How banks and clients are affected by LCH s new model for individually segregated accounts

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1 white paper #2/14 - April 2014 Yes, My Account Is an Island How banks and clients are affected by LCH s new model for individually segregated accounts Andreas Hümmerich and Stephan Lorenz Tags OTC Derivatives regulation EMIR LCH.Clearnet Ltd SwapClear client asset segregation individually segregated accounts ISA omnibus segregated account OSA central counterpart clearing collateral management Summary LCH.Clearnet Ltd. (LCH) will change its account model in Q2/2014 in order to fulfil EMIR requirements for Individually Segregated Accounts (ISA). With the new account model clearing members clients have now the possibility to move from value to assetsegregated accounts and benefit from a better protection of their assets. While the go live date for the technical upgrade is planned for March 2014, the actual client onboarding to the asset segregated accounts will only be possible after Bank of England s final approval, which is expected at the beginning of Q2/2014. The implementation of and the later onboarding to the new account structures remains challenging due to functional, technical and legal changes.

2 Relevant regulatory requirements under EMIR The European Market Infrastructure Regulation (EMIR) has required substantial changes for capital market participants. Simple and straightforward ( plain vanilla ) derivatives that are traded over the counter (OTC) need to be cleared through an approved Central Counterparty (CCP). By way of clearing the parties must provide margin collateral which minimises the risk of counterparty default. London and Paris based LCH.Clearnet is Europe s market leader for clearing OTC derivatives, handling about 50% of global clearing volume in interest rate swaps. However, EMIR does not only impose changes on trading banks, it also requires changes to the way LCH handles their members client accounts. EMIR Description 39.2 A CCP will offer an Omnibus Segregated Account model (OSA), and segregate clearing member positions and assets from that of the clearing member s clients A CCP will offer an Individually Segregated Account model (ISA), and allow a clearing member to open multiple ISAs for their clients For an ISA client, excess margin called from the client by the clearing member must be held at the CCP, be segregated from other clients and clearing members, and not be exposed to losses in any other account A CCP must publicly disclose all details of each account model, including levels of protection, costs, and legal implications in each jurisdiction Collateral held for specific ISA or OSA accounts must be used exclusively for the specific account. Any balance remaining after any default procedures should be returned to known clients, or if not the clearing member for the account of its clients. Figure 1: Client account related EMIR requirements Although LCH already has implemented the technical adaptions to support the new account structure required by EMIR, as shown in figure 1. The actual productive rollout of the segregated accounts can only start once the European Securities and Markets Authority s (ESMA) colloquium has approved their EMIR compliance. This cannot be taken for granted as seen with the rejection of EUREX in March In case of the LCH after a preliminary check by the Bank of England as corresponding regulator, the application is reviewed by the colloquium of ESMA, consisting of the 17 local regulators. LCH is still waiting for Bank of England s approval before facing the colloquium. A final approval of LCH s application is expected (according to LCH) for the second quarter of this year, but uncertainty remains whether this target can be met. 2

3 Account Model Overview Individually Segregated Account (ISA) The ISA is the account newly offered by LCH to fulfil the EMIR requirement LCH uses the approach of Asset-Tagging. This means the clearing member can tag the assets provided to LCH with the respective client account. LCH has now the information of the asset s beneficial owner in its books. Therefore, in case of a porting, the client has a full claim on the assets provided to LCH and all his cash positions. The initial margin can only be covered with collaterals on the client s own collateral account. Omnibus Segregated Account - Gross margin (OSA Gross) The OSA Gross model corresponds to the current LCH implementation better known as C- Account and addresses EMIR requirement An OSA only offers value segregation, meaning in case of a clearing member default or porting of positions, the client only has a partial claim up to his margin requirements. The initial margin is calculated for each client s portfolio separately and can be covered with all securities held on the shared collateral account. Any excess collateral can be utilised for any client in the OSA. Omnibus Segregated Account - Net margin (OSA Net) This account model resembles the OSA gross. Both differ only in the approach of the margin calculation. The margin requirements are calculated on a net basis over all positions in the account. There is no distinction between each client s portfolios. For any model, client margins are kept separately from the clearing member s margins! 3

4 Functional Changes 1. Initial Margin (IM) Figure 2: Account types at LCH Under ISA, the IM liabilites can only be covered by the collateral on the specific ISA collateral account, see figure 2. Under OSA Gross the sum of the IM liabilities must be covered by the assets held on the sahred collateral account. In the event of porting of liquidation each client has only shared claims over the assets in the account. 2. Variation Margin (VM) All non-im postings (VM, coupons, Price Alignment Interest (PAI)) are netted per currency to the net cash settlement account ( L ) in order to reduce the PPS payments (PPS being the London Protected Payments System used by LCH). 3. Mandatory Excess Collateral If the client intents to clear a new deal, he is obliged to provide excess collateral to his LCH collateral account. This is a consequence of the real-time trade Registration LCH introduced 4

5 in 2013 to fulfil the 60 seconds rule of the American regulator CFTC. Prefunding of excess collateral (cash or securities) by the clearing member is not possible any longer as any excess collateral posted by a client has to be held at LCH (EMIR 39.6). 4. Repay-Option not available for ISA While OSA offers the so called Repay-Option in the end of day where any excess cash collateral and intraday calls are automatically returned to the clearing member, this option is not available under the ISA model. Any excess cash collateral has to be withdrawn manually by entering an instruction in LCH s Collateral Management System (CMS), which was upgraded to support the selection of the new asset segregated accounts. LCH expects a sharp growth in collateral transaction and has introduced a detailed roadmap for future improvements (see section What s next). 5. Onboarding to ISA Clients have the choice whether to remain in the current value-segregated OSA Gross or to move into ISA. Clients need to instruct their clearing member in order to trigger the movement towards ISA. Once the new accounts have been set up by LCH, the client may prefund his positions prior to the migration. The ISA model seems clearly more attractive in terms of the protection of assets and the portability in case of a member default. Nevertheless the ISA also has some offsetting disadvantages for both clearing member and clients which have to be considered. Each ISA will cost an annual LCH fee of EUR to be paid by the client and the processing becomes more complex for the clearing member with an increasing number of accounts. Many clearing members plan to adjust their pricing model to reflect these extra efforts. The final assessment of the advantages/disadvantages lies in the responsibility of the client. Technical Changes Adaption of reporting All client specific SwapClear reports were enhanced in order to show the individual client account. Wherever there is currently a C as account, after the onboarding to ISA the individual identifier of the client will be displayed. These changes have to be checked carefully, especially if clearing members have an automated processing of the LCH reports. SwapClear Margin Approximation Tool (SMART) The report changes in LCH client reports (e.g. Report 102c) made an upgrade of both SMART GUI and API necessary. Therefore SMART version was introduced. Clients need to be 5

6 informed that previous versions aren t supported any more since the technical Go live of the new account model on 24 th of March. Enhanced LCH Banking Platform In order to support an increasing number of client accounts, LCH enhanced its complete banking system. All main reports where amended to include the information about the collateral account. This means for the clearing member that he is now required to process security, interest and account information per ISA and not only for one shared OSA. SWIFT MX Interface LCH introduced last December a possibility automated communication with LCH s Collateral Management System (CMS) through SWIFT MX messaging instead of manual interaction. The first big clearing members are currently in the middle of the onboarding process to the new service. LCH expects their Go Live in Q Legal Changes The numerous changes in the legal basis require a deep legal review. Clearing member and their clients should plan enough time and involve their legal department or counsel prior to a regulatory approval of the LCH EMIR solution targeted for Q Legal Basis LCH Rule book Client Clearing Documentation Deed of Assignment Deed of Release Security Deed Changes with ISA In order to reflect the changes in the account model, LCH had to amend its rule book, consequently resulting in an adaption of the Client Clearing Documentation. The changes due to the new asset segregated accounts are also reflected in the Client Clearing Agreement and Standard Terms. Furthermore have all references to the Deed of Assignment been removed, as the Security Deed steps in. LCH has already made two versions available on its website, one for clients operating under ISDA and a corresponding DRV version for clients operating under the German law. Both clearing members and clients have to let their legal departments check this with priority prior the approval of Bank of England. The Deed of Assignment will be terminated once the new LCH account model becomes effective. The tripartite Deed of Release has to be signed by LCH, Clearing Member and Client in order to terminate the existing Deed of Assignment. To ensure the porting of clients assets, all non-uk clearing members have to sign the new Security Deed. The client does

7 Service Level Agreement (SLA) not directly sign the Security Deed, as it is a bilateral contract between LCH and the clearing member. Nevertheless with the onboarding to ISA each client is recorded in the annex to the Security Deed. On request the client may ask LCH to confirm this record. Most of the clearing members have separate Clearing SLA Agreements with their clients. These have to be updated in order to reflect the mandatory posting of excess collateral and the deactivation of the repay-option. Key challenges for banks and lessons learned from our EMIR practice 1. expect more collateral transactions Due to the deactivation of the repay-option and separation of the accounts, clearing member need to instruct more collateral transactions in LCH s collateral management system. This is currently a time consuming manual process, which can only be automated with introduction of SWIFT MX messaging. 2. point out to the client the importance of posting excess collateral Without prefunding their collateral accounts, clients won t be able to clear any new business. While currently some clearing members prefund the C-Account, this won t be possible with the switch to ISA. This is a LCH-specific consequence of implementing real time trade registration (RTTR). The registration of backloaded deals is not subject to RTTR; they are processed in the daily backloading batch run. Initial Margin requirements resulting from the batch run cannot be prefunded, but are instead called afterwards by LCH. 3. think about handling of intraday calls especially in USD While most clients only provide EUR cash to the clearing member as cover for intraday calls, LCH calls in the afternoon in USD. For the current OSA gross this USD balance would be returned in the end of day due to the repay-option. With ISA this USD balance will remain on the client s collateral account until explicitly withdrawn. Problem is that most clients (at least in Germany) only provide EUR to the clearing member. If the clearing member wants to prevent any foreign exchange risk, he can either ask clients to fund late calls in USD or implement a process to withdraw the USD balance in the EOD (at the same exchange rate at which he called the client in EUR) and substitute it with EUR. 7

8 4. ensure early involvement of legal department or external legal counsel The numerous changes in the legal basis (e.g. Security Deed, Deed of Assignment, Deed of Release, and Client Clearing Agreement) require a deep legal review. Banks should ensure to plan enough time and involve their legal department or counsel as early as possible. 5. plan enough time and resources to the testing phase Early tests of the new reports and processes are critical for the successful implementation of the new account model. In case you missed to fully test all relevant LCH s mandatory Member tests in February 2014, LCH provides with their onboarding environment the platform for further tests. In addition, it is recommended to test the complete onboarding process with a client in order to ensure that the overnight switch to the new account model the clearing solution and all reports provided to the client work as expected. 6. do not underestimate the required time for the setup of the test region Most clearing members are not using the direct connection to LCH via the Clearlink API interface, but rather choose MarkitWire for connecting to LCH. It is therefore critical not only to plan enough time for the setup of the test region, but as well for the coordination and testing. Especially the request of access rights in MarkitWire to the new ISA accounts (provided by LCH) has been quite time-consuming. 8

9 What s next? With the presentation Collateral Management Service roadmap for 2014 during the SwapClear Programme Update (SPU) this February, LCH provided a strong signal for the significance of collateral management in the near future. The focus for enhancements lies on the following two areas: 1. Asset Protection and Portability LCH already provides clients the choice of the asset protection model which fits best their needs, by supporting the segregation by value, by actual assets and the efficient portability of assets upon a possible clearing member default. Key future initiatives in this area include: Real-time liability and headroom enquiry for asset segregated accounts to enable clients a more efficient handling of their collaterals. Move towards full physical segregation, signifying a segregation of the assets on custodial level. 2. Collateral Velocity and Efficiency LCH expects an increased number of collateral movements from client clearing, impacted by Real Time Trade Registration (RTTR) in combination with the new segregation model. Therefore excess collateral will gain importance due to EMIR 39.6 and require further improvements in efficient collateral handling. Key future initiatives in this area include: Real-time validation of cash and non-cash withdrawals, currently a manual process within LCH collateral management team. Hence the validation of a sufficient collateral balance and headroom will be processed automatically when a collateral reduction on an ISA is requested. Aggregation of PPS calls and payment across different asset segregated accounts when the same PPS bank is used. Provision of SWIFT statement of holdings (MT535) to clearing members. 9

10 Firstwaters white paper #3 Apr 2014: New LCH Account Model Conclusion LCH fulfils with the implementation of asset-segregated accounts LCH not only the requirements resulting from EMIR, but as well a central demand raised by many clearing clients asking for a stronger protection of their assets. While the changes mainly cause efforts for the clearing members to adapt their current processes (e.g. deactivation of the repayoption for ISA) and perform a legal review of the legal basis, clients should devote more thought into their handling of collaterals. Nevertheless both are well advised to look early into the new account model in order to avoid resource bottlenecks prior to the introduction of the clearing obligation in early About the authors Andreas Hümmerich is working in the capital markets practice as business consultant. Before joining Firstwaters in 2012 he worked for an international technology and management consultancy. andreas.huemmerich@firstwaters.de Stephan Lorenz has worked as a consultant for investment banks since Since 2012, he works as manager for the Firstwaters, supporting clients in all regulatory, trading and risk management related topics, especially in the trading & settlement system Murex and Calypso. stephan.lorenz@firstwaters.de 10

11 About Firstwaters Firstwaters is an independent consulting firm, providing consulting services to the financial services industry. With offices in Aschaffenburg and Munich, Firstwaters acts as engineering firm for banking corporations, specialised in linking business strategy and processes with technology by implementing ready-to-use and tailor-made software solutions. Firstwaters was founded in 2000 and has about 50 employees today Dämmer Tor Aschaffenburg Baierbrunner Strasse Munich fon info@firstwaters.de fon info@firstwaters.de 2014 Firstwaters GmbH. All rights reserved. 11