Committee on Payments and Market Infrastructures Board of the International Organization of Securities Commissions Implementation monitoring of PFMI: Level 3 assessment – Report on the financial risk management and recovery practices of 10 derivatives CCPs August 2016 This publication is available on the BIS website (www.bis.org) and the IOSCO website (www.iosco.org). © Bank for International Settlements and International Organization of Securities Commissions 2016. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISBN 978-92-9197-625-6 (online) ISBN 978-92-9197-626-3 (print) Abbreviations ................................................................................................................................................................................... viii 1. Executive summary ......................................................................................................................................................... 1 1.1 Scope of the assessment ........................................................................................................................... 2 1.2 Key changes to CCPs’ risk frameworks since implementation of the PFMI .......................... 2 1.3 Key findings of the assessment ............................................................................................................... 3 1.3.1 Governance of risk management ........................................................................................................... 4 1.3.2 Credit risk management ............................................................................................................................ 4 1.3.3 Liquidity risk management ....................................................................................................................... 5 1.3.4 Margin ............................................................................................................................................................... 5 1.3.5 Collateral policy and investments .......................................................................................................... 6 1.3.6 Default management and recovery planning ................................................................................... 6 2. Introduction ...................................................................................................................................................................... 8 2.1 Broader context of the Level 3 assessments ...................................................................................... 8 2.2 Objective of L3 assessments .................................................................................................................... 8 2.3 Scope of this review .................................................................................................................................... 9 3. Process and methodology ........................................................................................................................................ 11 3.1 Jurisdictional/CCP coverage ................................................................................................................... 11 3.2 Data collection and analysis ................................................................................................................... 13 3.3 Review of assessment findings by CCPs, relevant authorities and the parent committees 13 4. CCP risk frameworks .................................................................................................................................................... 14 4.1 Role of a CCP ................................................................................................................................................ 14 4.2 Sources of CCP risk and mitigation ..................................................................................................... 14 4.3 Key changes to CCPs’ risk frameworks .............................................................................................. 18 5. Key findings ..................................................................................................................................................................... 20 5.1. Governance of risk management ......................................................................................................... 20 5.1.1 Overview of implementation measures and consistency of implementation outcomes with the PFMI and across CCPs ............................................................................................................. 21 5.1.2 Key findings .................................................................................................................................................. 22 5.1.2.1 Identification and consideration of stakeholder interests (Principle 2, KC 7) ..................... 22 5.1.3 Other findings relevant to consistency of outcomes ................................................................... 23 5.1.4 Other observations .................................................................................................................................... 24 5.1.4.1 Governance arrangements and board structures (Principle 2, KC 2) ..................................... 24 5.1.4.2 Risk management framework (Principle 2, KC 6) ........................................................................... 24 Implementation monitoring of PFMI: Level 3 assessment iii 5.1.4.3 Authority and independence of risk management and audit functions (Principle 2, KC 6) ........................................................................................................................................ 25 5.1.4.4 Disclosure (Principle 2, KC 7) .................................................................................................................. 25 5.1.4.5 Risks that arise in or are borne by the CCP (Principle 3, KC 1) ................................................. 26 5.1.4.6 Review of risk management policies, procedures and systems (Principle 3, KC 1) .......... 26 5.1.4.7 Incentives to manage risks (Principle 3, KC 2) ................................................................................. 27 5.1.4.8 Material interdependencies and risk management tools (Principle 3, KC 3) ...................... 27 5.2 Credit risk management ........................................................................................................................... 28 5.2.1 Overview of implementation measures and consistency of implementation outcomes with the PFMI and across CCPs ............................................................................................................. 29 5.2.2 Key findings ................................................................................................................................................... 31 5.2.2.1 Sizing of prefunded resources (Principle 4, KC 4 and KC 5) ...................................................... 31 5.2.2.2 Responses to breaches of target coverage (Principle 4, KC 4 and KC 5) .............................. 37 5.2.2.3 Stress test assumptions and processes (Principle 4, KC 5) ......................................................... 38 5.2.2.4 Stress testing of financial resources (Principle 4, KC 5) ............................................................... 39 5.2.2.5 Stress testing scenarios (Principle 4, KC 6) ....................................................................................... 40 5.2.2.6 Stress testing model review and validation (Principle 4, KC 5) ................................................. 43 5.2.3 Other findings relevant to consistency of outcomes ................................................................... 44 5.2.3.1 Coverage targets (Principle 4, KC 4) .................................................................................................... 44 5.2.3.2 CCP contributions to prefunded financial resources (Principle 4, KC 4) ............................... 45 5.2.4 Other observations ..................................................................................................................................... 46 5.2.4.1 Credit risk frameworks and risk management tools (Principle 4, KC 1 and KC 2) ............. 46 5.2.4.2 Identification, monitoring and measurement of credit risk (Principle 4, KC 2) .................. 47 5.2.4.3 Reporting of stress-test results (Principle 4, KC 5) ........................................................................ 48 5.3 Liquidity risk management...................................................................................................................... 49 5.3.1 Overview of implementation measures and consistency of implementation outcomes with the PFMI and across CCPs ............................................................................................................. 50 5.3.2 Key findings ................................................................................................................................................... 52 5.3.2.1 Approaches and key model parameters used to determine the amount and to test the sufficiency of liquid resources (Principle 7, KC 9) ................................................................... 52 5.3.2.2 Scope of liquidity risk management framework and relevant currencies (Principle 7, KC 4) ........................................................................................................................................ 56 5.3.3 Other findings relevant to consistency of outcomes ................................................................... 56 5.3.3.1 Coverage of liquid resources (Principle 7, KC 4) ............................................................................ 56 5.3.3.2 Mitigating risks associated with access to qualifying liquid resources when needed (Principle 7, KC 5 and KC 7) .................................................................................................................... 57 5.3.3.3 Responses to breaches of coverage (Principle 7, KC 9) ............................................................... 59 iv Implementation monitoring of PFMI: Level 3 assessment 5.3.4 Other observations .................................................................................................................................... 60 5.3.4.1 Qualifying liquid resources (Principle 7, KC 5) ................................................................................ 60 5.3.4.2 Supplemental liquid resources (Principle 7, KC 6) ......................................................................... 62 5.3.4.3 Access to and use of central bank accounts and services (Principle 7, KC 8) ..................... 63 5.4 Margin practices ......................................................................................................................................... 63 5.4.1 Overview of implementation measures and consistency of implementation outcomes with the PFMI and across CCPs ............................................................................................................. 64 5.4.2 Key findings .................................................................................................................................................. 68 5.4.2.1 Choice of margin model (Principle 6, KC 1) ..................................................................................... 68 5.4.2.2 Key model parameters (Principle 6, KC 3) ......................................................................................... 69 5.4.2.3 Procyclicality (Principle 6, KC 3) ............................................................................................................ 71 5.4.2.4 Review, backtesting, sensitivity analysis and model validation (Principle 6, KC 6 and KC 7) ........................................................................................................................................................ 71 5.4.3 Other findings relevant to consistency of outcomes ................................................................... 73 5.4.3.1 Margin add-ons (Principle 6, KC 3) ...................................................................................................... 73 5.4.3.2 Portfolio margining (Principle 6, KC 5) ............................................................................................... 74 5.4.3.3 Timing and frequency of margin calls (Principle 6, KC 4) ........................................................... 75 5.4.4 Other observations .................................................................................................................................... 76 5.4.4.1 Price information (Principle 6, KC 2) ................................................................................................... 76 5.4.4.2 Target coverage (Principle 6, KC 3) ..................................................................................................... 77 5.4.4.3 Account structures (Principle 6, KC 3) ................................................................................................ 77 5.4.4.4 Discretion (Principle 6, KC 3) .................................................................................................................. 78 5.4.4.5 Wrong-way risk (Principle 6, KC 3) ...................................................................................................... 78 5.5 Collateral policy and investments ........................................................................................................ 79 5.5.1 Overview of implementation measures and consistency of implementation outcomes with the PFMI and across CCPs ............................................................................................................. 79 5.5.2 Key findings .................................................................................................................................................. 81 5.5.2.1 Investment strategy (Principle 16, KC 4) ............................................................................................ 81 5.5.2.2 Setting haircuts and reducing the need for procyclical adjustments (Principle 5, KC 2 and KC 3) .................................................................................................................... 83 5.5.3 Other findings relevant to consistency of outcomes ................................................................... 84 5.5.3.1 Valuation methods (Principle 5, KC 2) ................................................................................................ 84 5.5.4 Other observations .................................................................................................................................... 85 5.5.4.1 Assets accepted (Principle 5, KC 1) ...................................................................................................... 85 5.5.4.2 Concentration limits (Principle 5, KC 4) ............................................................................................. 86 5.5.4.3 Cross-border collateral (Principle 5, KC 5) ........................................................................................ 87 Implementation monitoring of PFMI: Level 3 assessment v 5.6 Default management and recovery planning .................................................................................. 87 5.6.1 Overview of implementation measures and consistency of implementation outcomes with the PFMI and across CCPs ............................................................................................................. 89 5.6.2 Key findings ................................................................................................................................................. 94 5.6.2.1 Appropriate plans for recovery or orderly wind-down (Principle 3, KC 4) ........................... 94 5.6.2.2 Addressing unforeseen potentially uncovered liquidity shortfalls; Replenishment of liquidity resources (Principle 7, KC 10) ............................................................................................... 95 5.6.2.3 Allocation of potentially uncovered credit losses (Principle 4, KC 7) ..................................... 96 5.6.2.4 Tools to re-establish a matched book following clearing participant default (Principle 4, KC 7) ..................................................................................................................................... 101 5.6.2.5 Replenishment of financial resources (Principle 4, KC 7) ......................................................... 102 5.6.2.6 Tools to address losses not caused by clearing participant default (Principle 15, KC 3)105 5.6.3 Other findings relevant to consistency of outcomes ................................................................ 105 5.6.3.1 Testing and review of clearing participant default rules and procedures (Principle 13, KC 4) .................................................................................................................................. 105 5.6.3.2 Composition of liquid net assets funded by equity (Principle 15, KC 4) ........................... 106 5.6.3.3 Raising additional equity (Principle 15, KC 5) ............................................................................... 106 5.6.4 Other observations .................................................................................................................................. 107 5.6.4.1 Clearing participant default rules and procedures and use of financial resources (Principle 13, KC 1) .................................................................................................................................. 107 5.6.4.2 Holding sufficient liquid net assets funded by equity to implement the recovery or orderly wind-down plan (Principle 15, KC 3) ................................................................................ 109 5.6.4.3 Consideration of insurance policies in the context of holding sufficient liquid net assets funded by equity to implement the recovery or orderly wind-down plan (Principle 15, KC 3) .................................................................................................................................. 109 6. Summary and conclusions ...................................................................................................................................... 110 6.1 Governance of risk management ...................................................................................................... 111 6.2 Credit risk management ........................................................................................................................ 111 6.3 Liquidity risk management................................................................................................................... 112 6.4 Margin .......................................................................................................................................................... 113 6.5 Collateral policy and investments ..................................................................................................... 113 6.6 Default management and recovery planning ............................................................................... 114 Annex A: Summary information for ASX Clear (Futures) .............................................................................................. 116 Annex B: Summary information for BM&FBOVESPA Clearinghouse ....................................................................... 120 Annex C: Summary information for Clearing Corporation of India limited (CCIL) ............................................. 125 Annex D: Summary information for CME Clearing.......................................................................................................... 128 vi Implementation monitoring of PFMI: Level 3 assessment Annex E: Summary information for Eurex Clearing AG ................................................................................................. 132 Annex F: Summary information for ICE Clear Credit ...................................................................................................... 137 Annex G: Summary information for JSCC (ETD, CDS, and IRS) .................................................................................. 141 Annex H: Summary information for LCH.Clearnet ltd (SwapClear) .......................................................................... 144 Annex I: Summary information for LCH.Clearnet SA ...................................................................................................... 148 Annex J: Summary information for Singapore Exchange Derivatives Clearing (SGX-DC) ............................... 151 Annex K: Members of the CPMI-IOSCO Implementation Monitoring Standing Group (IMSG) and assessment teams ...................................................................................................................................................... 155 Implementation monitoring of PFMI: Level 3 assessment vii Abbreviations BCBS Basel Committee on Banking Supervision CCP Central counterparty CDS Credit default swap CPMI Committee on Payments and Market Infrastructures CPSS Committee on Payment and Settlement Systems CRO Chief risk officer CSD Central securities depository DF Default fund ES Expected shortfall ETD Exchange traded derivatives FMI Financial market infrastructure FSB Financial Stability Board HVaR Historical simulation VaR IM Initial margin IMSG Implementation Monitoring Standing Group IOSCO International Organization of Securities Commissions IRD Interest rate derivatives KC Key Consideration L1 Level 1 L2 Level 2 L3 Level 3 OTC Over-the-counter PFMI Principles for financial market infrastructures PSG Policy Standing Group PSR Price scanning range SPAN Standardised Portfolio Analysis of Risk SSS Securities settlement system TR Trade repository VaR Value-at-risk VSR Volatility scanning range viii Implementation monitoring of PFMI: Level 3 assessment 1. Executive summary In April 2012, the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) published the Principles for financial market infrastructures (PFMI). The PFMI set expectations for the design and operation of key financial markets infrastructures (FMIs) to enhance their safety and efficiency and, more broadly, to limit systemic risk and foster transparency and financial stability. The Principles in the PFMI apply to all systemically important payment systems, central securities depositories (CSDs), securities settlement systems (SSSs), central counterparties (CCPs) and trade repositories (TRs) (collectively FMIs). These FMIs collectively clear, settle and record transactions in financial markets. Among other things, the PFMI provide important support for the G20 strategy to enhance financial system resilience by ensuring that standardised over-the- counter (OTC) derivatives are centrally cleared. CPMI and IOSCO members have undertaken to incorporate the PFMI in their jurisdictions’ legal and regulatory frameworks. Following the publication of the PFMI, the CPMI and IOSCO agreed to monitor their 1 implementation in 28 CPMI and IOSCO member jurisdictions. The implementation monitoring is being carried out in three levels. Level 1 self-assessments report on whether a jurisdiction has completed the process of adopting the legislation and other policies that will enable it to implement the Principles and Responsibilities. Level 2 assessments are peer reviews of the extent to which the content of the jurisdiction's implementation measures is complete and consistent with the PFMI. Level 3 (L3) peer reviews examine consistency in the outcomes of implementation of the Principles by FMIs and implementation of the Responsibilities by authorities. This implementation monitoring programme is conducted by a dedicated standing group of the CPMI-IOSCO Steering Group, the Implementation Monitoring Standing Group (IMSG). This report represents a L3 assessment of consistency in the outcomes of CCPs’ implementation of the PFMI with respect to their financial risk management and recovery practices. This first L3 assessment complements a broad work program on CCP resilience, recovery and resolution – the CCP Workplan – agreed in April 2015 by the Basel Committee on Banking Supervision (BCBS), the CPMI, the 2 Financial Stability Board (FSB), and IOSCO . In future L3 assessment rounds, different assessment themes are anticipated, with the goal of covering over time a broad range of Principles, FMI types and jurisdictions. L3 assessments are expected to inform the CPMI and IOSCO about the nature and potential causes of variations in approaches or outcomes because such variations may be due to challenges and interpretative issues that have emerged in implementing the PFMI. This information may feed into other CPMI and IOSCO work, including the work of the CPMI-IOSCO Policy Standing Group (PSG) on the ongoing development of standards and guidance. Given that this first L3 assessment deals with matters relevant to ongoing work by the PSG on CCP resilience and recovery under the CCP Workplan, the IMSG and PSG have coordinated their work. The findings of this L3 assessment have fed directly into the PSG’s deliberations on additional guidance to the PFMI in this area. This L3 assessment was carried out during 2015-16 by the IMSG with the help of experts from CPMI and IOSCO member jurisdictions. 1 The 28 jurisdictions that are participating in the PFMI implementation monitoring exercise are: Argentina, Australia, Belgium, Brazil, Canada, Chile, China, the European Union, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. 2 See www.bis.org/cpmi/publ/d134.htm or www.iosco.org/library/pubdocs/pdf/IOSCOPD508.pdf. Implementation monitoring of PFMI: Level 3 assessment 1 1.1 Scope of the assessment In this assessment, the IMSG has reviewed the financial risk management and recovery practices at a sample of 10 CCPs – including a mix of globally active and more regionally focused CCPs – that provide clearing services for derivatives. The 10 CCPs span nine jurisdictions. The analysis was grouped into six topics: governance of risk management, credit risk management, margin practices, liquidity risk management, collateral policy and investments, and default management and recovery planning. These topics span a number of Principles and Key Considerations (KCs) in the PFMI. The 10 CCPs participated voluntarily in the exercise, providing responses to a detailed survey covering all six risk management topics, responding to follow-up questions from the IMSG, and reviewing the final report for factual accuracy. The IMSG would like to thank the participating CCPs – and their supervisors and overseers – for their cooperation during this exercise. In addition to qualitative information on risk management policies, processes and models, CCPs were requested to provide quantitative data on matters such as available prefunded financial resources, stress testing outcomes, and results of margin back testing and sensitivity analysis. The effective date for the information found in this report is 30 June 2015 unless otherwise stated. Importantly, L3 assessments are peer-benchmarking exercises and not supervisory exercises. Accordingly, the focus of the report is on the consistency of outcomes of implementation of the relevant Principles and KCs across the group of CCPs as a whole rather than on each individual CCP’s specific outcomes of implementation. As noted in Responsibility D of the PFMI, it falls within the responsibility of the relevant supervisory authorities to ensure that the Principles are applied by individual CCPs. Furthermore, the findings in this report are based on the IMSG’s review of the 10 CCPs only and may not necessarily be representative of all CCPs. 1.2 Key changes to CCPs’ risk frameworks since implementation of the PFMI When published in April 2012, the PFMI strengthened and harmonised the three pre-existing sets of international standards for FMIs by raising minimum standards, providing more detailed guidance and broadening the scope of the standards to cover new risk management areas and a new type of FMI. For example, under the PFMI certain FMIs are expected to maintain a higher level of financial resources to address credit, liquidity and general business risks and set more detailed expectations for the governance of an FMI’s operations than previously expected. The CPMI and IOSCO therefore anticipated that the implementation of the PFMI would lead to wide-ranging enhancements to FMIs’ frameworks for managing risks. To verify this in the case of CCPs’ risk management practices and thereby gauge the impact and effectiveness of the reform, the CPMI and IOSCO also requested that each CCP participating in this first L3 assessment identify the most significant enhancements to its risk framework since the implementation of the PFMI. Many of the most significant enhancements cited by the CCPs were in the area of governance of risk management, including enhanced processes for approving changes to risk management practices, more formalised and comprehensive documentation of risk management frameworks, and the establishment of new risk committees with stakeholder representation. In addition to changes in their governance frameworks, the CCPs identified a number of other significant changes to their risk management practices. Many of these practices are described more fully as part of the detailed findings presented in this report, but include, by way of example: implementation of new ”Cover 2” liquidity and credit coverage targets; implementation of new risk monitoring and risk management systems; enhanced model validation, testing and review processes; introduction of new margin methodologies or 2 Implementation monitoring of PFMI: Level 3 assessment