and market netting:
(a) the status quo (ie not address the uncertainties associated with netting); and
(b) a legislative response.
Assessment of the impacts/costs and benefits of each option
Impact group identification
The parties affected by these options are the banks and their customers.  It would also affect the Reserve Bank in relation to the measures addressing problems with the Zero Hour Rule and the financial payment system. 
Costs and benefits 
Integrity of the financial payment system
Status quo
The Australian financial payment system and the netting arrangements associated with that system have worked adequately to date. 
In recent years, legal advice has highlighted the continuing legal uncertainty of those arrangements.  If that uncertainty were to continue, it has the potential to:
(a) undermine the achievement of payment finality under the RTGS system to be introduced for the settlement of high-value wholesale payments by around mid 1998; and
(b) wind back netted transactions for low-value retail payments; and
(c) result in the “systemic failure” of other participants in the system and a loss of confidence in the financial system generally.
Bilateral netting
Bilateral netting is a possible alternative to multilateral netting arrangements for the settlement of low-value retail payments. Under bilateral netting the obligations between a participant and each other participant are netted off, so that at the end of each day a separate netted amount is calculated between each participant and each other participant.  The benefit of this arrangement would be that, as there would be mutuality between the parties, statutory set-off would be available and the legislative amendments would not be required.  
On the other hand, the significant disadvantage (or cost) of this arrangement is that bilateral netting does not afford the same liquidity benefits as multilateral netting.  The cost of this alternative to liquidity in the payment system rules it out as a viable alternative.
Novation to a central clearing house
Another alternative to the multilateral netting arrangements for the settlement of low-value retail payments in the payment system, that has been examined but discounted, is to have the obligations between participants novated to a central clearing house (as happens in other parts of the financial system such as the Sydney Futures Exchange).  Once again, the benefit of this arrangement would be that all non-mutual contracts would become mutual with the clearing-house and thus statutory set-off would be available.
However, no central counterparty in Australia (other than the Reserve Bank) would have the necessary resources to be able to underwrite the obligations of the participants in the payment system.  Any such underwriting by the Reserve Bank would be tantamount to a Government guarantee of the settlement of all payment instructions.  The extent of the obligations and the associated costs involved would make any such Government guarantee untenable.
A legislative response 
Participating in netting systems confers a number of significant commercial benefits on banks because it reduces the number of inter-party settlements, thereby reducing costs.  It also reduces their counterparty credit and settlement risk exposure, and reduces their liquidity needs, thereby reducing costs.
To allow the existing legal uncertainties to remain would leave Australia well behind international best practice in payment system reform.  These uncertainties have already been addressed or are presently being addressed in a number of other jurisdictions, including the United Kingdom, Canada and New Zealand, and at the international level by the Basle Committee on Banking Supervision, to promote the legal enforceability of netting arrangements.  A legislative response could provide the certainty required by the financial markets for netting arrangements in the financial payment system.  The fact that clarifying legislation has been thought appropriate elsewhere, coupled with a concern (both in Australia and overseas) that the absence of netting legislation in Australia could affect the international competitiveness of Australian financial institutions, provides a strong case for legislation.
Integrity of real time gross settlement systems
The status quo
Without legislation, there will continue to be uncertainty concerning the application of the Zero Hour Rule to real time gross settlement systems.  The application of the Zero Hour Rule to high-value payments could undermine the irrevocable nature of RTGS payments and create severe liquidity, and potentially systemic, problems for participants in the payment system.
A legislative response
Removing the possibility of the Zero Hour Rule being applied to transactions processed in electronic high-value payment systems which settle in real time will have important benefits for the senders and beneficiaries of those transactions, as well as payment system participants (ie banks and their customers).  However, it may result in fewer assets being available for distribution among creditors of a failed participant in the payment system.
Legislation will provide certainty for real time gross settlement systems on the failure of a participant in the system.  This option is therefore, in the interests of participants in the payment systems generally – including both the participating institutions and their customers.
Integrity of close-out and market netting
The status quo
Without legislation, there will continue to be uncertainty concerning the legal effectiveness of close-out and market netting contracts.  
A legislative response
Legislation will provide certainty for concerning the legal effectiveness of close-out and market netting contracts. 
Providing integrity for close-out and market netting will make it easier for financial institutions and their customers to obtain all the benefits of transactions which are generally regarded as an essential part of sound financial management, such as interest rate and currency swaps and other arrangements which hedge exposures.
As netting will reduce the costs for individual transactions, it will make it possible for financial institutions to take on new business involving netting.  
Clarifying the law would assist Australian financial institutions to join Exchange Clearing House Limited (ECHO), an international clearing house for foreign exchange transactions.
The Netting Sub-Committee’s Background Paper, Netting in Financial Markets Transactions (December 1996), notes that reforms have now been adopted in a significant and growing number of industrialised countries, particularly in the United States and the United Kingdom
Impact on Government expenditure
None of the legislative responses will have any impact on government expenditure.
Consultation
The Bill will alter the effect, scope or operation of the Corporations Law.  Accordingly, as required by clause 510 of the Corporations Agreement between the Commonwealth, the States and the Northern Territory, the Commonwealth has notified the States and the Northern Territory of the Bill.
A draft of the provisions in the Bill concerning approved RTGS systems and netting arrangements, together with a supporting commentary, was exposed for public comment on 12 February 1998.  Comments and suggestions received on the draft Bill have been carefully considered to ensure that the legislation is appropriate and contributes to ensuring the integrity of the payments system.  There is strong support for legislation among participants in the financial system.
Legislation supporting close-out and market netting has been recommended by the CASAC Netting Sub-Committee, CASAC itself and the Financial Systems Inquiry.  The draft provisions supporting close-out and market netting legislation has been prepared with the assistance of a number of the members of the CASAC Netting Sub-Committee.  Business interests that would be affected by the Bill have expressed their strong support for legislation.
Conclusion and recommended option
The preferred option is to legislate to overcome the effect of the Zero Hour Rule in relation to real time gross settlement systems approved by the Reserve Bank, and to address legal uncertainties in relation to netting in the financial payments system and close-out and market netting.
The legislation would make the financial position of Australian financial institutions more secure.  Clarifying the law of netting will minimise risks associated with participating in multilateral netting in the payment system and the performance of certain large financial transactions involving netting systems. 
Many other industrialised countries have enacted legislation to clarify their netting laws.  By doing so they not only reduce possible risks for parties to netting arrangements, but also remove an impediment to the international competitiveness of their local financial institutions.  Legislation will therefore facilitate the establishment of Australia as a regional financial centre.
The fact that clarifying legislation has been thought appropriate elsewhere, coupled with a concern that the absence of netting legislation in Australia could affect the international competitiveness of Australian financial institutions, reinforces the need for legislation.
Evaluation Strategy
It is proposed that a joint review of the Bill be undertaken by Treasury and the Reserve Bank 5 years after its commencement, and that the review be completed within a further 6 months.  
 
Notes on clauses
Part 1 – Preliminary
Clause 1 - Short title
1.	This clause provides that the short title of the Act will be Payment Systems and Netting Act 1998. 
Clause 2 - Commencement
2.	This clause provides that the Bill will commence on the day that it receives Royal Assent. 
Clause 3 - Crown to be bound by the Act
3.	This clause provides that the Act will bind the Crown in all its capacities, but will not make the Crown liable to be prosecuted for an offence. 
Clause 4 - Application of Criminal Code
4.	This clause provides that the Criminal Code will apply to all offences against the Act. 
Clause 5 - Interpretation
5.	This clause provides the definitions for various terms used in the Bill. 
Close-out netting contract
6.	Close-out netting contracts are used in financial markets transactions such as currency (foreign exchange) and interest rate swaps.  They permit a party to the contract to terminate the contract if the counterparty becomes insolvent (or if some other condition is satisfied), to calculate the termination values of the obligations of the parties, and to set off the termination values so calculated to arrive at a net amount payable by one party to the other. 
7.	The obligations referred to in the definition are intended to apply broadly to encompass monetary obligations arising under a financial contract such as an interest rate or currency swap, and to non-monetary obligations such as an obligation to deliver commodities under a commodities derivative contract or securities under a securities derivative contract. The obligations covered by the definition are also intended to cover contingent obligations.  The definition is intended to operate broadly to encompass super-netting under a master netting contract. 
8.	A device of the kind used in Ex parte Mackay (1883) 8 Ch App 643 would not fall within the definition because it would not reflect any attempt to calculate the true termination value of the obligation under consideration. 
9.	The regulations may declare a contract to be a close-out netting contract (paragraph (b)).  While the definition should address the range of transactions it is designed to address, given the rapidly evolving nature of the financial markets, it will be possible to make regulations expanding the coverage of the term close-out netting contract should the definition prove to have insufficient coverage. 
10.	Similarly, there may be circumstances in which it is considered it would be inappropriate to extend the coverage of the protection to be afforded by the Bill to close-out netting contracts.  The regulations may therefore provide that a contract is not to be a close-out netting contract (paragraph (e)). 
11.	Section 46(2) of the Acts Interpretation Act 1901 will allow regulations to be made in relation to a class of contracts. 
12.	The Bill makes similar provision for close-out netting contracts in Part 4 and approved netting arrangements in Part 3.  In order to avoid overlap between the provisions, paragraph (c) of the definition will exclude from the concept of close-out netting contract arrangements that have been approved by the Reserve Bank under Part 3.  
13.	The Reserve Bank may consider that systemic disruption in the financial system could result if a party to a close-out netting contract went into external administration.  Clause 15 of the Bill will allow the Reserve Bank to make a declaration to that effect.  It is envisaged that the Reserve Bank would make a declaration under clause 15 in only the most exceptional circumstances.  It is intended that consideration would be given to approving under Part 3 of the Bill contracts in relation to which the Reserve Bank has made a declaration under clause 15.  The sunset clause on declarations made under clause 15 recognises that alterations to the scope of the definition of close-out netting contract should in the longer term be the subject of regulations made under paragraph (e) of the definition of close-out netting contract. 
Commonwealth constitutional reach
14.	This definition is used in clauses 9, 14 and 16 to bring those sections within the constitutional reach of the Commonwealth. 
Market netting contract
15.	The market netting provisions in Part 5 are intended to cover the netting of obligations arising under the rules of a netting market.  A netting market is a market approved under the Corporations Law or otherwise declared by the Regulations for the purposes of the definition. 
16.	Market netting typically arises under the rules of a stock exchange, futures exchange or clearing house.  The regulation making power is intended to allow the definition to be extended to markets not regulated by the Corporations Law, for example, the Exchange Clearing House Limited (ECHO).  
17.	Market netting is intended to extend to markets in which the rules novate market contracts to a clearing entity, to which deposits and margins are paid and security is provided.  The Bill will extend to rules requiring the netting of deposits and margins and the realisation and netting of securities (clause 16(2)(g)(iii). 
Part 2 – Integrity of approved RTGS systems
Clause 6 - External administration not to affect transactions carried out on day of appointment
18.	If the 3 conditions mentioned below are satisfied, clause 6 will deem a payment or transfer made by a participant through an approved RTGS system to have had the same effect it would have had if the participant had gone into external administration on the next day.  The 3 conditions are as follows. 
19.	First, it will apply where a participant in an approved RTGS system goes into external administration (clause 6(1)(a)).  Clause 9 of the Bill will allow the Reserve Bank to approve as an approved RTGS system a system supported by a legally enforceable arrangement for the irrevocable settlement of transactions in real time. The term external administration is defined in clause 5 and will include the winding up of a company by a court, for example. 
20.	Second, there is a transaction involving the payment of money, or the transfer of an asset, by the participant (clause 6(1)(c)).  The clause will therefore apply to both cash transfers and the transfer of ownership of an asset.  It will apply to both two-sided cash transfers and to both legs of security settlements (ie the cash transfer and the exchange of ownership). 
21.	Third, the transaction is executed through the approved RTGS system at any time on the day on which the external administrator is appointed (clause 6(1)(b)). 
22.	Any disposition of property of a company made after the commencement of its winding up by a court is void unless, among other things, the disposition is made by its liquidator (Corporations Law, section 468(1)).  Similar rules apply in relation to voluntary administrations and bankruptcy.  The insolvency laws of most countries include a similar rule. However, the clause will deem the participant to have gone into external administration on the day after it goes into external administration.  Consequently, Corporations Law section 468(1) and its corresponding insolvency laws, to the extent that they apply to transactions undertaken on the day the external administrator is appointed, will not affect transactions to which the clause applies.  
23.	The need for this section arises through the potential operation of the Zero Hour Rule.  The effect of this rule if it applies is to provide that when an event is specified to have occurred on a particular day then that event takes place at the earliest point in time after midnight on the commencement of that day.  The alternative to this rule is that the event occurs at the moment in the day that it actually took place. 
24.	If a court orders the winding up of a company at 3:30pm on a particular day, there is doubt about whether the winding-up commences immediately after midnight on the day that the order is deemed by the Corporations Law to take place (as would be the case if the Zero Hour Rule applies); or whether the winding-up commences at the time the time the order is made (ie 3:30pm) - see re Red Robin Milk Bar Limited [1968] NZLR 28 at 29 per McGregor J; re Seaford (deceased) Seaford v Seifert [1967] 2 All ER 458, and on appeal at [1969] 1 All ER 482 at 486; John Serafino ex parte: Classic Manufacturing Pty Limited, No P1358 of 1988 (unreported); Bankruptcy Act 1966 section 57A; re Pollard; ex parte Pollard [1903] 2 KB 41. 
25.	If the rule applies, then recipients of payments or transfers made by the failed participant could be required by the liquidator to unwind transactions made during the course of the day on which the liquidator was appointed.  At the same time, they would be unable to recover payments and transfers made by them to the failed participant on that day.  This possibility could lead to systemic risk among participants in the RTGS system.  The possibility will be exacerbated by the high value of the transaction proposed to be passed through approved RTGS systems and the fact that money and assets are often reused as soon as they are received. 
26.	Some time may pass between the appointment and the exclusion of the insolvent participant from the approved RTGS system.  Similarly, transactions may be irrevocably entered into the system before the appointment, but they may not be processed until after the appointment.  Consequently, clause 6 will validate transactions made after the external administrator is appointed until the following midnight. 
Clause 7 - Obligation to notify system administrator of external administration
27.	If the Zero Hour Rule applies, then the liquidator could require recipients of payments or transfers made by a failed participant during the course of the day on which the liquidator was appointed to be unwound.  Clause 6 will have the effect of preventing the liquidator unwinding transactions made through an approved RTGS system on the day the external administration actually occurs.  It will therefore reduce the pool of assets available to the liquidator for distribution to the creditors of the participant in external administration.  
28.	Clause 7 is intended to facilitate the removal of a participant who has entered external administration from the approved RTGS system as early as practicable on the day on which the external administration actually commences, where that is considered appropriate.  It is intended to limit the number of the transactions that will be ‘saved’ through the operation of clause 6, to the detriment of the creditors of the participant entering external administration. 
29.	If a participant in an approved RTGS system enters external administration, clause 7(1) will oblige the participant to notify the system administrator of that fact as soon as practicable after the participant becomes aware of the external administration.  If the participant settles obligations through the system on behalf of another participant, and the settling participant becomes aware that the other participant has entered external administration, then the settling participant will be required to notify the system administrator of that fact as soon as practicable. 
30.	A person will not contravene the obligation to notify the system administrator if they show that they took reasonable steps to comply with clause 7(1) (clause 7(2)). 
31.	A participant in an approved RTGS system who contravenes clause 7(1) will commit an offence carrying a maximum penalty of imprisonment for 5 years (clause 7(3)). 
Clause 8 - Application for approval of payment system
32.	A person will be able to apply to the Reserve Bank for approval of a payment or settlement system.  If the Reserve Bank approves the system it will be an approved RTGS system for the purposes of the Bill. 
Clause 9 - Reserve Bank may approve payment system
33.	The Reserve Bank will only be able to approve a system if is satisfied in relation to the matters mentioned in clause 9(1).  
34.	The Reserve Bank must be satisfied that, if the participant was not exempted by clause 6 from the possible application of the Zero Hour Rule in relation to transactions undertaken through the system, then systemic disruption in the financial system could result if a participant went into external administration (clause 9(1)(a)).  This criteria is designed to ensure that only economically significant arrangements have the benefit of clause 6, and that the approval avoids a knock-on effect to other significant entities in the event that a participant fails. 
35.	The system must also be supported by a legally enforceable arrangement between participants in the system for the irrevocable settlement of transactions in real time (clause 9(1)(b)).  This requirement is intended to confine the operation of clause 6 to RTGS systems. 
36.	The rules governing the system must confer on the system administrator a discretion to suspend from the system a participant who has entered external administration (clause 9(1)(e)).  The discretion recognises that it may not always be appropriate to suspend from an approved RTGS system a participant who has entered external administration. 
37.	No limit is imposed on the value of transactions passing through an approved RTGS system.  All transactions passed through an approved RTGS system will be given the benefit provided by clause 6.  While it is expected that for the most part transactions will be of a high value, there are a number of reasons why a transaction may be effected through an RTGS system, including that they are time critical or are demanded by the market to be settled on an RTGS basis. 
38.	The Reserve Bank will also be required to take a number of matters into account in deciding whether to approve a system (clause 9(2)). 
39.	The Reserve Bank will be able to approve both systems which have participants who are not able to settle on their own behalf, and also systems which require all members to settle on their own behalf (clause 9(2)(a)).  The Reserve Bank will also be required to take into account whether the system’s rules reinforce the notification obligations in clause 7 (clauses 9(2)(b)(ii) and (iii) and 9(2)(c)). 
40.	The Reserve Bank will also be able to impose terms and conditions on the grant of any approval (clause 9(3)(b)).  Given the potential impact of clause 6 upon the creditors of an insolvent participant in an approved system, an approval under clause 9 will be a disallowable instrument for the purposes of section 46A of the Acts Interpretation Act 1901.  This means that the Reserve Bank’s approval of a system will be tabled in both Houses of the Parliament and may be disallowed by a resolution of either the House of Representatives or the Senate.  As a disallowable instrument, any Reserve Bank approval will also be subject to the requirements of the Legislative Instruments Bill 1998.  That Bill requires the registration of all legislative instruments on a Federal Register of Legislative Instruments and generally requires consultation in relation to instruments likely to have a direct, or substantial indirect, effect on business.  It is envisaged that the consultation requirements of the Legislative Instruments Bill 1998 would usually apply to an approval under clause 6. 
Part 3 – Integrity of approved netting arrangements
41.	Multilateral netting arrangements involve the replacement of a series of gross payment obligations between parties by a single net position as between the parties. 
42.	Under insolvency law, liquidators may ‘claw back’ payments made to particular creditors when insolvency is imminent in certain circumstances.  For example, Division 2 of Part 5.7B of the Corporations Law renders a transaction voidable where: 
(a) it results in a creditor receiving from a company that has gone into liquidation in respect of an unsecured debt an amount greater than they would have received if they had proved in the winding up of the company; and
(b) at the time the transaction was entered into the company was insolvent or became insolvent as a result of the transaction.
43.	The Law provides a defence to a creditor who entered into a transaction in good faith and without reasonable grounds for suspecting that the company was insolvent or would become insolvent as a result of the transactions. 
44.	In certain circumstances a multilateral netting arrangement could give rise to transactions that are prima facie voidable preferences.  While the defence should afford protection to parties to a multilateral netting arrangement, concern has been expressed that the threshold for satisfying the defence is relatively high, and thus difficult to establish. 
45.	It is possible therefore that were a party to a multilateral netting arrangement to fail, and the defence was not strictly satisfied, its liquidator could require net payments made under such an arrangement which met the above criteria to be set aside as an unfair preference.  This means other participants could be required to meet their much larger gross obligations to the failed participant, but would have merely a right to prove in the liquidation for the debts owed to them by the failed participant. 
46.	The Law already recognises the concept of set-off: ie where one party holds money of a second party, and the second party owes money to the first party, the first party is entitled to claim, or ‘set-off’ the money in satisfaction of the outstanding claim against the second party.  Netting can therefore be seen as an extension of set-off.  There is, however, some uncertainty as to whether multilateral netting arrangements would satisfy the formal preconditions for the recognition of set-off under the Corporations Law. 
47.	There is also a fundamental principle of insolvency law, encapsulated in section 555 of the Corporations Law, that, subject to provisions to the contrary, all creditors are to share equally in the assets of a company on winding up - the pari passu rule.  There is an argument, reflected in the decision in British Eagle International Airlines Ltd v Campagnie Nationale Air France (1975) 1 WLR 758, that a netting arrangement could be void as contrary to public policy in that it leads to an outcome contrary to the pari passu rule. 
48.	There is also some doubt as to the efficacy of netting arrangements where a statutory regime for the priority of creditors in a winding up operates.  For example, section 16 of the Banking Act 1959 provides that in the event of a bank being unable to meet its obligations, liabilities to depositors are to be paid out in preference to all other debts owed by the bank.  It is possible that the assets of the bank for the purposes of this provision could be taken to include any gross payments owing to the bank, rather than the net payments calculated in accordance with a multilateral netting arrangement.  There are similar provisions in relation to the assets of life insurance companies in section 187 of the Life Insurance Act 1995, and also the other laws mentioned in the definition or the term specified provisions. 
Clause 10 - Effectiveness of approved multilateral netting arrangements
49.	The Bill will validate approved multilateral netting arrangements (AMNA) that are entered into in circumstances that are within Commonwealth constitutional reach.  Clause 10(1) validates AMNA where none of the participants have gone into external administration.  The arrangement will be enforceable according to its terms (clause 10(1)(a)). 
50.	Clause 10 (1)(b) is intended to overcome doubts about whether AMNA might be rendered ineffective by an assignment of rights held by a participant to the arrangement.  Clause 10 (1)(c) makes it clear that the assets and liabilities of a party to an AMNA are the net assets and liabilities arising out of the netting arrangement, rather than the assets and liabilities that were netted to arrive at the net amounts. 
51.	There may be circumstances in which, having incurred an obligation, a party is required to take further steps to have that obligation netted under the arrangement.  The appointment of an external administrator may prevent those further steps being taken as they may be regarded as a disposition of an asset and therefore void under section 468 of the Corporations Law or other similar provision.  In consequence, the net obligation that is provable or recoverable would not be a true reflection of all the gross payment obligations incurred by the party prior to the appointment of an external administrator. 
52.	If a party to an AMNA enters into external administration with obligations that would have been netted but for the fact of the external administration, then those obligations may be passed through the AMNA despite the external administration (clause 10(2)(a)(i)). 
53.	Moreover, if a party to an AMNA enters into external administration with assets or liabilities produced by an AMNA, and those assets or liabilities would but for the external administration have been passed through a further AMNA, then this will also be possible despite the external administration (clause 10(2)(ii)).  
54.	However, clause 10(2) is not intended to allow the party to settle an obligation after going into external administration.  It merely permits the net position to be established and that net position is then provable or recoverable in accordance with clauses 10(2)(c) or (d). 
55.	The Bill also provides as follows: 
(a) the gross obligations netted under the arrangement are to be disregarded in the external administration (clause 10(2)(b)); and
(b) any net obligation owed by the party that has gone into external administration that has not been discharged is provable in the external administration (see definition of “provable” in clause 5) (clause 10(2)(c)); and
(c) any net obligation owed to the party that has gone into external administration that has not been discharged may be recovered by the administrator (clause 10(2)(d)); and
(d) the netting and any payment made by the party under the AMNA to discharge a net obligation is not to be voidable in the external administration (clause 10(2)(e)).
56.	Clause 10(2)(e) is intended address concerns about the difficulty of establishing the defence to the voidable preferences provisions in relation to payments made under an AMNA.  It is intended that this provision apply to prevent netting from being void as against an external administrator or voidable under any law governing the external administration (see definition of “voidable” in clause 5), including the Corporations Law and Bankruptcy Act 1966.  External administration is also defined broadly to take account of the fact that parties to a netting arrangement may be incorporated in another country (see paragraph (c) of the definition of external administration). 
57.	By giving express recognition to multilateral netting arrangements, clause 10 of the Bill also removes the argument arising from the decision in British Eagle International Airlines Ltd v Campagnie Nationale Air France (1975) 1 WLR 758 that a netting arrangement could be void as contrary to public policy in that it leads to an outcome contrary to the pari passu rule. 
58.	Clauses 10(1) and (2) will apply despite any law, including the specified provisions (clause 10(3)).  For example, they will apply despite section 16(1) of the Banking Act 1959, which provides that if a bank is unable to meet its obligations its assets in Australia are to be available to meet its deposit liabilities in Australia in priority to all of its other liabilities.  This means that the assets of a failed bank will include any net, rather than gross, amounts owing to the bank.  Further, only net obligations owed by the bank under the netting arrangements will be provable in the winding up (rather than the gross obligations) and these will rank behind the protection afforded to depositors under section 16(1).  Section 16(2) of the Banking Act 1959 will operate to ensure that the assets of a bank will be sufficient to satisfy the liabilities to depositors.  Under section 16(2), a bank must hold assets (other than goodwill) in Australia of a value at least equal to the total of all of its deposit liabilities in Australia. 
59.	Although the validity of the netting arrangement as a whole will be protected, there may be circumstances in which the underlying obligation that is netted under the arrangement has all the hallmarks of an unfair preference that would have been voidable had it been settled via direct payment.  In these circumstances the nature of the payment, rather than the mechanism used for its settlement, is what classifies it as an unfair preference.  It would not be appropriate for the Bill to protect a transaction merely because it has been netted.  The Bill therefore provides that where an obligation has been netted, and if it had instead been settled directly it would have been voidable in an external administration, the administrator may recover for the benefit of creditors an amount equal to the amount of the obligation that would have been voidable (clause 10(4)). 
Clause 11 - Application for approval of netting arrangement
60.	A person will be able to apply to the Reserve Bank for approval of a multilateral netting arrangement. 
Clause 12 - Reserve Bank may approve netting arrangement
61.	Clause 12 sets out the matters about which the Reserve Bank must be satisfied before it approves a multilateral netting arrangement. 
62.	The Reserve Bank must be satisfied that systemic disruption in the financial system could result if a participant went into external administration and the arrangement were not approved under this section (clause 12(1)(a)).  This criteria is designed to ensure that only economically significant arrangements have the benefit of clauses 10(1) and (2), and that the approval avoids a knock-on affect to other significant entities in the event that a participant fails.  
63.	In addition, the arrangement must have a coordinator with the resources, competency and integrity to administer the arrangement, provide for netting to occur at least once each business day, require a party to notify the coordinator as soon as practicable of the commencement of an external administration and provide the coordinator with a discretion to exclude the party from the arrangement (clause 12(1)(b), (c), (d) and (e)). 
64.	Clause 12(1)(e)(ii) does not oblige the coordinator of an approved netting arrangement to remove from the arrangement a party who has entered into external administration.  However, the coordinator must have a discretion to do this.  It is envisaged that in most cases the coordinator would remove an externally administered participant.  The discretion is designed to address the exceptional case where this would not be appropriate. 
65.	In addition to the requirement for a party to notify the coordinator of their own external administration, the Reserve Bank must be satisfied that the rules governing the arrangement require any other party to notify the coordinator if they have reasonable grounds to suspect that another party to the arrangement is insolvent (clause 12(1)(f)).  In relation to this obligation, any party who gives notice of the suspected insolvency of another party is protected by qualified privilege (clause 13). 
66.	The Reserve Bank may impose terms and conditions on the grant of any approval (clause 12(2)(b)). 
Clause 13 - Qualified privilege
67.	Clause 13 will confer qualified privilege on a party to an approved netting arrangement who gives notice of the suspected insolvency of another party as required by clause 12(1)(f).  This means that the party is not liable to an action for defamation for giving a notice containing incorrect information unless the notice is given with malicious intent. 
Part 4 – Close-out netting contracts
68.	Part 4 addresses in relation to close-out netting contracts the issues addressed by Part 3 in relation to approved multilateral netting arrangements.  This part of the explanatory memorandum should therefore be read with the part on approved netting arrangements.  The term close-out netting contract is defined in clause 5. 
69.	Part 4 will put the following matters beyond doubt: 
(a) A master agreement for close-out netting is not contrary to any public policy rule against divestment on insolvency.
(b) A master agreement for close-out netting can effectively make the alienation of interests under a financial markets contract subject to the netting provisions.
(c) The ‘single contract’ approach taken in some master agreements for financial markets transactions is effective to prevent the liquidator of a failed counterparty from ‘cherry-picking’ by disclaiming unfavourable contracts.
(d) Amounts payable in a foreign currency can be converted to Australian currency at the rate of exchange applicable at the time of close-out, and non-debt obligations can be converted to debts by being valued at the time of close-out in accordance with the financial markets contract.
(e) The appointment of an administrator does not inhibit close-out netting.
Clause 14 - Effectiveness of close-out netting contracts
70.	Clause 14 is similar in effect to clause 10, concerning approved netting arrangements.  The term close-out netting contract is defined in clause 5. 
71.	Clause 14(1) preserves the validity of the netting provisions in a contract.  It only applies to close-out netting contracts that are both governed by Australian law and within Commonwealth constitutional reach (clauses 14(1)(a) and (b)).  It is otherwise similar to clause 10(1). 
72.	Clause 14(2) preserves the validity of close-out netting contracts on the external administration of a party to a contract where Australian law governs either the external administration or the contract.  
73.	The exclusion of an obligation acquired from another person with notice that the other person was insolvent is intended to prevent a party to a close-out netting contract from buying in debts with a view to setting them off against its obligations under the netting contract where the counterparty is insolvent (clause 14(3)). 
74.	Clauses 14(1) and (2) will have effect despite any other law.  For the avoidance of doubt, the Bill also provides that they are to have effect despite the specified provisions (clause 14(4)). 
75.	Obligations will also not have the benefit of clauses 14(1) or (2) if they would amount to a voidable preference (clause 14(5)). 
Clause 15 - Declaration that section 14 does not apply
76.	The netting arrangements approved under clause 10 would usually fall within the definition of close-out netting contract and therefore have the benefit of clause 14.  However, Part 3 contains a number of safeguards not required of close-out netting contracts.  For example, an approved netting arrangement must net at least once each business day.  This requirement is intended to put a break on the building up of liabilities under an approved netting arrangement. 
77.	Clause 15(1) will allow the Reserve Bank to make a declaration in relation to future close-out netting contracts, the effect of which will be to take those contracts outside the definition of close-out netting contract (see paragraph (d) of the definition of close-out netting contract, discussed above). 
Part 5 – Market netting contracts
78.	Part 5 addresses in relation to market netting contracts the issues addressed by Part 3 in relation to approved netting arrangements.  This part of the explanatory memorandum should therefore be read with the part on approved netting arrangements.  The term market netting contract is defined in clause 5. 
79.	The Bill will put the following matters beyond doubt: 
(a) The novation of market-netting contracts where they seek to achieve this.
(b) The efficacy of netting to produce a single settlement amount (either positive or negative) for settlement.
(c) The ability of the netting market to use cash margins and security for margins in accordance with the rules of the netting market to meet the obligations of a broker, without interference by the broker’s clients.
Clause 16 – Effectiveness of market netting contracts
80.	Clause 16(1) preserves the validity of market netting contracts that are both governed by Australian Law and within Commonwealth constitutional reach (clauses 16(1)(a) and (b)).  It is otherwise similar to clause 10(1). 
81.	Clause 16(2) preserves the validity of market netting contracts on the external administration of a party to the contract where Australian law governs either the external administration or the contract.  Clauses 16(2)(c), (d), (e), (f) and g(i) and (ii) correspond to Clauses 10(2) (a), (b), (c), (d) and (e) of the Bill.  Clause 16(2)(g)(iii) will extend the validation provided by the Bill to contracts entered into in accordance with the rules of a netting market requiring the netting of deposits and margins and the realisation and netting of securities. 
82.	Clauses 16(1) and (2) will have effect despite any other law.  For the accordance of doubt, the Bill provides that they are to have effect despite the specified provisions (clause 16(3)). 
83.	Clause 16 does not include a provision corresponding to clauses 10(4) or 14(3).  Clause 10(4) will allow the administrator of a participant in an approved netting arrangement to recover netted payments that would have been voidable preferences had they not been netted.  Clause 14(3) will have a similar effect in relation to close-out netting contracts.  
84.	Transactions undertaken on a netting market are ordinarily undertaken anonymously.  The parties are therefore not able to consider the solvency of the other party, and whether they should withdraw from the transaction because it would amount to a voidable preference.  Also, the netting arrangements are mandated under the rules of the netting market, and therefore the parties are unable to opt out of them.  For these reasons, it would not be appropriate to allow transactions undertaken on a netting market to be unwound because they involved a voidable preference. 
Part 6 – Administration
Clause 17 - Prescribed forms
85.	Clause 17 provides that where the Bill requires a person to use a prescribed form for the purposes of the Bill, and no form is prescribed by the regulations, then the Reserve Bank may prescribe a form. 
Clause 18 - Regulations
86.	Clause 18 will allow the Governor-General to make regulations for the purposes of the Bill.