Call for evidence outcome

Recognised clearing houses: call for evidence

Updated 27 November 2015

This was published under the 2010 to 2015 Conservative and Liberal Democrat coalition government

1. How to respond

The government seeks views on the questions set out in this call for evidence. Responses are requested by 8 May 2015. The government cannot guarantee that responses received after that date will be considered.

Printed copies of this document can be ordered on request from the address below.You may make copies of this document without seeking permission.

Responses can be sent by email to: RCH.CallForEvidence@HMTreasury.gsi.gov.uk.

Alternatively they can be posted to:

Recognised Clearing House Call for Evidence – Financial Services Group
HM Treasury
1 Horse Guards Road
London
SW1A 2HQ

2. Introduction

Part 18 of FSMA establishes the concept of Recognised Bodies (RBs). There are two categories of recognised body – Recognised Investment Exchanges (RIEs) and Recognised Clearing Houses (RCHs). The legal framework for RBs is separate from the FSMA authorisation framework for authorised firms, reflecting the different role of, and risks posed by, market infrastructure providers. RBs are exempted from the requirement to seek authorisation for regulated activities carried on in connection with the function for which they were recognised.

The Financial Services and Markets Acts 2000(Recognition Requirements for Investment Exchanges and Clearing Houses) Regulations 2001 (the RRRs) set out conditions with which RBs must comply if they are to be recognised. Compliance with the RRRs is overseen by the Bank of England for RCHs and the Financial Conduct Authority (FCA) for RIEs.

RB status comes with certain protections and special treatment. In general, RBs are subject to a different regulatory framework to that which governs authorised financial services firms. This means that when RBs carry on regulated activities within the scope of their exemption, those activities are governed by specific requirements for RBs instead of those applicable to authorised firms. This different regulatory framework reflects the different status of, and risks posed by, market infrastructure providers as compared to authorised firms.

The specific protections afforded to RBs include Part 7 of the Companies Act 1989 under which an RB’s default rules will take precedence over the general law of insolvency when a member of an RB defaults. This “safe harbour” enhances legal certainty in the financial markets, prevents trades from being unravelled by an administrator or liquidator, and permits the insolvency of the member to be managed with greater certainty and more effectively. However, its significance also underlines the importance of ensuring that only appropriate entities are afforded RB status^{[footnote 1]}.

Finally, under section 291 of FSMA, RBs benefit from limited statutory immunity when carrying out their regulatory functions. This is limited to functions which relate to an RB’s obligations under FSMA.

This call for evidence is only concerned with RCHs. Of the five current RCHs, four are central counterparties (CCPs) and one operates a securities settlement system. The five current RCHs are:

• Euroclear UK and Ireland Limited
• CME Clearing Europe Limited
• ICE Clear Europe Limited
• LCH Clearnet Limited
• LME Clear Limited

3. Clearing

Precise definitions of clearing vary. However, in essence the process involves the aggregation of the delivery and payment obligations of the participants in the clearing process and the striking of a single net balance in respect of each type of obligation for each participant. The net balances are then settled with the clearing house, acting as a central counterparty (for securities transactions or other contracts, including derivative and spot contracts). This offers participants a range of advantages. For example, where the clearing house acts as a central counterparty, the clearing house will guarantee performance of the cleared transactions under its rulebook, reducing the counterparty risk the participants are exposed to. Furthermore, the system enables multilateral netting among participants which can significantly reduce their liquidity needs and gross credit exposures.

4. EU developments in clearing and securities depositories

Regulation 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories ([the European Market Infrastructure Regulation]9http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32012R0648&qid=1424275412962) or “EMIR”) brought in new harmonised legal requirements for CCPs. Regulation 909/2014 of the European Parliament and of the Council of 23 July on improving securities settlement in the European Union and on central securities depositories (CSDR) will do the same for central securities depositories.

As a result of EMIR, Part 18 of FSMA and the RRRs were amended by the Financial Services and Markets Act 2000 (Over the Counter Derivatives, Central Counterparties and Trade Repositories) Regulations 2013 and the Financial Services and Markets Act 2000 (Over the Counter Derivatives, Central Counterparties and Trade Repositories) (No. 2) Regulations 2013. RCHs which are CCPs have applied for re-authorisation under EMIR. In order to be re-authorised, CCPs must comply with the requirements set out in Parts 3 and 4 of the Schedule to the RRRs. After authorisation, CCPs must comply with the directly applicable requirements of EMIR and the requirements set out in Parts 5 and 6 of the Schedule to the RRRs. Parts 3 and 4 contain a comprehensive list of regulatory requirements with regard to an RCH’s financial resources, its fitness and propriety to be a clearing house, safeguards for investors, high standards of integrity, its rules (including default rules), and complaints, whereas Part 5 and 6 contain only those requirements which are additional to the requirements in EMIR, including requirements to have recovery plans, loss allocation arrangements and measures to reduce the use of CCPs for market abuse or criminal purposes.

Once all UK CCPs have been authorised under EMIR, Parts 3 and 4 of the Schedule to the RRRs will apply only to the RCH which operates securities settlement systems, Euroclear UK & Ireland Limited.

At present the UK’s only CSD, Euroclear UK & Ireland, is recognised as a clearing house under Part 18 of FSMA and so must meet the relevant recognition requirements. Once CSDR is fully in force, some or all of those recognition requirements will need to be disapplied in relation to CSDs; they will be replaced by CSDR’s authorisation and operating requirements.

As part of the domestic implementation process for CSDR, the government needs to consider how best to amend legislation applying to CSDs in the UK. Under consideration is whether CSDs subject to CSDR authorisation requirements should continue to be regarded as clearing houses. If recognising CSDs as clearing houses is no longer appropriate once CSDs are authorised under CSDR, the Government needs to consider whether there should be a new CSD category of RB which will benefit from a FSMA exemption similar to that for other RBs. In order to gauge the extent of any exemption for CSDs under Part 18 of FSMA, it is essential to understand what services and activities are or are likely to be provided or carried on by CSDs in addition to the core and ancillary services listed in the Annex to CSDR.

Annex 2 sets out a more detailed explanation of EMIR, CSDR and the implementation of EMIR.

5. Market developments in clearing

Given the ongoing broader reforms and developments in financial markets, the government is aware that there are, and may continue to be, market innovations in clearing. For example, clearing systems are being proposed which seek to operate some form of multilateral netting of transaction exposures, possibly without the involvement of a central counterparty, and financial markets are also seeing new services and providers emerging.

It is important for the government to consider how these developments should fit within the existing approach to regulating market infrastructure providers. Given the importance of market infrastructure providers to the broader financial system, it is essential to identify entities which should have RB status and regulate them appropriately. However, the privileges that come with RB status should not be extended to entities if that would be inappropriate. The government wishes to strike a balance between these two objectives.

We would welcome your views on the following questions:

Question A

Can you provide examples of entities, or types of entity, which carry out or propose to carry out the activity of clearing in the financial markets but which are not CCPs? If so, could you provide a detailed description of how they work or might work and the scale of their activities?

Question B

Do you consider that this type of entity should fall within the RCH category?

Question C

If the answer to Question B is yes, do you consider that the RRRs or Part 7 of the Companies Act 1989 should be amended? If so, then how?

Question D

Do you consider that CSDs should fall within the RCH category once the authorisation regime for CSDs under CSDR is in operation?

Question E

If the answer to Question D is no, should a separate category of RBs be established for CSDs?

Question F

What services and activities are likely to be provided or carried on by CSDs in addition to the core and ancillary services listed in the Annex to CSDR?

6. Annex 1: Definitions/Glossary

We have used the following abbreviations and definitions in this call for evidence:

Bank means the Bank of England.

CCP means a central counterparty. EMIR defines a CCP as “a legal person that interposes itself between the counterparties to the contracts traded on one or more financial markets, becoming the buyer to every seller and the seller to every buyer.”

CSDR means Regulation (EU) 909/2014 of the European Parliament and of the Council of 23 July 2014 on improving securities settlement in the European Union and on Central Securities Depositories (CSDs) and amending Directive 98/26/EC.

EMIR means Regulation (EU) 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories.

ESMA means the European Securities and Markets Authority.

FSMA means the Financial Services and Markets Act 2000.

OTC means “over the counter”. So OTC derivatives are not traded on an exchange.

Part 18 of FSMA means Part 18 of FSMA (Recognised Investment Exchanges and Clearing Houses).

Position means the obligation to buy or sell securities make or take delivery of a commodity, or make a payment, arising out of a financial transaction.

RB means a Recognised Body

RCH means a Recognised Clearing House.

RRRs mean the Financial Services and Markets Act 2000 (Recognition Requirement for Investment Exchanges and Clearing Houses) Regulations 2001 (sometimes known as the “Recognition Requirements Regulations”).

7. Annex 2: EMIR and CSDR

The financial crisis revealed problems in OTC derivatives markets, most notably deficiencies in management of counterparty credit risk. This raised concerns about systemic risk and the lack of transparency about risk concentrations. At the G20 meeting in Pittsburgh in September 2009, leaders agreed that “…all standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.”

The EU implemented large parts of this agreement through EMIR. EMIR sets out regulatory and prudential requirements, and establishes authorisation and supervision regimes, for CCPs and trade repositories in Europe. EMIR also requires the central clearing of certain standardised OTC derivatives and imposes certain requirements on counterparties that trade OTC derivatives. Where derivatives are not centrally cleared, EMIR imposes risk mitigation requirements on the counterparties, in particular the exchange of collateral.

EMIR entered into force on 16 August 2012. However many of its substantive provisions did not take effect until the technical standards relating to them, and developed by European Securities & Markets Authority and the European Banking Authority and adopted by the European Commission, came into force. CCPs became required to comply with EMIR standards upon their re-authorisation.

7.1 UK implementation of EMIR

As EMIR is an EU Regulation, it is directly applicable, which means it takes effect automatically in UK law without domestic transposition. However, some amendments were made to UK law to facilitate its operation in the UK.

FSMA requires a person carrying on specified financial services (called “regulated activities”) to be authorised by the PRA and/or the FCA. It is an offence to carry on these activities without authorisation (called the “general prohibition”). Part 18 creates an exception for clearing houses and investment exchanges (the latter are irrelevant to this call for evidence).

Where a clearing house satisfies the relevant requirements set out in the RRRs, the Bank may make a recognition order. Where the clearing house is a CCP which has been granted authorisation under EMIR, the Bank may make a “central counterparty recognition order”. In other cases, the Bank may make a recognition order declaring the clearing house to be a recognised clearing house which is not a recognised central counterparty. Once a recognition order is made (of either type), the clearing house is regarded in FSMA as a “recognised clearing house” and its clearing activities are thereby exempt from the general prohibition.

The relevant requirements for recognition are set out in the Schedule to the RRRs. Parts 3 and 4 of the Schedule set out the requirements applicable to all clearing houses before the coming into force of EMIR. On the coming into force of EMIR, CCPs were required to comply with Parts 5 and 6 instead (which include by reference the requirements of EMIR itself). There are transitional arrangements for CCPs, so that Parts 3 and 4 continue to apply whilst their applications for authorisation under EMIR are determined. Once these applications are determined, non-CCP clearing houses will need to comply with Parts 3 and 4 and CCPs will need to comply with Parts 5 and 6.

Euroclear UK and Ireland Limited is currently the only non-CCP RCH. Assuming that no others apply for recognition, one would therefore expect Parts 3 and 4 of the Schedule to apply to Euroclear UK and Ireland Limited and Parts 5 and 6 of the Schedule to apply to CCPs once the CCPs’ applications for authorisation have been determined.

7.2 Central Securities Depositories

On 7th March 2011, the European Commission adopted a proposal for a regulation on improving securities settlement and on central securities depositories (CSDR). The Commission’s proposals aim to:

• create a regulatory and prudential framework to ensure the robustness and efficiency of central securities depositories (CSDs); and
• establish a competitive single market in CSD services, and improve the safety and efficiency of cross border settlement

Following agreement between the European Parliament and the Council of the European Union, the regulation was published in the Official Journal of the European Union on 28 August 2014.

Securities settlement concerns the delivery of securities between a buyer and a seller and the payment of the corresponding cash leg in order to settle a trade agreed between two counterparties, typically on an exchange and sometimes after being cleared on a central counterparty.

CSDs are systemically important financial market infrastructures. They allow the registration, safekeeping, and settlement of securities in exchange for cash, which supports the efficient processing of securities transactions in financial markets. The long-term failure of a CSD would have a major impact on the financial stability of a member state by severely disrupting its financial market as market participants would be unable to buy or sell securities or use their securities as collateral to raise liquidity.

The CSDR aims to increase the safety and efficiency of cross border transactions and to ensure a level playing field for cross border transactions by:

• establishing the core and ancillary services that a CSD can provide

• establishing new common rules for the authorisation and ongoing supervision of CSDs

• setting prudential, technical, legal and organisational requirements for the operation of CSDs and their services

• harmonising securities settlement rules including a mandatory settlement period, penal regimes for settlement failures, and dematerialisation of securities from paper certificates to electronic book-entry

• establishing common access rules to support the creation of a competitive single market in securities settlement services

According to the CSDR Annex, the core services a CSD can provide are:

1. Initial recording of securities in a book-entry system (notary service)

2. Providing and maintaining securities accounts at the top tier level (central maintenance service)

3. Operating a securities settlement system (settlement service)

Ancillary services of the non-banking type a CSD can provide are services that contribute to enhancing the safety, efficiency and transparency of the securities markets and do not entail credit or liquidity risks. In more detail these include services related to the settlement service, such as organising a securities lending mechanism as agents among participant of a securities settlement system; services related to notary and central maintenance services, such as services related to shareholders’ registers, processing corporate actions like tax and information services, instruction routing and processing and fee collection; collateral management services (as agent), IT services and regulatory reporting.

Ancillary services of the banking type a CSD can provide are those directly related to the core and ancillary services listed above. They include providing cash accounts to and accepting deposits from participants in a securities settlement system and holders of securities accounts; providing cash credit for reimbursement no later than the following business day, cash lending to pre-finance corporate actions and lending securities to holders of securities accounts; payment services involving processing of cash and foreign exchange transactions; guarantees and commitments related to securities lending and borrowing; and Treasury activities involving foreign exchange and transferable securities related to managing participants’ long business (all within the meaning of Annex I to CRD IV). A CSD needs additional authorisation to provide the banking type of ancillary services.

In addition, CSDR envisages that CSDs can provide MiFID services and activities.

1. It should be noted that Euroclear UK and Ireland Limited itself does not currently enter into “market contracts” and so elements of Part 7 of the Companies Act are not relevant to it. ↩