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

This section summarises actions taken by LCH Ltd over the 2018/19 assessment period to meet the Bank's regulatory priorities, and developments related to the Bank's areas of supervisory focus. It also summarises the regulatory priorities and areas of supervisory focus identified by the Bank for the next assessment period.

In June 2019, the Bank updated its policy approach to supervising and assessing CS facility licensees.^[1] The changes have sought to align the frequency, scope and level of detail of assessment of a CS facility licensee to be proportionate with the degree of systemic risk posed by the CS facility to the Australian financial system. In addition, for an overseas CS facility licensee, the approach allows for deference to the primary regulator when the home regulatory regime is sufficiently equivalent to that in Australia and there are satisfactory information sharing and cooperation arrangements with the relevant overseas authorities.^[2]

In line with the revised approach, as a systemically important overseas CS facility, LCH Ltd will be assessed against the FSS over a rolling four year period. These detailed compliance assessments will not be published. Certain standards may be reviewed more frequently depending on market and business developments, as well as the priorities of the Bank.

1.1 Review of Regulatory Priorities

1.1.1 Extension of operating hours

During the assessment period, LCH Ltd extended its flexible opening time by one hour to 4am UK time, and provided the Bank with a high-level analysis of the key challenges and considerations it would face when extending its operating hours further (section 2.1.1). The Bank has carried this regulatory priority forward to the 2019/20 assessment period (section 1.3.1).

1.1.2 Protected Payment System contingencies

LCH Ltd has made progress towards improving the effectiveness of its PPS contingency arrangements by implementing enhancements to its processes and by exploring contingency arrangements that are timely and robust for its members (section 2.1.2). As some of these developments remain in the early stages and the benefits are yet to be demonstrated, this regulatory priority has been carried forward to the 2019/20 assessment (section 1.3.2).

1.2 Progress in Areas of Supervisory Focus

1.2.1 Governance

Over recent years there has been a focus on the governance arrangements in place at LCH Ltd to improve the independence and effectiveness of its Board (section 2.2.1). During this assessment period, the Bank has reviewed the outcomes of these changes and is satisfied that LCH Ltd's approach to governance has become more robust. This area of supervisory focus is now closed.

1.2.2 Operational and cyber risk management

LCH Ltd has continued to take action to enhance its management of operational and cyber risks (section 2.2.2). LCH Ltd has focussed on improving how it manages relationships with related entities and outsourced critical service providers, including through greater oversight and performance monitoring. LCH Ltd has also made progress on several action items related to cyber risk from its resilience program of work. As this work is ongoing, the Bank will continue to monitor LCH Ltd's management of operational and cyber risks in the next assessment period (section 1.4.1).

1.2.3 Financial risk management

During the assessment period, the Bank reviewed LCH Ltd's access to foreign exchange markets for minor currencies and its validation of the SwapClear margin system against the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) Resilience of central counterparties (CCPs): Further guidance on the PFMI (CCP Resilience Guidance) (section 2.2.3). In almost all cases, LCH Ltd's practices align with the guidance. There is one area, related to the governance of LCH Ltd's model validations, where the Bank considers further evidence of analysis is required in the next assessment period (section 1.4.2).

1.2.4 Tiering

During the assessment period, LCH Ltd has taken steps to improve its management of risks associated with client clearing (section 2.2.4). In particular, LCH Ltd has clarified its approach for monitoring and managing tiering risk and has also made changes to its default fund allocation methodology to incorporate client risk directly. As a result of LCH Ltd's progress, the Bank has closed this area of supervisory focus.

1.3 2019/20 Regulatory Priorities

The Bank sets regulatory priorities for LCH Ltd based on its assessment of LCH Ltd. The Bank will engage directly with LCH Ltd regarding its progress towards these priorities.

1.3.1 Extension of operating hours

The regulatory priority on extending SwapClear's operating hours has been carried over from the current assessment period (sections 1.1.1 and 2.1.1). Although the flexible opening time was extended by one hour, SwapClear remains closed for at least four hours of the Australian business 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 this time.

The Bank agrees that in the near term, facilitating benchmark reforms and its potential resilience implications (including any impact on operating hours) should be a higher priority for LCH Ltd than further operating hours extensions. Nonetheless, in the next assessment period, LCH Ltd should provide the Bank with an approved timeline of how it will continue to extend operating hours in the medium term while maintaining the safety and resilience of its operations. LCH Ltd should continue to provide the Bank with updates on its plans and progress in this area.

1.3.2 Protected Payment System contingencies

This regulatory priority has been carried forward from the current assessment period as LCH Ltd is yet to fully develop, test and realise the benefits of enhancements to its PPS contingencies (sections 1.1.2 and 2.1.2). In the next assessment period, the Bank expects LCH Ltd to test the enhancements to its PPS contingency arrangements as part of an annual Group fire drill.

1.4 2019/20 Areas of Supervisory Focus

Areas of supervisory focus 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. These are areas where there is significant change underway at LCH Ltd that the Bank intends to monitor, or where the Bank considers further analysis is warranted. As appropriate, the Bank will seek information regarding these matters through its participation in the Multilateral Arrangement for Regulatory, Supervisory and Oversight Cooperation on LCH Ltd (Global College), bilaterally with the Bank of England (BoE) and through its regular engagement with LCH Ltd.

1.4.1 Operational and cyber risk management

This area of supervisory focus has been carried forward from the current assessment period reflecting (section 1.2.2) ongoing work by LCH Ltd to enhance the effectiveness of its cyber risk management.

1.4.2 Model validations

This area of supervisory focus has arisen from the 2018/19 area of supervisory focus on financial risk management (section 1.2.3). During the next assessment period, the Bank will monitor the outcomes of changes to the governance of LCH Ltd's model validations.

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 publication The Bank of England's Supervision of Financial Market Infrastructures – Annual Report.^[3] For the period from February 2019, the BoE will:

• further develop its supervisory approach and policy framework for operational resilience, including launching a pilot stress test of the financial services sector's resilience to cyber incidents in 2019
• conduct a range of targeted core assurance reviews to assess how FMIs are mitigating risks across their operations, including operational and financial resilience, and their compliance with expectations set out in the CPMI-IOSCO Principles for Financial Market Infrastructures (PFMI) and applicable regulations
• conduct work to oversee planned, structural changes to the payments landscape to promote the resilience of individual FMIs and the broader system. The PPS operated by LCH Ltd is regulated and overseen by the BoE as a ‘recognised payment system’ under the UK Banking Act 2009
• develop a supervisory stress test framework for UK CCPs to assess the systemic, macro-level impact of extreme market events that affect multiple CCPs at the same time
• continue its policy work to ensure the continuity of the regulatory framework for FMIs following the UK's withdrawal from the EU.

The Bank intends to engage with the BoE on these priorities (and to monitor progress), 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.

Footnotes

For more information see the Reserve Bank's Approach to Supervising and Assessing Clearing and Settlement Facility Licensees. Available at <https://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/standards/approach-to-supervising-and-assessing-csf-licensees.html>. [1]

The Corporations Act provides for two classes of CS facility licence: a ‘domestic’ licence granted under s824B(1); and an ‘overseas’ licence granted under s824B(2). [2]

This document is available at <https://www.bankofengland.co.uk/-/media/boe/files/annual-report/2019/supervision-of-financial-market-infrastructures-annual-report-2019>. [3]