Central counterparty for SETS. Service outline

Transcription

1 Central counterparty for SETS Service outline March 2000

2 Important note Recipients should not construe the contents of this document as investment, tax or legal advice and each recipient is urged to consult with his or her own professional advisers as to these matters. This document does not constitute an offer to sell or a solicitation of an offer to buy an investment and does not carry any legal rights. This document sets out the current position regarding the provision of central counterparty services for SETS which is, as is in the nature of development projects, subject to change. If you have any general queries relating to this document, or if you require further copies, please contact: CRESTCo Tel: gareth.jones@crestco.co.uk London Stock Exchange Tel: chanley@londonstockexchange.com London Clearing House Tel: cunninghamr@lch.co.uk Further copies of this document can also be downloaded in pdf format from the websites at and This document has been produced by CRESTCo, the London Stock Exchange and London Clearing House to assist users of their systems. While it has been prepared on the basis of the best information available, the authors accept no liability for decisions taken, or systems work carried out by any party, based on this document. This document does not form part of the contractual documentation between any of its authors and their customers. March 2000 CRESTCo Limited, registered in England and Wales No , London Stock Exchange Limited, registered in England and Wales No , and The London Clearing House Limited, registered in England and Wales No The CREST logo is a trademark of CRESTCo Limited. SETS, SEAQ, SEATS PLUS and the London Stock Exchange crest and logo are trademarks of London Stock Exchange Limited. The London Clearing House logo is a trademark of The London Clearing House Limited.

3 Contents 1 Introduction 4 2 Context 5 3 Benefits 6 4 Approach 7 5 Service overview Scope Trading and settlement LCH as central counterparty Example of the lifecycle of a trade 9 6 Implementation Approach Timescales Impact on participants Development beyond the first phase 12 7 Participants Clearing roles Clearing membership requirements Segregation Agency relationships Relationship between trading, clearing and settlement roles Role of settlement agents Information 20 8 Trading and settlement New trade initiation Settlement Corporate actions Taxation 26 9 Risk management Overview Initial margin Variation margin Margining process Margin calculation tool Default Payments and margin collateral Cash calls and payments Protected payments system Acceptable forms of cover Collateral lodgement and withdrawal procedures Interest 33 1

4 11 Reporting to members CREST system Existing LCH sources Tariffs Tariff approach Proposed tariff structure 35 Appendix acceptable LCH collateral 36 2

5 Guide to readership The guide to readership is intended to help readers find the most relevant sections of the document for them. Section Scope Readership Overview 1: Introduction Description of this document 2: Context 3: Benefits 4: Approach 5: Service overview 6: Implementation Detailed description 7: Participants 8: Trading and settlement 9: Risk management 10: Payment and margin collateral 11: Reporting to Members The business environment leading to the decision to implement a central counterparty The benefits that participants will receive as a result of introducing a central counterparty How the project is being delivered Overview of the central counterparty Key milestones towards delivery and the approach to subsequent phases Explains how market participants will operate Defines how trading and settlement will change Explains the different forms of margin and other risk protection Explains how margin is provided Information that LCH clearing members will receive All readers All users of the system, including front, middle and back offices, treasury departments, technical teams and compliance officers 12: Tariffs Proposed tariff structure Appendices Acceptable LCH collateral Types of security accepted by LCH for margin Treasury departments 3

6 1 Introduction During the last quarter of 1999, the London Stock Exchange ( the Exchange ), CRESTCo and The London Clearing House ( LCH ) engaged in work to consider the feasibility of providing a central counterparty for the Exchange s electronic order book, SETS. As a result of this work, the three organisations have agreed to proceed with the implementation of a central counterparty service. This document explains why the service is being developed, what it will mean to market participants and how it will work. It describes: the business drivers for a central counterparty the approach being taken to development and implementation the impact on market participants the processes by which trading and settlement will occur. Further documents will be published by CRESTCo, LCH and the Exchange detailing systems developments, rule changes, operational and implementation issues over the next 12 months before the service goes live in the first quarter of It should be noted that some details within this document must, where necessary, be approved and ratified by the relevant CRESTCo, LCH and Exchange bodies, e.g. risk functionality requires both LCH Risk Committee approval and Board ratification. Alterations to detail are therefore possible. Any significant changes will be notified to recipients in later versions of this Service Outline or other documents, as appropriate. The parameters and timings stated in this document are for illustrative purposes only. Actual values will be confirmed before implementation. In this document, the term Exchange refers to the London Stock Exchange, except where explicitly noted. The term member refers to membership of CREST, the Exchange or LCH, depending on the context. 4

7 2 Context Automated and online trading is a source of unprecedented growth in stockmarkets worldwide. In the UK, the Exchange introduced its electronic order book, SETS, in Since that time its market share has grown to over 50 per cent by value of Exchange business. In January 2000, the average number of automated trades on SETS approached 32,000 per day. In order to maintain the effectiveness and growth of its markets, the Exchange has announced a series of initiatives, aimed at providing increased functionality in its trading and information services. This includes plans to implement a central counterparty for trades conducted on SETS. There has been market demand for a central counterparty for SETS trades since before the order book went live. Originally, this focused on counterparty risk, which the Exchange dealt with by creating its Trade Compensation Scheme. A number of factors have lead to an increased demand for a central counterparty: the increased levels of cross-border business, involving a wider range of participants, requires the best possible counterparty risk protection an increasing realisation that market quality will be improved, with better liquidity on SETS, if post-trade anonymity is provided, in line with the European Alliance market model the desire of larger participants to reduce the post-trade processing cost of equity trading by introducing multi-lateral settlement netting, against the background of ever-increasing trading volumes. In addition, the benefits of a central counterparty have been widely acknowledged in a range of different markets, and many markets that do not already have a central counterparty have been planning to introduce one. 5

8 3 Benefits The central counterparty will deliver a number of benefits to the market. The Exchange s research and consultation in the past two years show that the introduction of a central counterparty will lead to increased liquidity on SETS as more business is attracted to it. This business will be existing non-sets business using the order book, as well as new business which will be generated through the improved pricing on SETS. The increased liquidity will lead to tighter spreads which will benefit the whole market, including business executed off the order book. Participants will be protected from the default of their market counterparties. The cost to participants of counterparty risk protection will be based on the risk generated by the business they have actually done. The central counterparty will provide the infrastructure for multi-lateral settlement netting. The principal long-term benefit of netting is perceived by many major market participants as being the reduction of industry costs by reducing the scale of back-office infrastructure and also helping to cap the number of settlements at times of high market activity. It is intended to hold a market-wide consultation on netting, before its introduction as an optional facility in a second phase of the central counterparty this is discussed further in section 6.4. The central counterparty will make use of a new real-time feed from SETS, via LCH into CREST. This will ensure that trades appear rapidly in CREST and will enable firms to maximise their matching performance. A scalable and generic central counterparty infrastructure will be built, designed to be extendable and to provide the basis for pan-european clearing and settlement. This will be achieved at minimum cost by making the maximum re-use of existing infrastructure. 6

9 4 Approach The implementation of the central counterparty will be managed as a joint project between CRESTCo, LCH and the Exchange. There are a number of reasons for this: it makes best use of each organisation s expertise: the Exchange in trading, LCH in risk management and CREST in high volume transaction processing and settlement it enables maximum re-use of existing infrastructure, thus minimising cost and time to market, and, as such, is in line with the principles of the European Securities Industry User Group (ESIUG) it enables a solution to be developed which minimises change and disruption to market participants. The solution is intended to be flexible. Although the intention is that the initial implementation will provide a straightforward central counterparty for automated trades on SETS, settling in CREST, it will also accommodate future expansion in a number of areas: enhanced functionality, such as settlement netting increased range of trades, executed by routes other than SETS, subject to the identification of suitable trade capture mechanisms increased range of securities, including some that might settle in systems other than CREST. 7

10 5 Service overview The central counterparty is intended to deliver all the benefits identified in section 3. The overview in this section, and the detail later in this document, shows how these benefits will be met by the proposed service. The approach to developments beyond the initial implementation is covered in section Scope It is intended that all the stocks that can currently be traded on SETS or in SEAQ auctions 1 and which can be settled in CREST will be cleared via the central counterparty service. In the rest of this document, the term SETS is generally used to cover automated executions on both SETS and in SEAQ auctions. Automated executions on SEATS PLUS will not be included in the central counterparty for the foreseeable future they will be traded and settled in the same way as currently. 5.2 Trading and settlement The service is being designed, as far as is possible and desirable, to enable market participants to continue to conduct business as they do currently: in particular, to trade and settle using existing processes. The main difference will be that trades automatically executed on SETS will always show LCH as the counterparty, and settlement will be against LCH, on a settle as dealt basis (see section 6.4 for more information on netting). Use of the central counterparty will be mandatory for these trades. SETS trades will be fed automatically to LCH and onwards into CREST. The LCH side of the settlements should appear in CREST within minutes of the trade executing on SETS. The introduction of a central counterparty will not stop participants from continuing to use settlement agents, if they wish. The central counterparty service is being designed to process trades emanating from multiple trading systems and to allow customers to settle in their system of choice, although the initial set of securities will all be settled in CREST. This is consistent with the policy of both CRESTCo and LCH. 5.3 LCH as central counterparty LCH will become the central counterparty to all SETS trades at the point of execution, providing post-trade anonymity for SETS and offering risk and operational benefits to its clearing members. The intention is to ensure that clearing members acting on behalf of firms trading on SETS are not exposed to any risk if another clearing member in the market defaults LCH provides this by assuming the risk itself. In order to achieve this, LCH requires methods of monitoring its exposure and protecting itself against the resulting risk. 1 This service, described in the Exchange s Guide to Release 3.1, is intended to be introduced during

11 In order to protect itself from the resulting market and credit risks, LCH determines minimum membership criteria, calculates exposures and uses a variety of risk management techniques, of which the most important is the use of margin calls (described further in section 9). In its simplest form, the legal relationships will change as follows: Firm A Firm B SETS execution without LCH Clearing Member Firm A London Clearing House Clearing Member Firm B SETS execution with LCH as central counterparty LCH will not hold principal positions for its own account. This is the same role that LCH performs for its clearing members relating to business from exchanges and OTC markets for which it currently clears. 5.4 Example of the lifecycle of a trade This section gives an example of the lifecycle of a single trade. The cross-references are to the sections in this document where the events are explained in more detail. In order to simplify the example, some assumptions have been made. 1. The market is operating under T+3 and the trade matches and settles on time with no problems. 2. There are no intra-day margin calls. 3. The impact of other trades is ignored, except where noted. 9

12 Date/time Event Cross-reference T Trade executed 8.1 T, shortly after execution T, shortly after being passed to the central counterparty T, later on the trade date Trade passed to central counterparty LCH side of settlement instruction ready for matching in CREST Settlement instruction matched in CREST T, overnight Margin calculated by LCH (note 1) 9.4 T+1, 6am Margin calls sent to clearing members PPS banks T+1, 9am Margin payments confirmed 10.1 T+1, overnight Margin calculated by LCH (note 2) 9.4 T+2, 6am Margin calls sent to clearing members PPS banks 10.1 T+2, 9am Margin payments confirmed 10.1 T+2, overnight Margin calculated by LCH (note 3) 9.4 T+3, 6am Margin calls sent to clearing members PPS banks 10.1 T+3, 6.30am (assumed) Settlement 8.2 T+3, 11am Notes Margin payments confirmed (note 4) 1. The margin is based on all outstanding items (including all unsettled trades, irrespective of the date of the trade), and is not calculated separately per trade. Thus one individual trade could increase or decrease the margin required. 2. Margin is recalculated because (i) it is based on all outstanding items, which could have changed since the previous day, (ii) the prices used in the calculation would have changed since the previous day. 3. This calculation will assume that the trade settles on its due date, i.e. this trade will not be included in the initial margin calculation. 4. For this one trade, the final margin movement should be a repayment, which would either have been re-allocated to a new position in the overnight calculation, or be instructed by LCH at approximately

13 6 Implementation 6.1 Approach Elements of the central counterparty are being developed by the Exchange, LCH and CRESTCo. Each organisation has some development of its own to do. Once this is complete, there will be a period of integration testing between the three organisations, followed by testing with market participants before the live date. Documentation will be produced, as appropriate, throughout this period. This will include: detailed descriptions of the service rule changes testing specifications. Customers will also be supported by business and technical seminars. The Exchange is making the necessary changes to its trading system as part of its Release 3.2, described in the Guide to Release 3.2 (due for publication in March 2000). The changes are being designed so that relevant parts (i.e. those enhancements that are nothing to do with the central counterparty) can be brought into live service separately from the launch of the central counterparty itself. LCH will integrate its service for the Exchange into its existing clearing services for on- and off-exchange business as far as possible. Amendments to LCH s systems, regulations and procedures will be advised during the course of the development. CREST will publish details of the enhancements to CREST in April 2000 and an updated Data Exchange Manual also in April Timescales The indicative timescales for the central counterparty are shown in the chart below. Actual dates will be confirmed later. 11

14 Q Q Q Q Q Announcement, Service Outline More detailed documentation Rule changes Development Participant testing Central Counterparty Live 6.3 Impact on participants The main change that trading participants need to make will be to establish a relationship with LCH. Participants trading on SETS will either have to be members of LCH, or to clear through a General Clearer that is itself a member of LCH. This is described in more detail in section 7. Many participants trading on SETS are already members of LCH; others have existing clearing relationships with members of LCH because they execute business on other markets currently cleared by LCH. Participants will have to prepare for the introduction of the central counterparty by setting up these clearing relationships, if they do not currently have them. A list of candidate General Clearers will be available in due course to assist trading participants to establish these relationships. Many participants will also be required to take part in the testing programme before live date. Details of which participants are affected and the tests included in the programme will be published during Development beyond the first phase The central counterparty service is being designed in a flexible way in its first phase so that will be able to accommodate various enhancements. Examples of possible enhancements are expected to be: to incorporate multi-lateral settlement netting to include a greater range of securities (both UK and international) or trade types. 12

15 It is intended to consult with the market on possible enhancements during Q2 2000, so that further central counterparty phases may be implemented as soon as possible after the first phase. 13

16 7 Participants Market participants will be able to trade on SETS and settle the resulting business in a similar way to today. However, they will need a relationship either directly or indirectly with LCH. Section 7.1 explains the types of relationship that participants can have with LCH, while section 7.2 outlines the requirements for membership of LCH. Section 7.3 explains how client business is segregated at LCH. Sections 7.1 and 7.4 explain some restrictions on agency relationships for SETS trades. The second half of this section shows how LCH s relationship fits into the wider picture of trading, clearing and settlement. It also defines what information participants will be required to supply to the Exchange, LCH and CRESTCo in order to operate within the central counterparty participation structure. 7.1 Clearing roles Relationship with LCH Each participant trading on SETS must either be a member of LCH, or must have a relationship with an LCH member firm who is prepared to act as their clearer. This means that each SETS trade has an associated LCH member firm that is clearing the business with LCH. This section explains the possible methods of interacting with LCH in more detail. It should be noted that LCH operates a strict principal-to-principal relationship with its members. This does not stop participants from trading as agents on SETS, but certain restrictions will apply. These are defined in section 7.4. Types of participant From the point of view of LCH, there will be three types of participant. Each participant will fall into one of the following categories. Non-Clearing Member (NCM). An NCM is an Exchange member firm that takes part in trading, i.e. it can execute its own orders and orders for its customers. However, an NCM is not a member of LCH. For clearing purposes in the sense of relating to LCH each NCM must have a relationship with a General Clearing Member (see below) to clear its SETS business. It should be noted that NCMs are not required to settle this business through the GCM, although they may choose to do so, see section 7.5. Individual Clearing Member (ICM). An ICM is an Exchange member firm and an LCH member that, in addition to executing its own and its customer orders, assumes its own clearing obligations from the resulting trades. It does not clear trades for other Exchange member firms. It should be noted that ICMs are not required to settle their own business, although they may choose to do so. General Clearing Member (GCM). A GCM is an Exchange member firm 2 and an LCH member that clears the trades of all those NCMs that have entered into a clearing 2 Exchange membership by the GCM is required for the Exchange to administer a defaulted NCM s contractual relationships. A GCM that does not trade will have a special class of Exchange 14

17 arrangement with it. The GCM may also deal and clear trades for itself and its own customers. These clearing roles define participants contractual relationship with LCH, i.e. as principal (in the case of GCMs and ICMs), or as having no such relationship (in the case of NCMs). Agency trades cannot be self-cleared by an ICM or GCM as this would make them both agent and principal. ICMs and GCMs can trade as agent, but for these trades, they will have to have a clearing arrangement with a separate GCM. They will act as NCMs for these trades. The clearing structure described above provides flexibility for firms to concentrate on trading only, to perform clearing only, or to combine these activities. Example of contractual relationships Two SETS users BBB and CCC trade on behalf of clients. The current method of trading is shown by the dashed lines in the diagram below. BBB is a Non-Clearing Member and has a clearing arrangement with a General Clearing Member AAA. CCC is an Individual Clearing Member. principal LCH principal GCM - AAA NCM - BBB original trade ICM - CCC principal Client Client The trading relationships and obligations in the existing pre-ccp structure are shown as dashed lines. Under the new arrangements, the contractual obligations will be as shown by membership, recognising that its obligations would be different from other members. Further details are available from the Exchange. 15

18 the solid lines. There is no contract between the two trading participants. There will be contracts between LCH and each of the two clearing members AAA and CCC and another contract between AAA and BBB. BBB can act as principal or as agent on behalf of its client; in the latter case, there will be a relationship between AAA and BBB s client. The contractual relationship between BBB and its client is unchanged, but the contract between CCC and its client must be a principal contract. If CCC wished to carry out an agency trade, it would have to use a GCM to clear this trade on its behalf. LCH contracts solely on a principal-to-principal basis with its clearing members. This enables all of the obligations that arise to and from LCH to be netted with each counterparty and the margin requirements to be minimised. 7.2 Clearing membership requirements As a central counterparty, LCH is exposed to the default of one of its members and consequently to the price risk of the defaulting member's portfolio that it inherits. LCH s ability to perform its inherited obligations and continue to perform to the remainder of its members, following the default of one member, is the crucial core function of a central counterparty. In order to ensure that LCH is able to manage the counterparty risk, it maintains minimum entry criteria for membership. The criteria for membership of LCH are standard and non-discriminatory. The standard criteria for LCH membership are the purchase of an LCH share, at a price of 297,619.05, and a contribution towards LCH s post-default backing. There are additional criteria that members must meet: A member must be an authorised or exempt person in terms of the Financial Services Act 1986 (or relevant subsequent legislation); or be a European investment firm as defined in the Investment Services Regulations If the applicant is a bank it must, at all times, be appropriately authorised by the banking supervisors of its home country and must additionally meet any notification or authorisation requirements set by banking supervisors in the United Kingdom. Members must have sufficient settlement and operational arrangements to deal with the types and business they are undertaking. Members must have Net Capital of either 5 million for ICMs; or 10 million for GCMs. Net Capital is broadly defined as Permanent Capital (i.e. excluding accumulated profit and loss and reserves available for distribution) plus Additional Capital (e.g. other equity reserves) less Disallowables (e.g. intangible fixed assets). Members that are currently active in other markets cleared by LCH may have higher total capital requirements. A full definition of the membership requirements is available from LCH. 7.3 Segregation House and client accounts Members are permitted to operate two accounts at LCH, known as the house and client accounts. LCH s account structure and regulations are designed to complement segregation 16

19 requirements under client money rules, which require that funds designated as client money should be kept separate from a firm s own resources. LCH s obligations as central counterparty relate separately to positions registered in a member s house and client accounts. In the event of member default, LCH cannot offset across positions registered in the separate accounts nor apply margin cover provided in relation to one account to meet shortfalls on the other account. These arrangements enable LCH members to segregate their business in accordance with their own requirements, separating proprietary margin from client margin passed on to LCH which requires segregation under client money rules. The introduction of central counterparty clearing is not, of itself, expected to mandate any additional segregation requirements. It is possible for some client business to be allocated to a member s house account, depending on the type of client and other factors. Segregating SETS trades All SETS trades must be allocated to one of the LCH accounts of the relevant clearing member. There will be a choice of ways of achieving this, to be used at the discretion of the trading firm. SETS users will be able to specify the LCH account for any resulting trades on each individual SETS order. Further details of the mechanism for achieving this will be published in the Exchange s Guide to Release 3.2. If no clearing account details are entered on the order, then any resulting trades will be automatically allocated to a pre-determined clearing account. This will be the client account unless the firm has explicitly notified LCH that the house account should be used for the firm. This approach can only be used where all of the firm s business (transacted under a single BIC code on SETS) is capable of being allocated to the same account if this is not the case, then the allocation must be entered on each order. 7.4 Agency relationships The requirement of LCH to contract as principal with clearing members does not, in itself, prevent agency relationships with underlying clients from existing. It is assumed that existing agency brokers will tend either to seek ICM status and therefore become principal both to LCH and to their underlying clients and subject to LCH s membership requirements, or enter as NCM into a relationship with a GCM. Only in the latter case can an agency relationship exist with the underlying client, and the GCM will have obligations to the client and vice versa. ICMs that undertake occasional agency business can arrange to have these cleared by a GCM. The central counterparty membership database will automatically map these agency trades to the appropriate GCM. 17

20 7.5 Relationship between trading, clearing and settlement roles Possible relationships The clearing roles described above do not circumscribe the means by which Exchange member firms settle their business. Any participant may choose to settle their own business or to use a settlement agent, as at present. The Exchange, CRESTCo and LCH will need to approve all such relationships before they are implemented. The diagram below shows the possible relationships between the trading, clearing and settlement roles with the central counterparty. TradingClearing Settlement ICM ICM Third party settlement agent ICM selfsettling GCM NCM1 NCM2 GCM GCM as settlement agent Third party settlement agent NCM1 as settlement agent NCM2 as settlement agent Overview of central counterparty trading, clearing and settlement roles Note that there need not necessarily be a one-to-one relationship between the trading member as legal entity and either the clearing member or the settlement entity. CREST participants Currently, a single CREST settlement participant can be used for settlement of both SETS and non-sets business. This will continue with the central counterparty. The use of CREST settlement participants with the central counterparty will be explained in more detail in Enhancing CREST: The Central Counterparty. CREST will be introducing two new participant types for the central counterparty service. 18

21 Central counterparty participant type A central counterparty participant type will be created in order to cater for the unique functionality required, particularly in relation to trade capture and corporate event processing. This participant type is not available to market participants: it will only apply to LCH for this service. Clearing member participant type There will be a new clearing member participant type in CREST. All clearing members must have a participant in CREST of this type irrespective of any other CREST participants they may have for settlement purposes. This participant type will be used by both ICMs and GCMs. A CREST participant that is a clearing member will have access to functionality allowing read-only access to open trading positions with the central counterparty for their own and related NCM business. It will also have access to LCH reporting information on margin and collateral held by LCH. This category of participant will not be a CREST member and consequently will not be allowed to hold and transfer stock, or have access to cash payment functionality. Role of GCM A GCM is responsible as principal to LCH for all aspects of their own and their clients trades, as well as for the trades of their associated NCMs. This means that any actions, such as margin calls are the responsibility of the GCM. A GCM has no obligation to margin their NCMs, although they may choose to do so. Each GCM will have a clearing member participant set up in CREST for each clearing account. This will allow the GCM read-only access to both their own and their NCMs open trading positions with the central counterparty and LCH reporting information. Alternatively, the GCM may choose to obtain NCM trade information directly from the NCM, rather than making use of the CREST facilities. Note that the GCM will only have access to their NCMs central counterparty business, irrespective of whether the NCM routes settlements with the central counterparty from SETS trades through the same CREST settlement participant as non-sets business. The GCM, as well as providing clearing services, may choose to carry out settlement functions for themselves and some or all of their NCMs. In this case the GCM may manage the settlement through either separate or pooled CREST settlement participants. If the GCM also performs proprietary trading or trades on behalf of its own customers (not NCMs), then the Exchange will require that it settles this business through a separate CREST participant from that used for settling NCM business. The exact membership structure will depend both on how the GCM wishes to receive data and how it wishes to make use of the CREST clearing member functionality. Role of ICM An ICM is responsible as principal to LCH for all aspects of its own and its clients trades. This means that any actions, such as margin calls, are the responsibility of the ICM. An ICM has no obligation to pass on margin calls to its customers, although it may choose to do so. 19

22 Each ICM will have a clearing member participant set up in CREST for each clearing account. This will allow the ICM read-only access to its own and its clients trading positions and LCH reporting information. The ICM, as well as self-clearing, may choose to carry out its own settlement. In this case, they will manage the settlement through their CREST settlement participant. Note that in this case an ICM will have both a CREST clearing member participant and a CREST settlement participant. An ICM may also choose a third party settlement agent, who will manage settlement on their behalf. In this case, the ICM does not require its own CREST settlement participant. Role of NCM LCH has no rights or obligations in respect of NCMs contractual relationship with their GCMs, although LCH must be aware of the GCM/NCM relationships for reporting purposes. This position is defined in an envisaged NCM Clearing Agreement to which LCH, the GCM and the NCM will be party. NCMs would have to be members of the Exchange. An NCM must have a GCM to clear on its behalf. The NCM may use the GCM to perform its settlement, or use a third-party settlement agent, or it may carry out its own settlement. 7.6 Role of settlement agents Currently, a settlement agent can act on behalf of any number of Exchange members, for both SETS business and non-sets business. This arrangement will not change with the central counterparty. The settlement agent can operate in Model A or Model B roles. However, NCM business cannot use the same CREST settlement participant account as either ICM or proprietary GCM business. 7.7 Information All member firms of the Exchange intending to trade on SETS will have to notify and agree certain information with the Exchange, LCH and CRESTCo before commencing trading. This applies to existing member firms at the point when the central counterparty starts operation, as well as any new member firms thereafter. The information that will have to be provided will include: whether the firm will be acting as an NCM, ICM or GCM the identity of the LCH member(s) that will act as a clearer for the firm (which could be itself) the identity of the CREST settlement participant(s) that will settle the resulting business (which could be its own settlement participant). Facilities will exist to enable firms to change their clearing and settlement relationships. 20

23 8 Trading and settlement 8.1 New trade initiation This section describes the processes involved in registering a new trade for clearing. Order entry All SETS participants/members will enter all trades into SETS exactly as currently, unless they wish to specify on an order by order basis segregation by house and client, in which case they will have to use the appropriate version of the order entry message. This is described further in the Exchange s Guide to Release 3.2. Trade execution LCH will contractually become counterparty to SETS trades, in eligible securities, by open offer at the instant the execution is effected. At no stage will there be a bilateral contract between executing SETS users each execution will indicate LCH as the buyer to every seller and the seller to every buyer (although this will only reflect the legal obligation in the case of a clearing member). Messages from SETS to participants for trades that are to be registered by the central counterparty will identify LCH as the counterparty the identity of the firm that entered the order executed against will never be visible to either the executing firms or the rest of the market. Executed trades will be immediately forwarded by SETS to the central counterparty for registration. Trade registration To register a trade successfully with LCH, each trading participant must be either a valid LCH member (a GCM or an ICM) or an NCM who has entered into a valid clearing arrangement with a GCM. The Exchange will prohibit firms from entering orders into SETS if they do not have a valid clearing arrangement as described in section 7.7. All trades registered by LCH will be governed by LCH s General Regulations, Default Rules and Procedures which will include a set of specific provisions for SETS trades. Trade validation The following validation will be carried out by the central counterparty for each trade submitted to it: the ISIN on the trade must exist and must be an eligible ISIN for the central counterparty the currency on the trade must be a CREST settleable currency the BIC code of the trading participant must be valid 21

24 the combination of trading participant (BIC), Agency/Principal indicator and optional House/Client indicator must have an associated valid CREST settlement participant and LCH clearing member account. Exception handling There are two possible reasons why trades could fail the validation described above: 1. The static data held by the central counterparty is incorrect; for example, a new eligible ISIN has not been added. In this case, the static data will be updated and the trade resubmitted. No action is required by the participant: the re-submission is carried out centrally. 2. The trade should never have been submitted to the central counterparty, for example if no valid clearing arrangement was in place. In these cases, the Exchange will be responsible for deciding the course of action. This may be to take the trade outside the central counterparty by telling the participants to settle directly with each other or for the Exchange to force a contra. The action taken by the Exchange will be considered on a case by case basis. Note that under no circumstances will the trade itself be modified by LCH, CRESTCo or the Exchange, it can only be re-submitted following an update to static data, or completed outside the central counterparty service. In particular, there is no mechanism to convert an agency trade to principal capacity. Trade enrichment For SETS participants there will be no change to their own post trade enrichment process, except that the counterparty will always be LCH. Entry of the settlement instruction into CREST will happen as currently. The central enrichment process will calculate the settlement consideration and settlement due date. Other CREST data will be created as necessary following the SETS approach that all conditions should be standard, e.g. standard bargain conditions will be imposed. CREST will then create two unmatched deliveries for LCH, one between the buying firm s settlement participant and LCH and one between LCH and the selling firm s settlement participant. These trades must be matched in CREST in the usual way. Margin calculations will be carried out on all unsettled trades received by the central counterparty from SETS, irrespective of their matching status. Accepted trades will be available in CREST for settlement and clearing participants to interrogate on a real time basis. Trade cancellation The Exchange will continue to accept cancellations of trades entered in error by generating contra trades. The existing contra processing within SETS will be changing in order to support anonymous counterparties for central counterparty trades and because a two-sided input is required to confirm the contra. The new process will be introduced from the live date of Release 3.2, in advance of the central counterparty live date. 22

25 Market Supervision will act as intermediary between the two counterparties, preserving their anonymity. The impact on customers will be minimised by using the existing trade cancellation message to request a contra or accept a contra request. All contras will have to be executed on the day of trade. Agreed contras will be broadcast to the market as currently. More details on the process are available in the Exchange s Guide to Release 3.2. For clearing purposes, however, the central counterparty will treat a contra as a separate transaction, i.e. the contra is created as an equal and opposite transaction to the underlying trade it does not delete the underlying trade. 8.2 Settlement Settlement will operate essentially unchanged from existing processes, apart from in a number of areas described below. In particular, matching is still required, with LCH as the counterparty. Linking CREST will link the pairs of central counterparty deliveries relating to an original underlying execution on SETS. The links will be similar to the existing links in CREST and each side of the link will still be able to settle separately. It will not be possible for market participants to amend or delete the link. Split deliveries CREST will provide functionality to ensure that all splits against LCH by buyers or sellers are automatically translated through the linking mechanism to the seller s or buyer s open transaction. This will help to ensure that LCH does not carry positions overnight, thus avoiding any unnecessary credit provision costs. Settlement fails Two different types of failure may occur. A firm may have insufficient stock within their account to fulfil a delivery obligation to LCH. While this constitutes a breach of the members obligations to LCH, it may, depending on the circumstances, be treated by LCH as a settlement failure rather than a default. A firm may have insufficient cash to meet an obligation to take delivery of stock from LCH. Again, this constitutes a breach of the members obligations to LCH, but in this case may be treated as a potential default by LCH, triggering the application of its Default Rules and the close-out of all the defaulter s positions. Settlement management CRESTCo currently operates a settlement discipline regime that fines participants with matching and settlement records below certain thresholds. CRESTCo will create a new matching category of settlement discipline for transactions with the central counterparty, but the intention is to set these initially at the existing market standards. This provides an incentive for firms to meet an acceptable level of performance. Changes to matching 23

26 standards will be subject to the approval of the CRESTCo Board Settlement Discipline Committee. The approach to specific settlement fails will be for the Exchange to use a buying-in regime at the buyer s request. The buying-in process will operate as follows. Buyers will be able to request buying-in for trades that are still unsettled five days after the intended settlement date (this may be tightened in the future). The Exchange will then issue a Buying-in Notice against the seller. If the stock has still not been delivered within a further five days, then the stock will be bought in. Any stock bought in by this approach will then flow through LCH to satisfy unsettled purchases. Failed settlements will continue to be margined throughout the buying-in process. This will provide some economic incentive for settlement. Note that the buying-in process for central counterparty business will not affect the existing timetable, which will continue to be used for the rest of the market. The exact timings for buying-in are still under discussion. 8.3 Corporate actions A number of enhancements to CREST processing of corporate actions will be introduced for the central counterparty. These are intended to automate processing as far as possible, therefore ensuring straight through processing of central counterparty trades. The corporate actions processes and procedures will be fully described in a future publication on central counterparty market practice. A number of changes to the Exchange rules will also be required to support these changes. Benefit reallocation Benefits where the central counterparty is a recipient will be reallocated by CREST using the claims mechanism. CREST intends to make a number of changes to claims handling in order to maximise the benefits of straight through processing. The settlement link on the original central counterparty deliveries will be replicated on the claims. Central counterparty claims will be created for settlement on payment date unless both sides have match deleted. Enhanced scrip dividends, scrip dividends and DRIPS will be processed by the central counterparty as stock or cash claims, in accordance with the default, i.e. there will be no options. 24

27 Transformations When corporate actions involving the central counterparty require transformation, CREST will automatically transform them. Again, certain modifications will be made to the transformations processing in CREST to support straight through processing. Mandatory auto transformations without options It will not be possible to skip automatic transformations where the counterparty is the central counterparty. The settlement link on the original central counterparty deliveries will be copied to the deliveries for each respective outturn stock and cash transfer. Mandatory automatic transformations with options (additional) The existing practice is for buyers not wishing to receive the default option to inform their counterparty of the desired election by fax or phone and then to use CREST messages to instruct CREST on how to transform. Following the introduction of the central counterparty, buyers will be required to give instructions using CREST messages and LCH will authorise CREST to replicate buy side instructions automatically on the sell side. CREST will reject buy side instructions received after the relevant deadline for the buyer to give instructions to the seller. Seller instructions will be rejected by CREST. If there were no inputs or the buyer does not input within the deadline, then the corporate action default will be imposed (where one exists). CREST will transform unsettled transactions in accordance with the buyer s instruction. The seller will still need to take up the appropriate election in accordance with the issuer s terms for that corporate action. Voluntary automatic transformations (e.g. takeovers) The current arrangement is that voluntary events are all processed manually and the automatic transformation process is not used. The following changes will be introduced for the central counterparty: Buyers will be required to instruct LCH using CREST messages and LCH will authorise CREST to replicate buy side instructions automatically on the sell side. CREST will recreate the buyer s instruction on the sell side of the transaction, which will count as a valid instruction from the buyer to LCH and LCH to the seller. The seller will still need to take up the appropriate election in accordance with the issuer s terms for that corporate action. The unsettled transactions will be transformed into the non-settling assented line (the QQ ISIN) after close of business on the day of the buyer s instruction and the resulting transactions will be included in future margin calculations. 25

28 Timescales will be set up for the respective corporate action deadlines (e.g. first close, wholly unconditional etc.) and buyers instructions will be validated against the relevant cut-off in advance of those deadlines. Takeovers lapsing or withdrawal rights will be processed by generating further corporate actions. Rights issues Rights issues will be processed in the same way as mandatory auto transformations with options, except for one unique factor relating to transactions where the buyer does not opt to take up the rights issue. Unsettled transactions will be transformed into a new non-settling line 3 which, at a later date, will be transformed into a cash out turn by a third corporate action when the cash amount (if any) for the rump stock is known. Using this mechanism, all the open transactions will continue to be margined until settled. 8.4 Taxation The Finance Act 1991 Part IV Sections 116 & 117 provide for the Treasury to be able to make regulations exempting Recognised Clearing Houses ( RCHs ), RCH members and RIE members from stamp duty and SDRT. LCH and its LIFFE and Tradepoint clearing members already have exemption under such regulation and it is anticipated that similar exemptions will become available for SETS business. A similar exemption is not currently available under Irish legislation, but the Exchange and LCH are in discussion on such an exemption with the Irish Revenue Commissioners. 3 The Exchange, as National Numbering Agency, will have to allocate this line an intermediate ISIN 26