2013/14 Assessment of LCH.Clearnet Limited's SwapClear Service 1. Introduction and Executive Summary

In accordance with its responsibilities under the Corporations Act 2001, the Reserve Bank (the Bank) carries out periodic assessments of how well each clearing and settlement (CS) facility licensee is complying with applicable Financial Stability Standards (FSS) determined by the Bank and the more general obligation to do all other things necessary to reduce systemic risk.[1] The Bank's findings are reported to the Minister with portfolio responsibility for Corporations Law, and are also notified to the Australian Securities and Investments Commission (ASIC) and published on the Bank's website.

LCH.Clearnet Limited (LCH.C Ltd) is incorporated in England and is primarily regulated by the Bank of England (BoE), under European Union (EU) and United Kingdom (UK) legislation. LCH.C Ltd offers central clearing for a range of products, of which it is licensed to offer a subset in Australia. In April 2013, LCH.C Ltd was granted an Australian CS facility licence permitting it to clear certain financial products traded on the Financial and Energy Exchange (FEX) market. This licence was varied in July 2013 to permit LCH.C Ltd to offer its SwapClear service. This report presents the Bank's Assessment of SwapClear for the year ending 30 June 2014, with a particular focus on its services to Australian participants. The FEX market is not yet operational.

The Bank conducted due diligence with reference to all of the applicable Financial Stability Standards for Central Counterparties (CCP Standards) prior to advising the Minister on LCH.C Ltd's application for a licence variation in 2013.[2] In 2013/14 the Bank assessed LCH.C Ltd's observance of all relevant requirements under the CCP Standards that had previously been subject to transitional relief. These came into effect in March 2014.

The 2013/14 Assessment period has been a time of transition for LCH.C Ltd, during which it has admitted its first Australian participants and begun to establish processes and arrangements to meet the needs of the Australian market. Accordingly, the Bank's Assessment in this period has been more narrowly focused than will be the case in future years. In particular, in addition to assessing LCH.C Ltd against the newly applicable CCP Standards, the Bank's Assessment has focused primarily on the tailoring of LCH.C Ltd's services to Australian participants. These developments have been considered in light of the initial regulatory priorities set by the Bank at the time of licensing. Consistent with the Bank's stated approach to assessing CS facility licensees, the Bank has not formally ‘rated’ the level of LCH.C Ltd's observance against the each of the sub-standards in the newly applicable CCP Standards.[3] The Bank has nevertheless described how LCH.C Ltd observes each sub-standard and has identified regulatory priorities, as appropriate.

In its future Assessments, the Bank will review LCH.C Ltd's observance of the requirements under all relevant CCP Standards. In contrast to its practice for domestically licensed CS facilities, the Bank will not present a formal rating of the level of LCH.C Ltd's observance of each high-level standard in the CCP Standards. A full evidence base for each applicable CCP Standard will nevertheless be reported. The absence of a formal rating reflects LCH.C Ltd's status as an ‘overseas’ CS facility licensee under section 824B(2) of the Corporations Act, and that in carrying out its oversight and Assessments the Bank places conditional reliance on reports and information from LCH.C Ltd's primary regulator, the BoE.[4] Nevertheless, based on its Assessments, the Bank's practice will be to set regulatory priorities where it expects LCH.C Ltd to conduct additional work to enhance its observance of the requirements under particular CCP Standards.

1.1 Overview of Activity at LCH.Clearnet Limited

LCH.C Ltd's SwapClear service is the world's largest central counterparty (CCP) for over-the-counter (OTC) interest rate derivatives (IRDs), clearing just over US$200 trillion, or around 91 per cent of the notional value outstanding of centrally cleared OTC IRDs. An estimated 98 per cent of the notional value outstanding of centrally cleared Australian dollar-denominated OTC IRD trades are cleared via SwapClear. Australian banks have previously been restricted to clearing their trades in SwapClear indirectly, as customers of other clearing participants. Since LCH.C Ltd's CS facility licence was varied in July 2013, however, three Australian banks have joined SwapClear as direct clearing participants and it is understood that other Australian banks plan to join in the future.

1.2 Assessment and Material Developments

As discussed above, the Bank's 2013/14 Assessment of LCH.C Ltd has focused primarily on LCH.C Ltd's progress against its initial regulatory priorities for SwapClear, set at the time LCH.C Ltd's licence was varied in July 2013. The Bank has also assessed LCH.C Ltd's observance of requirements under the CCP Standards that had previously been subject to transitional relief, and considered a number of additional material developments at LCH.C Ltd during the Assessment period.

1.2.1 Progress against 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 an initial set of regulatory priorities for LCH.C Ltd to ensure that its operational and governance arrangements promoted stability in the Australian financial system. Specifically, the Bank expected LCH.C Ltd to:

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

The Bank considers that with the formation of the Australian Member User Group (AMUG), LCH.C Ltd has met the recommendation that it should ensure Australian clearing participants are appropriately represented in governance arrangements. The Bank will continue to monitor the effectiveness of this arrangement. LCH.C Ltd is still progressing work to implement the remainder of the Bank's initial recommendations. The Bank expects LCH.C Ltd to finalise its work on these priorities during 2014/15.

1.2.2 CCP Standards previously subject to transitional relief

In 2013/14, the Bank assessed LCH.C Ltd's observance of all relevant requirements under the CCP Standards that had previously been subject to transitional relief. In its Assessment against these standards, the Bank identified one aspect of LCH.C Ltd's management of liquidity risk in which it recommended that LCH.C Ltd conduct additional work; this forms part of the Bank's 2014/15 regulatory priorities.

  • Recovery, wind-down and resolution. In the first half of 2014, LCH.C Ltd introduced a Recovery Plan and a Wind-down Plan, which set out how it would continue, or cease, respectively, its operations if it suffered extreme losses. The Recovery Plan envisages that LCH.C Ltd would largely utilise existing rules and work practices in a recovery situation – including rules to allocate uncovered losses arising from a clearing participant default to clearing participants, up to a cap. LCH.C Ltd also introduced new rules in May 2014 to allocate to clearing participants investment-related losses caused by the default of an issuer of a debt instrument or an investment counterparty. LCH.C Ltd maintains liquid net assets funded by equity to implement its Recovery Plan and Wind-down Plan. It has funds set aside to cover risks including operational and legal risk, uncovered credit, counterparty credit and market risks, and business risks, as well as the implementation of its Wind-down Plan.

    Since LCH.C Ltd is a UK-based CS facility, resolution would be expected to be led by the UK's resolution authority, the BoE. The Bank will continue to liaise with the BoE on this topic. In addition to this, as part of its resolution planning in the coming period, LCH.C Ltd may need to consider how relevant authorities could take effective crisis management actions to ensure that providers of outsourced critical services would be able to provide continuous reliable service in a crisis.

  • 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 of default of the two clearing participants and their affiliates that would generate the largest aggregate payment obligations in extreme but plausible scenarios (i.e. its ‘cover two’ liquidity needs). LCH.C Ltd has access to a number of tools that it could use to meet unforseen and potentially uncovered liquidity shortfalls; these are described in its internal liquidity management policies as well as in its Recovery Plan.

    LCH.C Ltd projects its cover two liquidity needs through liquidity stress testing. During the Assessment period, LCH.C Ltd also implemented a reverse stress-testing framework to assess the adequacy of its liquid resources. The Bank expects LCH.C Ltd to 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. The Bank will also engage with LCH.C Ltd as it continues to refine its proposed arrangements to manage its Australian dollar liquidity risk, utilising its ESA (if approved).

  • Segregation and portability of customer positions and associated collateral. During the Assessment period, LCH.C Ltd introduced new account structures in order to comply with EU regulations. EU regulations require CCPs to offer customers the option of both individual segregation and omnibus segregation. LCH.C Ltd also has rules and procedures to enable a participant's customer's positions and collateral to be ported to another clearing participant if its original clearing participants defaulted or was insolvent.

1.2.3 Material developments

In June 2014, LCH.C Ltd was authorised under, and became formally subject to, the harmonised European regulatory framework for CCPs, Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (commonly known as EMIR). EMIR and its associated technical standards largely implement the principles within the Committee on Payment and Settlement System (CPSS)[5] and International Organization of Securities Commissions (IOSCO) Principles for Financial Market Infrastructures (the Principles) in the EU. At the same time, LCH.C Ltd was also recognised by the BoE as a ‘recognised central counterparty’ under UK legislation. In advising the Minister regarding LCH.C Ltd's application for a variation to its CS facility licence, the Bank assessed that the stability-related requirements in the EU regulatory regime, alongside the additional UK requirements that were in place at the time, were sufficiently equivalent to the CCP Standards.

LCH.C Ltd made a number of material changes to its policies and practices to ensure its compliance with EMIR and to meet UK recognition requirements. Many of these changes enhance LCH.C Ltd's compliance with the CCP Standards. These, and other material developments relevant to LCH.C Ltd's SwapClear service, are discussed in Sections 3.6 and 3.7.

The remainder of this report is structured as follows. Section 2 summarises in tabular form the Bank's regulatory priorities with respect to its oversight of LCH.C Ltd. Section 3 draws out key developments over the Assessment period, including LCH.C Ltd's progress towards the Bank's regulatory priorities. Section 3 also describes LCH.C Ltd's regulatory and operating environment, as well as activity and risk management for the SwapClear service. The Appendix concludes with the Bank's detailed assessment of LCH.C Ltd's SwapClear service against the nine CCP sub-standards for which transitional relief expired during the Assessment period.

The Bank welcomes LCH.C Ltd's continued efforts towards ensuring its operations contribute to the stability of the Australian financial system and appreciates the cooperation of LCH.C Ltd staff and management during the preparation of this Assessment, and the open and constructive dialogue throughout the Assessment period.

The Bank has also engaged with the BoE throughout the same period, bilaterally and through the LCH.C Ltd Global College. The Bank looks forward to continuing the constructive dialogue.


Until June 2013, the Bank was obliged to carry out such assessments annually. A recent legislative amendment restricts the obligation to carry out annual assessments to CS facility licensees prescribed by regulation. No CS facility licensee has yet been prescribed for annual assessments. The Bank has nevertheless clarified in a policy statement that it is likely to carry out assessments of LCH.C Ltd on an annual basis; see ‘Frequency of Regulatory Assessments of Licensed Clearing and Settlement Facilities‘, available at <http://www.rba.gov.au/payments-system/policy-framework/frequency-of-assessments.html>. [1]

See RBA (2013), Assessment against the Financial Stability Standards for Central Counterparties of LCH.Clearnet Limited's SwapClear Service, June. Available at <http://www.rba.gov.au/payments-system/clearing-settlement/assessments/lch/>. [2]

For domestic CS facility licensees, the Bank's assessment reports discuss how well the licensee has observed each high-level standard. However, except in the case of special topics, the Bank does not separately classify the level of a CS facility's observance of each sub-standard. See ‘The Reserve Bank's Approach to Assessing Clearing and Settlement Facility Licensees’, available at <http://www.rba.gov.au/payments-system/clearing-settlement/standards/assess-csf-licensees.html>. [3]

The Bank may place reliance on an overseas regulator in respect of FSS for which a ‘materially equivalent’ standard is applied in the overseas regulatory regime, and the Bank receives satisfactory documentary evidence from the overseas regulator that the licensee has complied in all material respects with those requirements. The Bank is yet to formally consider the material equivalence for the UK regime. [4]

CPSS has recently been renamed the Committee on Payments and Market Infrastructures. [5]