Assessment of LCH Limited's SwapClear Service 1. Regulatory Priorities

This section summarises actions taken by LCH Ltd over the 2017/18 assessment period to meet the Bank's regulatory priorities, and developments related to the Bank's areas of supervisory focus. It also summarises the priorities and areas of supervisory focus identified by the Bank for the next assessment period. This section describes the Bank's approach to assessing the sufficient equivalence of LCH Ltd's home regulatory regime.

1.1 Progress against Regulatory Priorities

The Bank's previous Assessment set out two priorities for LCH Ltd, reflecting SwapClear's systemic importance in Australia.

LCH Ltd has partly addressed this regulatory priority. LCH Ltd has continued to analyse the technical and operational challenges to extending the operating hours of the SwapClear service (section 2.1.1). SwapClear's official opening hours remain from 6am UK time to 7pm New York time, but SwapClear can open from an hour earlier, at LCH Ltd's discretion. This regulatory priority has been carried forward to the 2018/19 assessment period (section 1.3).

LCH Ltd has fully addressed this regulatory priority. The final major Australian bank began using the Australian PPS in early 2018 (section 2.1.2). Going forward, the Bank expects that any direct participant of SwapClear with an active exchange settlement account (ESA) (and which joined since LCH Ltd was licensed to offer the SwapClear service in Australia) will settle its AUD obligations using the Australian PPS.

1.2 Progress in Areas of Supervisory Focus

The Bank's previous Assessment set out three areas of supervisory focus for LCH Ltd. These are areas in which LCH Ltd has made significant changes, or where the Bank considers further analysis was required. For much of this, the Bank was able to source appropriate information through its active participation in the Multilateral Arrangement for Regulatory, Supervisory and Oversight Cooperation on LCH Ltd (Global College) and via bilateral discussions with the Bank of England (BoE). The Bank also sourced information by engaging directly with LCH Ltd.

LCH Ltd has made changes to the structure of the LCH Ltd Board to enhance its independence, and worked to improve the effectiveness of its governance arrangements (section 2.2.1). For example, the roles of Chair of the LCH Group Holdings Limited (LCH Group) and of LCH Ltd were separated. The Bank will continue to monitor the effectiveness of LCH Ltd's new governance arrangements in the next assessment period (section 1.4).

In the assessment period, LCH Ltd has taken actions to improve how it manages operational and cyber risks (section 2.2.2). In particular, it is enhancing its management of risks from its outsourcing arrangements to both related entities and third-party critical service providers. LCH Ltd has also taken actions set out in its cyber roadmap, which details the steps LCH Ltd intends to take to enhance its cyber risk management. The Bank will continue to monitor LCH Ltd's management of operational and cyber risk in the next assessment period (section 1.4).

In almost all cases, LCH Ltd's risk management practices align with the CCP Resilience Guidance. There are two areas, related to CCP Standards 6 (Margin) and 7 (Liquidity risk), where the Bank considers further analysis is required (section 2.2.3):

• how LCH Ltd accesses foreign exchange markets for minor currencies, including in times of market stress
• LCH Ltd's validation of margin add-ons, and how it assesses the SwapClear margin system holistically.

Based on these findings, the Bank has set financial risk management as an area of supervisory focus for the next Assessment (section 1.4).

In the assessment period, the Bank reviewed LCH Ltd's recovery planning arrangements against the revisions to the Recovery Guidance, and is comfortable LCH Ltd's arrangements align with the revisions. This follows a review, by the Global College of LCH Ltd's Recovery and Wind-down Plans against the original Recovery Guidance in 2015/16.

1.3 2018/19 Regulatory Priorities

Based on this year's assessment, the Bank has set two regulatory priorities for LCH Ltd for the next assessment period. The Bank will engage directly with LCH Ltd regarding its progress towards these priorities.

The regulatory priority on extension of SwapClear's operating hours has been carried over from the last assessment because it has been only partly addressed (sections 1.1 and 2.1.1). SwapClear continues to be closed for much of the Australian trading day. When SwapClear is open, trades are cleared within 10 seconds of being submitted (depending on the execution venue). However, trades cannot be cleared while SwapClear is closed. Therefore Australian participants must manage bilateral credit risk exposures during much of the Australian business day.

In the next assessment period, the Bank expects more progress on this priority. LCH Ltd should finish its analysis of the technical and operational challenges to extend its operating hours, and the costs and benefits of doing so, and provide this analysis to the Bank along with a plan of how it expects to address this regulatory priority.

The PPS is used by LCH Ltd to settle cash payments to and from participants (CCP Standard 9.1). LCH Ltd calls funds from, or pays funds to, clearing participants across the books of PPS banks (commercial settlement banks) acting on behalf of those participants. PPS banks then make or receive payments to or from the LCH Ltd ‘concentration bank’ via the relevant real-time gross settlement system for each currency. They may use a correspondent bank if they do not have a local presence.

LCH Ltd has previously identified that its PPS contingency arrangements need to be improved to effectively manage payments to and from LCH Ltd (such as variation margin) in the event of a PPS bank outage or failure. The Bank has set this regulatory priority for LCH Ltd for 2018/19. The Bank expects LCH Ltd, in coordination with its members and PPS banks, to continue to work to ensure its current and future PPS contingency arrangements are timely, robust and effective. Over the next assessment period, the Bank expects LCH Ltd to demonstrate how it will make progress towards meeting this regulatory priority, and begin implementing the necessary changes.

1.4 2018/19 Areas of Supervisory Focus

This year, the Bank has identified four areas of supervisory focus for its supervision of LCH Ltd. These describe matters that the Bank considers will be an important part of its supervision of LCH Ltd's SwapClear service in the next assessment period. In each of these areas there is significant change underway at LCH Ltd that the Bank will monitor, or the Bank considers further analysis is warranted. As appropriate, the Bank will seek information regarding these matters through its participation in the Global College and bilaterally with the BoE. The Bank will also engage directly with LCH Ltd on these matters as needed.

LCH Ltd has made changes to its Board to improve its independence and effectiveness over the previous year. This area of supervisory focus has been carried forward from the last Assessment; the Bank will monitor the effects of these changes over the next assessment period (sections 1.2 and 2.2.1).

This area of supervisory focus has been carried forward from the last Assessment because LCH Ltd is continuing to undertake work to implement improvements in these areas (sections 1.2 and 2.2.2).

This area of supervisory focus has arisen from the 2017/18 area of supervisory focus on international guidance (sections 1.2 and 2.2.3). The Bank will monitor analysis related to these areas in the next assessment period.

Tiering is a new area of supervisory focus for 2018/19. Tiering is an arrangement where clients access CCPs indirectly, via a direct participant of the CCP. Client clearing has increased substantially at LCH Ltd in recent years; clients now contribute more than half of the total risk cleared through SwapClear (measured by initial margin).

Given LCH Ltd's growing client clearing business, the Bank will monitor developments in how LCH Ltd manages and mitigates potential risks associated with tiering over the next assessment period. See Box A for more information on the growth in client clearing at LCH Ltd and globally.

1.5 Bank of England Supervisory Focus

The BoE is the primary supervisor of LCH Ltd. The BoE outlines its supervisory focus, across all financial market infrastructures (FMIs) for which it has supervisory responsibilities, in its document Supervision of Financial Market Infrastructure – Annual Report.^[1] For the period from February 2018, the BoE will:

• continue to focus on embedding the approach to supervision of operational resilience and cyber security. The BoE will review FMI's self-assessments against the Cyber Guidance, and will also conduct work on its impact tolerance for operational disruptions at FMIs. The impact tolerance is a defined level of operational disruption the BoE is willing to tolerate in line with its objectives, which will produce expectations for FMIs.
• conduct a thematic core assurance review across payment system operators on their approach to IT resilience, as many FMIs are planning significant changes to their IT platforms. The PPS operated by LCH Ltd is regulated and overseen by the BoE as a ‘recognised payment system’ under the UK Banking Act 2009.
• review CCPs' risk models across selected service lines, incorporating initial margin methodologies, stress testing and default fund sizing, and collateral haircut models. This will enable the BoE to form a comprehensive view of the counterparty credit risk management framework.
• continue its review of certain FMIs' recovery plans.

The Bank will engage with the BoE on these priorities (and to monitor progress toward them), as far as they relate to LCH Ltd, through its participation in the Global College and via bilateral discussions as appropriate. The Global College is designed to facilitate information sharing and supervisory coordination among regulators, recognising the complex cross-border nature of LCH Ltd's business.

1.6 Sufficient Equivalence of LCH Ltd's Home Regulatory Regime

LCH Ltd is licensed in Australia under section 824B(2) of the Corporations Act 2001, which provides licensing for an overseas-based CS facility subject to requirements and supervision in its home country that are considered to be sufficiently equivalent to those in Australia. LCH Ltd is incorporated in England, and is primarily regulated by the BoE under UK and EU legislation.

The UK is preparing to leave the EU on 29 March 2019 (for more information, see Appendix B3). The Australian Securities and Investments Commission (ASIC) and the Bank will consider how this may affect the continued sufficient equivalence of LCH Ltd's home regime. If LCH Ltd's home regime changes, the Bank and ASIC will advise the Minister (or their delegate) on whether the regime continues to be sufficiently equivalent to the Australian regime.^[2]

Any actions by ASIC and the Bank depend on the outcome of UK-EU negotiations:

• In the event the implementation period (which has been provisionally agreed between the UK and the EU) comes into effect, EU law – including the European Market Infrastructure Regulation (EMIR) – will continue to have effect in the UK until the end of 2020.^[3],[4] There will be no need for the Bank and ASIC to reassess the sufficient equivalence of the regime until the end of the transition period, because LCH Ltd's home regime will not change during the transition period.
• In the event the implementation period does not eventuate, there are contingency arrangements in place that will allow applicable EU law, such as EMIR, to be converted into UK law.^[5] As LCH Ltd's home regime will have changed, the Bank and ASIC will reassess the sufficient equivalence of LCH Ltd's home regime. The UK's HM Treasury have stated that the statutory instruments to convert EU law (including EU Regulations) into UK domestic law ‘are not intended to make policy changes, other than to reflect the UK's new position outside the EU, and to smooth the transition’. The UK has released draft statutory instruments to this effect.^[6] The BoE has also released a consultation paper outlining its proposed changes to FMI-related Binding Technical Standards and the BoE's domestic rules for FMIs so that these work effectively in the UK after it leaves the EU.^[7] In the event the implementation period does not eventuate, ASIC and the Bank will advise the Minister of the sufficient equivalence of the new home regime for LCH Ltd. Subject to there being no significant changes to the approach the UK authorities are consulting on, the Bank expects the regime to continue to be sufficiently equivalent.

Footnotes

Available at https://www.bankofengland.co.uk/-/media/boe/files/annual-report/2018/supervision-of-financial-market-infrastructures-annual-report-2018.pdf?la=en&hash=58A07611A193B1C549E4A443DF3D0E7D19B23A95. [1]

When advising the Minister, the Bank takes into account a number of factors. See Assessing the Sufficient Equivalence of an Overseas Regulatory Regime. [2]

EMIR is the European regulatory regime for CCPs (Appendix B3). It is also known as Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories. [3]

See paragraph 1.2 in HM Treasury's approach to financial services legislation under the European Union (Withdrawal) Act. Available at https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/720298/HM_Treasury_s_approach_to_financial_services_legislation_under_the_European_Union__Withdrawal__Act.pdf. [4]

See paragraphs 1.8 and 1.9 in HM Treasury's approach to financial services legislation under the European Union (Withdrawal) Act. Available at footnote 4. [5]

Instruments relevant to EMIR include: draft The Central Counterparties (Amendment, etc., and Transitional Provision) (EU Exit) Regulations, available at http://www.legislation.gov.uk/ukdsi/2018/9780111171882/part/3; and draft Over the Counter Derivatives, Central Counterparties and Trade Repositories (Amendment, etc., and Transitional Provision) (EU Exit) Regulations 2018, available at https://www.gov.uk/government/publications/draft-over-the-counter-derivatives-central-counterparties-and-trade-repositories-amendment-etc-and-transitional-provision-eu-exit-regulations. [6]

UK Withdrawal from the EU: Changes to FMI rules and onshored Binding Technical Standards, BoE consultation paper, October 2018. Available at https://www.bankofengland.co.uk/-/media/boe/files/paper/2018/uk-withdrawal-from-eu-changes-to-fmi-rules-and-onshored-bts-complete.pdf?la=en&hash=DA90F953E776AA06A9C76C620325284050630BCD. [7]