Financial Stability Standards for Central Counterparties Standard 18: Tiered Participation Arrangements

Guidance

Tiered participation arrangements occur when some firms (indirect participants) rely on the services provided by other firms (direct participants) to use the central counterparty's clearing facilities.^[1]

The dependencies and risk exposures (including credit, liquidity and operational risks) inherent in these tiered arrangements can present risks to the central counterparty and its smooth functioning, as well as to the participants themselves and the broader financial markets. For example, if a central counterparty has few direct participants but many indirect participants with large values or volumes of transactions, it is likely that a large proportion of the transactions processed by the central counterparty depend on a few direct participants. This will increase the severity of the effect on the central counterparty of a default of a direct participant or an operational disruption at a direct participant. The credit exposures in tiered relationships can also affect the central counterparty. If the value of an indirect participant's transactions is large relative to the direct participant's capacity to manage the risks, this may increase the direct participant's default risk. In some cases, for example, central counterparties offering indirect clearing will face credit exposures to indirect participants (or arising from indirect participants' positions) if a direct participant defaults. There may also be legal or operational risk to the central counterparty if there is uncertainty about the liability for indirect participant transactions and how these transactions will be handled in the event of a default (see CCP Standard 1 on legal basis).

The nature of these risks is such that they are most likely to be material where there are indirect participants whose business through the central counterparty is a significant proportion of the central counterparty's overall business or is large relative to that of the direct participant(s) through which they access the central counterparty's services. Typically, the identification, monitoring and management of risks from tiered participation will therefore be focused on financial institutions that are the immediate customers of direct participants and depend on the direct participant for access to a central counterparty's services. In exceptional cases, however, tiered participation arrangements may require the central counterparty to look beyond the direct participant and its immediate customer.

There are limits on the extent to which a central counterparty can, in practice, observe or influence direct participants' commercial relationships with their customers. However, a central counterparty will often have access to information on transactions undertaken on behalf of indirect participants and can set direct participation requirements that may include criteria relating to how direct participants manage relationships with their customers insofar as these criteria are relevant for the safe operation of the central counterparty. At a minimum, a central counterparty should identify the types of risk that could arise from tiered participation and should monitor concentrations of such risk. If a central counterparty or its smooth operation is exposed to material risk from tiered participation arrangements, the central counterparty should seek to manage and limit such risk.

18.1.1 A central counterparty may be able to obtain information relating to tiered participation through its own systems or by collecting it from direct participants. A central counterparty should ensure that its procedures, rules and agreements with direct participants allow it to gather basic information about indirect participants in order to identify, monitor and manage any material risks to the central counterparty arising from such tiered participation arrangements. This information should enable the central counterparty, at a minimum, to identify: the proportion of activity that direct participants conduct on behalf of indirect participants; direct participants that act on behalf of a material number of indirect participants; indirect participants with significant volumes or values of transactions in the system; and indirect participants whose transaction volumes or values are large relative to those of the direct participants through which they access the central counterparty.^[2]

18.2.1 A central counterparty should identify material dependencies between direct and indirect participants that can affect the central counterparty. Indirect participants will often have some degree of dependence on the direct participant through which they access the central counterparty. In the case of a central counterparty with few direct participants but many indirect participants, it is likely that a large proportion of the transactions processed by the central counterparty would depend on the operational performance of those few direct participants. Disruption to the services provided by the direct participants – whether for operational reasons or because of a participant's default – could therefore present a risk to the smooth functioning of the system as a whole. The central counterparty should identify and monitor material dependencies of indirect participants on direct participants so that the central counterparty has readily available information on which significant indirect participants may be affected by problems at a particular direct participant.

18.2.2 In some cases, issues at an indirect participant could affect the central counterparty. This is most likely to occur where a large indirect participant accesses a central counterparty's facilities through a relatively small direct participant (see CCP Standard 18.3). Failure of this significant indirect participant to perform as expected, such as by failing to meet its payment obligations, or stress at the indirect participant, such as that which causes others to delay payments to the indirect participant, may affect the direct participant's ability to meet its obligations to the central counterparty. Central counterparties should therefore identify and monitor the material dependencies of direct participants on indirect participants so that the central counterparty has readily available information on how the central counterparty may be affected by problems at an indirect participant, including which direct participants may be affected.

Credit and liquidity risks in tiered participation arrangements

18.3.1 Tiered participation arrangements typically create credit and liquidity exposures between direct and indirect participants. The management of these exposures is the responsibility of the participants and, where appropriate, subject to supervision by their regulators. A central counterparty is not expected to manage the credit and liquidity exposures between direct and indirect participants, although the central counterparty may have a role in applying credit or position limits in agreement with the direct participant. A central counterparty should, however, have access to information on concentrations of risk arising from tiered participation arrangements that may affect the central counterparty, allowing it to identify indirect participants responsible for a significant proportion of the central counterparty's transactions or whose transaction volumes or values are large relative to those of the direct participants through which they access the central counterparty. A central counterparty should identify and monitor such risk concentrations.

18.3.2 In a central counterparty, direct participants are responsible for the performance of their customers' financial obligations to the central counterparty. The central counterparty may, however, face an exposure to indirect participants (or arising from indirect participants' positions) if a direct participant defaults, at least until such time as the defaulting participant's customers' positions are ported to another participant or closed out. If a participant default would leave the central counterparty with a potential credit exposure related to an indirect participant's positions, the central counterparty should ensure it understands and manages the exposure it would face. For example, the central counterparty may set participation requirements that require the direct participant, on the central counterparty's request, to demonstrate that it is adequately managing relationships with its customers to the extent that they may affect the central counterparty. A central counterparty should also consider establishing concentration limits on exposures to indirect participants, where appropriate.

Indirect participation and default scenarios

18.3.3 Default scenarios can create uncertainty about the status of indirect participants' positions and exposures. Default scenarios can also raise legal and operational risks for the central counterparty if there is uncertainty about whether the indirect or direct participant is liable for outstanding obligations to the central counterparty. A central counterparty should ensure that its rules and procedures are clear regarding the status of indirect participants' positions and exposures (including the point at which they become subject to the rules of the system and the point after which the rules of the system no longer apply). A central counterparty should also ensure that it adequately understands its direct participants' processes and procedures for managing an indirect participant's default.

Encouraging direct participation

18.3.4 Direct participation in a central counterparty usually provides a number of benefits, some of which may not be available to indirect participants. Moreover, indirect participants are vulnerable to the risk that their access to a central counterparty is withdrawn or disrupted. If these indirect participants have large values or volumes of business through the central counterparty, this may affect the smooth functioning of the central counterparty. For these reasons, where an indirect participant accounts for a material proportion of the transactions processed by a central counterparty, it may be appropriate to encourage direct participation. For example, a central counterparty may in some cases establish objective thresholds above which direct participation would normally be encouraged (provided that the firm satisfies the central counterparty's access criteria). Setting such thresholds and encouraging direct participation should be based on risk considerations rather than commercial advantage.

18.4.1 A central counterparty should regularly review risks to which it may be exposed as a result of tiered participation arrangements. If material risks exist, the central counterparty should take mitigating action as appropriate. The results of the review process should be reported to the board of directors and updated periodically and after substantial amendments to a central counterparty's rules.