2013/14 Assessment of LCH.Clearnet Limited's SwapClear Service Appendix A: Detailed Assessment of LCH.Clearnet Limited against the Financial Stability Standards

Introduction

This Appendix assesses LCH.C Ltd's SwapClear service against the CCP Standards that came into effect since the Bank's last assessment in June 2013.[1]

Standard 3: Framework for the Comprehensive Management of Risks

A central counterparty should have a sound risk management framework for comprehensively managing legal, credit, liquidity, operational and other risks.

LCH.C Ltd has identified two broad scenarios that could potentially prevent it from being able to provide its critical operations and services as a going concern: exposure to losses arising from clearing participant defaults; and non-clearing-participant-default losses. LCH.C Ltd's Recovery Plan sets out how it would continue its operations if it suffered extreme losses, and its Wind-down Plan sets out how it would cease its operations in an orderly way. It is expected that the resolution arrangements that would apply to LCH.C Ltd following a crisis will be discussed further with the BoE and other regulators over coming months.

3.5 A central counterparty should identify scenarios that may potentially prevent it from being able to provide its critical operations and services as a going concern and assess the effectiveness of a full range of options for recovery or orderly wind-down. A central counterparty should prepare appropriate plans for its recovery or orderly wind-down based on the results of that assessment. Where applicable, a central counterparty should also provide relevant authorities with the information needed for purposes of resolution planning.

LCH.C Ltd has a Recovery Plan and Wind-down Plan that sets out how it would continue or cease, respectively, its operations if it suffered extreme losses. The Recovery and Wind-down Plans apply to all of LCH.C Ltd's services, although individual services could be wound down while other services continued operating. LCH.C Ltd has identified two broad scenarios that could potentially trigger these plans: exposure to losses arising from clearing participant defaults; and non-clearing-participant-default losses arising from, for example, fraud or treasury investment losses.

LCH.C Ltd discusses these scenarios and the ways that it would respond to them in detail in its Recovery Plan and Wind-down Plan. In addition, the Wind-down Plan describes how LCH.C Ltd would voluntarily cease operating.

Recovery

The Recovery Plan sets out how LCH.C Ltd would continue its operations if it suffered extreme losses. The Plan largely utilises existing rules and working practices, with additional analysis to consider the risks of applying these rules and working practices in times of market stress.

The LCH.C Ltd Board approved the Recovery Plan in April 2014. The Recovery Plan was developed by the Recovery and Resolution Plan Programme (RRP) Board, which consisted of senior representatives from across the LCH.C Group from compliance, finance, risk, legal and CaLM. The RRP Board was established only for the initial creation of the Recovery Plan; subsequent reviews of the plan will be coordinated by the COO and approved by the LCH.C Ltd Board. The Recovery Plan will be reviewed annually and following material changes to LCH.C Ltd's business model, rules and procedures. The Bank also expects LCH.C Ltd to review its Recovery Plan in light of CPSS-IOSCO guidance on recovery, when finalised. The COO is also responsible for overseeing implementation of the Recovery Plan, in conjunction with the LCH.C Ltd Management Committee and Board.

The Recovery Plan discusses the circumstances in which it would be triggered and the recovery tools that would be available. In the event of a clearing participant default, the Recovery Plan would be triggered when prefunded default funds for a given service were exhausted. In the event of a non-clearing-participant-default loss, the Recovery Plan would be triggered by treasury investment losses greater than €15 million arising from the default of an issuer of a debt instrument (such as a sovereign) or the default of an investment counterparty. It would also be triggered by operational or general business risk losses that consumed the regulatory capital that LCH.C Ltd holds against these risks. Finally, the Recovery Plan would be triggered by liquidity shortfalls that arose from a clearing participant default or non-clearing-participant-default loss.

With respect to uncovered credit losses and replenishment in the SwapClear service, LCH.C Ltd has powers to call funds from non-defaulting clearing participants (see Standard 4.8 for more information). First, it has powers to call for Unfunded Contributions from non-defaulting clearing participants to the value of their last default fund contribution, once for each default, subject to a maximum of three defaults in any six-month period. Second, LCH.C Ltd would invoke its Loss Distribution Process and subject the cumulative net gains owed to non-defaulting clearing participants to haircuts. This process would end if the amount called from a single non-defaulting clearing participant reached the higher of £100 million or the value of its previous default fund contribution (unless this cap was raised by way of all non-defaulting clearing participants agreeing to this). Third, LCH.C Ltd would ask non-defaulting clearing participants to make voluntary contributions. If insufficient voluntary payments were made to cover the remaining credit losses, LCH.C Ltd would close the SwapClear service and remaining credit losses would be allocated to non-defaulting participants on a pro-rata basis.

LCH.C Ltd also has rules in place to ensure, once the default management process was complete, that the SwapClear default fund would be replenished by contributions from non-defaulting clearing participants within two days to at least the value of the SwapClear default fund floor, which is currently set at £1 billion. The default fund would be replenished to its full level after 30 days.

If a default at the SwapClear service (or any individual service) was large enough to exhaust the specified default resources available for that service, that individual service could be closed while leaving the remaining services operational.

LCH.C Ltd has recently determined, for the purposes of complying with separate UK legislation, the potential non-clearing-participant-default loss events that are considered solvency-threatening. Accordingly, it has identified the tools to recover from these scenarios as shown below.

  • Investment-related losses caused by the default of an issuer of a debt instrument or an investment counterparty. The first €15 million of such a loss would be allocated to LCH.C Ltd, with the remainder allocated to clearing participants in proportion to each clearing participant's average margin weight. Rules to allocate investment losses to clearing participants came into force in May 2014.
  • Other non-clearing-participant-default losses. LCH.C Group holds insurance policies that provide protection against various operational and business risks. LCH.C Ltd also holds capital against business and operational risks. It could also utilise its surplus capital to cover any remaining losses.

LCH.C Ltd has undertaken analysis of underlying structural weaknesses that could contribute to non-clearing-participant-default losses. This analysis identified two types of weaknesses: operational issues, such as the failure of a settlement bank; and general business risks, such as the poor performance of a business line. It has addressed operational issues through contingency plans embedded in its Business Continuity and Recovery Plans and the Group Settlement, Payment and Custodian Risk Policy. The LCH.C Ltd Management Committee is responsible for overseeing general business risks.

LCH.C Ltd has a number of tools to deal with liquidity shortfalls that would be caused by a clearing participant default or non-clearing-participant-default loss. These tools are discussed in CCP Standard 7.9.

LCH.C Ltd has a capital raising strategy in place that would replenish capital used in loss allocations as part of the Recovery Plan. Capital would likely be raised by LCH.C Group and provided to LCH.C Ltd rather than raised directly by LCH.C Ltd.

Wind-down

The Wind-down Plan sets out how LCH.C Ltd would cease its operations in the event of a clearing participant default, a non-clearing-participant-default loss, or a decision to wind-down voluntarily. The plan includes detailed estimates of how LCH.C Ltd would shut down its operations and how long this would take, which affects the amount of capital that must be set aside for this purpose (see CCP Standard 14.3). The Wind-down Plan was approved in April 2014 by the LCH.C Ltd Board. The Wind-down Plan will be reviewed at least annually or more frequently if there is a material change to LCH.C Ltd's business model; reviews will be coordinated by the COO and approved by the LCH.C Ltd Board.

The decision to wind-down LCH.C Ltd would ultimately be made by the LCH.C Ltd Board, although a number of bodies would be consulted, such as shareholders, the LCH.C Group Board and regulators. With respect to regulators, LCH.C Ltd would primarily consult with the BoE; in turn, it would be expected that the BoE would be involved in discussions with the EMIR and Global Colleges and with the CFTC.

With respect to clearing participant defaults, LCH.C Ltd has determined that its viability would only be likely to be threatened by the closure of several services. In the case of a non-clearing-participant-default loss, wind-down would be triggered by regulatory order or if LCH.C Ltd was at risk of becoming insolvent.

The Wind-down Plan contains estimates of the time it would take LCH.C Ltd to close its operations under the various scenarios, differentiating between the time taken to close critical and non-critical support functions. LCH.C Ltd has determined that it could complete wind-down in less than six months. This would include a period in which clearing participants would be required to flatten their positions so that there were no positions outstanding at the end of the notified termination period. Clearing participants would only be permitted to place new positions in order to close out existing positions or if LCH.C Ltd accepted new positions to help to reduce market impact. Under all scenarios, all staff would become subject to redundancy processes when their roles were no longer required. LCH.C Ltd has plans in place to ensure that key personnel would be retained through the wind-down process.

Resolution

As LCH.C Ltd is a UK-based CS facility, resolution would be expected to be led by the UK's resolution authority, the BoE. Legislation establishing a resolution regime for UK CCPs received royal assent in December 2012, although the relevant legislative provisions are not yet in force and the UK authorities are developing supporting secondary legislation that will establish the date on which the resolution regime for CCPs will enter into force. The crisis management arrangements that would apply to LCH.C Ltd have important implications for all jurisdictions in which LCH.C Ltd operates, including for Australia, and it is intended that LCH.C Ltd's recovery plans and crisis management will be considered further in conjunction with the BoE and other regulators.

Standard 4: Credit Risk

A central counterparty should effectively measure, monitor and manage its credit exposures to participants and those arising from its clearing processes. A central counterparty should maintain sufficient financial resources to cover its credit exposure to each participant fully with a high degree of confidence.

LCH.C Ltd has rules and procedures in place that address how it would meet losses from clearing participant defaults. It has prefunded financial resources from: the defaulting clearing participant's margin; LCH.C Ltd's own resources; and the SwapClear default fund. If those resources were insufficient to meet the losses, LCH.C Ltd has powers to: call for further contributions from non-defaulting clearing participants; withhold amounts owed to non-defaulting clearing participants with cumulative net gain positions; and ask non-defaulting clearing participants to make voluntary contributions. LCH.C Ltd also has powers to call non-defaulting clearing participants for funds to ensure that the SwapClear default fund is at or above its minimum size after the SwapClear Default Management Process was completed. The determination of SwapClear default fund contributions would revert to the usual resizing method 30 days after the SwapClear Default Management Process was completed.

4.8 A central counterparty should establish explicit rules and procedures that address fully any credit losses it may face as a result of any individual or combined default among its participants with respect to any of their obligations to the central counterparty. These rules and procedures should address how potentially uncovered credit losses would be allocated, including the repayment of any funds a central counterparty may borrow from liquidity providers. These rules and procedures should also indicate the central counterparty's process to replenish any financial resources that the central counterparty may employ during a stress event, so that the central counterparty can continue to operate in a safe and sound manner.

Allocation of credit losses

LCH.C Ltd's SwapClear service has rules and procedures that set out how it would cover losses from a defaulting clearing participant. The first level of protection is its prefunded financial resources, which would be applied in the following order:

  • the defaulting clearing participant's margin across all services
  • the defaulting clearing participant's default fund contributions across all services
  • LCH.C Ltd's own resources (€36 million)
  • non-defaulting clearing participants' default fund contributions (as of 30 June 2014, £2.3 billion minus the value of the defaulting clearing participant's contribution).

If the losses were greater than the size of these resources, the service continuity processes within the Default Management Process would be utilised to cover the uncovered credit losses (see Standard 3.5 for more information).

  • First, SwapClear would have powers to call non-defaulting clearing participants for Unfunded Contributions if the default fund was reduced, or if SwapClear determined that it would be likely to be reduced, by 25 per cent or more. The value of Unfunded Contributions for each default would be capped at the value of each non-defaulting clearing participant's last default fund contribution and subject to a maximum of three defaults in any six-month period.
  • Second, SwapClear would have powers to invoke its Loss Distribution Process if uncovered losses remained unallocated. Under this process, SwapClear would allocate uncovered credit losses by not paying the full amount that non-defaulting clearing participants with cumulative net gains since the default (from variation margin, coupons, fees and price alignment interest) were due. Payments to non-defaulting clearing participants with cumulative net gain positions would be determined by the distribution haircut fraction, which is the value of the uncovered loss divided by the total cash gain. At the same time, non-defaulting clearing participants with cumulative net loss positions would be expected to pay the full amount. The Loss Distribution Process would continue each day until the defaulting clearing participant's trades were successfully auctioned and transferred under the SwapClear Default Management Process. The Loss Distribution Process would end if the loss applied to a single non-defaulting clearing participant reached the higher of £100 million or the value of its previous default fund contribution, although this cap could be increased by the agreement of all non-defaulting clearing participants.
  • Third, SwapClear could request that non-defaulting clearing participants make voluntary payments if the Loss Distribution Process cap was reached and uncovered losses remained unallocated. The voluntary payments stage would allow clearing participants or a subset of clearing participants to provide additional funds to keep the service open without requiring unanimous consent from clearing participants. Non-defaulting clearing participants would not be obliged to make voluntary payments and could continue to be SwapClear clearing participants if they did not contribute. LCH.C Ltd acknowledges in the Recovery Plan that there would be a coordination risk associated with this process because clearing participants might refuse to contribute if they expected other clearing participants to do the same.

If insufficient voluntary payments were made to cover the remaining credit losses, SwapClear would make an Insufficient Resources Determination and close the SwapClear service (see Standard 3.5). If the SwapClear service were wound down, all outstanding SwapClear contracts would be closed. SwapClear would unwind payments withheld as part of the Loss Distribution Process and calculate a sum owing between it and each non-defaulting clearing participant. Clearing participants that owed funds would be obliged to pay in full. If there were insufficient funds to meet the claims of participants that were owed funds, these claims would be reduced pro rata. Separately, each clearing participant would be entitled to the return of its cash initial margin, and the amount owed to or from a clearing participant would be set off against the return of any cash initial margin to form a net sum. Non-cash collateral would be returned separately.

Replenishment

SwapClear has rules and procedures to replenish the default fund when the SwapClear Default Management Process is completed. If the value of the SwapClear default fund was lower than the SwapClear Fund Floor (i.e. the minimum size of the default fund – currently set at £1 billion) when the SwapClear Default Management Process was completed, SwapClear would call non-defaulting clearing participants for Supplementary Contributions in order to bring the SwapClear default fund up to no less than the SwapClear Fund Floor. The determination of SwapClear default fund contributions would revert to the usual resizing method 30 days after the SwapClear Default Management Process was completed.

Standard 7: Liquidity Risk

A central counterparty should effectively measure, monitor and manage its liquidity risk. A central counterparty should maintain sufficient liquid resources in all relevant currencies to effect same-day and, where appropriate, intraday and multiday settlement of payment obligations with a high degree of confidence under a wide range of potential stress scenarios that should include, but not be limited to, the default of the participant and its affiliates that would generate the largest aggregate liquidity obligation for the central counterparty in extreme but plausible market conditions.

LCH.C Ltd has arrangements in place to ensure that it has access to sufficient liquid resources to meet its projected payment obligations on time in the event that the two participants and their affiliates that would generate the largest aggregate payment obligations were to default in extreme but plausible scenarios. LCH.C Ltd projects its liquidity needs through liquidity stress testing, and during the Assessment period introduced a framework to reverse stress test its liquid resources. The Bank expects LCH.C Ltd to continue to enhance this framework so that it can demonstrate how its approach to modelling variation margin outflows for the purposes of liquidity stress testing captures a sufficient range of extreme but plausible scenarios.

The actions that LCH.C Ltd would take to address a liquidity shortfall or replenish its liquidity resources are described in the LCH.C Ltd Liquidity Plan and in LCH.C Ltd's Recovery Plan.

LCH.C Ltd has applied to the Bank to open an ESA. LCH.C Ltd proposes to use its ESA to manage its Australian dollar liquidity requirements. The Bank expects to continue to engage with LCH.C Ltd as it refines its Australian dollar liquidity model.

7.3 A central counterparty should maintain sufficient liquid resources in all relevant currencies to settle securities-related payments, make required variation margin payments and meet other payment obligations on time with a high degree of confidence under a wide range of potential stress scenarios that should include, but not be limited to, the default of the participant and its affiliates that would generate the largest aggregate payment obligation to the central counterparty in extreme but plausible market conditions. In addition, a central counterparty that is involved in activities with a more complex risk profile or that is systemically important in multiple jurisdictions should consider maintaining additional liquidity resources sufficient to cover a wider range of potential stress scenarios that should include, but not be limited to, the default of the two participants and their affiliates that would generate the largest aggregate payment obligation to the central counterparty in extreme but plausible market conditions.

Liquidity risk management by LCH.C Ltd is governed by a group-wide Group Liquidity Risk Policy. The policy is written by the LCH.C Group Risk Department and approved by LCH.C Ltd's Board. Each CCP with LCH.C Group must be able to meet its own liquidity requirements independently. LCH.C Ltd also maintains a Liquidity Plan, which describes the principles and procedures that are applied to meet the Liquidity Risk Policy. Within LCH.C Ltd, liquidity is managed at a cross-service level, as liquidity from one clearing service can be used to meet liquidity requirements in other clearing services.

LCH.C Ltd identifies two main sources of liquidity needs:

  • Operational liquidity requirements – that is, business as usual liquidity draws, unrelated to a participant default. These include: repayment of excess cash collateral; changes in margin liabilities; substitution of cash collateral upon participant request; provision of liquidity to facilitate settlement; and an overall reduction in initial margin and thus cash posted for margin coverage.
  • Default liquidity requirements – that is, liquidity requirements in the default of a clearing participant. These include: fulfilment of settlement obligations of the defaulting participant; posting variation margin to non-defaulting participants; potential losses due to liquidation of cleared positions and collateral; and potential investment losses if the defaulting participant is also an investment counterparty.

These liquidity requirements cover needs arising from both direct clearing participants and customers, where relevant.

Other potential draws on liquidity include disruptions in liquidity markets and settlement/payment flows.

To ensure it maintains sufficient liquid resources, LCH.C Ltd sets a ‘default liquidity requirement’ and daily ‘operational liquidity targets’ (discussed below). Together, these form LCH.C Ltd's total liquidity requirement. LCH.C Ltd must maintain a minimum LCR – that is, it must ensure that the value of its available liquid resources relative to its total liquidity requirement is above 100 per cent and a buffer amount set internally.

Monitoring the LCR, as well as other day-to-day management of liquidity risk, is the responsibility of LCH.C Ltd's Collateral and Liquidity Risk Management (CaLRM) function. Any breaches of the LCR must be notified to the ALCo and the ERCo,[2] and ALCo would make recommendations to address the breach (e.g. based on the options discussed in CCP Standard 7.9). CaLRM also monitors variations in the liquidity buffer (the value of available liquidity resources above the stressed liquidity requirement). A material reduction in the value of the liquidity buffer must be immediately reported to ERCo, the Group CRO, the CRO of LCH.C Ltd and the head of CaLRM for LCH.C Ltd, who would determine the action required. In the case of currencies that are less actively traded within the CCP (including the Australian dollar), risk monitoring is conducted as described below.

Operational liquidity targets

To ensure that sufficient liquidity is available to meet business as usual requirements, LCH.C Ltd sets operational liquidity targets for each currency for which LCH.C Ltd considers it has meaningful operational exposures (based on internal thresholds). The targets are set assuming that the CCP will not receive additional cash from clearing participants (in any currency) – that is, only outflows are considered. LCH.C Ltd's CaLRM function is responsible for recalculating and monitoring the operational targets daily.

Default liquidity requirement

LCH.C Ltd defines the default liquidity requirement as the liquidity required in the event of the default of the two clearing participants and their affiliates that would generate the largest aggregate liquidity obligations (the cover two requirement). The default liquidity requirement is calculated daily through liquidity stress-testing. These stress tests are conducted at an aggregated level across all currencies. They are also run individually at the currency level on the most active currencies, assuming complete closure of the foreign exchange (FX) markets. Liquidity stress testing is conducted by LCH.C Ltd's CaLRM function.

The key test used to determine the default liquidity requirement is the ‘daily liquidity stress test’, which forecasts liquidity requirements that arise over a 30-day liquidity horizon following the default of the two clearing participants with the largest liquidity requirements. The test covers all liquidity risks related to clearing participants and their affiliates including settlement obligations, variation margin requirements and investment losses (which would arise if the defaulter was also a LCH.C Ltd investment counterparty).

  • Settlement obligations: On the default of a clearing participant, LCH.C Ltd would assume obligations to fulfil physical settlement for its EquityClear and RepoClear services. These are fixed obligations, for which LCH.C Ltd estimates its stressed default liquidity needs based on gross cash outflows – that is, it does not allow offsets from potential cash inflows where securities were delivered to the non-defaulting members to generate cash flows. Under its contract with the London Metal Exchange (LME), LCH.C Ltd does not need to settle physically until the defaulter's positions are hedged or sold. LME is targeting a transfer of its clearing operations to LMEClear in September 2014.

  • Variation margin requirements: Similar to settlement obligations, LCH.C Ltd will need to ensure sufficient liquidity is available to cover potential variation margin losses the defaulter's portfolio may incur before they are fully liquidated. The prevailing initial margin model in each service is used to estimate the potential loss over the liquidation period. It is assumed there is no offsetting of variation margin payments across services. During 2013/14, LCH.C Ltd implemented a reverse stress-testing framework to assess the adequacy of its liquid resources. The Bank expects to engage with LCH.C Ltd over the coming period to ensure that LCH.C Ltd can clearly demonstrate how its approach to modelling variation margin flows for the purposes of liquidity stress testing captures a sufficient range of extreme but plausible scenarios.

    In addition, as part of its regular review of its liquidity stress-testing model, LCH.C Ltd intends to examine the methodology it uses in its liquidity stress-testing model to allocate variation margin outflows across currencies. This review is scheduled to occur in the third quarter of 2014 and the Bank will expect to engage with LCH.C Ltd regarding the results.

In addition to the daily liquidity stress test, LCH.C Ltd also runs several other stress tests, including modelling the impact of restricted access to liquid resources due to closure of certain parts of the repo market. Additional tests also cover the impact of a regional economic crisis and the default of multiple clearing participants.

Sources of liquidity

LCH.C Ltd's primary sources of liquidity are cash posted by clearing participants to meet margin requirements, cash contributions to the default fund, and LCH.C Ltd's own capital. Cash is invested in line with the Group Investment Policy, predominantly in very short dated transactions with daily maturities, as well as in highly liquid government securities. Other sources of liquidity include sale or repo of assets, credit lines, liquidity facilities and FX swaps (discussed further in CCP Standard 7.9). When assessing its available liquid resources against its total liquidity requirement, LCH.C Ltd makes various assumptions regarding the availability of certain collateral to raise liquidity.

LCH.C Ltd's stress-testing results indicate it typically maintains a sizeable buffer of liquid resources beyond its stressed liquidity requirements.

Model validation

LCH.C Ltd sought independent external validation of its liquidity stress-testing model during the fourth quarter of 2013. The test concluded that the model was fit for purpose. Several recommendations were made, which have now been implemented.

Liquidity management of currencies that are less active in the CCP

Liquidity needs in currencies that are less active in LCH.C Ltd (which include the Australian dollar) are monitored daily, based on historical operational and variation margin flows. Since the majority of LCH.C Ltd's variation margin flows in these currencies arise from SwapClear, LCH.C Ltd also monitors the ‘worst case loss’ in SwapClear for each less active currency. This is calculated using the same PAIRS methodology for computing initial margin requirements. Observed increases in operational flows or potential exposures in these currencies are investigated by CaLRM and reported to ALCo, as required.

Management of Australian dollar liquidity

As discussed in Section 3.5, LCH.C Ltd has applied to the Bank to open an ESA. LCH.C Ltd has also applied to open an account with Austraclear to hold Australian dollar securities. LCH.C Ltd proposes to use its ESA (if approved) to manage its Australian dollar liquidity requirements.

Specifically, LCH.C Ltd proposes to access Australian dollar liquidity by holding securities eligible for repo with the Bank. These securities will be held in LCH.C Ltd's Austraclear account. LCH.C Ltd proposes to use Bank intraday facilities to manage its Australian dollar settlements on a day-to-day basis, allowing it to pay out Australian dollar variation margin prior to receiving all pay-ins. Bank repo facilities would also be used in the case that LCH.C Ltd required Australian dollar liquidity to manage a clearing participant default.

LCH.C Ltd does not currently accept Australian dollar cash as initial margin (see Section 3.5). Therefore in the first instance its Australian dollar liquidity requirements will relate only to variation margin. LCH.C Ltd proposes to hold sufficient Australian dollar securities to cover a potential outflow due to the default of the largest two clearing participants and their affiliates.

Australian dollar liquidity needs will be monitored by CaLRM as part of its day-to-day liquidity monitoring.

The Bank expects to continue to engage with LCH.C Ltd as it refines its Australian dollar liquidity model. The Bank also expects LCH.C Ltd to ensure processes are in place so that it can demonstrate the adequacy of its Australian dollar liquid resources on an ongoing basis.

7.9 A central counterparty should establish explicit rules and procedures that enable the central counterparty to effect same-day and, where appropriate, intraday and multiday settlement of payment obligations on time following any individual or combined default among its participants. These rules and procedures should address unforeseen and potentially uncovered liquidity shortfalls and should aim to avoid unwinding, revoking or delaying the same-day settlement of payment obligations. These rules and procedures should also indicate the central counterparty's process to replenish any liquidity resources it may employ during a stress event, so that it can continue to operate in a safe and sound manner.

The actions that LCH.C Ltd would take to address a liquidity shortfall or replenish its liquidity resources are described in the LCH.C Ltd Liquidity Plan and in LCH.C Ltd's Recovery Plan. The Liquidity Plan covers the tools that would be used to address what LCH.C Ltd calls ‘business as usual’ shortfalls, i.e. how LCH.C Ltd would fund liquidity to meet operational or default liquidity needs, as described under CCP Standard 7.3. As discussed under CCP Standard 7.3, LCH.C Ltd typically holds a substantial buffer of liquid resources in excess of those required to meet the projected operational and default liquidity requirement. Therefore LCH.C Ltd would be able to continue to use these ‘business as usual tools’ in the event of a liquidity stress that exceeded ‘business as usual’ requirements (e.g. an event beyond a cover two default). The Recovery Plan addresses the additional tools that could be applied.

LCH.C Ltd has a range of tools routinely available to manage day-to-day liquidity, all of which would also be available to address a liquidity shortfall. These include, but are not limited to: allowing investments to mature without reinvesting the proceeds (cash would be held on deposit at institutions approved under the LCH.C Group Investment Risk Policy until the liquidity requirement crystallised); sale or repo of non-cash collateral held in LCH.C Ltd's investment portfolio; accessing credit or FX lines with commercial banks; or intraday liquidity facilities with central securities depositories or international central securities depositories.

LCH.C Ltd also has access to a number of other tools, set out in its Rulebook and procedures, that give it the ability to manage the level of liquidity within the firm both under normal market conditions and during periods of reduced market liquidity. These include active management of member collateral movements such as changing the notice period and/or approval limits for collateral substitutions, as well as prioritisation regarding the return of excess collateral. LCH.C Ltd also has the ability under its Rulebook to change the currency in which it settles obligations; this might enable LCH.C Ltd to resolve a situation in which there was a liquidity shortfall in a specific currency. LCH.C Ltd would prioritise the various tools depending on the timing, size and duration of the liquidity requirements and the prevailing market conditions.

The Liquidity Plan and the Recovery Plan consider possible constraints on access to each source of liquidity, including whether they would be available during periods of market stress or during a ‘liquidity crisis’ (a liquidity crisis can reflect market-wide conditions, or be linked to a particular market). LCH.C Ltd incorporates restricted access to liquidity sources in its liquidity stress testing.

Testing

Some of the tools LCH.C Ltd would use to address a liquidity shortfall are applied on an ongoing basis as part of LCH.C Ltd's standard investment and liquidity management activities (e.g. maturing investments, and the purchase and sale of securities). To ensure that it could access liquidity using the tools that are not applied on a day-to-day basis (e.g. repo, borrowing, FX swaps), LCH.C Ltd conducts regular ‘war games’. As part of these tests, LCH.C Ltd also simulates the liquidation of a defaulting clearing participant's collateral. These tests are conducted by CaLM quarterly on a rolling basis, so that LCH.C Ltd tests its ability to apply each tool least once a year.

Standard 13: Segregation and Portability

A central counterparty should have rules and procedures that enable the segregation of positions of a participant's customers and the collateral provided to the central counterparty with respect to those positions.

LCH.C Ltd has rules and procedures that enable a clearing participant's customer's positions and collateral to be segregated from those of its clearing participant. LCH.C Ltd also has rules and procedures to enable a clearing participant's customer's positions and collateral to be ported to another clearing participant if its original clearing participant defaulted or was insolvent. The SwapClear service offers a number of account options that provide different combinations of individual and omnibus position accounts and asset segregation (which seeks to protect the clearing participant's customer's specific collateral) and value segregation (which only seeks to protect the value of the clearing participant's customer's collateral).

LCH.C Ltd has arrangements in place to ensure it is highly likely that a defaulting clearing participant's customer's positions and collateral could be ported to another clearing participant. For example: SwapClear knows the identities of its clearing participant's customers; it encourages its clearing participant's customers to nominate a backup clearing participant to which its positions would be offered if its clearing participant defaulted (customers can nominate up to three backup clearing participants); and would provide a clearing participant's customers time to find a backup clearing participant if it did not have one and its clearing participant defaulted or was insolvent.

13.1 A central counterparty should, at a minimum, have segregation and portability arrangements that effectively protect a participant's customers' positions and related collateral from the default or insolvency of that participant. If the central counterparty additionally offers protection of such customer positions and collateral against the concurrent default of the participant and a fellow customer, the central counterparty should take steps to ensure that such protection is effective.

LCH.C Ltd has rules and procedures that are intended to protect a clearing participant's customers' positions and collateral from a default or insolvency of that clearing participant. LCH.C Ltd has informed the Bank that a customer's positions and collateral are segregated from those of its clearing participant at all times. The extent to which SwapClear accounts protect against the concurrent default of the clearing participant and a fellow customer (i.e. from fellow customer risk) depends on the specific SwapClear account type (see Standard 13.2 for a detailed explanation of the alternative account types offered).

13.2 A central counterparty should employ an account structure that enables it readily to identify positions of a participant's customers and to segregate related collateral. A central counterparty should maintain customer positions and collateral in individual customer accounts or in omnibus customer accounts, or equivalent.

LCH.C Ltd has recently changed its account structures in order to comply with EMIR regulations. Under EMIR regulations, CCPs are required to offer customers the option of both individual segregation and omnibus segregation. To meet EMIR requirements, individually segregated accounts must protect each customer's assets using the so-called ‘asset segregation’ model. Under this model, specific assets lodged as collateral are recorded into each customer's account with its clearing participant. Those specific assets could then potentially be ported to another clearing participant along with the customer's positions in the event of the default of its clearing participant. This contrasts with the so-called ‘value segregation’ model, under which the value of a non-defaulting customer's lodged collateral is protected, but the customer is not identified with, and therefore is unlikely to have returned to it, the specific assets that it has lodged.

LCH.C Ltd now offers three broad types of customer accounts: an ISA; an OSA using gross margin; and an OSA using net margin.[3] The accounts differ in the extent to which each individual customer's positions and collateral are segregated from those of other customers (i.e. the degree of protection from fellow customer risk) and the probability that its positions could be ported. The precise account offering differs across the LCH.C Ltd services, although each service offers an ISA and at least one type of OSA.

The account structure offered by the SwapClear service to customers of clearing participants (i.e. direct customers) is described below. SwapClear clearing participants are free to choose which of these accounts they offer their customers, although they are obliged by EMIR to offer their customers the option of individual and omnibus segregation.

  • Individual segregation. The ISA is an asset-segregated individual position account. It contains positions of a single legal entity and positions are not exposed to losses from positions outside that particular account (and accordingly are not exposed to fellow customer risk). Initial margin requirements are netted across all positions within the account. Each position account has its own corresponding collateral account (on LCH.C Ltd's books), into which specific cash and non-cash assets lodged in respect of the customer are recorded and which are thereby segregated for that customer's benefit upon its clearing participant's default. In addition, a customer's excess margin is posted to the CCP and segregated from the margin of other customers and clearing participants. If, in the event of a clearing participant default, the positions of each of the defaulting clearing participant's ISA customers needed to be ported to another clearing participant, each customer's specific non-cash collateral assets could be transferred alongside its positions (rather than solely the value of lodged collateral).
  • Gross omnibus. The Gross OSA is a value-segregated account. Within the account, customer positions are managed in ‘position sets’: individual position sets contain positions from a single legal entity, while joint position sets contain positions from multiple legal entities.[4] Participation in each joint position set is controlled by the clearing participant or an asset manager with the agreement of a clearing participant. Initial margin is called on a net basis within each position set, but margin obligations are not netted across position sets. A customer with positions in an individual position set is not exposed to other customer's positions. While a customer with positions in a joint position set is exposed to fellow customer risk from other customers' positions within that set, it is not exposed to positions outside the position set in which it resides. Lodged collateral is held on a comingled basis across all position sets. If, in the event of a clearing participant default, the positions of the defaulting clearing participant's Gross OSA customers needed to be ported to another clearing participant, any positions in a joint position set would have to be ported together to the same alternative clearing participant. Individual position sets, on the other hand, may be ported independently.
  • Net omnibus. The Net OSA is an asset-segregated joint position account. It may contain positions of more than one legal entity. Each clearing participant can have multiple Net OSA accounts, including dedicated accounts for affiliated entities; participation in a Net OSA account is controlled by the clearing participant or an asset manager with the agreement of a clearing participant. Initial margin requirements are netted across all positions within an account. A customer with positions in a Net OSA is exposed to fellow customer risk from the positions of other customers within that Net OSA, but not to any other positions outside that account. Lodged cash and non-cash collateral is segregated in its own collateral account and the specific assets lodged are recorded to the account. Collateral is therefore segregated in collective favour of all customers within that account, rather than in favour of individual customers. In the event of a clearing participant default, all positions in a Net OSA would have to be ported together to the same clearing participant. The specific assets attributed to the customers in the net OSA could be ported alongside those positions (rather than solely the value of lodged collateral).

SwapClear also offers account segregation for indirect customers (i.e. the customers of clearing participants' customers). LCH.C Ltd has informed the Bank that positions of all indirect customers of each direct customer are held in an omnibus sub-account specific to that direct customer. Initial margin is called on a net basis across all the indirect customers' positions in that sub-account.

In order to register trades into the SwapClear Client Clearing Service, the clearing participant or direct customer must provide certain information to SwapClear about the direct customer, such as name of the legal entity, ultimate parent name, country of incorporation, registered address and key contact details. By contrast, SwapClear collects no information on the identity of indirect customers, beyond identification of the direct customer with which they are associated.

SwapClear has arrangements in place that are intended to protect the interests of customers in a default by ensuring it has the right to deal with relevant positions and assets in such a way that recognises the beneficial entitlement of the customer. These arrangements are necessary because positions are entered into, and assets lodged as collateral, by the clearing participant as principal. Absent those arrangements, a defaulting clearing participant's customer's assets could potentially be included as part of the defaulting clearing participant's insolvency estate. SwapClear has informed the Bank that it seeks legal opinions to determine whether the legal jurisdictions of the clearing participants that wish to offer customer clearing services have laws that enshrine these arrangements. In cases where this does not exist, the clearing participant is required to enter into a security deed in favour of its customers, which is enforceable in the event of a default of the clearing participant (over the customer's collateral or value of collateral, as appropriate).

Clearing participants must be approved by SwapClear before they are permitted to provide customer clearing services.

The Australian-based clearing participants are currently unable to offer clearing services to their customers but LCH.C Ltd is in discussions with the Bank and ASIC to allow them to do so.

13.3 To the extent reasonably practicable under prevailing law, a central counterparty should structure its portability arrangements in a way that makes it highly likely that the positions and collateral of a defaulting participant's customers will be transferred to one or more other participants.

If a clearing participant defaulted, LCH.C Ltd has arrangements in place to enable that clearing participant's customers' positions, initial margin and record of the cumulative variation margin for those positions since registration to be transferred to another clearing participant. These arrangements would be overseen and implemented by SwapClear Client Services. Customers are encouraged to nominate at least one backup clearing participant to which its positions would be offered if its clearing participant defaulted (customers can nominate up to three backup clearing participants).[5] Although backup clearing participants do not guarantee to accept transferred trades, the likelihood of portability is increased because nominated backup clearing participants would have an established relationship with the customer and operational arrangements in place. If a customer's nominated backup clearing participant was also in default, the customer would be given the opportunity to locate another backup clearing participant. LCH.C Ltd's rules do not allow it to close out a customer's positions and collateral until 24 hours after a clearing participant's default (or 12 hours if initial margin had been eroded by 50 per cent or more). This rule is in place to comply with Articles 48(5) and 48(6) of EMIR, which requires CCPs to have a defined period after default before customer positions and collateral can be closed out.

If a clearing participant default occurred, SwapClear Client Services would confirm with each individual customer of the defaulted clearing participant whether it intended to transfer or liquidate its positions. If a customer intended to transfer, SwapClear Client Services would confirm with the customer the identity of its backup clearing participant. SwapClear Client Services would post a suite of reports to the backup clearing participant to enable it to assess the customer's portfolio. These reports would contain position and trade information, initial and variation margin details, sensitivities and valuation of portfolios. The backup clearing participant would have 48 hours after the time of default to consent to the transfer. Positions that were unable to be transferred by that time would be closed out. The likelihood of portability would also be partly contingent on the type of customer account in which the positions and collateral were held. Positions and collateral held in accounts with other customers – that is, a Net OSA or a joint position set within a Gross OSA – could only be ported if all positions of all customers within the account or position set were ported to the same backup clearing participant. If this could not be achieved, positions would be closed out. Portability would be more straightforward for positions and accounts held for a single customer – that is, an ISA or an individual position set within a Gross OSA. LCH.C Ltd publicly discloses aspects of its portability arrangements on its website.

LCH.C Ltd delivered the internal technical and functional changes to support portability in March 2014. In addition, portability procedures are tested in SwapClear Fire Drills, which are exercises run by SwapClear every six months for SwapClear and its clearing participants to practise aspects of the default management processes.

SwapClear also supports the ability of customers to port positions as part of ordinary, non-default operations. SwapClear aims to complete porting requests within two days; for this to occur the request must be received by LCH.C Ltd by 17:00 London time on day 0. Requests are initiated by the clearing participant receiving the positions (the receiving clearing participant) and made to SwapClear Client Services. The request must designate the positions to be transferred, noting whether collateral will be transferred and providing evidence that the request has been made on behalf of the customer. The receiving clearing participant is required to approve the transfer of positions and collateral by 17:00 London time on day 2. If approval is not given by that time, the transfers will be rejected. A clearing participant has no powers to prevent a customer of good standing from transferring its positions to another clearing participant. There are, however, provisions to prevent a customer that is in breach of its financial obligations to the clearing participant, or that is insolvent or bankrupt, from transferring its positions.

Standard 14: General Business Risk

A central counterparty should identify, monitor and manage its general business risk and hold, or demonstrate that it has legally certain access to, sufficient liquid net assets funded by equity to cover potential general business losses so that it can continue operations and services as a going concern if those losses materialise. Further, liquid net assets should at all times be sufficient to ensure a recovery or orderly wind-down of critical operations and services.

LCH.C Ltd has sufficient liquid net assets funded by equity to implement its Recovery Plan and Wind-down Plan. It has funds set aside to cover risks including operational and legal risk, uncovered credit, counterparty credit and market risks, and business risks, as well as the implementation of its Recovery and Wind-down Plans. LCH.C Ltd's capital is invested in accordance with the LCH.C Group's investment and liquidity policies.

14.3 A central counterparty should maintain a viable recovery or orderly wind-down plan and should hold, or have legally certain access to, sufficient liquid net assets funded by equity to implement this plan. At a minimum, a central counterparty should hold, or have legally certain access to, liquid net assets funded by equity equal to at least six months of current operating expenses. These assets are in addition to resources held to cover participant defaults or other risks covered under CCP Standard 4 on credit risk and CCP Standard 7 on liquidity risk. However, equity held under international risk-based capital standards can be included where relevant and appropriate to avoid duplicate capital requirements.

As at 30 June 2014, LCH.C Ltd had share capital and audited reserves of €439 million. Of that, LCH.C Ltd has allocated capital to cover a range of risks including operational and legal risk, uncovered credit, counterparty credit and market risk, business risks, and to implement its Recovery and Wind-down Plans. The allocated capital cannot be used for any other purpose. The minimum capital requirement and the amount of available capital are recalculated daily.

LCH.C Ltd's capital is invested in accordance with the LCH.C Group's investment and liquidity policies. At least 95 per cent of LCH.C Ltd's cash invested with counterparties on average each month must be secured by highly marketable securities. All sovereign, explicitly guaranteed or supranational security purchases must be eligible for repo with the relevant central bank or a commercial counterparty. Collateral received using reverse repo transactions (i.e. in which LCH.C Group is the cash lender) is also subject to haircuts and concentration limits.

Standard 16: Operational Risk

A central counterparty should identify the plausible sources of operational risk, both internal and external, and mitigate their impact through the use of appropriate systems, policies, procedures and controls. Systems should be designed to ensure a high degree of security and operational reliability and should have adequate, scalable capacity. Business continuity management should aim for timely recovery of operations and fulfilment of the central counterparty's obligations, including in the event of a wide-scale or major disruption.

LCH.C Ltd is a UK-based facility and any crisis management actions would be expected to be led by the UK resolution authority, the BoE. It is expected that these arrangements will be considered further with the BoE and other regulators over coming months. Nonetheless, LCH.C Ltd's CMT Plan does consider crisis management for LCH.C Ltd's outsourced IT arrangements with Tata Consultancy Services (TCS), which is considered to be a critical service provider.

Business continuity

LCH.C Ltd's approach to business continuity is set out in the Group Business Continuity Management Policy. That document makes reference to several other documents that outline procedures for ensuring continuity of service in a crisis. These documents are the CMT Plan, the Major Incident Management Process and the IT Disaster Recovery Plan. The Group Business Continuity Management Policy, CMT Plan and the Major Incident Management Process are LCH Group documents; the IT Disaster Recovery Plan is an LCH.C Ltd policy, although it also covers production services provided by LCH.C Ltd to LCH.Clearnet SA (LCH.C SA) and LCH.C LLC.

The CMT Plan provides detailed information about how the CMT process would be activated across the entire LCH.C Group, which includes LCH.C Ltd, LCH.C SA and LCH.C LLC. There are detailed sections about CMT members and their alternates, their roles and responsibilities and their contact information. The plan contains a checklist of required actions needed to assess, react to, manage and recover from an incident. Incidents would be managed by the Local CMT in London, Paris or New York, but would be escalated to the CMT if they could not be managed at the local level (e.g. if there was a city-wide metropolitan crisis, a pandemic or a crisis affecting more than one location).

The Major Incident Management Process categorises incidents according to one of five levels of severity and sets out how they should be resolved:

  • A Priority 1 incident is one that prevent LCH.C Group CCPs fulfilling their financial, legal or regulatory obligations or causes widespread unavailability of critical business services to all participants or partners.
  • A Priority 2 incident is one that affects LCH.C Group CCPs from fulfilling their financial, legal or regulatory obligations or causes limited availability of critical business services to multiple participants or partners.
  • A Priority 3C incident is one that affects LCH.C Group CCPs' service (and unless resolved will become a Priority 2 incident) or causes limited availability of non-critical business services to a small number of participants or partners.
  • A Priority 3 incident is one that affects LCH.C Group CCPs' service or causes limited availability of non-critical business services to a small number of participants or partners.
  • A Priority 4 incident is one that is minor, falls outside the other categories and has only an internal effect.

The Incident Handling Team, which would comprise the Service Desk and IT Production Operations, would be responsible for the immediate handling of an incident. Incidents categorised as Priority 1 or 2 would be escalated to the Duty Production Manager. The Duty Production Manager would be responsible for the technical resolution of an incident and for coordinating escalation to the CMT. The CMT would be invoked for all Priority 1 incidents and notified of all Priority 2 incidents. Priority 1 incidents should be responded to within five minutes and resolved within 60 minutes. Priority 2 incidents should be responded to within ten minutes and resolved within 90 minutes.

The IT Disaster Recovery Plan provides business continuity and disaster recovery plans for IT services. LCH.C Ltd has the objective of recovering its core clearing services within two hours of the point of failure and must be able to perform end-of-day settlement of transactions on the same business day. It also has the objective of completely recovering its data should its critical IT systems fail.

LCH.C Ltd's recovery time objectives are supported by maintenance of three geographically separate data centres. Two of these centres are connected with synchronous data replication. This means that data are posted to both sites at the same time so that data remain current at both sites. The third data centre uses asynchronous data replication, which means that data would need to be transferred to it before production services could be run. This data centre was subject to extensive testing in 2013 and recovery was achieved within two hours. A partial recovery test between the two other sites was completed in early 2014. A full test between these sites is to be scheduled.

The CMT plan and the IT Disaster Recovery Plan are reviewed at least annually and following the introduction of new services, major incidents, identification of new risks, organisational changes and major changes to the technical infrastructure. The CMT plan is signed off by the CMT Group Governance members and the IT Disaster Recovery Plan is signed off by LCH.C Ltd's Audit Committee and Board.

16.11 A central counterparty should organise its operations, including any outsourcing or critical service provision arrangements, in such a way as to ensure continuity of service in a crisis and to facilitate effective crisis management actions by the Reserve Bank or other relevant authorities. These arrangements should be commensurate with the nature and scale of the central counterparty's operations.

Since LCH.C Ltd is a UK-based CS facility, any crisis management actions would be expected to be led by the UK resolution authority, the BoE. Legislation establishing a resolution regime for UK CCPs received royal assent in December 2012, although the relevant legislative provisions are not yet in force and the UK authorities are developing supporting secondary legislation that will establish the date on which the resolution regime for CCPs will become effective. The crisis management arrangements that would apply to LCH.C Ltd have important implications for all jurisdictions in which LCH.C Ltd operates, including for Australia, and it is intended that LCH.C Ltd's crisis management will be considered further in conjunction with the BoE and other regulators over coming months. In addition, LCH.C Ltd's crisis management arrangements form part of the Bank's regulatory priorities for LCH.C Ltd.

The CMT Plan considers crisis management arrangements for outsourced IT functions. The Plan specifically covers LCH.C Ltd's arrangement with TCS, which is considered to be a critical service provider. TCS provides IT production services (to enable LCH.C Ltd to offer 24 hour coverage), IT support and IT development resources, including testing, from its site in Bangalore. LCH.C Ltd remains accountable for IT production, including overall management control. TCS has an alternative site in Bangalore that could be used if its primary site was affected. In the case of a Bangalore-wide event, LCH.C Ltd and TCS have a contingency strategy for critical services to be provided by London. LCH.C Ltd's Master Service Agreement with TCS ensures that LCH.C Ltd and its regulators have access to TCS's facilities, personnel and records. LCH.C Ltd may need to consider how relevant authorities could take effective crisis management actions to ensure that TCS was able to provide continuous reliable service in a crisis, as part of its resolution planning in the coming period. The Bank will engage further with LCH.C Ltd and the BoE on this matter.

Footnotes

RBA (2013), Assessment against the Financial Stability Standards for Central Counterparties of LCH.Clearnet Limited's SwapClear Service, June. Available at <http://www.rba.gov.au/payments-system/clearing-settlement/assessments/lch/>. [1]

ALCo is a sub-committee of ERCo that focuses on investment and liquidity policies. Like ERCo, it comprises representatives from each LCH.C Group CCP, and issues affecting an individual CCP are decided by the representatives of that CCP. [2]

SwapClear also offers the CFTC-recognised FCM model of clearing participation. Clearing services are offered to customers using the LSOC model. This model seeks to legally segregate customers from other customers, and to ensure that in the event of a default a customer's positions and assets cannot be used to meet the obligations of any other party. [3]

Although customers holding positions in a joint position set or account are likely to be affiliated in some way, they do not have to be part of the same corporate group or have any other form of relationship. Accordingly, they may not know the identity of other customers with positions in that set or account. [4]

Under the FCM model, LCH.C Ltd would seek to – under advice and approval from the CFTC – port the participant's customers to another FCM clearing participant. [5]