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• Finalised Guidance on Counterparty Credit Risk (12/08)

Finalised Guidance on Counterparty Credit Risk (12/08)

9 February 2012

Background

The global financial crisis led major market regulators and international regulatory bodies to review their supervisory approaches and standards. The FSA has previously outlined their more intrusive approach to the supervision of bodies regulated by them including Recognised Clearing Houses (RCHs) and Recognised Overseas Clearing Houses (ROCHs).  In addition at this time the clearing market is undergoing a period of major change whereas both market participants and regulators have indicated a desire to increase the scale and scope of financial instruments through central counterparties. (CCPs). Increased competition and consolidation also add to the pressure on the future shape of the clearing industry.

As a consequence, the FSA continues to receive a substantial number of applications for new clearing services, and notifications of extensions to existing services. In addition, the FSA is undertaking a rolling programme for review of existing CCP services. The FSA assesses both applications and existing services against the UK standards for CCPs in Part 18 of the Financial Services and Markets Act and the Recognition Requirements. These requirements are set out, with accompanying FSA guidance, in Chapter 2 of the FSA specialist handbook, Recognised Investment Exchanges and Recognised Clearing Houses (REC).

On 11 July 2011 the FSA commenced a consultation process on this guidance.

The FSA received a number of comments, and met with respondents to discuss their views. This guidance has been updated to reflect the views of respondents where appropriate.

 

Scope

The document is focused on specific aspects of counterparty credit risk management, namely risk models and associated governance processes and procedures. This specific focus represents both important areas of counterparty credit risk management, as well as areas where a number of stakeholders have asked for additional guidance. However it is important to note that there remain other aspects related to counterparty credit risk management, for instance, participant entry criteria, which, while viewed by the FSA as equally critical, are being discussed in other regulatory debates.

 

Application

This guidance is aimed at providing additional context to the review process the FSA undertakes when considering counterparty credit risk management by CCPs. It provides further information as to how the FSA assesses compliance with the Act and the Recognition Requirements and, where relevant, provides examples of the kind of evidence which might support a positive assessment of a proposal against them. While we have outlined the typical approach the FSA takes, it is important to note that any review will necessarily be customised to the specifics of the proposed clearing service. The guidance will be revised in due course to be consistent with the Technical Standards for CCP Requirements to be defined by the relevant European Supervisory Authorities upon the finalisation of the EU regulation on OTC derivatives, central counterparties and trade repositories which was proposed by the EU Commission in September 2010.

 CCPs that are proposing to submit applications for provision of clearing services in the UK are encouraged to contact the Clearing and Settlement supervision team prior to submission.

 

Risk management governance and counterparty credit risk control framework

Within the governance framework the FSA will consider to what extent the appropriate governing body is ultimately responsible for managing risks and for setting the risk appetite. As part of its review of the CCR management governance arrangements the FSA may typically consider aspects of risk management governance such as:

 

Organisational structure of the CCR management function Governance of risk models and policies CCR control framework

In the review of the organisational structure of the risk management function the FSA may typically consider to what extent:

1. Staffing is adequate and independent reporting to senior management of the CCP
2. Its operations are appropriate to support the markets for which the CCP provides services
3. It is able and authorized to challenge models and risk practices in all cases

Governance of risk models and policies

In the review of the governance of risk models and policies the FSA may typically consider to what extent:

• risk models and policies have been specifically agreed by the risk management function and are periodically reviewed annually or more frequently, as needed;
• the approval process for new models, model changes and risk policies are documented and new models or significant model changes or changes to policies are subject to independent validation and sign-off by an appropriate governing body;
• the CCP's risk management policies take account of market risk, liquidity risk, and legal and operational risk that can be associated with CCR;
• the governing body of the CCP is actively involved in the CCR control process and is aware of the limitations and assumptions of the risk models used andthe CCP's CCR management system is documented and provides an explanation of the empirical techniques used to measure CCR.

The CCR Control Framework

In the review of the CCR control framework the FSA may typically consider:

1. the risk management the outputs of the risk measurement models as a part of the process of planning, monitoring and controlling the CCP's CCR and overall risk profile;
2. the risk assessments include an assessment of the CCP's ability to liquidate the position upon the default of the counterparty;
3. the risk management function controls model input data integrity;
4. that the risk assessment produces and analyses reports based on the output of the risk measurement models.

Initial margin model

The FSA takes a strong interest in the risk models used by CCPs. In considering the adequacy of the modelling approach for both new and existing models, the FSA may typically consider the following aspects:

1. Structure and properties of the initial margin model
2. Diversification benefit Margin period of risk
3. Margin frequency
4. Market data and use of proxies
5. Price data and pricing models

Structure and properties of the initial margin model

In the review of the structure and properties of the initial margin model the FSA may typically consider to what extent:

1. the CCP performs analysis during the development of a new margin model to identify the risk factors relevant for the measurement of exposure;
2. the CCP's initial margin model produces a reliable forecast distribution of exposures, and accounts for the possible non-normality of the exposure distribution, at product level and at member level
3. the risk measure chosen (e.g. percentile, expected shortfall) as the target coverage of the margin model is calibrated at member level for client and house account separately or whether the initial margin model target coverage is calibrated in a way such that it would be at least as conservative as calibration at member level;
4. where portfolio margining is used, exposure is measured over the maximum of the margin period of risk of each product cleared in a portfolio;
5. the initial margin model reflects transaction terms and specifications in a complete and conservative fashion. Where contract terms are updated these should be updated in the initial margin model;
6. the CCP assesses the conservativeness of non risk-sensitive approaches where such approaches are adopted;
7. the transaction terms and specifications are maintained in a database that is subject to formal and periodic audit.

Diversification benefit

The FSA considers that appropriate measurement of diversification benefit is one of the key components of the initial margin calculation. In the review of the diversification benefit within the initial margin model the FSA may typically consider to what extent:

the initial margin model jointly captures the relationship between risk factors to account for diversification benefit; andthe CCP performs analysis to verify the conservativeness of the measurement of the diversification benefit when risk factors are not jointly modeled.

Margin period of risk

In the review of the process around the definition of the margin period of risk the FSA may typically consider:

the definition of the margin period of risk  and  thatthe assumptions relative to the margin period of risk are documented and subject to ongoing review.

Margin frequency

In the review of the frequency of margin calls the FSA may typically consider to what extent the CCP has the ability and authority to calculate mark-to-market of all positions and call initial margin on a daily basis.

Market data and use of proxies

In the review of the use of market data and proxies the FSA may typically consider to what extent the margin model employs current market data to compute initial margin;

Price data and pricing models

 Does the CCP have in place clear procedures to select the source of price data and documented criteria to define the acceptability of a price quote;

Variation Margin

The FSA considers the ability to calculate and promptly call variation margin a key aspect of CCR mitigation.

Default fund

The FSA considers the default fund one of the key elements of the financial safeguard package available to CCPs. In considering the adequacy of the default fund the FSA may typically consider to what extent:

Stress testing governance

FSA are looking here for a documented stress testing policy in place highlighting risk appetite and the use of stress testing in risk management.

 

Governance

This concerns: General wrong way risk management and Specific wrong way risk management.

 

Conclusion of the Review Process

For existing clearing services, at the conclusion of the review process, the FSA will form views on the appropriateness of the CCR framework within the CCP. Where there are areas for improvement, the FSA will work with the entity to make improvements within the standard supervisory framework.

Where a new clearing service is proposed (either by a new CCP or existing CCP), the FSA anticipates that any improvement areas for the CCR framework would be addressed prior to launch.

This is a complex and lengthy technical document that can be found in full here. If you have any queries in the first instance please contact your CPA account manager.

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© CPA Audit LLP. 9 February 2012.