United Kingdom
Observance by LCH CLEARNET LIMITED of the CPSS-IOSCO Recommendations for Central Counterparties Detailed Assessment of Observance
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International Monetary Fund
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In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

Abstract

In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

I. Introduction

A. Objective and Scope of the Assessment

1. This assessment was undertaken in the context of an IMF Financial Sector Assessment Program (FSAP) exercise for the United Kingdom over the period January-July 2011.1 The assessment covered LCH’s observance of the CPSS-IOSCO Recommendations for Central Counterparties (RCCPs).

2. This assessment covers LCH.Clearnet Limited (LCH), the main CCP active in the U.K.’s financial markets. LCH is a wholly owned subsidiary of LCH.Clearnet Group Limited, which is a private company, limited by shares and registered in the United Kingdom. It is a holding company created as part of a merger in December 2003 to oversee the two wholly-owned operating subsidiaries of the Group; LCH (formerly The London Clearing House Limited), and Banque Centrale de Compensation SA (which trades under the name of LCH Clearnet SA and became an independent legal entity at the time of the merger, having previously been part of the Euronext group of companies).

Scope of coverage of the CCP

3. LCH is one of the main CCPs in Europe, serving major international exchanges and platforms, as well as a range of over-the-counter (OTC) markets. It clears a broad range of asset classes including: securities, exchange traded derivatives, energy, freight, interbank interest rate swaps, and euro and sterling denominated bonds and repos. LCH operates in a number of currencies,2 among which the main ones are sterling, euro and U.S. dollar.

4. LCH provides CCP services for:

  • London Stock Exchange (LSE);

  • NYSE Euronext LIFFE (LIFFE);

  • London Metal Exchange (LME);

  • EDX London;

  • SIX Swiss Exchange;

  • Nodal Exchange; and

  • Several European Multilateral Trading Facilities (MTFs).

In addition, it offers a number of OTC derivatives services, most notably SwapClear for interest rate swap and RepoClear for cash bond and repo trades in the following markets: Austrian, Belgian, Dutch, German, Irish, Finnish, Portuguese, Slovakian, Slovenian, Spanish, and U.K. government bonds.

Institutional and market structure

5. Currently, in addition to LCH, there are two CCPs based in the United Kingdom and two more are expected to begin operations in 2011 and 2012:

  • EuroCCP, a subsidiary of the U.S. DTCC, was implemented in August 2008 to clear equities from issuers in 19 markets traded on multilateral trading facilities and stock exchanges in Europe.

  • ICE Clear Europe, a subsidiary of the U.S. Intercontinental Exchange (ICE), began providing clearing services for the futures markets of ICE Futures Europe and ICE’s OTC energy markets in 2008, and in July 2009 launched separate clearing services for credit default swaps (CDS).

  • In addition, U.K. regulators gave approval in December 2010 to Chicago Mercantile Exchange (CME) Group to launch clearing for the OTC derivative trades in London in early 2011, through CME Clearing Europe, a subsidiary of CME.

  • Finally, NYSE/EURONEXT has announced its project to provide a dedicated CCP to clear LIFFE’s transactions by 2012.3

In addition, several non-U.K. CCPs hold a Recognized Overseas Clearing House license, which allows them to clear U.K. securities and derivatives outside the United Kingdom.

6. U.K. equities are traded across a number of trading platforms, including exchanges and Multilateral Trading Facilities (MTFs). In 2010, in terms of value, around 60 percent of equities were traded on the LSE and cleared via LCH and SIX x-clear. The remainder of equity trading was undertaken over-the-counter, and through the MTFs, mostly Chi-X, BATS and Turquoise, with Chi-X and BATs cleared by EMCF, and Turquoise cleared by Euro CCP. The PLUS Markets exchange offers trading in the alternative, junior equities market (AIM) and is cleared by LCH. Transactions are settled in CREST; Euroclear Bank SA/NV (Euroclear), the Brussels-based International Central Securities Depository (ICSD); and SegaInterSettle (SIS), and the Zurich-based ICSD.

7. Bond trading is undertaken via MTFs, bilateral trading systems, and voice brokers. Part of it is cleared by LCH.

8. Financial derivatives are traded at LIFFE and EDX, and commodity derivatives at the LME and LIFFE, with clearing taking place at LCH. LCH together with Nodal Exchange provides trading and clearing of cash settled financial Nodal power contracts in North America.

9. In terms of volume cleared by LCH.Clearnet Group Limited, the overall trade volume for 2009 was down on the previous year at 1.6 billion (just over two billion contracts in 2008), volume falling most in equity and listed derivative markets. RepoClear and SwapClear, which are LCH’s two flagship OTC clearing services, have held up well: SwapClear currently clears more than 40 percent of the interest rate swap market, representing trades with a total notional principal of $248 trillion. RepoClear clears 250,000 traded sides per month, representing a nominal value of €11 trillion.

Regulatory structure—overview

10. The current tripartite structure in the United Kingdom was established in 1997. It brings together those authorities with responsibilities connected to financial stability—HM Treasury (HMT), the Financial Services Authority (FSA) and the Bank of England (the BoE). The Memorandum of Understanding (MoU) between HMT, the BoE, and the FSA (2006) sets out the respective roles of each authority:

  • The treasury is responsible for the overall institutional structure of financial regulation and the legislation which governs it, including the negotiation of European directives; informing, and accounting to Parliament for the management of serious problems in the financial system and any measures used to resolve them; and accounting for financial sector resilience to operational disruption within government.

  • The FSA is responsible for, inter alia, the supervision of financial markets, securities listings and of clearing and settlement systems; the conduct of operations in response to problem cases affecting firms, markets and clearing and settlements systems within its responsibilities; and regulatory policy in these areas, including that intended to promote the resilience to operational disruption of authorized firms and Recognized Bodies.

  • The BoE contributes to the maintenance of the stability of the financial system as a whole—one of its two core purposes. This includes overseeing financial system infrastructure systemically significant to the United Kingdom, in particular payments systems whether based in the United Kingdom or abroad. It falls to the BoE to advise the Chancellor, and answer for its advice, on any major problem arising in these systems. The BoE is also closely involved in developing and improving the infrastructure and strengthening the system to help reduce systemic risk.

11. Regulation and oversight of LCH is carried out by the FSA and the BoE. The FSA is the main regulator of LCH as a Recognized Clearing House, while the BoE’s oversight remit focuses on LCH’s inter-bank payment system.

12. February 2011 treasury’s consultation indicates that the government intends to transfer regulation and supervision of CCPs to the BoE by end 2012. Under the proposed framework, the BoE would be directly responsible for supervising the providers of systemically important infrastructure. It would, therefore, remain the regulator of payment systems under Part 5 of the Banking Act 2009 and it would take over the FSA’s responsibility for regulating settlement systems under the Uncertificated Securities Regulations 2001. The BoE would also be the regulator of central counterparties under the FSMA. This would bring the regulation of all three types of body together for the first time.

Information and methodology used for assessment

13. During the 2002 FSAP, a detailed assessment was made of CREST against the RSSS, including RSSS4 on central counterparties where LCH was assessed on a global basis. No detailed assessment of LCH was conducted since the CPSS-IOSCO had not released the RCCP at that time. LCH was, in June 2006, assessed by the FSA and the BoE against the RCCPs. In 2009, LCH conducted a self-assessment against the RCCPs. The FSA reviewed it, together with additional material requested in support of it, and validated it at end 2009, with the BoE’s input on recommendations relating to LCH’s payment arrangements. For the FSAP mission, the FSA provided the 2009 assessment, which is published on LCH Clearnet’s website, and a summary of the main changes having affected the system since then. It also provided a number of documents relevant for the assessment. Extensive meetings were held with officials from the FSA and the BoE, supplemented by discussions with officials from LCH as well as with three LCH members and settlement banks, and two exchanges.

14. The Assessment methodology used was the one developed in parallel with the CCP recommendations themselves in 2004. In accordance with the assessment methodology, the assignment of an assessment category with respect to a recommendation is based on the current situation existing without regard to any proposed or ongoing actions. Material changes underway are presented in the description and/or comment sections.

15. Each recommendation was assessed on a qualitative basis based on a five-fold assessment categorization: observed, broadly observed, partly observed, non-observed, and not applicable. The categorization follows the guidelines in the assessment methodology. As a general principle, a recommendation is considered observed whenever all assessment criteria are generally met without any significant deficiencies. A Recommendation is considered broadly observed whenever only minor shortcomings are found, which do not raise major concerns and when corrective actions to achieve full observance with the Recommendation are scheduled and realistically achievable within a prescribed period of time. A Recommendation is considered partly observed whenever the shortcomings are sufficient to raise doubts about the ability to achieve observance within a reasonable time frame. A Recommendation is considered non-observed whenever major shortcomings are found in adhering to the assessment criteria. Whenever a Recommendation is assessed to be broadly, partly or non-observed, suggestions are proposed for achieving full observance. A Recommendation is considered not applicable whenever it does not apply given the structural, legal, and institutional conditions.

16. No obstacles were faced in the work. The authorities and others were fully cooperative.

II. Detailed Assessment

A. Executive Summary of the Recommendation by Recommendation Assessment

17. The regulation of LCH by the FSA and the oversight of its payment arrangements by the BoE are ground in statute. A clear legal basis exists for LCH to act as a CCP, and for its netting arrangements, rights in collateral, and its procedures upon default. Where necessary, LCH protects itself further by obtaining or requiring legal opinions.

18. LCH sets and monitors requirements for its members that depend on and are commensurate with the type of membership and the markets to be cleared. These include minimum levels of financial resources and credit worthiness, and an appropriate level of operational capacity.

19. LCH regularly measures its exposures to members, and this is done using intraday positions in all markets except the LIFFE one. LCH should develop a routine capacity for doing so in the LIFFE market. LCH limits its exposures to potential losses from default through a variety of measures, including membership requirements, collection of initial margin including additional margin where necessary, contributions to a default fund, and the monitoring of position limits. Even though there is risk mutualization through a single default fund, the main focus is on initial margins, mostly following a defaulter-pay model.

20. LCH uses various initial margin models for the different markets it clears, such as SPAN, PAIRS, and ERA. Its margining assumptions are generally conservative, and it regularly back-tests the intended coverage. LCH can and does make both routine and ad hoc intraday margin calls, subject to a minimum transfer threshold. For the LIFFE market, if prices are particularly volatile, then LCH will make an intraday call based on the previous day’s positions. LCH should develop a routine capacity to do so using current positions. LCH takes a conservative approach with regard to its collateral eligibility for initial margin.

21. LCH has designed its default fund, which is comprised only of cash, in order that it will have sufficient resources to cover more than the single largest default. This is tested daily using historical and theoretical scenarios, with end-day positions. In the event of a default, LCH needs access to sufficient liquidity to fulfill its obligations in a timely manner. LCH’s liquidity management is comprehensive and conservative, but it should put in place other safe and reliable funding options, which should include committed credit lines subject only to presentment, and could also include other options like mutualization of liquidity risk among the CCP’s membership. This would help it face extreme but plausible circumstances, such as disruptions to its tri-party repo arrangements or dislocations in the repo market.

22. In the event of a default, LCH has broad authority to close out the defaulter’s contracts, transfer its open contracts, and sell its securities. LCH has an internal Default Management Framework, which provides a reference guide and a high-level and detailed operational procedures manual to assist in the process of managing issues that will arise as a consequence of a default. In the event of a default, it would be in close contact with its regulators. LCH has successfully managed five defaults, and discussions with regulators and market participants suggest that the Lehman default was managed effectively.

23. LCH’s Treasury Investment Policy is comprehensive and conservative, with safety taking priority over revenue maximization. The vast majority of cash is secured, and the policy outlines minimum credit rating criteria for its counterparties, concentration limits at the counterparty group level, diversification of assets, and criteria to mitigate interest rate risk. Noncash collateral is mainly held at two European Central Securities Depositories (CSDs), and one custodian bank in the United States. LCH needs to confirm that the U.S. custodian it employs, and any new custodians it uses, conform to Recommendation 12 of the RSSS (i.e. that they employ accounting practices and safekeeping procedures that fully protect customers’ securities).

24. The system is reliable and secure, and has adequate, scalable capacity. Contingency plans and back-up facilities are in place to allow for timely recovery of operations and completion of the settlement process. However, there is no compulsory contingency testing for the largest participants, and no second IT back-up site (three sites architecture).

25. LCH mainly uses a private settlement bank model, which exposes the CCP to intraday credit risk. LCH should find a way to reduce its settlement exposures, with settlement in central bank money when possible and practicable.

26. The CCP clearly states its obligations with respect to physical deliveries. The risks from these obligations are identified and managed.

27. LCH currently interoperates with the Swiss CCP SIX x-clear in the clearing of trades executed on the London Stock Exchange and on the SIX Swiss Exchange; and with Oslo Clearing for the EDX market. Each link is a peer-to-peer model, in which both CCPs lodge initial margin with the other CCP, and either CCP can be placed in default should it fail to meet its contractual arrangement to the other CCP. Each CCP calculates the margin it requires from the other using the standard margin methodology it applies to its members. However, neither CCP contributes resources to the other’s default fund, to minimize contagion risk from defaulting members between the CCPs. Inter CCP exposures are collateralized. LCH has also applied to interoperate with EuroCCP and EMCF. This is under review by the competent authorities.

28. LCH has in place procedures to control its costs of operation and undertakes regular analysis and benchmarking on charges. Over the past three years, competition has led to significant fee reductions.

29. A three-year program to align the ownership of the Group more closely to its users through a significant share buyback came to an end in 2009. LCH.Clearnet Group Limited is now owned 83 percent by its users and 17 percent by exchanges that clear through it. As a U.K. incorporated company, LCH’s Board and management are accountable to the shareholders. The Board includes four independent Board members (including the Chairman). LCH publishes its rules and procedures for the various markets cleared, together with information on risk management, application costs and procedures, minimum contributions towards (and interest rates on) the default fund, and the transaction tariffs. Margin calculation models are provided to the participants; but not the CCP’s activity statistics, nor its detailed objectives4 and the extent to which they are met.

30. The role and responsibilities of relevant public authorities with respect to clearing activities are clearly defined and transparent. The CCP’s supervision and oversight are risk-based and thus are implemented on a prioritization basis. They have been strengthened since the crisis, both at the BoE and the FSA. Hiring and keeping the right expertise is challenging. The government intends to transfer regulation and supervision of central counterparty clearing houses to the BoE by 2013.

Table 1.

United Kingdom: Collation of Assessment Results by Assessment Category

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Table 2.

United Kingdom: Detailed Assessment of Observance of the Recommendations for Central Counterparties

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B. Recommended Actions

Table 3.

United Kingdom: Actions to Achieve Observance

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Table 4.

United Kingdom: Additional Actions

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C. Authorities’ Response to the Assessment

31. The UK authorities welcome this assessment of the LCH.Clearnet Ltd (LCH) against the CPSS IOSCO recommendations for central counterparties (RCCPs).

32. The UK’s supervision and oversight of LCH has changed since the financial crisis. It is therefore reassuring that the IMF notes the strengthened supervision and oversight of LCH.

33. The assessment identifies recommended action which would improve observance with the RCCP and the UK authorities will consider and review all of the assessors’ recommendations.

34. Finally, the authorities wish to express their strong support of the Financial Sector Assessment Program initiative and look forward to a continuing dialogue with the IMF and other global counterparts to seek to improve the stability and effective supervision of the global financial system.

1

The assessors were Christine Sampic, IMF Senior Financial Sector Expert, and Nikil Chande, Principal Researcher in the Department of Financial Stability at Bank of Canada.

2

Australian dollar, Canadian Dollar, Swiss franc, Czech koruna, Danish kroner, euro, sterling, Hong Kong dollar, Hungarian forint, Islandic krona, Japanese yen, Norwegian krone, New Zealand dollar, Polish zloty, Swedish krona, South African rand and the U.S. dollar.

3

Today LIFFE’s transactions are technically cleared by LCH Clearnet Limited.

4

They can be provided on demand and were presented to 10 of LCH’s largest customers in January 2011.

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United Kingdom: Observance by LCH CLEARNET LIMITED of the CPSS-IOSCO Recommendations for Central Counterparties Detailed Assessment of Observance
Author:
International Monetary Fund