Assessment of LCH Limited's SwapClear Service Appendix B: Risk Management, Governance and the LCH Limited Regulatory Environment

B.1 Risk Management

A CCP acts as the buyer to every seller, and the seller to every buyer, in a market. This is commonly achieved by the CCP 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. However, these arrangements 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. LCH Ltd manages this risk in a number of ways, including through participation requirements, margin collection, the maintenance of pooled resources and loss allocation arrangements.

B.1.1 Clearing participation requirements

To limit its exposure to its participants, LCH Ltd only allows institutions to become SwapClear clearing participants if they meet certain financial and operational requirements. Prospective clearing participants of SwapClear are required to have net capital of at least US$50 million, as well as appropriate payment arrangements, staff with sufficient experience, and 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.

B.1.2 Margin collection

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

  • Variation margin. All SwapClear positions are marked-to-market at the end of the day and three times intraday. At the end of each day, variation margin is collected from participants with net loss-making positions and paid to those with net profit-making positions. This practice ensures that uncovered losses on SwapClear participants' positions do not accrue over time.
  • Initial margin. In the event of a clearing participant default, LCH Ltd would be exposed to risk arising from potential changes in the market value of the defaulting participant's open positions between the last settlement of variation margin and the close-out of these positions. LCH Ltd collects initial margin to mitigate this risk. Most trades will only be registered if, at the point of registration, there are sufficient pre-funded resources at the clearing participant level, either in the form of initial margin or the RTTR component of the default fund (Appendix B.1.3) to cover the potential future exposure of the trade (up to a given confidence level).[19]
  • Additional margin. LCH Ltd collects various forms of additional margin to cover any risks – including credit, liquidity, concentration and sovereign risks – not captured by the base initial margin model. Additional margin is calculated at the end of each day.

LCH Ltd monitors participants' portfolios intraday to take account of changes in both prices and positions; LCH Ltd makes intraday margin calls where margin liabilities (variation margin or initial margin) exceed predetermined participant-specific credit thresholds. Margin is not paid out intraday to participants whose margin requirements have fallen.

LCH Ltd calculates initial margin requirements for SwapClear using its PAIRS model. The model sets initial margin requirements to cover potential losses over a five-day close-out period for participants with 99.7 per cent confidence, based on historical movements in yield curves and exchange rates over a 10-year lookback period. LCH Ltd also imposes a floor on initial margin requirements based on a 10-year (unscaled) lookback period to counteract procyclicality and prevent initial margin requirements falling during periods of low volatility. In 2018, the lookback period was modified to progressively increase and include the 2½ year global financial crisis period (1 January 2008 – 30 June 2010) as a set of permanent scenarios. LCH Ltd assumes that an additional two-day period will be required to close out client positions; initial margin requirements and the floor for initial margin requirements on the positions of clients of participants are scaled up accordingly.[20] LCH Ltd assesses the performance of its margin model through daily and monthly backtesting. LCH Ltd also assesses the adequacy of the model assumptions through monthly sensitivity analysis and performs annual model validation reviews of the PAIRS model and individual margin add-ons.

B.1.3 Pooled financial resources

In the event of a clearing participant default, any losses would first be covered by the margin and other collateral posted by the defaulter across all LCH Ltd services in which it participated.[21] Should these resources prove insufficient to meet LCH Ltd's obligations, LCH Ltd may draw on other resources in the Rates service default waterfall. The Rates service default fund covers the SwapClear and Listed Rates services, as LCH Ltd allows for portfolio margining between these services.[22] The available resources are depicted in Figure 1, which shows the order in which financial resources would be used to cover default losses.

Prefunded resources

The Rates service default fund is a pool of mutualised resources, prefunded by clearing participants. The Rates service default fund comprises two components: a core component and an additional component that supports the intraday provision of credit needed to facilitate real-time trade registration (see ‘Default fund real-time trade registration component’ below). Both components are available to cover losses from participant defaults. Both SwapClear and Listed Rates participants contribute to the core component, but only SwapClear participants contribute to the RTTR component.

In the event that all of the defaulting clearing participant's margin and other collateral, including its contribution to the Rates service default fund, were exhausted, LCH Ltd would allocate remaining losses arising from the default to its capital contribution to the default fund waterfall (€57.1 million as at 30 September 2019). Should this also prove insufficient, losses would be allocated to the Rates service default fund.

Figure 1
Figure 1: Rates Service Default Waterfall

Default fund core component and default fund additional margin

The core component of the default fund is calibrated to cover any losses LCH Ltd would incur if the two clearing participants (including their affiliates and clients) with the largest exposures defaulted under extreme but plausible conditions, after using the defaulters' initial margin and monthly default fund additional margin (DFAM). 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. LCH Ltd calculates this by summing the largest two participant STLOIM over a 60-day lookback period, adding a buffer, and then subtracting the amount of monthly DFAM called.[23]

Each SwapClear participant's contribution to the core component is equal to its average share of total STLOIM for both house and client positions over the previous month. The share of each participant's stress test losses is adjusted according to the portability of each of its clients' portfolios.[24] Prior to March 2019, participants' contributions were based on their share of total initial margin requirements for house positions only.

Contributions are subject to a minimum of £17.5 million for SwapClear participants who are also Listed Rates participants, £10 million for SwapClear-only clearing participants and £500,000 for Listed Rates-only clearing participants. Contributions are rebalanced each month when the core component is resized. Participants are informed of their new contributions on the third business day of the month, and payments are due the following day if their contribution has changed.

LCH Ltd uses monthly DFAM to achieve a balance between defaulter-pays and mutualised resources, ensuring that participants with large exposures relative to other Rates service members provide larger contributions to the resources required to cover those exposures. Monthly DFAM is called from the largest participant if its STLOIM exceeds a specified threshold of the sum of the combined stressed exposure value and buffer, determined by its internal credit score (ICS). Monthly DFAM is not mutualised; it can only be used to cover losses from the participant that posted it.

LCH Ltd also calls daily DFAM from those participants and affiliates with STLOIM that exceed a predefined proportion of the default fund.[25] Daily DFAM can be called from any participant. The relevant default fund proportion is based on those participants' ICSs. The amount called is the difference between the participant's STLOIM and the relevant proportion of the default fund on that day, less any monthly DFAM. Like monthly DFAM, daily DFAM is not mutualised; it can only be used to cover losses from the participant that posted it.

Graph 12
Graph 12: Rates Service: Default Fund and Stress Test Losses

Over the assessment period, LCH Ltd maintained sufficient financial resources to meet the cover two requirement (Graph 12). That is, stress test losses in excess of initial margin and daily and monthly DFAM of the two participants with the largest exposures were smaller than the default fund core component. For most of the assessment period, the Rates service default fund was at its cap. LCH Ltd raised the default fund cap from £5 billion (£4.6 billion core component and £400 million RTTR component) to £6 billion (£5.4 billion core component and £600 million RTTR component) in September 2019; the cap remained binding after the increase. Where the cap is binding, LCH Ltd maintains sufficient prefunded financial resources to meet its cover two requirement by collecting monthly DFAM.

Default fund real-time trade registration component

To meet European regulatory requirements, SwapClear must novate or reject new trades within 10 seconds. Most trades are novated provided that the incremental margin requirement arising from the trade is covered by collateral lodged by that participant, or is below a tolerance limit set by LCH Ltd. LCH Ltd assigns these tolerance limits to participants based on their ICSs. By extending credit to participants through tolerance limits, the frequency with which LCH Ltd can register trades is not restricted by the frequency with which LCH Ltd can collect margin.

LCH Ltd mitigates the credit risk that arises from offering trade registration tolerance limits through an additional RTTR component in the default fund. The proportion of each SwapClear participant's contributions to the RTTR is based on their utilisation of their RTTR limit relative to that of other participants over the previous 20 business days, subject to a floor of £4 million and a cap of £30 million. Listed Rates-only participants do not contribute to the RTTR component of the default fund. Participant contributions to the additional component are rebalanced on the same timeline 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 half of this component at any time.

Participants can register sub-block trading venue trades without this credit check. Sub-block trading venue trades are trades below a certain size which are transacted on an electronic trading facility.[26] Participants can register these trades even if they do not have sufficient collateral held by LCH Ltd or RTTR component tolerance available. However, participants will need to meet any incremental initial margin requirement at the next intraday margin call.

Unfunded loss allocation rules

In extreme cases it is possible that prefunded financial resources could be insufficient to fully absorb default-related losses, leaving the CCP with an uncovered credit loss shortfall. In such an event, LCH Ltd would allocate remaining losses to surviving clearing participants through ‘loss allocation rules’:

  • Unfunded contributions. For each default, LCH Ltd is able to call unfunded contributions from non-defaulting participants up to the value of their last default fund contribution, subject to a maximum of three defaults in any six-month period.
  • Loss distribution process. LCH Ltd may apply haircuts to the variation margin payments owed to non-defaulting SwapClear participants whose positions make gains. Participants in the Listed Rates service would be allocated losses in proportion to their default fund contributions. These haircuts are capped at the higher of £200 million or twice a participant's default fund contribution, and the Loss Distribution Process is limited to 10 days. In the event a participant reaches the cap, or variation margin gains haircuts were likely to extend beyond 10 days, participants will vote on whether the Loss Distribution Process should continue.
  • Voluntary service continuity contributions. Should losses remain, LCH Ltd would ask non-defaulting participants to make voluntary contributions. Participants can make these payments at any time during the default management process, but are not obliged to make any voluntary payments.
  • Service closure. If insufficient voluntary payments were made to cover the remaining credit losses, the Rates service Default Management Group (DMG) would make an Insufficient Resources Determination and LCH Ltd would close the SwapClear and Listed Rates services. In the event the SwapClear and Listed Rates services were wound down, all outstanding SwapClear and Listed Rates contracts would be terminated and the Rates service DMG would calculate a sum owing between LCH Ltd and each non-defaulting clearing participant.

B.2 Governance

B.2.1 Structure of LCH Group

LCH Ltd is a wholly owned subsidiary of LCH Group (Figure 2). As at the end of September 2019, LCH Group is 82.6 per cent owned by the London Stock Exchange (C) Limited, a wholly owned subsidiary of LSEG, and 17.4 per cent owned by others, including clearing participants.

LCH Group is a holding company incorporated in the UK. In addition to LCH Ltd, LCH Group has another majority owned subsidiary that actively operates central clearing services, LCH SA. It also has a US CCP subsidiary, LCH.Clearnet LLC, which holds a Commodity Futures Trading Commission Derivatives Clearing Organization licence, although this licence became dormant in May 2019. The three CCPs are legally separate entities. LCH Group's SwapAgent service, which offers processing, margining and settlement services for non-cleared derivatives, is provided by a separate subsidiary.

Figure 2
Figure 2: LCH Group Structure

B.2.2 LCH Group and LCH Ltd governance arrangements

LCH Group and LCH Ltd (as well as the other LCH Group CCPs) have independent governance structures, including their own boards, board-level committees and executive-level committees (Figure 3).

Figure 3
Figure 3: LCH Group Board and Committee Structure

Although LCH Ltd, LCH Group and the other LCH Group CCPs each operate under independent governance arrangements, there is close coordination between each entity. To promote consistency and to avoid duplication, a number of the CCP and LCH Group board-level and executive-level committees have overlapping memberships, with some routinely sitting together (see below). Many of the key policies that govern LCH Ltd's operations – such as the Financial Resources Adequacy Policy, the Collateral Risk Policy and the Operational Risk Policy – are Group policies. Group policies are developed by LCH Group and the LCH Group CCPs in coordination, and apply across each of the CCPs. LCH Group Risk policies must be approved by the LCH Ltd Board to be applicable to LCH Ltd; all LCH Group Risk policies are approved by the LCH Ltd Board after review by the board-level Risk Committee.[27]

LCH Ltd also coordinates closely with LCH Group and the other LCH Group CCPs in day-to-day processes; some processes, such as the assignment of ICSs and model validations, are performed at the LCH Group level, rather than the individual CCP level.

LCH Group and LCH Ltd Boards

The LCH Group Board is responsible for the overall management and strategic direction of the LCH Group. The LCH Group Board has 15 members, including six independent directors (including the Chair). The LCH Group Board meets at least five times a year and on an ad hoc basis, as required. Four members of the LCH Group Board – three of the independent directors and the CEO of LCH Group – also sit on the LCH Ltd Board.

The LCH Ltd Board has ultimate responsibility for LCH Ltd. This includes responsibility for: establishing clear objectives and strategies; establishing and overseeing the risk management function; ensuring compliance with legal, regulatory and contractual responsibilities; overseeing the compliance and internal control functions; and monitoring LCH Ltd senior management. Where there is overlap in the matters reserved for the LCH Group and LCH Ltd Boards, the relevant matter will require the approval of both boards. The LCH Ltd Board has 10 directors, including five independent directors (including the Chair), the CEO of both LCH Group and LCH Ltd, the LCH Group Chief Risk Officer (CRO), two member representatives and one director nominated by LSEG. As at 30 September 2019, the LCH Group CEO is also the interim LCH Ltd CEO and there is a vacancy for an independent director.

Group-level, board-level and executive-level committees

LCH Ltd and LCH SA have similar board-level and executive-level committee structures. The committees have overlapping, but not identical memberships. The board-level Risk Committees routinely sit together, facilitating cooperation and coordination, and reducing repetition. The CCP board-level Audit and Remuneration Committees may also sit together with the equivalent Group-level committees. Issues specific to a particular CCP can be considered at combined meetings.

Key LCH Group and LCH Ltd board-level and executive-level committees include:

  • LCH Ltd Risk Committee. The LCH Ltd Risk Committee is a board-level committee with key responsibilities including providing independent advice to the LCH Ltd Board on risk policy, new markets and products, and amendments to margin and stress testing methodologies. The Risk Committee considers and comments on all aspects of LCH Ltd's risk appetite, tolerance and strategy, and assists the LCH Ltd Board to fulfil its responsibility for the oversight of risk management of LCH Ltd.
  • LCH Ltd Technology, Security and Resilience Committee. The board-level LCH Ltd Technology, Security and Resilience Committee assesses the adequacy of LCH Ltd's strategies and plans for the management of technology, security, operational and cyber risks, and assists the LCH Ltd Board in reviewing the frameworks, policies and strategies that set the internal control environment in relation to LCH Ltd's technology, operational resilience and security.
  • LCH Group Executive Committee. The LCH Group Executive Committee is the most senior LCH Group management committee. It is an advisory body, which provides advice and recommendations to the Group CEO and the CEOs of the Group's CCPs. The Executive Committee is made up of: the Group CEO, who acts as the Chair; the CEOs of each of the Group CCPs; the business line heads; and the Group functional heads.
  • Local Management Committees. Each of LCH Ltd, LCH SA and SwapAgent has a Local Management Committee (LMC). Unlike some of the board-level committees and other executive-level committees, the LMCs do not sit jointly. This allows the LCH Ltd LMC to consider issues from the perspective of LCH Ltd in isolation. The LCH Ltd LMC provides support and advice to the LCH Ltd CEO on risk management, strategy, financial management and reporting, operational management, audit and governance. The LCH Ltd LMC reports directly to the LCH Ltd Board and provides direction and oversight to the LCH Ltd Executive Risk Committee (ERCo). Permanent members of the LCH Ltd LMC include senior management from both LCH Ltd and LCH Group. LMC members are allowed to nominate delegates to attend in their place.
  • Executive Risk Committees. LCH Ltd, LCH SA and SwapAgent each have an ERCo. The ERCos have overlapping membership, meet concurrently and are chaired by the Group CRO. Each ERCo is responsible for the management, monitoring and oversight of all material risks faced by the relevant entity. The LCH Ltd ERCo reports directly to the LCH Ltd Risk Committee and, via the Ltd CRO, provides regular updates on its activities to the LCH Ltd LMC.
  • Other key committees and working groups. Various committees support decision-making within LCH Ltd. These include (among others): the Group-level Risk Resilience Committee and, at a CCP level, the Change Management Committee and Rule Change Committee. In addition, the LCH Group Financial Risk Working Group typically considers matters related to financial risk at LCH Ltd before they are submitted to the LCH Ltd ERCo for review or approval.

Senior management

LCH Group and LCH Ltd have similar senior management structures and reporting lines (Figure 4). Some positions across LCH Ltd and LCH Group are held by the same person (‘double hat roles’).

Figure 4
Figure 4: Senior Management Positions and Reporting Lines

B.2.3 Departments in LCH Ltd

LCH Ltd is organised into departments based on its core functions and the products it offers. The ‘functional’ departments include: Audit, Collateral and Liquidity Management (CaLM), Compliance, Finance, Human Resources, Information Technology, Legal, Operations and Risk. Departments are further divided into teams. For example the Risk department includes teams responsible for credit risk, default management, risk resilience, reporting, collateral and liquidity risk. It also includes several product-specific Risk teams which operate as a second line of defence to the first-line Risk functions operated by each business. The CaLM department is responsible for ensuring investment activities are conducted in accordance with the relevant Group Risk policies and regulations and is separate to the Collateral and Liquidity Risk Management function, which is responsible for monitoring and assessing various risks against Group Risk policies. ‘Product’ departments are structured around LCH Ltd's various clearing services and include the SwapClear business unit.

B.2.4 Governance of SwapClear

The Global Head of Rates, Securities and Collateral, a Group-level position, is responsible for developing and managing the SwapClear and Listed Rates services, and has the authority to develop and implement business strategy, operational plans, policies and budgets for SwapClear and Listed Rates. The Global Head of Rates, Securities and Collateral reports directly to the CEO of LCH Ltd and to the CEO of LCH Group and has responsibility for launching and extending the SwapAgent service. LCH Ltd also maintains regional representation for SwapClear in Australia. The Asia-Pacific Head for LCH Ltd, who reports directly to the LCH Ltd CEO, is responsible for overseeing the strategy and business operations of the SwapClear and other services in Australia and the Asia-Pacific region.

SwapClear operates as a distinct business unit within LCH Ltd, although it is not a separate legal entity. SwapClear has its own executive management team overseeing its operations and has a dedicated team that performs risk management functions consistent with policies set at the LCH Ltd and LCH Group levels. The Rates service risk management team's responsibilities include determining stress test scenarios and sizing the Rates default fund, pricing positions and calling variation margin, calling additional margin, determining and performing backtesting for initial margin, and determining SwapClear default management protocols. The Head of the Rates service Risk team reports directly to the Global Head of Rates, Securities and Collateral. The Group-level Risk department performs the second line of defence including the maintenance of risk policies aligned to the LCH Ltd Board's risk appetite, analysis of margin and default fund adequacy and methodologies, risk aggregation and reporting, default management coordination, determination and monitoring of ICSs and monitoring of credit risk related limits, new product approvals and the risk governance process.

B.3 Regulatory Environment

LCH Ltd is licensed in Australia under section 824B(2) of the Corporations Act 2001, which provides licensing for an overseas-based CS facility subject to requirements and supervision in its home country that are considered to be sufficiently equivalent to those in Australia. LCH Ltd is incorporated in England, and is primarily regulated by the BoE under UK and EU legislation.

The Bank has a memorandum of understanding in place with the BoE regarding supervision of CS facilities.[28] The memorandum provides a framework for bilateral cooperation, including information sharing and investigative assistance. The Bank also engages with the BoE on LCH Ltd supervision matters through the LCH Ltd Global College, which was established in 2012 (see below).

B.3.1 The regulatory regime

LCH Ltd's operations are subject to a number of regulatory regimes:

  • EU regulation. In July 2012, the EU introduced EMIR, a harmonised framework for the regulation of FMIs, including CCPs, incorporated in the region. In May 2018, EMIR was incorporated into the European Economic Area Agreement.[29] EMIR is therefore in force in the European Economic Area, which covers the EU and Iceland, Liechtenstein and Norway. EMIR and its associated technical standards largely implement the PFMI in the EU. Under EMIR, primary regulatory authority over a CCP is given to the national competent authority in the country in which that CCP is established; since LCH Ltd is established in the UK, this is the BoE.
  • UK regulation. Within the UK, LCH Ltd is regulated by the BoE as a ‘recognised central counterparty’ under the UK Financial Services and Markets Act 2000. This sets recognition requirements for UK CCPs including EMIR compliance, maintaining a recovery plan and loss allocation rules, and instituting measures to monitor and reduce potential market abuse. The PPS operated by LCH Ltd is regulated and overseen by the BoE as a ‘recognised payment system’ under the UK Banking Act 2009.
  • Regulation in other jurisdictions. LCH Ltd's operations span several jurisdictions. Outside the European Economic Area and Australia, LCH Ltd has been formally licensed or granted an exemption in the US, Switzerland, Japan, the Canadian provinces of Ontario and Québec, Mexico, Hong Kong and Singapore, allowing it to offer a range of clearing services in those jurisdictions.

B.3.2 The EMIR College and the Global College

EMIR provides a framework for cooperative oversight of CCPs among EU authorities, requiring that a supervisory college be established for each EU-based CCP.

The EMIR supervisory college for LCH Ltd (EMIR College) is chaired by the BoE and plays a role in the ongoing supervision of LCH Ltd, including when LCH Ltd applies to the BoE to expand its services or make significant changes to its risk models. The EMIR College also facilitates the exchange of information among its members.

The BoE has also established a Global College for LCH Ltd, membership of which extends beyond the EMIR College. The Bank is represented on the Global College.

B.3.3 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 its role as supervisor, the BoE aims to ensure FMIs are ‘managed in a manner that is consistent with the public interest including reducing systemic risk’.[30] The BoE takes a risk-based approach to oversight, prioritising its supervisory efforts 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 Ltd with a single set of supervisory priorities, covering its operations as a CCP and as a payments system. The BoE also conducts thematic reviews across all CCPs for which it has oversight responsibility.

The BoE publishes an annual report on its oversight of UK CCPs and other FMIs. The latest report, published in February 2019, summarised the BoE's supervisory priorities and thematic reviews during the period from February 2018 to February 2019, as they applied across all FMIs, and the FMIs' progress against them.[31] The relevant priorities and reviews, focusing on their applicability to the UK CCPs, were:

  • Operational resilience. The BoE continued work on developing an approach to operational resilience stress testing for FMIs, and are planning a pilot test of the approach in 2019. In collaboration with the Prudential Regulation Authority and the Financial Conduct Authority, the BoE published a discussion paper on operational resilience, which will help inform policy development.[32]
  • Cyber security and IT resilience. The BoE reviewed CCPs' adherence to the CPMI-IOSCO Guidance on Cyber Resilience for Financial Market Infrastructures (the Cyber Resilience Guidance). The review concluded that CCPs have continued to maintain their focus on enhancing cyber resilience, and that progress has been made in a number of areas. The BoE also conducted CBEST tests of relevant UK FMIs. CBEST is a framework for controlled, bespoke, intelligence-led cyber security tests assisting financial institutions to remain resilient to cyber attack.
  • Financial resilience. The BoE completed an evaluation of CCPs' self-assessments against the CCP Resilience Guidance. The review found that CCPs' financial risk management frameworks were broadly consistent with the guidance but identified some areas requiring further work. The BoE also performed a cross-CCP review of model governance, and core assurance reviews of financial resilience, including margin and default fund calculation processes, liquidity risk management and collateral management. The BoE initiated reviews into indirect clearing, and the capital positons and business models of the CCPs it supervises.
  • EU withdrawal. The BoE has been focusing on ensuring continuity of essential payment, clearing and settlement services in the event of a no-deal Brexit. This includes working with CCPs to ensure they are able to identify potential risks and have robust contingency plans in place. The BoE has also worked to ensure the domestic regulatory framework, including the BoE's new responsibilities, will be fully effective once European law ceases to apply.

The BoE's supervisory priorities for the period from February 2019 are discussed in section 1.5.

B.3.4 Resolution

As a UK-based CCP, any resolution of LCH Ltd would be governed by UK law. Under the UK's legal framework, resolution of CCPs is governed by the UK Banking Act 2009 (which was extended to include CCPs by the UK Financial Services Act 2012). In August 2014, secondary legislation was introduced to enter the resolution regime into force for CCPs.[33] The BoE is the resolution authority for UK CCPs. Dependent on the timing and nature of the UK's withdrawal from the EU, clarification as to how a resolution scenario would work in practice is expected to develop in light of the UK's HM Treasury's negotiations with the European Commission about the pending EU regime for CCP recovery and resolution.

The BoE leads the LCH Ltd Crisis Management Group (CMG), of which the Bank is a member. The role of the CMG is to discuss and facilitate development of a resolution plan for LCH Ltd.

B.4 Operational Risk Management

Operational risk is the risk that deficiencies in information systems, internal processes and personnel, or disruptions from external events, will result in the reduction, deterioration or breakdown of services provided by a CCP. Operational failures can damage a CCP's reputation or perceived reliability, lead to legal consequences, and result in financial losses incurred by the CCP, participants and other parties. In certain cases, operational failures can also be a source of systemic risk.

LCH Ltd uses a ‘three lines of defence’ approach to assign responsibilities for identifying, monitoring and managing operational risks:

  • The first line of defence is embedded within business lines and support functions, including the Business, First Line Risk, Operations and IT departments. These areas are responsible for the day-to-day management of operational risks within risk appetite, including maintaining effective internal controls and ensuring that all material risks are identified.
  • The second line of defence is provided by LCH Ltd Risk Resilience department and the LCH Group Risk Resilience Committee and is responsible for maintaining and supporting the development of policies consistent with the Operational Risk Management Framework. It provides oversight, support and challenge to the first line of defence in relation to risk management activity and adherence to the framework. The second line also produces aggregated risk reporting to senior executive committees and the LCH Ltd Board.
  • The third line of defence is internal audit, encompassing the LCH Ltd Internal Audit department and the LCH Ltd Audit Committee, who are responsible for reviewing the effectiveness of the management and governance of operational risk, including the system of internal controls and the operational risk framework, and providing assurance to the Board.

LCH Ltd classifies the different aspects of operational risk into distinct ‘resilience’ risks and maintains policies, procedures and controls to address each of these risks:

  • Technology risk is the risk technological failures disrupt critical services provided by LCH Ltd. As the primary objective of IT systems is to support LCH Ltd's services, IT systems are managed to minimise the potential for the disruption of service. This includes maintaining sufficient capacity for service growth, service availability targets and technology change management processes to ensure critical systems maintain a high level of performance.
  • Business continuity risk refers to potential losses arising from a failure to recover from the disruption of critical business or IT processes due to adverse circumstances or events. The LCH Ltd Board expects that adequate processes are in place to minimise disruption. These processes include service availability targets, the regular testing of back-up and recovery plans to recover critical systems within two hours of a disruptive event, and the operation of geographically distinct secondary processing sites capable of running all critical functions.
  • Information and cyber security risk refers to the risk to LCH Ltd's operations, assets, staff and partners arising from unauthorised access, use, disclosure, disruption, modification, or destruction of information and/or information systems. To manage these risks, LCH Ltd expects that appropriate checks are performed prior to information leaving LCH Ltd in the normal course of business and cyber security threats are appropriately evaluated and key controls remain adequate. This is complemented by employing the NIST cyber security framework and the Cyber Resilience Guidance.
  • Default management risk covers the risk that adequate processes are not in place prior to a default event, which leads to a material deterioration in the market value of assets held by LCH Ltd. To minimise this risk, LCH Ltd has policies and procedures in place that set out the key roles and responsibilities in managing a clearing participant default. LCH Ltd conducts Group-wide and partial fire drills at least annually to test both clearing participants' and the CCP's awareness of and ability to implement the default management process.
  • Operational risk, as defined within the LCH Group Risk Governance Framework, refers to all other risks where loss may arise from inadequate or failed internal processes, people and systems, or from external events. The LCH Ltd Board has a low appetite for operational risks and requires these risks to be managed in a proactive manner to minimise the impact to LCH Ltd.

When any resilience risk is assessed to be outside or near LCH Ltd's risk appetite, a mitigation plan must be developed and implemented to bring the risk within the specified risk appetite. Any outside appetite risks that will take longer than six months to return within LCH Ltd's risk appetite must be notified to the LCH Ltd Board. The LCH Ltd Board is responsible for determining the LCH Ltd appetite for operational risk.


Participants can register sub-block trading venue trades without this credit check. [19]

The additional two-day holding period for client positions allows time for clients to decide whether to seek to port their portfolio to another clearing participant, as well as time to carry out any such transfer. [20]

A clearing participant that defaulted would be deemed to have defaulted in all LCH Ltd services. If any of that clearing participant's margin and default fund contributions for a given service were not required to meet losses in that service, they would be applied to losses in any other service of which that clearing participant was a member. [21]

Losses in one LCH Ltd service cannot be applied to the mutualised resources of the default waterfall of another LCH Ltd service (apart from within the Rates service). In an extreme situation, a given LCH Ltd service could be closed, while the other services remained open (apart from the services within the Rates service). [22]

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 clients of the participant and its affiliates. [23]

Portability refers to the ease with which LCH Ltd is able to transfer a client's positions and associated collateral from one direct participant to another. Portability is assessed with reference to the number of live backup clearing arrangements of each client account. [24]

Participants can ask clients to cover their own stress test losses (rather than the member paying DFAM) through stress loss margin. Members and clients jointly agree to provide additional collateral to LCH Ltd in order to reduce the exposure generated by that client. [25]

Further information is available at <>. [26]

The LCH Group Risk policies are: the Financial Resource Adequacy Policy; Liquidity Risk Policy; Operational Risk Policy; Investment Risk Policy; Collateral Risk Policy; Counterparty Credit Risk Policy; Contract and Market Acceptability Policy; Default Management Policy; Settlement, Payment and Custody Risk Policy; Model Governance, Validation and Review Policy; Procyclicality Policy; Information Security and Cyber Risk Policy; and the Business Continuity Risk Policy. [27]

The memorandum is available at <>. [28]

More information is available at <>. [29]

BoE (2013), The Bank of England's approach to the supervision of financial market infrastructures. Available at <>. [30]

BoE (2019), The Bank of England's supervision of financial market infrastructures – Annual Report. Available at <>. [31]

BoE, PRA and FCA (2018), Building the UK financial sector's operational resilience. Available at <>. [32]

More information on the circumstances under which resolution tools would be used is available at <>. [33]