Financial Stability Standards for Central Counterparties Standard 13: Segregation and Portability

Guidance

Segregation of customers' positions and collateral plays an important part in the safe and effective holding and transfer of customers' positions and collateral, especially in the event of a participant's default or insolvency. Customers' positions and collateral should be segregated from those of the participant through which the customers clear. In addition, individual customers' positions and collateral may be held separately from the positions and collateral of other customers of the same participant to protect customers from each other's default. Where such segregation is offered by the central counterparty, positions and collateral should be protected effectively from the concurrent default or insolvency of the participant and a fellow customer.

Effective segregation arrangements can reduce the impact of a participant's insolvency on its customers by providing for clear and reliable identification of a participant's customers' positions and related collateral. Segregation also protects customers' collateral from becoming lost to a participant's other creditors. In addition, segregation facilitates the transfer of customers' positions and collateral. Even if no transfers take place, segregation can improve a customer's ability to identify and recover its collateral (or the value thereof), which, at least to some extent, contributes to retaining customers' confidence in their clearing participants and may reduce the potential for ‘counterparty runs’ on a deteriorating clearing participant.

By facilitating transfers from one participant to another, effective portability arrangements lessen the need for closing out positions, including during times of market stress. Portability thus minimises the costs and potential market disruption associated with closing out positions and reduces the possible impact on customers' ability to continue to obtain access to central clearing.

The effectiveness of segregation and portability measures taken by a central counterparty depends in part on applicable legal frameworks, including those in foreign jurisdictions in the case of remote participants, and on measures taken by other parties, for example, where customers post excess collateral to the participant.

13.1.1 In order to achieve fully the benefits of segregation and portability, the central counterparty's arrangements to protect and transfer the positions and collateral of a participant's customers should be supported by the legal framework applicable to the central counterparty.^[1] The legal framework will influence how the segregation and portability arrangements are designed and what benefits can be achieved. The relevant legal framework will vary depending upon many factors, including the participant's legal form of organisation, the manner in which collateral is provided (for example, security interest, title transfer or full ownership right), and the types of assets (for example, cash or securities) provided as collateral. The appropriate model may therefore vary for central counterparties across relevant jurisdictions. However, a central counterparty should structure its segregation and portability arrangements (including applicable rules) in a manner that protects the interests of its participant's customers and achieves a high degree of legal certainty under applicable law. A central counterparty should also consider potential conflicts of law when designing its arrangements. In particular, the central counterparty's rules and procedures that set out its segregation and portability arrangements should avoid any potential conflict with applicable legal or regulatory requirements.

13.2.1 In considering the appropriate account structure, including the level of segregation and the basis for margin collection (that is, gross or net), a central counterparty should take into account stakeholders' views and assess the important benefits of individual customer protection alongside all relevant legal and operational factors. Such factors might include applicable insolvency regimes, costs of implementation and operational implications (for example, operational challenges associated with maintaining and managing individual customer accounts).

Customer account structures

13.2.2 This Standard is particularly relevant for central counterparties that clear positions and hold collateral belonging to customers of a participant. This clearing structure allows customers (such as buy-side firms) that are not direct participants of a central counterparty to obtain access to central clearing where direct access is either not possible (for example, due to an inability to meet membership criteria) or not considered commercially appropriate (for example, due to the cost of establishing and maintaining the infrastructure necessary to perform as a clearing member or contributing to a central counterparty's default resources). A central counterparty should employ an account structure that enables it readily to identify positions belonging to a participant's customers and to segregate related collateral. Segregation of customer collateral by a central counterparty can be achieved in different ways, including through individual or omnibus accounts.

13.2.3 The degree of protection achievable for customer collateral will depend on whether customers are protected on an individual or omnibus basis and the way initial margin is collected (gross or net basis) by the central counterparty. Collecting margin on a gross basis means that the amount of margin a participant must post to the central counterparty on behalf of its customers is the sum of the amounts of margin required for each such customer. Collecting margin on a net basis means that the participant may, in calculating the amount of margin it must post to the central counterparty on behalf of its customers, offset the amounts of margin associated with the portfolios of different customers. Each of these decisions will have implications for the risks the central counterparty faces from its participants and, in some cases, their customers. The central counterparty should understand, monitor and manage these risks. (See also CCP Standard 18 on tiered participation arrangements.)

Individual account structure

13.2.4 Similarly, there are advantages and disadvantages to each type of account structure that the central counterparty should consider when designing its segregation regime. The individual account structure provides a high degree of protection to the clearing level collateral of customers of participants in a central counterparty, even in the case where the losses associated with another customer's default exceed the resources of the participant. Under this approach, each customer's collateral is held in a separate, segregated individual account at the central counterparty, and depending on the legal framework applicable to the central counterparty, a customer's collateral may only be used to cover losses associated with the default of that customer (that is, customer collateral is protected on an individual basis). This account structure facilitates the clear and reliable identification of a customer's collateral, which supports full portability of an individual customer's positions and collateral or, alternatively, can expedite the return of collateral to the customer. Since all collateral maintained in the individual customer's account is used to margin that customer's positions only, the central counterparty should be able to transfer these positions from the customer account of a defaulting participant to that of another participant with sufficient collateral to cover the exposures. The use of individual accounts and the collection of margin on a gross basis provide flexibility in how a customer's portfolio may be ported to another participant or group of participants. Maintaining individual accounts, however, can be operationally and resource intensive for the central counterparty in settling transactions and ensuring accurate bookkeeping. Finally, effectively achieving the advantages of maintaining individual accounts may depend upon the legal framework applicable to the insolvency of the participant.

Omnibus account structure

13.2.5 Another approach is to use an omnibus account structure where all collateral belonging to all customers of a particular participant is commingled and held in a single account segregated from that of the participant. This approach can be less operationally intensive, while continuing to protect customers' collateral from being used to cover a default by the direct participant.

13.2.6 However, depending on the legal framework and the central counterparty's rules, omnibus accounts may expose a customer to ‘fellow customer risk’ – the risk that another customer of the same participant will default and create a loss that exceeds both the amount of available collateral supporting the defaulting customer's positions and the available resources of the participant. As a result, the remaining commingled collateral of the participant's non-defaulting customers is exposed to the loss. Fellow customer risk is of particular concern because customers have limited, if any, ability to monitor or to manage the risk of their fellow customers.

13.2.7 One potential solution is for omnibus account structures to be designed in a manner that operationally commingles collateral related to customer positions while protecting customers legally on an individual basis – that is, protecting them from fellow customer risk. Such individual protection does require the central counterparty to maintain accurate books sufficient to promptly ascertain an individual customer's interest in a portion of the collateral. A failure to do so can lead to delays or even losses in returning margin and other collateral that has been provided to the central counterparty to individual customers in the event that a participant becomes insolvent.^[2]

13.2.8 The degree to which portability is fostered for a customer whose assets are held in an omnibus account also varies depending on whether the central counterparty collects margin on a gross or net basis. As with account structure, there are advantages and disadvantages to the alternative ways in which margin may be collected by the central counterparty that employs an omnibus account structure. Margin calculated on a gross basis to support individual customer portfolios results in less netting efficiency at the participant level; however, it is likely to mitigate the risk of under-margined customer positions when ported. As a result, central counterparties can port a participant's customers' positions and related margin in bulk or piecemeal. Gross margining enhances the feasibility of portability, which is desirable since porting avoids the transaction costs, including bid-offer spreads, associated with terminating and replacing a participant's customers' positions. When margin is collected on a gross basis, it is more likely that there will be sufficient collateral in the omnibus account to cover all positions of a participant's customers.

13.2.9 When margin is collected by the central counterparty on a net basis but held in an omnibus account structure, there is a risk that full portability cannot be achieved. Since the collateral maintained in the omnibus account covers the net positions across all customers of a particular participant, upon a participant default, any excess collateral maintained by the defaulting participant may not be readily available for porting to another participant to adequately collateralise a customer's positions.^[3] Moreover, other than a bulk transfer of all customer positions of the defaulting participant, along with the aggregate of the customer collateral held at the central counterparty and at the participant, any transfer of a customer's positions to another participant would depend on the ability and willingness of customers to provide additional collateral. Otherwise, porting individual customer portfolios, with their pro rata share of net margin, to multiple transferee clearing members is likely to result in under-margined customer positions. Transferee clearing members are unlikely to accept such positions unless the margin shortfall is remedied by the customer.

Alternative arrangements for cash markets

13.2.10 Under certain circumstances, central counterparties clearing cash markets may be able to achieve materially equivalent protection of customer assets by alternative means. Such alternative arrangements should ensure that: customer positions can be identified in a timely manner; customers will be protected by an alternative mechanism (for example, an investor protection scheme) designed to move customer accounts from the failed or failing participant to another participant in a timely manner; and customer assets can be restored. In these cases, the central counterparty should consult with the Reserve Bank and other relevant authorities to demonstrate that the applicable legal or regulatory framework achieves materially equivalent protection for customers to that which would otherwise be achieved by the segregation and portability arrangements described elsewhere in this Standard.

13.3.1 Efficient and complete portability of a participant's customers' positions and related collateral is important in both pre-default and post-default scenarios but is particularly critical when a participant defaults or is undergoing insolvency proceedings.^[4] A central counterparty's ability to transfer customers' positions and related collateral in a timely manner may depend on such factors as market conditions, sufficiency of information on the individual constituents, and the complexity or sheer size of the portfolio. To the extent reasonably practicable under prevailing law, a central counterparty should therefore 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 effectively transferred to one or more other participants, taking into account all relevant circumstances. In order to achieve a high likelihood of portability, a central counterparty will need to: have the ability to identify positions that belong to customers; identify and assert its rights to related collateral held by or through the central counterparty; transfer positions and related collateral to one or more other participants; identify potential participants to accept the positions; and disclose relevant information to such participants so that they can evaluate the counterparty credit and market risk associated with the customers and positions, respectively. A central counterparty's rules and procedures should require participants to facilitate the transfer of a participant's customers' positions and collateral upon the customer's request, subject to any notice or other contractual requirements. The central counterparty should obtain the consent of the direct participant to which positions and collateral are ported. If there are circumstances where this would not be the case, they should be set out in the central counterparty's rules, policies or procedures. A central counterparty's policies and procedures also should provide for the proper handling of positions and collateral of customers of a defaulting participant. (See also CCP Standard 12 on participant default rules and procedures.)

13.4.1 A central counterparty should state its segregation and portability arrangements, including the method for determining the value at which customer positions will be transferred, in its rules, policies and procedures. (See CCP Standard 20 on disclosure of rules, key policies and procedures, and market data.) A central counterparty's disclosure should be adequate such that customers can understand how much customer protection is provided, how segregation and portability are achieved, and any risks or uncertainties associated with such arrangements. Disclosure helps customers to assess and manage the related risks and conduct due diligence when entering into transactions that are cleared or settled through a direct participant in the central counterparty, reducing the risk of financial spillover via customers in the event of a participant default. Customers should have sufficient information about which of their positions and collateral held at or through a central counterparty are segregated from positions and collateral of the participant and the central counterparty. Disclosure regarding segregation should include: whether the segregated assets are reflected on the books and records at the central counterparty or unaffiliated third-party custodians that hold assets for the central counterparty; who holds the customer collateral (for example, the central counterparty or a third-party custodian); and under what circumstances customer collateral may be used by the central counterparty. In particular, the central counterparty should disclose whether customer collateral is protected on an individual or omnibus basis.