Initiatives for the Future Enhancement of. Clearing Functions. Study Group on the Enhancement of Clearing Functions

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1 Initiatives for the Future Enhancement of Clearing Functions Study Group on the Enhancement of Clearing Functions April 24, 2008

2 Contents Introduction I. Current state of clearing 1. Clearing functions and effects and the necessity for their reinforcement 2. Major course of events leading to the development of related systems in the commodity field 3. Conditions and trends surrounding clearinghouses in the commodity field overseas 4. Conditions and trends surrounding clearinghouses in Japan II. Basic approach of present examination for the reinforcement of clearing functions 1. Basic awareness of clearinghouses in Japan 2. Basic approach of the present examinations 3. Relationship between clearinghouses and other market related actors, etc. III. Establishment of a clearinghouse management foundation 1. Development of the organization and structure 2. Securing management financial resources 3. Clarification of management policies IV. Reinforcement of creditworthiness in clearing 1. Enhancement of financial resources for contract breach countermeasures (1) Basic way of thinking (2) Approach to specific initiatives 1) Appropriate acquisition of financial resources to cover breaches (trading margins and clearing deposits) 2) Reinforcement of the clearinghouse financial base 2. Reinforcement of the creditworthiness of clearing members (1) Review of clearing qualification requirements, etc. (2) Development of an environment that enables a seamless shift as a result of the review of clearing qualification requirements 3. Approach to clearing risk management, etc. (1) Approach to clearing risk management (2) Approach to default procedures (procedures for dealing with breaches of contact) V. Other examination items for the reinforcement of clearing functions 1. Approach to the improvement of convenience for clearing members premised on the reinforcement of discipline and creditworthiness 2. Other items to be examined, etc. Conclusion 1

3 Introduction The reinforcement of the competitive strength of commodity futures markets in Japan has become a matter of urgency as inter-market competition intensifies transcending national boundaries and fields against a background of international competition for the acquisition of resources, globalization of funding transfers, dissemination of Internet transactions and so forth. Within this context, the Ministry of Agriculture, Forestry and Fisheries and the Ministry of Economy, Trade and Industry are currently promoting examinations and initiatives for the broad range of issues with the aim of boosting market liquidity such as the approach to commodity exchange management, diversification and expansion of market participants, collaboration and integration with the financial field and so forth in the Commodity Exchange Committee of the Industrial Structure Council and in their various research projects. Meanwhile, in order to reinforce the competitive strength of commodity futures markets in Japan, together with these initiatives, it will also be necessary to strengthen the clearing functions that are indispensable for the purpose of improving market credibility and develop an environment enabling trading activities by market participants both in Japan and abroad with a stronger sense of security. In particular, as reviews of price limits and other initiatives proceed, matters of urgency include the reinforcement of creditworthiness and the formulation of other measures to improve market credibility in response to the above initiatives through the establishment of a clearinghouse management foundation, reviews of the qualifications for clearing members and other activities. Our study group has examined and compiled specific measures to be implemented for the purpose of reinforcing clearing functions with the aim of improving market credibility as well as their schedules taking into account the environment surrounding the issue of clearing both in Japan and overseas. 2

4 I. Current state of clearing 1. Clearing functions and effects and the necessity for their reinforcement (1) Clearing functions and effects (refer to Reference 1) 1) Clearinghouses (central counterparties) fulfill important roles (functions) for the purpose of ensuring market credibility as indicated below. They guarantee the execution of settlements on behalf of the respective counterparties as direct parties in the debt-credit relationships that arise when transactions are established in markets, i.e., as seller with respect to the buyer and as buyer with respect to the seller. The credit risk 1 of the individual market participants (sellers and buyers) is impeded by this clearing mechanism. 2) The major effects as a result of these functions are as indicated below. Market participants are able to participate in the market with a sense of security without concern for the credit risk of the other market participants. A chain reaction of defaults (breaches of contract) 2 is prevented and the market gains stability. 3) However, in order to fully demonstrate such functions and effects, firm clearing mechanisms that can be trusted are necessary. (2) Necessity to reinforce clearing functions It is necessary to develop an environment in which market participants both in Japan and overseas can engage in transactions with a stronger sense of security and to reinforce clearing functions from the standpoint of enhancing market credibility taking into account the importance of these functions and effects of clearing. 2. Major course of events leading to the development of related systems in the commodity field (1) 1990 Until that year, transactions in exchanges were required to be settled through the commodity exchange and, under law, no clearinghouse system existed. However, through a partial amendment of the Commodity Exchange Law, it became possible, at the option of individual exchanges, to introduce in-house type clearinghouses 3. (Note) The need for central counterparties was examined frequently by councils and other organizations Risk of the occurrence of default due to deterioration in the credit conditions of trading partner If a breach of contract by a certain transaction party occurs under conditions in which the debt-credit relationship of that party exerts a direct impact on the other party in market transactions, this is a default on the obligation of the other party and leads to breaches of contract. Commodity exchanges that are engaged in commodity trading debt assumption operations on their own 3

5 as early as the late 1960s. (2) 2003 The Tokyo Commodity Exchange introduced an in-house type clearinghouse in June (3) 2004 In addition to 1) the settlement method implemented through the commodity exchange and 2) in-house type clearinghouses, a partial amendment of the Commodity Exchange Law made it possible to establish outside-type clearinghouses 4 enabling settlements between exchanges. (4) The Japan Commodity Clearing House Co., Ltd., was established as an outside-type clearinghouse that enables settlements between exchanges and its operations were launched. (Note) December 24, 2004: Organizing registration: April 25, 2005: Approval of debt assumption operations pursuant to the Commodity Exchange Law May 2, 2005: Start of operations 3. Conditions and trends surrounding clearinghouses in the commodity field overseas (1) Major clearinghouses overseas in the commodity field (refer to Reference 2-1 and 2-2) Europe USA LCH Clearnet (outside-type) 5, etc. CME Clearing 6 (in-house type) NYMEX Clear Port 7 (in-house type) ICE Clear US 8 (in-house type) * Commodity markets in China, India and other countries in Asia also have clearing functions for transactions. (2) Important points relating to conditions and trends 1) Western countries (London, Chicago, etc.) have a history of involvement in clearing going back more than 100 years and, within that context, a strong awareness of the importance of clearing functions, related costs, etc., is fostered among the people involved in the markets Organizations separate from commodity exchanges that engage in commodity trading debt assumption operations Outside-type clearinghouse in the UK; organized in a holding company format with LCH Clearnet Ltd. (former London Clearing House Ltd) and LCH Clearnet SA (former Clearnet SA) as affiliates, it accepts clearing of trading of LIFFE, LME, ICE Futures Europe trades, etc. The clearing department of the Chicago Mercantile Exchange (CME); it accepts clearing of trading of CME, CBOT, One Chicago LLC, etc. The clearing department of the New York Mercantile Exchange (NYMEX); besides the trading of the NYMEX, it also accepts clearing of a portion of the trading of the Dubai Mercantile Exchange (DME). Clearing department of the ICE Futures U.S. (ICE Futures Exchange, USA) 4

6 2) Clearinghouses have a firm management foundation and strong creditworthiness. - Organization (authority of top management, professional human resources, etc.), management resources (clearing commissions, etc.), etc. - Strong creditworthiness Clearing members 9 are primarily world-class financial institutions, etc. Acquisition of appropriate margins and deposits and a firm financial foundation Exhaustive clearing risk management, flexible implementation of transfers 10, etc. 3) There are exchanges in the USA that are oriented toward in-house clearing prompted by exchange mergers and so forth in recent years, while the US Justice Department has expressed the view that clearinghouses for which the exchanges have control authority should be closely investigated (January 31, 2008). This view actually suggests a move toward the separation of matching and clearing functions, so there is also a debate regarding the monopolization of clearinghouses. 4) Initiative are also being developed premised on the globalization of exchanges such as the Recommendations for Central Counterparties (CPSS-IOSCO, November 2004) Conditions and trends surrounding clearinghouses in Japan (1) Current state of clearing (compared to overseas) 1) The history of involvement in clearing in Japan is much shorter than in the western countries and it would be difficult to say that an shared awareness of the importance of clearing functions, etc., is necessarily being fostered among the market participants. 2) Meanwhile, due to various circumstances at the time of the establishment of the Japan Commodity Clearing House Co., Ltd., (JCCH), it has a special management configuration characterized by a certain sharing of roles for clearing functions with the exchanges. (Note) Therefore, when assessing the clearing functions of commodity futures markets in Japan, it is necessary to assess not only the initiatives of the JCCH but in a more all-encompassing manner including the initiatives of the exchanges. 3) Although the clearing mechanism itself has been developed to a certain degree, almost three years have elapsed since operations started and the following issues have been pointed out. - The management foundation of the clearinghouse has not been sufficiently established and there is probably room for improvement. Organization, management resources, management policies, etc. - There is probably room for improvement from the perspective of the reinforcement of Counterparties (clearing members) of debt assumption operations implemented by clearing organization The transfer of unsettled contracts held by certain clearing members to other clearing members 15 recommendations jointly prepared by the CPSS-IOSCO (Committee on Payment and Settlement Systems/International Organization of Securities Commissions) in November 2004 as the minimum standards to be satisfied by central counterparties (CCPs). 5

7 creditworthiness. Low level of credibility of clearing members: Four corporate clearing members 12 already defaulted during the three years or so since the start of business Suitability of trading margins and clearing deposits and the fragility of the financial foundation Approach to clearing risk management, suitability and clarity of rules for the disposition of breaches of contract, etc. 4) The current conditions and trends in clearing in the domestic financial commodity field are as indicated in Reference 3-1 to 3-3. (2) Recent observations regarding the approach to clearing Within this context, the following has been pointed out at council meetings and in study groups. 1) Study Group Report on the Enhancement of Competitiveness of the Non-Agricultural Commodity Futures Markets (June 27, 2007) A comprehensive study on the Japan Commodity Clearing House ( JCCH ) is also necessary, including its clearing system, reinforcing its financial condition, reviewing its qualification requirement and raising its financial requirements for clearing members. 2) Interim Report, Commodity Exchange Committee, Industrial Structure Council (December 7, 2007) 2) Issues for the improvement of market credibility (a) Reinforcement of the clearing system <Current conditions and issues> It is essential to develop a solid clearing system in order to ensure that investors both in Japan and abroad have more confidence in the commodity futures markets of Japan. Still, the clearing systems of Japan is not necessarily as robust as those in other countries, marked as they are by a lack of rigorous financial requirements for clearing members and a low level of creditworthiness. <Direction for the future> It is therefore necessary to promote the reinforcement of the clearing systems in order to realize improvements in market credibility. It has been pointed out that there are issues to be examined at that time such as, for example, those indicated below and it is necessary to organize the issues, including at least these issues, and urgently undertake the required reviews. - Enhancement and reinforcement of the auditing system for the prevention of default - Utilization of a transfer system 12 Marumura (6/3/05), MMG Arrows (3/30/06), Trifo (9/10/07) and Nippon First Securities (3/21/08) 6

8 - Review of the requirements for clearing member qualifications - Enhancement of trading margins, clearing deposits, reserves against defaults, etc. - Promotion of membership by financial institutions with a high level creditworthiness as clearing members, etc. 7

9 II. Basic approach of present examination for the reinforcement of clearing functions 1. Basic awareness of clearinghouses in Japan (1) The ideal form of clearinghouses 1) There are demands for clearinghouses to ensure the effective blocking of counterparty risk 13 by preventing and appropriately handling breaches of contract. As basic assumptions, it is necessary to maintain robust governance, clearing members with a high level of creditworthiness, rigorous clearing risk management, appropriate acquisition of margins and deposits, solid financial foundation, reliable, rapid and impartial disposition of contract breaches, etc. 2) At the same time, it is also necessary for clearinghouses to infuse credibility and stability in the markets unified with initiatives for the purpose of boosting liquidity in the markets by exchanges to serve as the foundation for the sound development of commodity futures markets. (2) Realities surrounding clearinghouses in Japan 1) The clearinghouses of commodity futures markets in Japan have a difference composition of clearing members compared to the clearinghouses of the western countries, which are composed of clearing members based on world-class financial institutions, etc., and are also characterized by disparities in the management foundation, creditworthiness and other areas when viewed internationally 2) Furthermore, due to the circumstances at the time of its founding, the current JCCH has a special management configuration in which management is implemented in the form of a role-sharing arrangement for clearing functions with exchanges. (3) Direction in which Japanese clearinghouses should proceed in the future 1) Clearinghouses in Japan achieve the basic functions and roles to a certain degree of impeding counterparty risk coupled with initiatives, role-sharing and so forth at exchanges. Even so, taking into account the ideal form described above, the mounting demands both in Japan and abroad for clearing risk management and other factors, it cannot be denied that there are various areas that need improvement from the perspective of the establishment of a management foundation, reinforcement of creditworthiness and so on. 2) Clearinghouses in Japan should develop an environment in which essential functions of clearinghouses are demonstrated such as promptly and reliably implementing those improvements, developing their potential as clearinghouses and gradually adjusting the ratio of role-sharing, etc., with exchanges in line with that potential. It will be necessary for the clearinghouses in Japan to serve as the foundation for sound development as the core element of the credibility and stability of the commodity futures markets of Japan. 13 Risk of the occurrence of default by a transaction counterparty 8

10 2. Basic approach of the present examinations (1) Positioning of the examinations Examinations have been pursued centered in items that should be undertaken for the present due to the need to start immediately with specific initiatives amidst intensifying market competition transcending national boundaries and fields, mounting demands for clearing risk management and so forth. It need not be said that, to achieve that, initiatives must be promoted for the reinforcement of clearing functions while implementing the initiatives of this report and furthermore taking into account the trends, etc., in the markets in Japan and overseas. (2) Items to keep in mind regarding the examinations Though there are various areas in the clearing functions of the commodity futures markets of Japan that need to be improved, as indicated above, the clearinghouses do achieve the basic functions of impeding counterparty risk and role-sharing to a certain degree. Meanwhile, there is also a need to examine the configuration of the initiatives while comprehensively taking into account various aspects including the actual current potential of the JCCH itself and the market environment, differences in the rules of the various exchanges, future relationships between exchanges and the lack of transparency of moves involving clearinghouses both in Japan and overseas. (3) Basic perspectives for the realization of improvements It is necessary to promote improvements primarily from the perspectives indicated below taking the current conditions of clearinghouses in Japan into account. It is especially important at that time to strengthen discipline in the relationship between clearinghouses, exchanges and clearing members. [Establishment of a management foundation] 1) Development of the organization and structure (reinforcement of governance, securing and training professional human resources, etc.) 2) Acquisition of management resources (raising clearing commissions) 3) Clarification of management policies (formulation of medium-term business plans) [Reinforcement of creditworthiness] 4) Enhancement of financial resources to deal with contract breaches (Securing appropriate trading margins and clearing deposits and reinforcement of the financial foundation) 5) Review of the requirements for clearing member qualifications (raising net asset requirements) 6) Reinforcement of clearing risk management and ensuring appropriate disposition of breaches, etc. (4) Implementation of initiatives with a sense of speed and in an orderly manner It is necessary to promptly implement initiatives requiring immediate implementation and other realistic items with a sense of speed. However, for example, initiatives for enhancing clearing functions of securities markets in Japan are being implemented with consideration for the impact on market trading and on the actual work of market-related personnel. So, with the prompt implementation of initiatives as 9

11 the basic principles, it is necessary to carefully determine the implementation schedule for each individual item to be improved depending on the situations surrounding such items, while taking into account the impact of such implementation. (5) Relationship to the Recommendations for Central Counterparties (CPSS-IOSCO Report, November 2004) The report Recommendations for Central Counterparties (refer to Reference 4) serves as an important guide when examining the approach to clearinghouses in the future. Meanwhile, there are various practical applications in their implementation and there are also more fundamental issues involving clearinghouses of commodity futures markets in Japan such as the establishment of a management foundation. It is therefore important to be aware of the content and direction of these recommendations while taking the current state into account and they are used as a reference for the present examinations. 3. Relationship between clearinghouses and other market related actors, etc. (1) Relationship between clearinghouses and exchanges 1) Clearinghouses and exchanges frequently have relationships marked by conflicts of interest and it is necessary to maintain a certain degree of discipline (independence) in the relationship between the two. 2) Still, due to the history and circumstances of clearing in Japan thus far, it is a mechanism that places greater relative importance on the exchanges in decisions regarding trading margins and clearing deposits, as well as the composition of shareholders and directors. Meanwhile, taking the conditions of the JCCH into account, it cannot necessarily be said that it would be realistic to immediately change these basic mechanisms and allow JCCH to take the initiative in all respects. It will therefore be necessary in the future to gradually balance the weight in the relationship between the two by developing JCCH s potential and, in accordance with that, for JCCH to become involved to a degree in decisions regarding trading margins and clearing deposits from the perspective of managing clearing risk by securing and training human resources with professional knowledge and the practical application of clearing risk management. In addition, it is also necessary from the perspective of reinforcing governance to interject a certain degree of discipline (independence) between JCCH and the exchanges. (2) Relationship between clearinghouses and clearing members 1) Clearinghouses and clearing members have a relationship characterized by conflicts of interest such as, for example, the fact that clearing members are in a position to be subjected to monitoring and audits of trading, financial and other conditions by clearinghouses. There is thus a need for more rigorous discipline than ever before and maintaining this discipline can be considered a core element in market credibility. 2) Meanwhile, clearing members are clearinghouse users and it is necessary to strive to improve convenience for them to the extent that guarantees the above discipline and creditworthiness. However, it cannot be said that clearing members are necessarily being given ample opportunities for communication with clearinghouses at present, it will be necessary hereafter to provide such 10

12 opportunities. (3) Relationships with exchanges in clearinghouses 1) While there are differences in the ways of thinking regarding the trading rules of exchanges, handling of contract breaches and so forth, breach countermeasures and disposition are managed in a form that impedes default risk in each designated commodity market. 2) In regard to that management, it is necessary to give comprehensive consideration to the creditworthiness of the clearing members, practical application in other markets, strict risk management, appropriate and reasonable burden of risk, sense of security of market participants, etc. To that end, given the current conditions of differing trading rules in each exchange, it is necessary to impede default risk in each designated commodity market and to devise measures such as reserves against defaults and other breach countermeasures taking the scale of risk, etc., into account. 3) Commodity futures markets, in particular, are different from securities markets and risk hedgers 14 (businesses that handle petroleum, agricultural produce, etc.) participate in the former markets. It cannot be considered appropriate for these businesses to bear risk in other markets in which they themselves do not participate and, from this perspective, it is necessary to impede default risk in each designated commodity market Businesses that engage in trading in order to avoid future price fluctuations and other uncertainties Commodity markets engaging in trading that gives rise to obligations subject to the debt assumption operations of the JCCH 11

13 III. Establishment of a clearinghouse management foundation 1. Development of the organization and structure [Reference] Recommendation 13 (Governance) Governance arrangements for a CCP should be clear and transparent to fulfill public interest requirements and to support the objectives of owners and participants. In particular, they should promote the effectiveness of a CCP s risk management procedures (1) Composition of directors <Current state> 1) As indicated below, the board of directors is composed of market-related people centered in exchange directors, etc. Officers: 9 directors (including 2 full-time directors) and 3 auditors (including one full-time auditor) (as of April 1, 2008) Representative director and president: Representative director and vice president: Senior managing director: Managing director: Director: Director: Director: Director: Director: Auditor: Auditor: Auditor: Yoshiaki Watanabe (Chairman, Tokyo Grain Exchange) Masaaki Nangaku (Chairman, TOCOM) Nobuya Noguchi (full-time) Kentaro Iwamoto (full-time) Takashi Inushima (Deputy director, Japan Commodity Futures Industry Association) Makoto Iwamura (Chairman, Kansai Commodities Exchange) Masakazu Kato (Director, Japan Commodity Futures Industry Association) Fumihiko Kimura (Chairman, Central Japan Commodity Exchange) Jitsuo Tatara (Director, National Futures Protection Fund) Takashi Fujinuma (full-time auditor) Yasukiyo Seki Jun Masuda 2) No full-time representative director and president (top management) has been assigned. The top management of exchanges, who may also be in relationships marked by conflicts of interest 12

14 concurrently, serves as the top clearinghouse management. In addition, there are also no outside directors consisting of knowledgeable persons, experts, clearing members, etc. <Direction for the future> 1) Persons with no conflicting interests are assigned as full time representative directors with the aim of reinforcing governance, thoroughgoing clearing risk management, discipline with exchanges, clarification and reinforcement of the structure of management responsibility, etc. (a Selection Committee (tentative name) will be established early in FY2008 to promote examinations with the aim of accelerating the assumption of posts). 2) It was decided from the standpoint of strengthening governance to assign a reasonable number of outside directors consisting of experts and clearing members, etc., while focusing attention on vigorous discussion, rapid decision-making (assigning a small number of directors without overly expanding the number), well-balanced composition, conflicting interests, etc., also taking into account practical applications in other markets (outside directors will be assigned early in FY2008 and will be gradually expanded taking the examinations of the Selection Committee (tentative name) into account). 3) The following points must be heeded when electing outside clearing member directors at that time. (a) While communication between clearing members and clearinghouses, reflection of their views, etc., are necessary, discipline with clearinghouses is important. (b) The composition is to be well-balanced reflecting the views of a diversity of clearing members including domestic and foreign businesses. [Reference] Composition of Japan Securities Clearing Corporation (JSCC) company officers (source: the company s website, as of April 1, 2008) Number of officers: 11 directors (including 2 full-time directors) and 3 auditors (including 1 full-time auditor) Representative director and president: Executive Director & General Manager: Director (outside): Director (outside): Director (outside): Director (outside): Director (outside): Director (outside): Yoshimasa Yamashita Hirokazu Fujisawa Hideki Ishibashi (Managing Director, Legal and Compliance, Credit Suisse Securities (Japan) Limited) Masakazu Kubota (Managing Director, Japan Business Federation) Shigeharu Kobayashi (Representative Senior Executive Officer, Jasdaq Securities Exchange, Inc.) Akio Takahashi (Managing Director, Daiwa Securities SMBC Co. Ltd.) Yasuo Tobiyama (Executive Vice President, COO & CFO, Tokyo Stock Exchange Group, Inc.) Mikio Hinoide (Branch Manager, Tokyo Branch, Osaka Securities 13

15 Exchange Co., Ltd.) Director (outside): Director (outside): Director (outside): Full-time auditor: Auditor: Auditor: Seiji Miyauchi (Senior Executive Officer, Kyokuto Securities Co., Ltd.) Yusuke Yamada (Counselor, Nomura Securities Co., Ltd.) Eiji Watanabe (Executive Deputy President, Nikko Cordial Securities Inc.) Sakae Tanaka Shigeru Nakajima (Attorney) Tsutoo Matsumoto (Certified public accountant) (2) Employee composition <Current state> There are currently 22 employees consisting primarily of personnel on temporary transfer from the various exchanges. :7 from the Tokyo Commodity Exchange, 6 from the Tokyo Grain Exchange <Direction for the future> 1) While assuming that there will be no increase in management costs, a structure will be developed capable of accumulating relevant specialized knowledge and expertise in clearinghouses through the recruitment of permanent personnel with sophisticated specialized knowledge and expertise relating to clearing risk management as well as the utilization, etc., of outside resources (implementation as appropriate beginning in FY2008). 2) It should be constituted as a lean and effective organization consisting of a group of sophisticated professionals taking into account at that time the burden on clearing members and practical applications in other markets. (3) Business management structure <Current state> Generally speaking, a business management structure such as that indicated below has been adopted. 14

16 General meetings of shareholders Board of Directors Board of Auditors General Affairs Committee Qualification Screening Committee Auditors Representative director and president Representative director and vice president Directors General Affairs Group Operations Group Manager in charge of general affairs Manager in charge of accounting Manager in charge of auditing Manager in charge of settlements (clearing operations) General Affairs Group <General affairs manager> Items relating to formulation and revision of various meeting activities, articles of association, business and service documents and various other rules, general affairs and public information <Accounting manager> Items relating to accounting, clearing and budget proposals, management of assets, etc., and management of trading margins and clearing deposits Operations Group <Auditing manager> Items relating to auditing and management of clearing members, applications and approval for the acquisition or loss of qualifications, etc. <Clearing manager> Items relating to clearing operations, computer system management, management of securities relating to trading margins and clearing deposits (excluding items under the control of accounting) and defaults <Direction for the future> 1) The business management structure will be again verified and assessed to ensure that it is appropriate for effectively and efficiently implementing clearing operations and clearing risk management and those areas requiring review will be reviewed. In addition, such verifications, assessments and reviews will continue to be conducted constantly (verification will be conducted during the first half of FY2008 and those areas requiring review will be promptly subjected to review (with reviews also conducted constantly thereafter). 2) At that time, it will be necessary to have a mechanism (establishment of in-house committees, etc.) for implementing seamless communication with clearing members with the aim of instituting checks and balances relating to improvements in the convenience of clearing members assuming at least the reinforcement of discipline and creditworthiness as well as the effectiveness of management by clearing members, suitability of business management (in addition to discipline by shareholders, board of directors, etc.) (examination early in FY2008 and implementation beginning in the first half). 3) The JCCH will moreover examine the possibility of establishing a Clearing Risk Management Committee (tentative name) for the purpose of appropriately implementing clearing risk management. 15

17 (4) Shareholder composition, etc. <Current state> As indicated below, while centered in four exchanges, the Japan Commodity Futures Industry Association and other organizations that represent the interests of futures commission merchants (FCMs) 16 (clearing members) have stock holdings of a certain ratio. Individual clearing members, financial institutions, etc., are not shareholders. Tokyo Commodity Exchange: 26.0% Japan Commodity Futures Industry Association: 16.0% Tokyo Grain Exchange: 26.0% Kansai Commodities Exchange: 8.0% Central Japan Commodity Exchange: 20.0% National Futures Protection Fund: 4.0% <Direction for the future> There is a need to consider capital injections by individual clearing members, financial institutions, etc., for the present as indicated below. In regard to clearing members that are FCMs, the Japan Commodity Futures Industry Association currently maintains stock holdings of a certain ratio. Meanwhile, there are demands for strict discipline between clearinghouses and clearing members that have a relationship marked by conflicts of interest and it is necessary to ensure impartiality between clearing members. Therefore, as in western countries, a strong awareness of the importance of clearing functions and the costs, etc., involved therein will be fostered among concerned parties and share holdings by individual clearing members should be examined once strict discipline, impartiality and other conditions are assured. It is necessary rather to take the composition of directors, business management structure and other systems comprehensively into consideration from the perspective of strengthening governance. Communication, etc., between clearinghouses and clearing members will be important at that time, even if it is not based on stock holdings, and, as indicated above, there will be a need for a mechanism for providing such opportunities. In addition, though capital injections by financial institutions, etc., would be desirable in terms of both funding procurement and the reinforcement of governance, as indicated below, it would be difficult to say that that would be realistic at present if net profit for the term is set aside as reserves against defaults instead of distribution as dividends. [Reference] For example, in the securities field in Japan, in which the situation is similar, all of the shares in the Japan Securities Clearing Corporation (JSCC) are held by various exchanges while the clearing members have no holdings. It can probably be said that there is no particular problem at the present point in time with the shareholder composition itself centered as it is in exchanges taking into account this practical application and the current state of clearing in the commodity futures markets of Japan. 16 Parties that obtain the approval of the minister in charge to engage in commodity trade acceptance operations based on the stipulations of Article 190, Paragraph 1, of the Commodity Exchange Law 16

18 * JSCC shareholder composition (source: company website) Tokyo Stock Exchange Group, Inc. Osaka Securities Exchange Co., Ltd. Jasdaq Securities Exchange, Inc. Nagoya Stock Exchange, Inc. Fukuoka Securities Exchange Sapporo Securities Exchange 2. Securing management financial resources <Current state> 1) Clearing commissions are 1/transaction. That produces an income of 150 million per year, while JCCH management costs at the present time amount to over 400 million. In other words, clearing commission income does not even cover basic management costs (at present, interest revenue derived from margins, etc., is applied to management costs). 2) Due to circumstances, etc., at the time of the establishment of the JCCH, clearing commissions are first of all collected by the exchanges from the clearing members and are then paid to the JCCH, which itself does not collect commissions directly from the clearing members. An awareness of the burden involved in clearing is therefore not necessarily fostered among the clearing members. [Transitions in JCCH clearing] <Revenues> Unit: 1,000 Account item FY2005 FY2006 FY2007 (projected) <Commission revenue> 199, , ,222 Clearing commissions 199, , ,822 Clearing qualification acquisition commissions <Interest revenue> 588, ,191 1,070,481 <Other> 19,407 44,232 20,502 Net revenues 807,751 1,211,184 1,239,205 <Expenditures> <Operating expenditures> 377, , ,947 <Software and other depreciation costs> 17,932 26,525 26,423 <Other> ,658 0 Net expenditures 395, , ,370 Net income before taxes 712, , ,835 Net income after taxes 225, , ,301 3) Although it is necessary to make comparisons taking merit of scale, differences in the line of 17

19 business, etc., into account, clearing commissions at clearinghouses overseas are generally in the range of 10-80/transaction. In addition, the clearing commissions that are collected in the securities markets of Japan, for example, in the case of the JSCC, greatly exceed management costs (refer to Reference 5). <Direction for the future> 1) From the perspective of ensuring the unassailable viability of commodity futures markets in Japan, it is necessary for the present, as indicated below, to stand on the premise of steadily accumulating that portion equivalent to JCCH s interest revenue (excluding amounts paid in tax) for reserves against defaults as a financial resource to deal with contract breaches while also raising settlement commissions, currently at the level of 1/transaction, to a level that makes it possible to at least cover basic clearinghouse management expenses. 2) Assuming the JCCH s prospective expenditures (about 600 million/year*) and calculating prospective income based on a somewhat conservative estimate of future turnover taking recent turnover trends into account, it will be necessary for clearing commissions to be at least 6/transaction at that time. The current level of clearing commissions of 1/transaction should therefore be raised by 5 to a total of 6/transaction. * This is an amount estimated by the JCCH. According to the JCCH, the future amount of prospective expenditures reflects a simple continuation of current operations and the amount does not include any possible changes in the margin system, the cost of computer system modification if a some sort of solution becomes necessary as a result of 24-hour/day operations, the cost of insurance premiums if insurance contracts are entered into and so forth. After sufficient coordination with exchanges and clearing members regarding the need and cost of such expenditures while applying the general rule of covering them through maximum efforts by the JCCH for enhanced efficiency for those judged by concerned parties to be necessary and unavoidable and, for those that cannot be offset in this manner, it will probably be necessary to appropriately increase clearing commissions to cover the additional expenses. (Note) When raising clearing commissions, the special properties of the products, markets, etc., should also be taken into consideration to the extent necessary. 3) Moreover, the perspective of the former portion of item 1) above will be shared by the various exchanges and the exchanges will examine the possibility of reducing their fixed rate membership fee. Specifically, while the clearing commission is raised to 6/transaction, they will explore the possibility of introducing a reduction of about 1/transaction, at least for the time being. 4) While the measures of items 1) - 3) above should be implemented as quickly as possible, a certain period of time and transitional measures should also be established due to the impact exerted on the business management of the exchanges and clearing members. Specifically, the concerned parties will undertake coordination and, in principle, it will be carried out step by step according to the schedule below. 18

20 Clearing commissions Exchange fixed rate membership fees Oct. 1, 2008, onward To be raised from the current 1/transaction by 2.5 and then to 3.5 Exchanges will examine the possibility of reducing their fixed rate membership fees to an appropriate level (about 0.5/transaction at least for the present). April 1, 2009, onward Total implementation ( 6/transaction) Exchanges will examine the possibility of reducing their fixed rate membership fees to an appropriate level (about 1/transaction at least for the present). 5) Though not realistic under the current conditions, if revenues derived from clearing commissions exceed expenditures (management costs) due, for example, to revenues exceeding the assumed level due to an increase in turnover that exceeds the basic assumption, that amount would, in principle, be earmarked for reserves against defaults. 6) If we were to stand on the assumption that at least an amount equivalent to the JCCH s interest income will be steadily accumulated as a financial resource for reserves against defaults to deal with contract breaches and raised clearing commissions to a level that would make it possible to cover JCCH s basic management expenses, the JCCH should not, from the standpoint of maintaining discipline relating to revenues and expenditures, allocate revenues equivalent to interest revenues to management expenses without reasonable cause, especially during that time when initiatives based on this assumption are being implemented. The basic rule should be to cover such required expenditures through its own efforts to enhance efficiency before devising any such measure. In addition, if there is reasonable cause for expenditures to unavoidably exceed revenues due to new expenditure items or for other reasons as the result of a change in the circumstances and if it is possible to obtain the understanding of the exchanges, clearing members and other concerned parties, the basic rule should be to not allocate revenues equivalent to interest income for necessary expenditures and to raise clearing commissions to a level appropriate for such necessary expenditures from the standpoint of maintaining discipline relating to revenues and expenditures. 7) A shift toward the direct collection of clearing commissions by the JCCH should be examined while bearing in mind the efficiency and other aspects of the procedure (implementation of necessary preparations during FY2008 for introduction in FY2009). 8) The introduction of volume discounts 17 for clearing commissions will also be examined. Furthermore, the JCCH will make maximum efforts at all times to realize enhanced efficiency in the use of management expenses in order to avoid inducing useless cost increases for clearing members. 3. Clarification of management policies <Current state> Though more than three years have elapsed since first established, the JCCH has not formulated a 17 Commission system applying commission rates that are lower than usual when more than a given fixed number of clearings are implemented during a given period of time 19

21 medium-term business plan. <Direction for the future> 1) A medium-term business plan, which will set forth basic management policies, will be promptly prepared (a Management Reform Promotion Council (tentative name) will be established early in FY2008 and examinations will begin; the plan will be formulated during FY2008 for implementation beginning in FY2009). 2) While using the Recommendations for Central Counterparties as a guide, specific and realistic initiatives should be established that are well matched to the JCCH s potential at the time with the aim of reinforcing clearing functions with a sense of speed and in an orderly manner taking fully into account the conditions of the JCCH, conditions of exchanges and clearinghouses both in Japan and overseas, the market environment, practical applications in other markets, the necessary cost-effectiveness, etc. 3) Furthermore, besides establishing specific initiatives in the medium-term business plan to be undertaken for measures involving the reinforcement of governance, appropriate prevention of breaches of contract, disposition of breaches, etc., the following items should also be taken into account. - Items relating to risk in the organization management of the clearinghouse itself (Recommendations 7-9) - Items relating to requests from clearing members (efficiency (Recommendation 12) and transparency (Recommendation 14)), improvements in convenience premised on the reinforcement of discipline and creditworthiness, facilitation of communication, etc. [Reference] Items relating to risk in the organization management of the clearinghouse itself Recommendation 7, Custody and investment risks A CCP should hold assets in a manner whereby risk of loss or of delay in its access to them is minimized. Assets invested by a CCP should be held in instruments with minimal credit, market and liquidity risks. Recommendation 8, Operational risk A CCP should identify sources of operational risk and minimize them through the development of appropriate systems, controls and procedures. Systems should be reliable and secure, and have adequate, scalable capacity. Business continuity plans should allow for timely recovery of operations and fulfillment of a CCP s obligations. 20

22 Recommendation 9, Money settlements A CCP should employ money settlement arrangements that eliminate or strictly limit its settlement bank risks, that is, its credit and liquidity risks from the use of banks to effect money settlements with its participants. Funds transfers to a CCP should be final when effected. Items relating to requests from clearing members (efficiency and transparency) Recommendation 12, Efficiency While maintaining safe and secure operations, CCPs should be cost-effective in meeting the requirements of participants. Recommendation 14, Transparency A CCP should provide market participants with sufficient information for them to identify and evaluate accurately the risks and costs associated with using its services. 4) When formulating medium-term business plans, the understanding of shareholders as well as clearing members is to be obtained regarding the suitability and necessity of the initiatives, anticipated costs, etc., and the conditions of implementation are to be periodically assessed. 21

23 IV. Reinforcement of creditworthiness in clearing 1. Enhancement of financial resources for contract breach countermeasures Appropriate acquisition of financial resources for covering breaches and the reinforcement of the clearinghouse financial foundation (1) Basic way of thinking 1) Creditworthiness is necessary in order to strengthen clearing functions. To that end, in addition to high creditworthiness on the part of clearing members and the implementation of appropriate clearing risk management, it is also important to provide fully for security and financial resources in preparation for breaches of contract (defaults) in the event that they should occur. 2) Should a breach of contract occur, it is necessary first of all to compensate (defaulter s pay) as much as possible for losses incurred by a default using trading margins, clearing deposits and other financial resources for breach guarantees provided by the party in breach. It is important to appropriately secure financial resources for such breaches for that purpose. 3) Furthermore, if it is not possible to compensate for losses due to default using financial resources for covering breaches of the party in breach, it is important to develop a system capable of completing the compensation caused by default to the utmost using the financial resources for breach countermeasures or other resources of the clearinghouse (third parties pay) at the stage before extending to the financial resources, etc., for the purpose of covering breaches of clearing members other than the party in breach (survivors pay). Therefore, given the fact that the amount of the compensation for loss by exchanges or other third parties is prescribed by the contracts entered into by the relevant parties, it is important to reinforce the financial base of the clearinghouse (accumulate more reserves against defaults). 4) Taking this into consideration, it is important to appropriately secure financial resources to cover breaches and reinforce the financial base of the clearinghouse from the perspective of developing an environment in which market participants are able to participate in trading with a sense of security and reinforcing creditworthiness. [Reference] Overview of the sequence of compensation for losses in the event that JCCH sustains losses due to default (for each designated commodity market) 1) Trading margins, clearing deposits, etc., entrusted to the JCCH by the party in breach 2) Money and other guarantee funds for which the party in breach has the right to claim restitution from the JCCH Defaulters pay 3) JCCH s reserves against defaults 4) Compensation for damage, loss guarantees, etc., by an exchange or other third party Third parties pay 5) Clearing deposits of clearing members other than the party in breach 6) Profit variance of benefiting clearing members Survivors pay 22