2013/14 Assessment of LCH.Clearnet Limited's SwapClear Service 3. Assessment of LCH.Clearnet Limited against the Financial Stability Standards

3.1 Introduction

A CCP acts as the buyer to every seller, and the seller to every buyer in a market. It does so by interposing itself as the legal counterparty to all purchases and sales via a process known as novation. These arrangements provide substantial benefits to participants in terms of counterparty credit risk management as well as greater opportunities for netting of obligations. At the same time, however, they result in a significant concentration of risk in the CCP. This risk can crystallise if a clearing participant defaults on its obligations to the CCP, since the CCP must continue to meet its obligations to all of the non-defaulting participants. Accordingly, in order to promote overall stability of the Australian financial system, it is critical that the CCP identifies and properly controls risks associated with the operation of the CCP and conducts its affairs in accordance with the CCP Standards. Primary responsibility for the design and operation of a CCP in accordance with the CCP Standards lies with a CS facility licensee's board and senior management.

LCH.C Ltd operates a number of clearing services from its London operations. LCH.C Ltd holds an Australian CS facility licence allowing it to:

  • clear commodity, energy and environmental derivatives traded on the FEX market. The FEX market is not yet operational.
  • offer its SwapClear service in Australia. SwapClear is a CCP for OTC IRDs.

LCH.C Ltd is required under the Corporations Act to comply with applicable FSS determined by the Bank and to do all other things necessary to reduce systemic risk. This report presents the Bank's Assessment of the SwapClear service for the year ending 30 June 2014. The Bank's Assessment in this period has focused on the tailoring of LCH.C Ltd's services to Australian participants and LCH.C Ltd's observance of the requirements under the CCP standards that had previously been subject to transitional relief.

3.2 Activity in SwapClear

3.2.1 Global activity in SwapClear

Globally, an estimated 65 per cent of the US$354 trillion notional value outstanding of OTC IRDs is centrally cleared.[1] LCH.C Ltd's SwapClear service is the world's largest CCP for these products, clearing just over US$200 trillion, or around 91 per cent of the notional value outstanding of centrally cleared OTC IRDs. SwapClear clears a variety of OTC IRD types in 17 different currencies, and has participants from the UK, many other Western European countries, the United States (US), Canada, Australia and Hong Kong.

A few major currencies comprise the vast majority of activity in SwapClear (Graph 1). Of the notional value outstanding in SwapClear at end June 2014, around 45 per cent was denominated in euros, 27 per cent in US dollars, 14 per cent in British pounds, and 14 per cent in other currencies. Around 2 per cent was in Australian dollars.

The recent decline in notional value outstanding, visible in Graph 1, largely reflects trade compression activity. Since LCH.C Ltd reintroduced ‘triReduce’ dealer trade compression in November 2013, clearing participants have had the ability to participate in periodic multilateral trade compression cycles conducted by compression vendor TriOptima. Compression is the practice of identifying offsetting trades in participants' portfolios and terminating them, while leaving those participants' market-facing exposures unchanged (within a stated tolerance). Termination reduces the operational overhead, and operational risk, of managing a large volume of redundant trades. It also simplifies default management processes, reducing the volume of trades that would need to be priced and auctioned in the event of a participant default. Since the reintroduction of dealer compression in November 2013, the notional value compressed each month has varied between £3 trillion and £9 trillion (Graph 2). Since November 2013, a total of £39 trillion of notional value has been compressed.[2]

SwapClear clears six types of IRD product: interest rate swaps, zero-coupon swaps, basis swaps, forward rate agreements, overnight index swaps and variable notional swaps. Graph 3 and Graph 4 depict notional value registered and notional value outstanding, respectively, by product type. Interest rate swaps constitute the largest component of the outstanding value of open trades. These products are a larger proportion of the stock than the flow because they have longer tenors than overnight index swaps and forward rate agreements.

3.2.2 Australian activity in SwapClear

Since early 2012, the major Australian banks have centrally cleared a significant proportion of their OTC IRD trades indirectly, as customers of other clearing participants. In July 2013, the Minister varied LCH.C Ltd's CS facility licence to allow SwapClear to admit Australian entities as direct clearing participants. Since then, three Australian banks have joined SwapClear as clearing participants: ANZ joined in September 2013; National Australia Bank (NAB) joined in October 2013; and the Commonwealth Bank (CBA) joined in August 2014.

The total notional value outstanding of Australian banks, whether clearing as customers or as clearing participants, has increased strongly since late 2012 (Graph 5). According to a survey conducted by Australian regulators in early 2014, Australian dealers now centrally clear almost all new interdealer trades that are eligible for clearing.[3] However, given that not all existing trades are eligible for clearing and that Australian entities have not yet ‘backloaded’ previously non-centrally cleared trades, only around 22 per cent of Australian entities' notional value outstanding of Australian dollar-denominated OTC IRDs is centrally cleared.

OTC IRDs comprise the majority of OTC derivatives activity in Australia. Single-currency OTC IRDs comprise about 65 per cent of the notional value and 45 per cent of the gross market value of Australian dealers' outstanding OTC derivatives. The majority of Australian dealers' OTC IRDs are interest rate swaps (Graph 6).

An estimated 98 per cent of the notional value outstanding of all centrally cleared Australian dollar-denominated OTC IRD trades are cleared via SwapClear. Australian banks' clearing activity has been part of a broader upward trend in notional value outstanding of Australian dollar-denominated OTC IRDs cleared via SwapClear. The total notional value outstanding of Australian dollar-denominated OTC IRDs cleared via SwapClear has doubled from A$2 trillion in December 2012 to A$4 trillion in June 2014 (Graph 7). However, in May 2014 the notional value outstanding of Australian dollar-denominated contracts fell due to a triReduce compression cycle for Australian dollar-denominated trades, which compressed around A$535 billion.[4] While the rate at which new Australian dollar-denominated trades are registered has been fairly stable over the past year (Graph 8), notional value outstanding has continued to increase in the long term because many contracts have long tenors.

3.3 Risk Management in SwapClear

A CCP is exposed to potential losses arising in the event of clearing participant default. LCH.C Ltd manages this risk in a number of ways, including participation requirements, margin collection, the maintenance of pooled resources and loss allocation arrangements.

3.3.1 Clearing participation requirements

To limit its exposure to its participants, LCH.C Ltd only allows institutions to become clearing participants if they meet certain financial and operational requirements. Prospective participants of SwapClear are required to have net capital of at least US$50 million, appropriate banking arrangements, staff with sufficient experience, and appropriate systems to manage their clearing activities. Prospective participants must also demonstrate their operational capability to participate effectively in default management processes, including their ability to value and bid on the portfolio of a defaulting participant.

3.3.2 Margin collection

LCH.C Ltd covers its credit exposures to its SwapClear participants by collecting several types of margin.

  • Variation margin. All SwapClear positions are marked to market on at least a daily basis. Variation margin is collected from participants with loss-making positions and paid to those with profit-making positions. This practice ensures that LCH.C Ltd's valuations of SwapClear participant positions remain current and that uncovered losses do not accrue over time.
  • Initial margin. LCH.C Ltd is exposed to risk arising from potential changes in the market value of a defaulting participant's open positions between the last settlement of variation margin and the close out of these positions. To mitigate this risk in normal market conditions, LCH.C Ltd will only register trades if, at the point of registration, there are sufficient resources at the clearing participant level.
  • Intraday margin. LCH.C Ltd monitors participants' portfolios intraday, to take account of changes in both prices and positions; LCH.C Ltd makes intraday margin calls where margin liabilities exceed predetermined participant-specific credit thresholds.
  • Additional margin. LCH.C Ltd collects various forms of additional margin to cover any credit, liquidity, concentration and sovereign risks not captured by the base initial margin model. This includes, for example, daily or monthly ‘default fund additional margin’ (DFAM), which is called from participants with large exposures identified through stress testing (see Section 3.3.3).

LCH.C Ltd calculates initial margin requirements for SwapClear using its Portfolio Approach to Interest Rate Scenarios (PAIRS) model. The model sets initial margin requirements to cover potential losses over a 5-day close-out period with 99.7 per cent confidence, based on historical movements in yield curves and exchange rates over a 10-year look-back period. LCH.C Ltd assumes that an additional two-day period will be required to close out customer positions;[5] initial margin requirements on the positions of customers of participants are scaled up accordingly.

Graph 9 shows the total initial margin requirement for all participants in SwapClear. LCH.C Ltd assesses the performance of its margin model through daily and monthly back-testing (described in Section 3.7.3); in addition, the adequacy of the model assumptions is assessed using monthly and quarterly sensitivity analysis (see Section 3.7.5).

3.3.3 Pooled financial resources

In the event of a counterparty default, any losses arising would first be covered by the margin and other collateral posted by the defaulter. Should this prove insufficient to meet LCH.C Ltd's obligations, it may draw on other resources in the SwapClear default waterfall.[6] This is depicted in Figure 1, which shows the order in which financial resources would be used to cover default losses in excess of the defaulter's collateral, as at June 2014.

Prefunded Resources

After using all the defaulter's margin and other collateral (including the defaulter's contribution to the SwapClear default fund), LCH.C Ltd would cover participant default losses using prefunded pooled resources.

All clearing participants of SwapClear are required to contribute to the SwapClear default fund. This is a pool of prefunded mutualised resources to which default losses could be allocated. The SwapClear default fund comprises two components: a core component (around £1,900 million at June 2014) and an additional component that supports the intraday provision of credit needed to facilitate ‘real time’ trade registration (£400 million as at June 2014). Both components are available to cover losses from participant defaults. LCH.C Ltd would use a slice of its own capital (€36 million as at June 2014) before the default fund contributions of non-defaulting participants, as required by EMIR.

Default fund core component

The purpose of the core component is to cover any losses LCH.C Ltd would incur if the two clearing participants (including their affiliates and customers) with the largest exposures defaulted under extreme but plausible conditions, after using the defaulters' initial margin and additional margin. This is intended to meet the cover two requirement under CCP Standard 4.4 and its equivalent under EMIR.

The core component is resized on the first business day of each month. As part of its process for sizing the core component, LCH.C Ltd may call monthly DFAM from a participant and its affiliates if they had an ‘outsized’ stress-test loss over initial margin (STLOIM) in the previous 60 business days.[7] LCH.C Ltd holds monthly DFAM until the default fund is resized next month. Monthly DFAM is not mutualised; it can only be used to cover losses from the participant that posted it. The size of the core component of the default fund is then set to equal the two largest STLOIMs from the same scenario in the previous 60 business days, plus a buffer, less the amount of monthly DFAM called by LCH.C Ltd. LCH.C Ltd uses monthly DFAM to balance between ‘defaulter pays’ and mutualised resources, ensuring that participants with large exposures relative to the other SwapClear members sufficiently contribute to the resources required to cover those exposures.

Each day, LCH.C Ltd calls daily DFAM from participants and affiliates whose STLOIMs on that day exceed a predefined proportion of the default fund based on those participants' internal credit scores (ICS). The amount called is the difference between that STLOIM and the relevant proportion of the default fund on that day. Graph 10 demonstrates how the combination of default fund resizing based on scenario exposures and calling additional margin on concentrated risk positions through the daily DFAM mechanism ensures that, in aggregate, LCH.C Ltd maintains sufficient financial resources from a cover two perspective. Graph 10 shows: the default fund core component; the two highest STLOIM for the same scenario, net of daily DFAM (solid line), which is always lower than the default fund size; and the two highest STLOIMs for the same scenario, without adjusting for daily DFAM (dotted line).

The proportion of the core component that each SwapClear participant is obliged to contribute is calculated according to the average initial margin requirement on its house positions for the previous month as a share of SwapClear participants' total initial margin requirements. Contributions are subject to a minimum of £10 million per legal entity and are rebalanced each month.

Default Fund Real-time Trade Registration Component

To meet US regulatory requirements, SwapClear novates new trades every 60 seconds. Trades are novated provided that the incremental margin requirement arising from the trade is covered by collateral held by LCH.C Ltd, or is below a tolerance limit set by LCH.C Ltd. LCH.C Ltd assigns these tolerance limits to participants based on their ICSs. By extending credit to participants through tolerance limits, the frequency with which LCH.C Ltd can register trades is not restricted by the frequency with which LCH.C Ltd can collect margin.

LCH.C Ltd mitigates the credit risk that arises from offering trade registration tolerance limits through an additional component in the default fund. This additional component is currently sized at £400 million. The proportion that each participant is obliged to contribute is based on its tolerance limit utilisation relative to that of other participants over the prior 20 business days, subject to a floor of £3 million and a cap of £30 million. Participant contributions to the additional component are rebalanced on the same time line as those to the core component. Usage of this additional component is limited on a cover two basis, which means that no clearing participant may use more than £200 million of this component at any time.

Unfunded Loss Allocation Rules

If default losses exhausted the default fund, they would be allocated to participants through ‘loss allocation rules’, which are described in detail in Appendix A (CCP Standard 4).

  • Unfunded contributions. LCH.C Ltd would call unfunded contributions from non-defaulting participants to the value of their last default fund contribution, once for each default, subject to maximum of three defaults in any six-month period.
  • Variation Margin Gains Haircutting. LCH.C Ltd would apply haircuts to the variation margin payments owed to non-defaulting participants whose positions make gains, up to a cap.
  • Voluntary Service Continuity. Should losses remain, LCH.C Ltd would ask non-defaulting participants to make voluntary contributions.

3.4 LCH.Clearnet Limited's Regulatory and Operating Environment

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

3.4.1 The regulatory regime

EU regulation

In July 2012, the EU introduced a harmonised framework for the regulation of financial market infrastructure (FMIs), including CCPs, incorporated in the region: EMIR.[8] EMIR and its associated technical standards largely implement the Principles in the EU. Under EMIR, primary regulatory authority of a CCP is given to the national competent authority (NCA) in the country in which that CCP is established; since LCH.C Ltd is established in England, this is the BoE.

EMIR required CCPs incorporated in the EU to apply to their NCA for authorisation to continue offering clearing services. Authorisation is the point at which the CCP formally becomes subject to the requirements of EMIR. The BoE granted LCH.C Ltd authorisation under EMIR on 12 June 2014 (see Section 3.7 below).

UK regulation

Within the UK, LCH.C Ltd is regulated by the BoE as a ‘recognised central counterparty’ under the UK Financial Services and Markets Act 2000 (FSMA). FSMA sets recognition requirements for UK CCPs, which, among other things, require a CCP to:

  • comply with EMIR and its technical standards
  • develop a recovery plan, and adopt rules for the allocation of default losses and non-default losses that may threaten the CCP's solvency
  • ensure under its rules that the positions or assets of customers of defaulting participants cannot be ported to a non-defaulting participant without the consent of the customer and the non-defaulting participant
  • take measures to monitor and reduce financial crime and market abuse.

The BoE recognised LCH.C Ltd as a recognised central counterparty on the same date that it authorised LCH.C Ltd under EMIR. Prior to this date, LCH.C Ltd was regulated as a ‘recognised clearing house’ under FSMA. The recognition requirements for recognised clearing houses that are not EMIR-authorised CCPs are less detailed than the provisions in EMIR. Nevertheless, during the transition period prior to authorisation under EMIR, the BoE committed to be guided by EMIR and the Principles in its application of those recognition requirements to applicant CCPs. Further, the recognition requirements for recognised central counterparties concerning recovery and allocation of default losses, and allocation of non-default losses, became effective in February and May 2014, respectively.

In addition, the Protected Payments System (PPS) operated by LCH.C Ltd (the system that provides for settlement of margins and other payments between LCH.C Ltd and its clearing participants) is regulated and overseen by the BoE as a ‘recognised payment system’ under the UK's Banking Act 2009. The BoE requires LCH.C Ltd to operate this system having regard to the Principles.

Regulation in other jurisdictions

LCH.C Ltd's operations span several jurisdictions. Outside the EU, LCH.C Ltd has been formally licensed or granted an exemption in the US, Norway, Switzerland, Japan, the Canadian provinces of Ontario and Quebec, and Singapore, allowing it to offer a range of clearing services in those jurisdictions.

3.4.2 The EMIR College and the LCH.C Ltd Global College

EMIR establishes a framework for cooperative oversight of CCPs among EU authorities, requiring that a supervisory college be established for each EU-based CCP. EMIR specifies that membership of the college for each CCP be drawn from the EU authorities responsible for supervising: the CCP itself; clearing participants of the CCP; trading venues served by the CCP; central securities depositories to which the CCP is linked; and other interoperating CCPs. Membership should also include the central banks of issue of the most relevant EU currencies of the instruments cleared by the CCP.

The EMIR supervisory college for LCH.C Ltd is chaired by the BoE. The college was part of the decision-making process to authorise LCH.C Ltd under EMIR. The EMIR supervisory college will play a role in the ongoing supervision of LCH.C Ltd; it will be part of the decision-making process should LCH.C Ltd apply to the BoE to expand its services. The college will also facilitate the exchange of information among its members.

The BoE has also established a Global College for LCH.C Ltd's SwapClear service, membership of which extends beyond the EMIR supervisory college. The Bank is represented on the Global College. The College facilitates the exchange of information and discussion of supervisory matters concerning LCH.C Ltd's SwapClear service, including through in-person meetings and regular exchanges of data. The BoE will review the organisation, scope and membership of the Global College during the second half of 2014.

3.4.3 The Bank of England's oversight approach and supervisory priorities

The BoE has a mandate to protect and enhance the stability of the UK financial system. In a published statement on its approach to oversight of FMIs,[9] the BoE states that its role as supervisor is to ensure that FMIs for which it has oversight responsibility are ‘managed consistently with the public interest, maintaining and enhancing financial stability and reducing systemic risk’. The BoE takes a risk-based approach to oversight, prioritising its supervisory effort in areas where it considers risks to financial stability are greatest.

The BoE conducts at least an annual assessment of the risks each UK FMI presents to financial stability. Based on its assessment, the BoE sets expectations of risk-mitigating actions the FMI should take, in the form of supervisory priorities. The BoE provides LCH.C Ltd with a single set of supervisory priorities, covering its operations as a CCP and as a payments system.

In March 2014, the BoE published a report on its oversight of UK FMIs.[10] The report summarises the BoE's supervisory priorities during the period from March 2013 to March 2014, as they apply across all FMIs. These priorities, focusing on their relevance to the UK CCPs, were:

  • Credit and liquidity risk. This included CCP margin and default fund methodologies, and monitoring of liquidity risk.
  • Recovery and resolution. During the year to March 2014, the BoE required all FMIs to begin work to ensure they are able to manage unexpected financial losses. As discussed above, all UK CCPs were required, by February 2014, to have in place a recovery plan and rules to allocate clearing participant default losses in excess of prefunded resources.
  • Operational risk. A key focus of the BoE's work on FMI operational resilience has been management of cyber risk. This work, conducted in conjunction with other UK authorities, will continue into 2014.
  • Governance. The BoE noted that LCH.C Ltd had appointed two independent directors during the period, who will not serve as directors in any other LCH.Clearnet Group (LCH.C Group) company.
  • Disclosure. The BoE stated that all FMIs made progress towards meeting the CPSS-IOSCO disclosure requirements.

The report also summarised the BoE's broad supervisory priorities for the 2014/15 period:

  • Credit and liquidity risk. CCP stress-testing practices will be a particular focus of the BoE's oversight during this Assessment period.
  • Recovery and resolution. UK legislation required that by 1 May 2014 all CCPs have rules or other effective arrangements to allocate non-default losses that threatened the solvency of the CCP. The BoE also noted that further work would be required to refine CCPs' recovery plans. In addition, the UK is working to implement a special resolution regime, which would cover CCPs. Legislation required to implement this was submitted to the UK Parliament in June 2014.
  • Operational risk. The BoE will continue its program to increase the resilience of FMIs against cyber attack, as well as addressing operational risk management more broadly.

The BoE noted that its priorities were subject to review, should new issues or risks emerge.

3.5 Progress against the Bank's 2013/14 Regulatory Priorities

In assessing LCH.C Ltd's application to vary its CS facility licence to offer its SwapClear service, the Bank took the view that the service could rapidly become systemically important in Australia. On the licence variation being granted in July 2013, the Bank determined a set of regulatory priorities for LCH.C Ltd to ensure that its operational and governance arrangements promoted stability in the Australian financial system. These priorities reflect the expectations set by the Council of Financial Regulators (CFR) in July 2012 in its policy ‘Ensuring Appropriate Influence for Australian Regulators over Cross-border Clearing and Settlement Facilities’ (CFR Regulatory Influence Policy).[11] These expectations are reflected in the FSS. The Bank's initial regulatory priorities for LCH.C Ltd were:

  • to extend operating hours and operational support to the Australian time zone
  • to open an ESA
  • to consider accepting Australian dollar cash as initial margin
  • appropriate representation of Australian membership in governance
  • appropriate representation of Australian membership and regulators in default management.

LCH.C Ltd agreed to work with the Bank to address these priorities within a reasonable time frame. LCH.C Ltd's progress against these priorities during the 2013/14 Assessment period is summarised in Table 3 and described in more detail below. The Bank will continue to engage with LCH.C Ltd on a number of these regulatory priorities throughout the 2014/15 Assessment period.

LCH.C Ltd's progress towards the first three regulatory priorities was contingent on LCH.C Group's continued implementation of a new liquidity and collateral management system. Phase II of the system's implementation was completed in May 2014 when LCH.C Ltd's collateral management was transferred from the legacy system to the new system; an earlier stage of the system's implementation (Phase I) transferred LCH.C Ltd's cash and liquidity management. The new collateral management platform now supports the cover distribution process (which is the process in which lodged collateral is allocated to cover margin requirements), PPS calls and Society for Worldwide Interbank Financial Telecommunication (SWIFT) messaging, the management of non-cash collateral, and internal and external messaging and reporting for LCH.C Ltd. The project is now completed and has created a common collateral and liquidity management platform across LCH.C Ltd and LCH.Clearnet LLC (LCH.C LLC).

3.5.1 Extend operating hours and operational support to the Australian time zone

The Bank expects LCH.C Ltd to extend its operating hours and to provide appropriate support to participants in the Australian time zone. The operating hours of the SwapClear service (currently from 07:30 to 00:00 UK time) are such that operational support and payment arrangements are unavailable during much of the Australian business day, and trades executed during the Australian business day when the SwapClear service is closed are not novated to LCH.C Ltd until the Australian evening when the SwapClear service reopens. This leaves Australian banks and their counterparties with temporary bilateral credit risk exposures, which have to be managed via bilateral compensation arrangements and result in greater operational complexity and uncertainty.

The Bank's expectation that LCH.C Ltd should have the operational capability to novate trades and collect margin during the Australian business day is reflected in CCP Standard 6.8, which requires that a CCP ‘consider the operating hours of payment and settlement systems in the markets in which it operates’ in designing its margin system, and CCP Standard 16.5, which requires that ‘[w]here a central counterparty operates in multiple jurisdictions, managing [operational] risks may require it to provide adequate operational support to participants during the market hours of each relevant jurisdiction’.

LCH.C Ltd intends to increase SwapClear's operating hours in a number of phases, beginning later in 2014.

  • The first phase will decrease the amount of time the SwapClear service is closed from 7½ hours to 4 hours – when this takes effect, SwapClear will be open from 04:00 to 00:00 UK time (13:00 to 09:00 Sydney time in winter; 15:00 to 11:00 Sydney time in summer). LCH.C Ltd plans to launch this phase in the third quarter of 2014.
  • The second phase will decrease the amount of time the SwapClear service is closed from 4 hours to 2 hours, with SwapClear open from 02:00 to 00:00 UK time (11:00 to 09:00 Sydney time in winter; 13:00 to 11:00 Sydney time in summer). LCH.C Ltd currently plans to launch this phase late in the fourth quarter of 2014.
  • A third and final phase, to reduce the time the service is closed to 30 minutes, is also under consideration.

A number of system changes will also be required to facilitate these changes. The extension of LCH.C Ltd's operating hours is also subject to non-objection from LCH.C Ltd's home regulator, the BoE.

Ahead of those changes, SwapClear implemented operational changes in May 2014 so that trades registered in the early morning in Australia are eligible to be cleared immediately if the SwapClear system is open. Before the changes were in place, trades entered in the early hours of the Australian day were held in a queue and processed the next business day, even if the SwapClear system was operating. For example, trades registered for clearing early on Tuesday morning in Sydney were held in a queue until SwapClear opened in London on Tuesday – even if the SwapClear system had been operating (on Monday evening London time) when the trades were registered. Now that the rule changes are in place, such trades are eligible to be cleared immediately if the SwapClear service is open. Using the earlier example, a trade registered for clearing on early Tuesday morning in Sydney will be eligible to be cleared immediately if SwapClear is still open, and if that occurs will be reported as being cleared on the Monday.

In setting this regulatory priority, the Bank acknowledged that LCH.C Ltd was already undertaking an upgrade of its banking and collateral management systems to facilitate novation of trades and the collection of margin over an extended operating day. However, the Bank noted that these changes were not due to take effect until the first half of 2014 and that operational support arrangements for Australian-based participants must be adequate in the interim. At present, Australian participants can seek operational support from LCH.C Ltd's current Sydney-based staff or via LCH.C Ltd staff in London or New York, although there is a gap in the middle of the Sydney day when support from the London or New York offices is unavailable. To support its extended hours of operation, LCH.C Ltd intends to have additional operational and management staff in its Australian office from the third quarter of 2014, bringing the total to around 10.

Recommendation. The Bank expects LCH.C Ltd to continue its work to extend operating hours and operational support in the Australian time zone.

3.5.2 Open an Exchange Settlement Account

The Bank requires LCH.C Ltd to open an ESA if it becomes systemically important in Australia and to use its ESA to settle its Australian dollar obligations. This is in accordance with the CFR Regulatory Influence Policy and CCP Standard 9.1. In the first instance, LCH.C Ltd intends to settle Australian dollar variation margin through its ESA. LCH.C Ltd is also considering accepting Australian dollar cash as initial margin (see below); settlement of this would be implemented in a second phase. Similarly, as required by CCP Standard 7.7, the Bank expects LCH.C Ltd to use its ESA to enhance its management of its Australian dollar liquidity risk.

LCH.C Ltd has submitted an application to the Bank to open an ESA and is currently engaging with the relevant sections of the Bank. Subject to the Bank approving LCH.C Ltd's application, LCH.C Ltd is aiming to have its ESA operational by the end of the fourth quarter 2014. Several interim steps must be completed ahead of this, including the completion of LCH.C Ltd's application to join the Australian Payments Clearing Association's High Value Clearing System and testing of the arrangements. As a requirement of holding an ESA, LCH.C Ltd will also need sufficient management resources located in Australia, with the ability to make timely decisions to operate the account (see Section 3.5.1 above on LCH.C Ltd's staff in Australia).

LCH.C Ltd has also applied to open an account with Austraclear to hold Australian dollar securities collateral. LCH.C Ltd expects its Austraclear account to be open in the fourth quarter of 2014. LCH.C Ltd intends to hold collateral eligible for repo with the Bank in its Austraclear account to facilitate management of its Australian dollar liquidity needs. LCH.C Ltd intends to hold sufficient eligible collateral to manage its potential Australian dollar liquidity needs in the event of the default of the two clearing participants with the largest projected Australian dollar obligations (see CCP Standard 7 in Appendix A).

To facilitate payments to and from its clearing participants, LCH.C Ltd operates a payment system known as the PPS. LCH.C Ltd is working to establish Australian dollar PPS arrangements through its ESA, and is currently in discussions with potential Australian dollar ‘PPS banks’ (i.e. the banks that will facilitate flows of clearing participants' Australian dollar settlement obligations to and from LCH.C Ltd's ESA). Although arrangements are not yet finalised, it is expected that they will largely mirror LCH.C Ltd's existing settlement arrangements. Nonetheless, the Bank expects any clearing participant that has joined the SwapClear service as a direct clearing participant since LCH.C Ltd had its CS licence varied to allow it to offer that service in Australia, and that also has an active ESA, to become a PPS bank and to use those PPS arrangements to settle its Australian dollar obligations using its ESA (i.e. to ‘self-PPS’). LCH.C Ltd expects its Australian PPS arrangements to be in place in the first quarter of 2015. The Bank expects to continue to engage with LCH.C Ltd regarding its Australian dollar PPS arrangements, including regarding potential concentration risks in these arrangements. The Bank will also engage with LCH.C Ltd regarding its arrangements for managing its Australian dollar liquidity needs.

Recommendations. LCH.C Ltd should finalise its application for an ESA.

LCH.C Ltd should develop and implement arrangements for the settlement of Australian dollar obligations through its ESA.

LCH.C Ltd should develop and implement arrangements to manage its Australian dollar liquidity risk, utilising its ESA.

3.5.3 Consider accepting Australian dollars as initial margin

The Bank expects LCH.C Ltd to review its collateral acceptance policy and consider the inclusion of Australian dollar cash for initial margin payments. This would ‘support effective access by accommodating local market practices’ as contemplated by the CFR Regulatory Influence Policy, and also contribute to LCH.C Ltd's compliance with CCP Standard 5.2. This requires that a CCP ‘consider allowing the use of collateral commonly accepted in the relevant jurisdictions in which it operates’.

LCH.C Ltd is considering accepting Australian dollar cash as initial margin in early 2015. This proposal will still need to be formally approved through LCH.C Ltd's internal risk governance processes and is subject to non-objection from the BoE.

Recommendation. LCH.C Ltd should consider accepting Australian dollar cash as initial margin.

3.5.4 Appropriate representation of Australian membership in governance

The Bank expects LCH.C Ltd to establish appropriate governance mechanisms to reflect the views of Australian-based participants. This is consistent with CCP Standard 2.8, which requires that ‘[g]overnance arrangements [should] provide for consultation and stakeholder engagement through appropriate forums on operational arrangements, risk controls and default management rules and procedures’.

LCH.C Ltd liaises with Australian participants in a number of ways. It formed the AMUG for Australian direct participants in March 2014. The AMUG provides a means for LCH.C Ltd to seek input from Australian participants on proposed changes to policy and risk management procedures and to provide timely updates on material changes. It also provides an opportunity for Australian participants to propose to LCH.C Ltd policy changes that should be developed or prioritised at internal SwapClear governance forums. The AMUG is scheduled to hold face-to-face meetings quarterly and conference calls monthly. Membership of the AMUG is currently restricted to Australian direct clearing participants (and to entities that will be joining the SwapClear service imminently as Australian direct participants), although LCH.C Ltd is considering inviting Australian subsidiaries of overseas-based SwapClear participants. The Bank will monitor the effectiveness of these arrangements over the coming Assessment period.

Before the AMUG was established, Australian participants had the opportunity to take part in LCH.C Ltd's SwapClear International Advisory Meetings, which are convened three times a year to discuss specific policy changes with participants. These meetings are open to all participants but focus on serving participants without a dedicated regional user group (such as the AMUG). In addition, LCH.C Ltd convenes a ‘SwapClear Programme Update’ to disseminate information related to operations testing and development changes to clearing participants every two weeks.

As discussed above, LCH.C Ltd is also liaising with prospective PPS banks in Australia. An informal technical workshop was recently held for the prospective Australian PPS banks. When the PPS arrangements are established, LCH.C Ltd expects that it will convene meetings for the Australian dollar PPS banks three or four times a year to discuss technical, policy and risk management issues.

3.5.5 Appropriate representation of Australian membership and regulators in default management

The Bank expects LCH.C Ltd's crisis management arrangements to take appropriate account of Australian stability interests in the event that Australian-based direct participation in the SwapClear service becomes material. This is likely to imply some role for both the Bank and Australian-based participants in default management arrangements. Accordingly, the Bank will seek to enter into dialogue with LCH.C Ltd to discuss in detail how it is envisaged that the default of an Australian-based participant, or any participant with a large Australian dollar-denominated portfolio, would be managed. It is expected that such dialogue will clarify the roles of the Bank and Australian-based participants in this process. Meeting the Bank's expectations in this area would enhance LCH.C Ltd's compliance with CCP Standard 12.5, which requires that ‘[a] central counterparty should demonstrate that its default management procedures take appropriate account of interests in relevant jurisdictions and, in particular, any implications for pricing, liquidity and stability in relevant financial markets’.

One aspect of this is the involvement of Australian participants in SwapClear Fire Drills, which provides SwapClear and its participants the opportunity to practise aspects of its default management processes. In those tests, auction packs (i.e. hypothetical portfolios) are generated by SwapClear and participants are required to import and reconcile trade files and reports, value the auction packs and bid for each auction pack. ANZ and NAB took part in two Fire Drills during the Assessment period, in November 2013 and May 2014. In addition, before joining the SwapClear service prospective participants are required to take part in ‘driving tests’, which are tests undertaken outside the main Fire Drill to demonstrate their ability to value portfolios and bid for them. ANZ and NAB conducted tests in US dollars before they joined in 2013 and participated in other currencies as a driving test during the November 2013 Fire Drill, and CBA conducted a similar driving test before it joined in 2014.

The Bank will continue to work with LCH.C Ltd to ensure that its default management arrangements take appropriate account of Australian stability interests. The Bank will also consider the implications that a broader crisis within LCH.C Ltd, triggering (for example) recovery, wind-down or actions to resolve LCH.C Ltd, might have for financial stability within Australia. In the event of a crisis affecting LCH.C Ltd, the BoE would be the lead regulatory authority, in its capacity as LCH.C Ltd's primary regulator and also as the UK resolution authority. The Bank will continue to liaise with the BoE on this topic. The crisis management arrangements that would apply to LCH.C Ltd have important implications for all jurisdictions in which LCH.C Ltd operates, including for Australia, and it is expected that discussions with the BoE and other regulators to further consider LCH.C Ltd's crisis management arrangements will begin over the coming months.

Recommendation. LCH.C Ltd should ensure that its crisis management arrangements take appropriate account of Australian stability interests.

3.6 CCP Standards Previously Subject to Transitional Relief

In December 2012, the Bank determined new FSS. Transitional relief was granted for nine of the CCP sub-standards, covering matters related to: recovery, wind-down and resolution; liquidity risk management; and segregation and portability of customer positions and associated collateral. These CCP Standards came into force in March 2014. The Bank has assessed LCH.C Ltd's observance of all relevant requirements under these standards. Further detail of LCH.C Ltd's observance of each of the relevant CCP Standards is discussed in Appendix A.

3.6.1 Recovery, wind-down and resolution

Recovery and wind-down

In April 2014, the LCH.C Ltd Board approved LCH.C Ltd's Recovery Plan and its Wind-down Plan. The Recovery Plan describes how LCH.C Ltd would continue its operations if it suffered extreme losses; the Wind-down Plan describes how it would cease its operations. LCH.C Ltd has identified two broad scenarios that could potentially trigger these plans: losses arising from clearing participant defaults; and non-clearing-participant-default losses.

The Recovery Plan indicates that LCH.C Ltd would largely utilise existing rules and working practices in a recovery situation. The Plan includes additional analysis to consider the risks of applying these rules and working practices in times of market stress. With respect to losses arising from clearing participant defaults, the Recovery Plan describes how prefunded resources would be used to meet the losses and how uncovered losses would be met. The Recovery Plan also sets out the trigger for individual service closure, which could occur while leaving the remaining services operational. LCH.C Ltd introduced new rules in May 2014 to allocate investment-related losses caused by the default of an issuer of a debt instrument or an investment counterparty. The rule allocates the first €15 million of such losses to LCH.C Ltd and the remaining losses to clearing participants in proportion to each clearing participant's average share of initial margin.

The Wind-down Plan includes detailed estimates of how LCH.C Ltd would shut down its operations and how long this would take. In the case of a non-clearing-participant-default loss, wind-down would be triggered by regulatory order or if LCH.C Ltd was at risk of becoming insolvent. The decision to wind-down LCH.C Ltd would ultimately be made by the LCH.C Ltd Board, although a number of bodies would be consulted, such as shareholders, the LCH.C Group Board and regulators.

Both the Recovery Plan and the Wind-down Plan will be reviewed annually and following material changes to LCH.C Ltd's business model, rules and procedures. Reviews will be coordinated by the Chief Operating Officer (COO) and approved by the LCH.C Ltd Board. The COO is also responsible for overseeing implementation of the Recovery Plan and Wind-down Plan, in conjunction with the LCH.C Ltd Management Committee and Board. The plans, and their governance, are discussed in more detail in Appendix A (CCP Standard 3.5).


Since LCH.C Ltd is a UK-based CS facility, any crisis management actions would be expected to be led by the UK resolution authority, the BoE. Legislation establishing a resolution regime for UK CCPs received Royal Assent in December 2012, although the relevant legislative provisions are not yet in force and the UK authorities are developing supporting secondary legislation that will establish the date on which the resolution regime for CCPs will enter into force. The crisis management arrangements that would apply to LCH.C Ltd have important implications for all jurisdictions in which LCH.C Ltd operates, including for Australia, and it is expected that LCH.C Ltd's crisis management will be discussed further with the BoE and other regulators. In addition, LCH.C Ltd's crisis management arrangements form part of the Bank's regulatory priorities for LCH.C Ltd.

3.6.2 Liquidity risk management

LCH.C Ltd has arrangements in place to ensure that it has access to sufficient liquid resources to meet its projected payment obligations on time in the event that the two participants and their affiliates that would generate the largest aggregate payment obligations were to default in extreme but plausible scenarios. LCH.C Ltd projects its liquidity needs through liquidity stress testing, and during the Assessment period introduced a framework to reverse stress test its liquid resources. The Bank expects LCH.C Ltd to continue to enhance this framework so that it can demonstrate how its approach to modelling variation margin outflows for the purposes of liquidity stress testing captures a sufficient range of extreme but plausible scenarios.

The actions that LCH.C Ltd would take to address a liquidity shortfall or replenish its liquidity resources are described in the LCH.C Ltd Liquidity Plan and in LCH.C Ltd's Recovery Plan.

LCH.C Ltd has applied to the Bank to open an ESA. LCH.C Ltd proposes to use its ESA to manage its Australian dollar liquidity requirements. The Bank expects to continue to engage with LCH.C Ltd as it refines its Australian dollar liquidity model.

Recommendation. LCH.C Ltd should use its reverse stress-testing framework to demonstrate how its approach to modelling variation margin outflows for the purposes of liquidity stress testing captures a sufficient range of extreme but plausible scenarios.

3.6.3 Segregation and portability

LCH.C Ltd introduced new account structures during the Assessment period in order to comply with EMIR regulations. LCH.C Ltd's SwapClear service now offers three broad types of customer accounts: an individually segregated account (ISA); an omnibus segregated account (OSA) using gross margin; and an OSA using net margin.[12] The accounts differ in the extent to which individual customers' positions and collateral are segregated from those of other customers (i.e. the degree of protection from fellow customer risk) and the probability that a customer's positions could be ported (see CCP Standard 13 in Appendix A).

The assets of customers that have opted to use an ISA are protected using the ‘asset segregation’ model. Under this model, specific assets lodged as collateral by a particular customer are recorded to that customer's individual account. In the event of the default of the customer's clearing participant, those specific assets could be ported to another clearing participant along with its positions. This contrasts with the ‘value segregation’ model, under which the value of a non-defaulting customer's lodged collateral is protected, but the customer might not be returned the specific assets that it had lodged. In addition, SwapClear now offers account segregation for indirect customers (i.e. the customers of clearing participants' customers).

LCH.C Ltd has arrangements in place that are intended to make it highly likely that a defaulting clearing participant's customer's positions and collateral could be ported to another clearing participant.

3.7 Material Developments Relevant to LCH.C Ltd's SwapClear Service

3.7.1 Legal basis

EMIR authorisation

As discussed in Section 3.4, the EU has introduced a harmonised framework for the regulation of FMIs (including CCPs) incorporated in the region, EMIR. On 12 June 2014, the BoE granted LCH.C Ltd authorisation under EMIR. This authorisation permits LCH.C Ltd to continue providing its current clearing services (including SwapClear), and formally subjects it to the requirements of EMIR.

LCH.C Ltd made a number of material changes to its policies and practices during the EMIR application process. These included, among others: changes to governance arrangements; introducing EMIR-compliant account structures for segregation and portability of customer positions; introducing a wind-down plan and ensuring sufficient capital is held to cover business risk losses; enhancing model validation practices; the introduction and enhancement of tools to limit procyclicality; and implementing changes to record keeping and regulatory reporting. Many of these material changes also enhance LCH.C Ltd's compliance with the CCP Standards, and are discussed Section 3.6 and the remainder of Section 3.7 below. In addition, LCH.C Ltd has introduced a revised, EMIR-compliant Rulebook, which implements many of the changes discussed above. The revised Rulebook came into effect on the day of LCH.C Ltd's EMIR authorisation.

LCH.C Ltd's application for EMIR authorisation did not cover clearing for the market operated by FEX. LCH.C Ltd is currently engaging with the BoE regarding offering clearing services to this market.

Authorisation in the United Kingdom

Within the UK, LCH.C Ltd is regulated under the UK FSMA. On the same date as it authorised LCH.C Ltd under EMIR, the BoE recognised LCH.C Ltd as a ‘recognised central counterparty’ under FSMA. As discussed in Section 3.4, the UK regime for CCPs was amended in early 2013 to adopt the provisions of EMIR, as well as several other recognition requirements specifically for CCPs. Until the time of its authorisation, LCH.C Ltd was formally subject to the ‘recognition requirements for clearing houses’, which are less comprehensive than the provisions in EMIR.[13]

The UK recognition requirements were further amended in July 2013 to require CCPs to: adopt loss allocation rules for default losses and to have recovery plans in place; and have rules or other effective arrangements in place to address losses from other sources that could threaten the CCP's solvency. These requirements became effective in February and May 2014, respectively. LCH.C Ltd addresses these requirements in its Rulebook and Recovery Plan (which was approved by the LCH.C Ltd Board in April 2014). The Bank's CCP Standards impose similar requirements; LCH.C Ltd's compliance with these is described in Section 3.6 and Appendix A (CCP Standard 3).

3.7.2 Governance

Senior executive and board changes

There were a number of senior management changes within LCH.C Group and LCH.C Ltd during the Assessment period. Following the resignation of Ian Axe from the role of Chief Executive Officer (CEO) of LCH.C Group and LCH.C Ltd in July 2013, Suneel Bakhshi was appointed CEO of LCH.C Group and Michael Davie was appointed CEO of LCH.C Ltd. Michael Davie also continued to hold the role of CEO of SwapClear until March 2014, when he was replaced by Daniel Maguire.

In the first half of 2014, LCH.C Ltd appointed Jonathan Eliot and Simon Davies to the LCH.C Ltd Board as independent non-executive directors. With these appointments, the LCH.C Ltd Board comprises the Group CEO, the Group Chief Risk Officer (CRO), the LCH.C Ltd CEO, two directors connected to exchanges or similar, two directors connected to users, and five independent non-executive directors (one of whom is the Chairman of the LCH.C Ltd Board).

Establishment of the LCH.C Ltd management committee

LCH.C Ltd established the LCH.C Ltd Management Committee in October 2013. The Committee's main responsibilities are to:

  • assist the LCH.C Ltd CEO in carrying out his responsibilities
  • review matters requiring approval from the LCH.C Ltd Board prior to presenting them to the Board
  • oversee the LCH.C Ltd Operating Committee, LCH.C Ltd Executive Risk Committee (ERCo) [14] and LCH.C Ltd Financial Committee, which are sub-committees of the Management Committee
  • make recommendations relating to risk management, strategy, financial management and the findings of internal and external audit.

The Committee, which meets at least twice a month, is chaired by the LCH.C Ltd CEO, and comprises LCH.C Ltd senior executives, as well as two representatives from LCH.C Group. The establishment of this executive-level Committee has not altered the responsibilities or flows of information to the LCH.C Ltd Board-level committees (e.g. the Risk and Audit Committees).

The SwapClear Banks

LCH.C Ltd has been working with a group of 14 of the largest global banks, who have provided expertise, financial resources and strategic direction to LCH.C Ltd's SwapClear service.[15] The SwapClear Banks' role in SwapClear was defined in an agreement established with LCH.C Ltd most recently entered into in 2010, under which the governance, costs and financial returns of SwapClear were shared. In April 2014, the agreement was amended to substantially change the SwapClear Banks' role – in particular, changing their role in the governance of SwapClear from a directive to a consultative function. The revised agreement, which is summarised on LCH.C Ltd's website, also altered the financial arrangements between LCH.C Ltd and the SwapClear Banks.

Establishment of the Australian Member User Group

LCH.C Ltd formed the AMUG for Australian direct clearing participants in March 2014. The AMUG provides a formal structure for LCH.C Ltd and Australian clearing participants to discuss policy and risk management issues (see Section 3.5 for a more detailed discussion).

Processes for making rule changes

In June 2014, LCH.C Ltd formalised its processes for making rule changes by establishing a Rules Change Committee. This process is now set out in Regulation 44 in LCH.C Ltd's revised Rulebook (discussed above). The Rules Change Committee is responsible for approving all proposed changes to the Rulebook and determining the appropriate level of consultation with members on proposed changes. The Committee comprises representatives from LCH.C Ltd's Legal and Compliance departments, including the Head of Legal and the Chief Compliance Officer, as well as a business representative.

During the Assessment period, LCH.C Ltd also amended its Rulebook and Clearing Membership Agreement (a legally binding agreement between LCH.C Ltd and its clearing participants) to remove the requirement that LCH.C Ltd ballot clearing participants regarding certain rule changes. Previously, LCH.C Ltd needed to obtain written consent from at least 50 per cent of SwapClear's participants to make material changes to SwapClear's rules on default management, including to the size of SwapClear's default fund. LCH.C Ltd will nevertheless continue to consult with participants when proposing rule changes.

3.7.3 Credit risk

Internal credit scores

Under its Group Counterparty Credit Risk policy, LCH.C Ltd assigns ICSs to its counterparties. Based on their performance in a range of areas, such as financial ratios and operations, counterparties are assigned a score between 1 and 10, with 1 representing the highest credit quality. The ICS is a key tool used by LCH.C Ltd to determine the exposures it will accept against a given counterparty; it also determines the intensity of LCH.C Ltd's ongoing monitoring of that counterparty.

In February 2014, the LCH.C Ltd Board approved changes to the Group Counterparty Credit Risk policy, notably extending its application beyond clearing participants to a number of other counterparties, including investment counterparties and custodians. The revised policy also introduced a tailored framework for assigning ICSs to sovereigns and interoperating CCPs.

In revising the policy, LCH.C Ltd made modifications to the framework for assigning ICSs to particular types of counterparty, notably to reduce the weight on external credit ratings and market implied ratings (default probabilities inferred from market data), and increase the weight on LCH.C Ltd's own assessments of the counterparty's default risk. Additionally, the frequency with which ICSs are reviewed was increased, to a minimum of once each year.

The revised policy was externally validated in the fourth quarter of 2013 and found to be fit for purpose.

Model validation and review

LCH.C Group maintains a Model Governance, Validation and Review Policy, which applies to margin models, models used for valuing financial products guaranteed by LCH.C Ltd or received as collateral, and models used for assigning ICSs. The policy sets out the process by which LCH.C Ltd adopts new models, changes its existing models, conducts regular model validations and monitors the performance of its models with back-testing.

The policy specifies that independent model validation is required when adopting a new model or making a material change to an existing model. In February 2014, LCH.C Group amended this aspect of the policy to allow for such validations to be performed by the Independent Model Validation Team, which is a team within LCH.C Group that is not involved in building or testing the model. The team reports to the Finance Group and is independent of the Risk Group. The policy allows for model validation by an external party, although this is not required. Previously, validations were performed by an external party, except in the case of changes to low-importance models (defined as models that would not lead to a shortfall in a margin or haircut if they were incorrect). The revised policy also specifies that all models covered by the policy must be reviewed at least annually by the Independent Model Validation Team. The next validation of the SwapClear initial margin model is scheduled for late 2014.

The amendments to the policy also increase the involvement of senior management in model reviews and validation. In particular, the amendments clarify that approval by the relevant Board is required before a new model is introduced, or before a material change is made to any existing model (other than those deemed to be of low importance).

LCH.C Ltd conducts daily and monthly back-testing of initial margin models to monitor their performance, using both static observed portfolios and hypothetical portfolios. LCH.C Ltd examines all breaches and near-misses. If numerous breaches occur, or if a specific member or customer has consecutive breaches, the issue will be escalated within LCH.C Ltd. LCH.C Ltd may then call additional margin from specific members or review its initial margining methodology. The Model Governance, Validation and Review Policy now requires that back-testing results be reported monthly to the ERCo and quarterly to the Risk Committee; results were previously reported only to the Market Risk Management Committee (MRMC).[16]

The Model Governance, Validation and Review Policy does not cover LCH.C Ltd's processes for reviewing and validating its liquidity risk and collateral haircut models; these are set out in LCH.C Ltd's liquidity risk and collateral risk policies, respectively. These policies were amended in June 2014 to add substantial detail on the frequency, scope and internal governance of reviews and validations of these models. The Model Governance, Validation and Review Policy is also distinct from LCH.C Ltd's policies for validating its stress-testing models and conducting reverse stress testing, which are discussed below.

Review of SwapClear stress-testing model

In December 2013, an independent review of the stress tests used to size the SwapClear default fund was completed. The review found that SwapClear's current and proposed historical and theoretical stress scenarios fell within a ‘reasonable interpretation’ of extreme but plausible. However, a number of recommendations were proposed and have now been implemented.

Reverse stress testing

During the Assessment period, LCH.C Ltd implemented a reverse stress-testing framework to assess the adequacy of its default and liquidity resources, as contemplated in the guidance to CCP Standards 4 and 7. Reverse stress testing falls under the broader LCH.C Group Financial Resource Adequacy policy, as one of the tools used to assess the adequacy of each CCP's financial resources. The reverse stress-testing framework, which applies across each of the LCH.C Group CCPs, broadly establishes how LCH.C Ltd will identify and assess the plausibility of scenarios that could lead to losses in excess of the CCP's existing resources. Scenarios considered include: the default of multiple clearing participants; extreme market moves; and impaired access to liquidity. If such plausible scenarios were identified, LCH.C Ltd would consider increasing its resources and amending its stress-testing framework.

Reverse stress testing is conducted at least quarterly, and the results are reviewed by ERCo.

3.7.4 Collateral

Banking and collateral management system

During the Assessment period, LCH.C Ltd completed the implementation of its new liquidity and collateral management system. Phase II of the system's implementation was completed in May 2014 when LCH.C Ltd's collateral management was transferred from the legacy system; an earlier stage of the system's implementation (Phase I) transferred LCH.C Ltd's cash and liquidity management. The new system now supports the cover distribution process (which is the process by which lodged collateral is allocated to cover margin requirements), PPS calls and SWIFT messaging, the management of non-cash collateral, and internal and external messaging and reporting. The project has created a common collateral and liquidity management platform across LCH.C Ltd and LCH.C LLC.

Collateral haircuts

To reflect credit risk not captured by its base haircut model, LCH.C Ltd applies add-ons to the haircuts on sovereign debt received as collateral. In May 2014, LCH.C Ltd changed its methodology for setting this ‘sovereign credit risk haircut add-on’, in part reflecting the introduction of its ICS framework for sovereigns (see Section 3.7.3 above). Under the new policy, sovereigns may be subject to a credit add-on based on their ICS. Changes to credit risk add-ons take effect with a delay, typically of two weeks, to limit the procyclical impact of the change.

3.7.5 Margin

Introduction of an initial margin floor to reduce procyclicality

SwapClear calibrates initial margin to cover potential losses over a 5 day liquidation period with 99.7 per cent confidence, based on historical movements in yield curves and exchange rates over a 10-year look-back period. The model contains features intended to moderate procyclical margining changes, such as the use of a relatively long look-back period and exponentially weighted moving average volatility scaling. In May 2014, LCH.C Ltd introduced an initial margin floor as an additional measure to mitigate procyclicality. LCH.C Ltd calculates the margin floor corresponding to each participant's portfolio on a daily basis. The floor is calibrated to cover potential losses over a 5 day liquidation period with 99.5 per cent confidence, based on a 10-year look-back period, without scaling historical observations.

Sensitivity analysis

LCH.C Group introduced a framework for conducting sensitivity analysis on its margin models, effective from the fourth quarter of 2013. The primary objective of this testing program is to assess the adequacy of key margin model parameters (volatility, correlations, decay factors, returns) and assumptions on an ongoing basis.

All sensitivity tests are performed on either a monthly or a quarterly basis.

The results, analysis and conclusions of each test are presented to the Model Working Group (MWG)[17] and MRMC each quarter for review. These results may prompt the MWG and MRMC to recommend model changes; to date the sensitivity analysis conducted for the SwapClear margin model has not prompted any changes to the model assumptions.

3.7.6 Liquidity risk

Cap on participants' use of liquid resources

In the second half of 2013, LCH.C Ltd introduced a concentration framework to ensure sufficient liquidity is available within each service. The framework seeks to limit the total non-cash collateral a participant can post relative to LCH.C Ltd's available liquid resources. The framework is monitored by Collateral and Liquidity Management (CaLM); the Asset and Liquidity Committee (ALCo) is responsible for determining how any breaches to the framework should be resolved.

Intraday liquidity stress testing

LCH.C Ltd introduced intraday liquidity stress testing in late 2013. The tests are used to assess the intraday ‘liquidity coverage ratio’ (LCR) at various intervals throughout the day, aligned with times at which LCH.C Ltd has scheduled settlement cycles or obligations to pay (see CCP Standard 7 in Appendix A for details of LCH.C Ltd's daily stress-testing model).

The results of intraday stress testing are reported to the Risk, CaLM, Finance, Compliance and Collateral teams within LCH.C Ltd each day. Results are also discussed with senior management in the Risk, CaLM and Finance divisions on a weekly and monthly basis. The intraday stress-testing model will be reviewed quarterly, with the results reported to ALCo.

LCH.C Ltd commissioned an external independent validation of its intraday liquidity stress-testing model in late 2013. This review followed an independent validation of LCH.C Ltd's broader liquidity risk model (including its full liquidity stress-testing model), which was conducted during the fourth quarter of 2013. The reviewer found the intraday stress-testing model to be fit for purpose.

3.7.7 Default management

LCH.C Ltd conducts SwapClear default management Fire Drills every six months for SwapClear and its participants to practise aspects of the default management processes. Australian clearing participants took part in two Fire Drills during the Assessment period, in November 2013 and May 2014. In each test, SwapClear generated auction packs (i.e. hypothetical portfolios) and participants were required to import and reconcile trade files and reports, value the auction packs and bid for each auction pack.

3.7.8 Operational risk

Operational risk reviews

LCH.C Ltd commissions reviews of its operational risk environment from time to time. LCH.C Ltd is currently undertaking such a review, which is scheduled to be completed in August 2014.

In late 2013, LCH.C Ltd completed an internal review of operational risk in SwapClear. None of the review's recommendations were identified as business critical. The LCH.C Group Operations Committee has accepted all of the review's recommendations and allocated a budget for their implementation.

Cyber risk

Over the past 12 months, LCH.C Group has undertaken a number of reviews and exercises to increase its resilience against cyber attacks. In September 2013, an independent party conducted a review of LCH.C Group's cyber security. This review made a number of recommendations around governance and technology, which have since been implemented. LCH.C Group also commissioned a consulting firm to run a cyber attack exercise, which ran in October 2013. The firm found that the LCH.C Group Crisis Management Team (CMT) performed well overall; LCH.C Group has since implemented the recommendations resulting from the exercise, which focused on internal and external communication.

Additionally, LCH.C Ltd has collaborated with UK financial institutions and regulators to increase system-wide cyber resilience. In November 2013, LCH.C Ltd participated in ‘Waking Shark II’, a cyber attack exercise with participants from across the UK financial system. The exercise resulted in a publicly available report that recommends measures for increased collaboration on cyber resiliency. As discussed in Section 3.4, cyber risk is one of the BoE's supervisory priorities. As part of its work, the BoE has reviewed cyber risk in UK FMIs, including LCH.C Ltd.

LCH.C Ltd also conducts regular tests of its information technology (IT) infrastructure.


The data are sourced from the Bank for International Settlements as at the end of 2013, adjusted for the double counting that occurs when a trade is novated to a CCP. The gross market value of OTC IRDs was US$14 trillion as at the end of 2013. [1]

This figure counts one side of each centrally cleared trade. Counting both sides of each centrally cleared trade would result in a figure that is twice as large. [2]

See CFR (2014), Report on the Australian OTC Derivatives Market, April. Available at <http://www.cfr.gov.au/publications/cfr-publications/2014/report-on-the-australian-otc-derivatives-market-april/pdf/report.pdf>. [3]

The A$535 billion figure counts one side of each centrally cleared trade. If both sides were counted, the figure would be A$1.07 trillion. [4]

The additional 2-day holding period for customer positions allows time for customers to decide whether to port their portfolio to another clearing participant, as well as time to carry out the port. [5]

LCH.C Ltd maintains a default waterfall for the SwapClear Global service, while LCH.C LLC maintains a default waterfall for the SwapClear US-based service. Each default waterfall has a separate default fund. [6]

The STLOIM of a participant and its affiliates is based on the stress-test losses and initial margin of the participant, its affiliates, and all the customers of the participant and its affiliates. [7]

As EMIR is an EU Regulation, implementing legislation is not required for it to be legally binding in each EU member state. [8]

BoE (2013), ‘The Bank of England's approach to the supervision of financial market infrastructures’. Available at <http://www.bankofengland.co.uk/financialstability/Documents/fmi/fmisupervision.pdf> [9]

BoE (2014), The Bank of England's Supervision of Financial Market Infrastructures — Annual Report. Available at <http://www.bankofengland.co.uk/publications/Documents/fmi/fmiap1403.pdf>. The report, which will be issued annually, is the first since the BoE became responsible for the supervision of securities settlement systems and CCPs in April 2013. It replaces the BoE's annual ‘Payment Systems Oversight Report’. [10]

The CFR Regulatory Influence Policy is available at <http://www.treasury.gov.au/ConsultationsandReviews/Consultations/2012/cross-border-clearing>. [11]

SwapClear also offers the US Commodity and Futures Trading Commission (CFTC)-recognised Futures Commission Merchant (FCM) model of clearing participation. Clearing services are offered to customers using the legally separated operationally comingled (LSOC) model. This model seeks to legally segregate customers from other customers, and to ensure that in the event of a default a customer's positions and assets cannot be used to meet the obligations of any other party. [12]

Nevertheless, in its published statement on its supervisory approach, the BoE stated that during the transitional phase prior to authorisation, it would be guided by the requirements of EMIR and the Principles when conducting its oversight of UK CCPs. [13]

Each of the LCH.C Group CCPs has an ERCo. These all meet jointly as a LCH.C Group-level ERCo, which is the committee responsible for the management of risks across LCH.C Group and the Group CCPs, including ensuring risks remain within LCH.C Group's stated risk appetite. [14]

The SwapClear Banks are as follows: Bank of America Securities Limited, Barclays Bank plc, BNP Paribas, Citigroup Global Markets Limited, Credit Suisse AG (acting through its Guernsey Branch), DB UK Holdings Limited, The Goldman Sachs Group Inc., HSBC Bank plc, J.P. Morgan Financial Investments Limited, Merrill Lynch International, Morgan Stanley Fixed Income Ventures Inc., Nomura European Investment Limited, The Royal Bank of Scotland plc, Société Générale and UBS AG (acting through its London Branch). [15]

The MRMC is responsible for assisting the LCH.C Group Head of Market Risk in the management of market risk at LCH.C Group and its subsidiaries. The Group comprises senior executive staff from across LCH.C Group. [16]

The MWG consists of quantitative experts from across LCH.C Group. Its role is to support the MRMC and ERCo in the consideration of the effectiveness of quantitative models and risk management methodologies, including model development, validation and testing. [17]