Amendments to the recognition requirements for investment exchanges and clearing houses

Amendments to the recognition requirements for investment exchanges and clearing houses January 2013

Amendments to the recognition requirements for investment exchanges and clearing houses January 2013

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Contents Page Chapter 1 Introduction 3 Chapter 2 Proposed changes 5 Chapter 3 Summary 9 1

1 Introduction 1.1 This paper seeks to gain industry views on two amendments to the Recognition Requirements for Investment Exchanges and Clearing Houses under the Financial Services and Markets Act 2000. The first amendment would add a requirement for UK recognised clearing houses providing central counterparty (CCP) services, to have rules and arrangements to allocate uncovered losses amongst members and other related parties. The second amendment would add a requirement for UK recognised clearing houses providing CCP services, to have recovery plans in place. In both instances, these proposals formalise steps already underway by some industry members to manage the risks associated with central clearing; and both complement the existing arrangements already in place to protect against default. The changes would apply only to clearing houses in the UK providing CCP services. Clearing houses based overseas would not be subject to these rules. Background 1.2 Since the financial crisis of 2007-09, a wide programme of financial sector reform has been underway at a domestic, European and G20 level. The reform has not only focused on banks, but also on investment firms and financial market infrastructure (FMIs) (such as CCPs, central securities depositories (CSDs), and payment systems), which also have the potential to cause major wide-spread disruption to the financial system. The Financial Stability Board (FSB) endorsed by the G20 has recommended that resolution regimes are put in place for all systemically important financial institutions including FMIs. 1.3 In July 2012, the Committee on Payment and Settlement Systems and the International Organisation of Securities Commissions (henceforth CPSS-IOSCO) published a consultative report 1 outlining the features of effective recovery and resolution regimes for FMIs. This was in accordance with the FSB s Key Attributes of Effective Resolution Regimes for Financial Institutions including a consideration of the need for CCPs, and other FMI (that take credit risk) to introduce loss sharing rules, and to have resolution regimes. This built upon the updated Principles for Financial Market Infrastructures published by CPSS-IOSCO in April 2012, which identified a number of measures that FMIs should take to prepare for and facilitate the implementation of their own recovery or orderly wind-down plans. 2 1.4 In September 2012, the European Commission published its own consultation 3 on recovery and resolution frameworks for non-bank institutions. However, the timetable for implementing any findings from the consultation is uncertain. 1.5 In the UK, the Government has implemented a resolution regime for banks, through the Banking Act 2009. In accordance with the recommendations of the FSB, 4 the UK Government has taken additional steps to extend the resolution regime to investment firms and UK 1 CPSS-IOSCO consultative report http://www.bis.org/publ/cpss103.htm 2 See paragraph 1.25 of the consultative report: http://www.bis.org/publ/cpss101a.pdf 3 http://ec.europa.eu/internal_market/consultations/2012/nonbanks/consultation-document_en.pdf 4 http://www.financialstabilityboard.org/publications/r_111104cc.pdf [Section 1.2] 3

recognised clearing houses. After an industry-wide consultation 5 over the summer, the Government laid legislation in the Houses of Parliament via amendments to the Financial Service Bill which received Royal Assent on 19 December 2012. 5 Financial sector resolution: broadening the regime www.hmtreasury.gov.uk/financial_sector_resolution 4

2 Proposed changes Central counterparties 2.1 CCPs play a vital role in the financial system; acting as the seller to every buyer and the buyer to every seller. They seek to reduce counterparty risks in trades; and in doing so facilitate trading activity, provide certainty to market participants, and increase confidence within the market. In the UK, there are only a small number of recognised clearing houses 1 that are central counterparties. However, given their role and significant financial exposure to other market participants their failure could pose significant risks to the operation of the UK financial system, and be a potential source of contagion. 2.2 Furthermore, mandatory clearing obligations for over-the-counter (OTC) contracts under the Regulation on OTC derivatives, central counterparties and trade repositories (commonly known as the European Market Infrastructure Regulation or EMIR ) are expected to result in a significant increase in the volume of trades cleared through CCPs, increasing the risk concentration, and hence their systemic importance. European Market Infrastructure Regulation 2.3 The financial crisis revealed problems in OTC derivatives markets, most notably deficiencies in management of counterparty credit risk raising systemic risk concerns, and a lack of transparency regarding risk concentrations. The G20 committed to tackling this by strengthening financial market infrastructure through improved transparency measures and regulatory oversight of over-the-counter derivatives. 2.4 The EU is taking a large part of this change forward through EMIR. EMIR puts in place stringent regulatory requirements for CCPs including: requirements on the amount of permanent and available capital to be held by a CCP; the minimum required level of collateral a CCP must collect from its members; the forms of collateral that are eligible to be posted by members; requirements to maintain default funds; and rules about investment policies. 2.5 All CCPs providing clearing services in the EU will have to demonstrate how they meet these enhanced regulatory standards as part of their respective applications for authorisation or recognition under EMIR. 2.6 EMIR will bring in a framework for a mandatory clearing obligation for standardised OTC derivatives contracts that will be identified in technical standards. EMIR came into force across Europe on 16 August 2012; however, many of the operative provisions require technical 1 A UK recognised clearing house is a CCP which has been authorised, by the regulator, to operate in the UK 5

standards to enter into force before they can be applied. The expectation is that these technical standards will come into force in early 2013. From the date that the technical standards enter into force, all CCPs providing clearing services in the EU will have a six month transitional period within which they can continue to operate under the relevant national regime under which they currently provide services. By the end of this six month period, the CCPs must have applied for authorisation or recognition under EMIR. CCPs will continue to be governed by national rules while the authorisation or recognition procedure progresses. 2.7 EMIR also allows Member States to adopt or continue to apply additional requirements to those set out in EMIR in respect of CCPs established in their jurisdiction. 2 The proposed policy changes in this document are intended to fall within the scope of additional requirements. EMIR does not address the need for CCPs to have loss sharing rules, or recovery and resolution plans. UK recognised clearing houses 2.8 UK clearing houses weathered the last financial crisis well. They are governed by robust regulatory arrangements and have in place a number of defences against failure. Members of a clearing house are required to post significant levels of collateral against the value of their or their clients, positions which is pegged to the changing risk of the trade and the markets. Each clearing house also maintains a default fund, contributed to by members, which acts as a buffer against extraordinary losses. The capital a clearing house has in its own reserve may also act as protection. 2.9 These existing funds and reserves are designed to be sufficient to protect a clearing house against most foreseeable financial shocks, such as the default of the one or two largest clearing members. But they are finite. So in certain extreme circumstances, such as the default of several major clearing members, the existing funds and reserves could be exhausted. In the absence of arrangements to allocate such a loss, the clearing house would then be insolvent. 2.10 The insolvency of a clearing house could pose a serious threat to financial stability. Trading could be disrupted in the markets that the clearing house clears, and clearing members might not be able to access their collateral and default fund contributions for some time. These risks are growing in importance as clearing houses become more systemically significant following the G20 mandate for all standardised OTC derivatives to be centrally cleared. 2.11 Given the systemic significance of clearing houses, the UK authorities think it essential that arrangements are in place to guard against more extreme shocks. Clearing houses have, in most cases, begun the process of putting loss allocation rules in place to allow for circumstances where losses exceed existing resources. The Government thinks that such rules need to be in place for all clearing house products. 2.12 This is consistent with the international Principles for Financial Market Infrastructures developed by CPSS-IOSCO. 3 The Bank of England s Financial Policy Committee has also encouraged the development of loss-allocation rules. 4 2.13 Therefore, the Government is proposing to make a change to the recognition requirements for UK recognised clearing houses providing CCP services, through secondary legislation. 5 This 2 Under recital (50) of EMIR and Article 14(5) it is made clear that the requirements set out in EMIR do not prevent Member States from adopting or apply additional requirements to CCPs in their jurisdiction. 3 Principle 4 (key consideration 7): an infrastructure s rules and procedures should address how potentially uncovered credit losses would be allocated [and] should also indicate the FMI s process to replenish any financial resources that the FMI may employ during a stress event, so that the FMI can continue to operate in a safe and sound manner. 4 Bank of England Financial Stability Report, December 2011, page 53. The FPC welcomed ongoing work to ensure that UK CCPs have robust arrangements to manage potential losses, which should include rules for allocating amongst their participants, and therefore absorbing losses that are not covered by margin, default fund and other financial resources. 6

change would be in addition to those under EMIR. It would sit alongside the EMIR regulations and would stipulate that a UK recognised clearing house providing CCP services must have rules and arrangements in place which allocate losses that arise as a result of member default or otherwise, and which are in excess of the CCP s available resources to cover such losses. These rules would be expected to reinforce existing arrangements (posting of initial margin and other collateral, default fund contributions, capital) for managing financial shocks to the CCPs, and, therefore, prevent failure and to be able to ensure service continuity. 2.14 The UK authorities believe that such rules would significantly reduce the likelihood of a clearing house failing in a way that would constitute a threat to wider financial stability or potentially put public finances at risk through a resolution. 2.15 Complementing this change, and to aid recovery and resolution planning, the Government intends also to make a change to the recognition requirements so as to stipulate that a UK recognised clearing house providing CCP services must have a recovery plan in place. This is analogous to the requirement under Financial Services Act 2010 for banks to maintain recover and resolution plans. The Government believes this is an issue the CCPs are likely to have given some thought to given that the CPSS-IOSCO Principles for Financial Market Infrastructures state that an FMI should prepare appropriate plans for its recovery or orderly wind-down (Principle 3 Key Consideration 4). 6 It is also consistent with the objectives of the EMIR draft technical standards submitted by the European Securities and Markets Authority (ESMA) and the European Banking Authority (EBA). 2.16 Robust recovery plans enhance a company s resilience to a shock by improving its ability to deal with an adverse set of consequences if they arise. 2.17 Information and analysis from a UK recognised clearing house which facilitates resolution planning by the Authorities, is clearly a pre-requisite for effective use by the Authorities of the resolution regime for UK recognised clearing house s contained in the Financial Services Bill. We are of the view that this information and analysis may be obtained by the Authorities from the UK recognised clearing house under existing UK recognised clearing house recognition requirements and FSA rules. 2.18 The Government recognises and welcomes the good practice already underway in the sector on recovery and resolution planning and therefore, see these changes as building on and formalising that good practice. 2.19 The proposed text of these requirements is as follows: A central counterparty must have in place within six months of these Regulations coming into force (a) rules to allocate losses that arise as a result of member default that remain after the resources to which the central counterparty has access (pursuant to paragraph 16 [of this schedule] or Article 45 of the OTC derivatives, central counterparties and trade repositories regulation, as relevant at the time) are exhausted; and (b) effective arrangements (which may include rules) to allocate losses that arise otherwise than as a result of member default; such that these rules and arrangements ensure that the central counterparty may, consistent with its statutory obligations (including, where 5 As part of the new EMIR authorisation process 6 The plan should contain, among other elements, a substantive summary of the key recovery or orderly wind-down strategies, the identification of the FMI s critical operations and services, and a description of the measures needed to implement the key strategies. An FMI should have the capacity to identify and provide to related entities the information needed to implement the plan on a timely basis during stress scenarios. [Paragraph 3.3.8 of the Principles]. 7

relevant, the OTC derivatives, central counterparties and trade repositories regulation), allocate losses capable of threatening its financial viability, with a view to the central counterparty being able to continue to provide clearing services. A central counterparty must have in place a recovery plan that sets out the steps that it will take with a view to maintaining continuity of clearing services in the event that such continuity is threatened. Question 1: Is the intended wording of this requirement clear? Question 2: Are there any unforeseen consequences in amending the recognition requirements in this way? Question 3: Does the proposed requirement complement the draft EMIR Regulatory Technical Standards? Transition period 2.20 It is important that the transition to these new recognition requirements does not present a risk to market stability nor places a significant administrative burden on industry. The Government understands that these changes would have to be phased in to give industry time to make the necessary changes and put in place the loss allocation mechanisms. For loss allocation rules, we intend to allow a transition period of six months from the time the legislation came into force. For recovery planning, the timetable would be the same. Question 4: Are these transitional periods reasonable? 2.21 It is likely that by the time the proposed change to recognition requirements takes effect, responsibility for the supervision of recognised clearing houses will have passed from the FSA to the Bank of England. The Bank will expect UK recognised clearing houses providing CCP services to be guided by the CPSS-IOSCO publications and by the Key Attributes in meeting the requirement and will engage directly with the UK recognised clearing houses about the design of the relevant rules and arrangements and in respect of the preparation of the recovery plan. Question 5: What, if any, further information do you require to implement these requirements? 8

3 Summary 3.1 The Government is of the view that a change to the recognition requirements, which ensures UK recognised clearing houses that provide CCP services in the UK, have adequate loss allocation rules in place and robust recovery and resolution plans, significantly reduces the risk of using a resolution regime to restore a failing clearing house to viable health. Therefore, an amendment to the recognition requirements which provides for these would significantly reduce the likelihood of a UK recognised clearing house entering into a resolution regime. List of consultation questions Question 1: Is the intended wording of this requirement clear? Question 2: Are there any unforeseen consequences in amending the recognition requirements in this way? Question 3: Does the proposed requirement complement the draft EMIR Regulatory Technical Standards? Question 4: Are these transitional periods reasonable? Question 5: What, if any, further information do you require to implement these requirements? 9

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