Sweden
Financial Sector Assessment Program Update-Detailed Assessment of Observance on NASDAQ OMX DM Observance of the CPSS-IOSCO Recommendations for Central Counterparties

This paper is a detailed assessment of NOMX DM, undertaken in the context of the IMF Financial Sector Assessment Program (FSAP) Update for Sweden in 2011. NOMX DM, the only Central Counter-parties (CCP) in Sweden, has provided clearing services for equity, fixed income derivatives, and repo transactions since 2010. Even though NOMX DM has a comprehensive risk management framework, relevant points were brought up in the assessment related to governance and risk management. Swedish authorities have taken necessary measures to improve the system.

Abstract

This paper is a detailed assessment of NOMX DM, undertaken in the context of the IMF Financial Sector Assessment Program (FSAP) Update for Sweden in 2011. NOMX DM, the only Central Counter-parties (CCP) in Sweden, has provided clearing services for equity, fixed income derivatives, and repo transactions since 2010. Even though NOMX DM has a comprehensive risk management framework, relevant points were brought up in the assessment related to governance and risk management. Swedish authorities have taken necessary measures to improve the system.

I. Information and Methodology Used for Assessment

1. The assessment of NOMX DM against the CPSS/IOSCO Recommendations for Central Counterparties (RCCPs) was undertaken in the context of the IMF’s Financial Sector Assessment Program (FSAP) Update for Sweden, March 9–22, 2011.1 Prior to the mission, NOMX DM conducted a comprehensive and clear self-assessment following the methodology of the RCCPs published in 2004. The assessor also benefited from discussions with FI, RB, as well as NOMX DM senior management and staff, and some participants in the system. The Swedish authorities were fully cooperative and all relevant documentation to fulfill the assessment was made readily available. Relevant authorities and the operator of the system have been very cooperative in providing supplemental information and organizing additional meetings, when required.

II. Institutional and Market Structure—Overview

2. NOMX DM, as the only CCP based in Sweden, provides CCP services for equity and fixed income derivatives, as well as repos transactions since 2010. It clears products issued in SEK, DKK, NOK, EUR, but the bulk of the products are in SEK. Products cleared are either exchange traded on Nordic markets operated by NOMX Group or OTC traded but highly standardized.

3. NOMX DM has no specific legal existence, but is included within NOMX STO which operates the Swedish stock exchange. NOMX STO is a subsidiary of NOMX Nordic Limited which belongs to the NOMX Group, an international group that offers services for trading securities in more than 50 countries. In 2008, NOMX Group acquired Nord Pool Clearing, a CCP in power derivatives and other contracts traded on the Nord Pool power exchange in Norway. In December 2009, Nord Pool Clearing was incorporated in NOMX STO and its activities have been conducted since then as a Norwegian branch of NOMX STO (see chart above and figures below).

Table 1.

Sweden: Key Statistics of NOMX DM, 2006–10

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Source: RB.

III. Regulatory Framework and Oversight

4. NOMX STO is authorized as an exchange and has a permit from FI to conduct clearing operations in accordance with the Securities Market Act. NOMX STO is subject to supervision by Finansinspektionen (FI). As NOMX DM is a secondary legal name (brandname) for NOMX STO, the same legal status and supervision applies to NOMX DM as to NOMX STO. NOMX DM is also subject to the Riksbank’s (RB) oversight. Both FI and RB cooperate to monitor NOMX DM activities. In conducting their supervisory and oversight responsibilities regarding NOMX DM, FI and RB apply the RCCPs.

IV. Main Findings

Legal framework (Rec. 1)

5. NOMX DM clearing activities are governed by a consistent and solid set of laws, rules, and contractual provisions. In particular, this legal framework supports the enforcement of transactions, netting procedures, protection of customer assets, and delivery-versus-payment (DvP) with finality. There are adequate rules for addressing the event of a participant default, including the effective use of collateral, and these rules can legally be enforced.

Participation requirements (Rec. 2)

6. NOMX DM access and exit criteria are well defined and publicly disclosed. NOMX DM requirements for participants’ financial resources and operational reliability are defined according to membership category. All members must be regulated entities and must have a minimum capital requirement. They also must have adequate operational capability. NOMX DM has procedures in place to monitor participation requirements are met on an ongoing basis. However, direct pledge end customers, which are characterized by having direct relationships with NOMX DM, are not subject to specific requirements though NOMX DM has direct counterparty risk with them. NOMX DM should set participation requirements for direct pledge end customers.

Financial risk management (Rec. 3–6)

7. NOMX DM has a comprehensive risk management framework composed of objectives, measures, and tools. NOMX DM monitors its participants’ exposure on a real time basis, and conducts intraday calls for margins when a specific threshold is hit. NOMX DM regularly validates coverage of the models and parameters used to determine margin requirements.

8. In the absence of a mutualized default fund, the financial resources set aside to face extreme losses are brought by NOMX STO itself, which might create moral hazard. They are ring-fenced, but through a highly complex mechanism structure which raises several concerns: high complexity which potentially may result in legal uncertainty and delay in having access to the funds in case of needs, thus a lack of liquidity. Within NOMX STO, both trading and clearing activities are conducted and two different clearing activities are conducted under two different brand names: clearing of financial derivatives by NOMX DM and clearing of commodities products by NASDAQ OMX Commodities Markets (NOMX COM). Though both CCPs do not share the same participants, they share the same “regulatory capital” dedicated to cover losses in case of a member’s default. As a consequence, difficulties in one of them could have spillover effects on to the other one. The financial resources do not provide a sufficiently reliable liquidity level. NOMX DM accepts as collateral bank guarantees which by definition are not liquid resources. In addition, these bank guarantees are provided by banks which are also NOMX DM’s members, while two of them are the sole liquidity providers. It should be noted that the interest of access to central bank credit is enhanced by the fact that the highly concentrated nature of the Swedish banking sector makes it nearly impossible for NOMX DM to sufficiently diversify its liquidity providers.

9. NOMX DM default procedures are clearly stated in the system’s rules and published on its website. The structure of customer segregation under the agent clearing model highly facilitates the transfer of collateral and positions of end-customers in case of a member’s default.

Custody and investment risks (Rec. 7)

10. NOMX DM relies on custodian banks, which are also CCP’s members, for collection of collateral, valuation, application of haircuts, compliance with concentration limits. This current set up is risky as NOMX DM may not have access to the collateral in case of a custodian default. In addition NOMX DM does not sufficiently monitor the activities of the custodians. NOMX DM has no real time knowledge on the composition of collateral collected as well as no ex post information on it, except when it conducts a test once in a year.

Operational risk (Rec. 8)

11. NOMX DM identifies and analyses source of operational risks through a framework also encompassing outsourced operations. NOMX DM has two mirrored sites and a Business Continuity Plan (BCP) in place which is regularly tested. The operational risk is under the scope of Internal Audit.

Money settlements (Rec. 9)

12. NOMX DM uses the central bank model for SEK and DKK which represent 99 percent of settlement flows. Payments made and received by NOMX DM are effected on its accounts with RB and Nationalbank. Payments made and received through commercial banks are negligible and not relevant from a risk management perspective.

Physical deliveries (Rec. 10)

13. NOMX DM deliveries of securities are carried out through securities settlement systems that ensure DVP, thus eliminating the risk of payment without delivery, and its obligations for physical delivery are clearly stated

Risks in links between CCP (Rec. 11)

This recommendation is not applicable since there is no link in place.

Efficiency (Rec. 12)

14. NOMX DM reviews its pricing and service levels, as well as capacity level on a regular basis and it performs periodic benchmarking studies with other CCPs in other European countries to assess its costs and fees.

Governance (Rec. 13)

15. Governance arrangements of NOMX DM are clearly specified and information about them is publicly available on the website. They support robust risk management by a separation in the reporting lines between risk management and other operations. In both the Clearing risk committee and the Default committee, the head of risk management has a veto power. NOMX DM does not sufficiently request feedback on its clearing services from members on a multilateral basis. Participants are not represented on NOMX STO Board or through participant committees within NOMX DM that would bring their specific perspectives and interests.

Transparency (Rec. 14)

16. NOMX DM discloses to its clearing members and other market participants its rules as well as relevant documentation in an easy to understand style on its website. These rules and documents cover, among other things, the rights and obligations of participants, procedures for handling risks, and fees for using its services. NOMX DM has published a comprehensive self-assessment following the RCCPs assessment methodology.

Regulation and oversight (Rec. 15)

17. The legal basis for an effective regulation and oversight exists. FI and RB have the ability and the resources to carry out regulation and oversight activities effectively. The responsibilities as well as roles and major policies of FI and RB are clearly defined and publicly disclosed. FI and RB require NOMX DM to provide information necessary for regulation and oversight. However, they do not have a sufficient level of information and understanding of the activities conducted by NOMX COM which would be required by the spillover effects this latter one could have on NOMX STO and notably NOMX DM. FI and RB cooperate with each other and with other relevant authorities, but efficiency gains may be reaped by more effective cooperation and by adopting a more risk based approach.

Table 2.

Detailed Assessment of Observance of NASDAQ OMX Clearing of the CPSS-IOSCO Recommendations for Central Counterparties

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Table 3.

Summary of the Detailed Assessment of the Observance of NOMX DM with the CPSS-IOSCO Recommendations for Central Counterparties

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Table 4.

Key Recommendations

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Table 5.

Additional Recommendations

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V. Authorities’ Response to the Assessment

18. The Swedish authorities welcome the detailed assessment of NASDAQ OMX Derivatives Markets carried out by the IMF. The recommendations are constructive and we look forward to using them in our supervisory and oversight processes. Work has already been initiated in response to many of the views expressed in the assessment and plans are being developed in order to analyze the remaining comments. The Swedish authorities have the following comments to the recommendations currently graded as not fully observed by IMF.

Recommendation 2: Participation requirements

19. The assessment correctly states that a process for setting specific requirements for direct pledge clients is under way. The Swedish authorities agree with the recommendation and are following the progress and development closely.

Recommendation 4: Margin requirements

20. NASDAQ OMX Derivatives Markets (NOMX DM) currently accepts bank guarantees as collateral for clearing, which according to the assessment is undesirable as they are illiquid and rely on institutions which are also members of NOMX DM. The recommendation is sensible and the Swedish authorities will enter into discussions with NOMX DM about the use of bank guarantees as accepted collateral.

Recommendation 5: Financial resources

21. In order to adjust to coming European regulation, NOMX DM is running a project to introduce a default fund. The Swedish authorities follow this project and will give recommendations to NOMX DM on how to set up its financial resources in the future. Furthermore, a review of the liquidity framework is also taking place. The Swedish authorities will further consider the recommendation given regarding legal separation of clearing and trading.

Recommendation 7: Custody and investment risks

22. NOMX DM is, as expressed in the assessment, currently in the middle of a project aiming to introduce a new collateral management system in 2012. Swedish authorities are monitoring the progress, which will address the current shortcomings.

Recommendation 13: Governance

23. Swedish authorities will, in line with the assessment, engage NOMX DM to ensure that members are appropriately involved in the governance, also when it comes to the clearing activities. Further involvement from the members will most likely also come natural due to other developments within NOMX DM.

Recommendation 15: Regulation and oversight

24. Relevant points were brought up in the assessment, and the comments are taken seriously by the Swedish authorities.

1

The assessment was prepared by Philippe Troussard from Banque de France.