Financial Stability Standards for Central Counterparties – December 2012 Standard 10: Physical Deliveries
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A central counterparty should clearly state its obligations with respect to the delivery of physical instruments or commodities and should identify, monitor and manage the risks associated with such physical deliveries.
Guidance
A central counterparty may take on obligations involving the settlement of transactions using physical delivery, which is the delivery of an asset, such as an instrument or a commodity, in physical form.[1] For example, the settlement of futures contracts cleared by a central counterparty may allow or require the physical delivery of an underlying financial instrument or commodity. A central counterparty that provides physical settlement should have rules that clearly state its obligations with respect to the delivery of physical instruments or commodities.[2] In addition, a central counterparty should identify, monitor and manage the risks and costs associated with the storage and delivery of such physical instruments and commodities.
10.1 A central counterparty's rules should clearly state its obligations with respect to the delivery of physical instruments or commodities.
10.1.1 A central counterparty's rules should clearly state its obligations with respect to the delivery of physical instruments or commodities. The obligations that a central counterparty may assume with respect to physical deliveries vary based on the types of assets that the central counterparty settles. A central counterparty should clearly state which asset classes it accepts for physical delivery and the procedures surrounding the delivery of each. A central counterparty also should clearly state whether its obligation is to make or receive physical deliveries or to indemnify participants for losses incurred in the delivery process. Clear rules on physical deliveries enable the central counterparty and its participants to take the appropriate steps to mitigate the risks posed by such physical deliveries. A central counterparty should engage with its participants to ensure that they have an understanding of their obligations and the procedures for effecting physical delivery.
10.2 A central counterparty should identify, monitor and manage the risks and costs associated with the storage and delivery of physical instruments or commodities.
Risk of storage and delivery
10.2.1 A central counterparty should identify, monitor and manage the risks and costs associated with the storage and delivery of physical instruments or commodities. Issues relating to delivery may arise, for example, when a derivatives contract requires physical delivery of an underlying instrument or commodity. A central counterparty should plan for and manage physical deliveries by, for example, establishing: definitions for acceptable physical instruments or commodities; the appropriateness of alternative delivery locations or assets; rules for warehouse operations; and the timing of delivery, when relevant. If a central counterparty is responsible for the warehousing and transportation of a commodity, it should make arrangements that take into account the commodity's particular characteristics (for example, storage under specific conditions, such as an appropriate temperature and humidity for perishables).
10.2.2 A central counterparty should have appropriate processes, procedures and controls to manage the risks of storing and delivering physical assets, such as the risk of theft, loss, counterfeiting or deterioration of assets. A central counterparty's policies and procedures should ensure that the central counterparty's record of physical assets accurately reflects its holdings of assets, for example, by separating duties between handling physical assets and maintaining records. A central counterparty also should have appropriate employment policies and procedures for personnel that handle physical assets and should include appropriate pre-employment checks and training. In addition, a central counterparty should consider other measures, such as insurance coverage and random storage facility audits, to mitigate its storage and delivery risks (other than principal risk).
Matching participants for delivery and receipt
10.2.3 In some instances, a central counterparty serving a commodity market can reduce its risks associated with the physical storage and delivery of commodities by matching participants that have delivery obligations with those due to receive the commodities, thereby removing itself from direct involvement in the storage and delivery process. In such instances, the legal obligations for delivery should be clearly expressed in the rules, including default rules, and any related agreements. In particular, a central counterparty should be clear whether the receiving participant should seek compensation from the central counterparty or the delivering participant in the event of a loss. Additionally, a central counterparty holding margin should not release the margin of the matched participants until it confirms that both have fulfilled their respective obligations. A central counterparty should also monitor its participants' performance and, to the extent practicable, ensure that its participants have the necessary systems and resources to be able to fulfil their physical delivery obligations.
Footnotes
Examples of physical instruments that may be covered under this Standard include securities, commercial paper and other debt instruments that are issued in paper form. [1]
The term ‘physical delivery’ in the credit default swap market typically refers to the process by which the protection buyer of a credit default swap contract ‘delivers’ an instrument to the protection seller after a credit event, but does not necessarily involve the delivery of an instrument in paper form. This type of ‘physical delivery’ is outside the scope of this Standard. [2]