[Federal Register Volume 84, Number 220 (Thursday, November 14, 2019)]
[Notices]
[Pages 61947-61950]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-24693]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-87485; File No. SR-LCH SA-2019-005]


Self-Regulatory Organizations; LCH SA; Order Approving Proposed 
Rule Change Relating to (i) Introduction of Clearing of the New Markit 
iTraxx Subordinated Financials Index CDS and the Related Single Name 
CDS Constituents; (ii) Enhancements to Wrong Way Risk Margin; and (iii) 
Modification to Default Fund Additional Margin

November 7, 2019.

I. Introduction

    On August 2, 2019, Banque Centrale de Compensation, which conducts 
business under the name LCH SA (``LCH SA''), filed with the Securities 
and Exchange Commission (``Commission''), pursuant to Section 19(b)(1) 
of the Securities Exchange Act of 1934

[[Page 61948]]

(``Act''),\1\ and Rule 19b-4 thereunder,\2\ a proposed rule change to 
amend its rules to (i) introduce clearing of new Markit iTraxx 
Subordinated Financials Index CDS and the Related Single Name CDS 
Constituents (together ``Subordinated Financials''); (ii) incorporate 
changes to the Wrong Way Risk (``WWR'') margin recommended as a result 
of a risk model validation; and (iii) modify the Default Fund 
Additional Margin (``DFAM''). The proposed rule change was published 
for comment in the Federal Register on August 9, 2019.\3\ On August 30, 
2019, the Commission designated a longer period for taking action on 
the proposed rule change to November 7, 2019.\4\ The Commission did not 
receive comments on the proposed rule change. For the reasons discussed 
below, the Commission is approving the proposed rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Securities Exchange Act Release No. 86576 (Aug. 6, 2019), 84 
FR 39386 (Aug. 9, 2019) (SR-LCH-SA-2019-005) (``Notice'').
    \4\ Securities Exchange Act Release No. 86834 (Aug. 30, 2019), 
84 FR 46984 (Sep. 6, 2019) (SR-LCH-SA-2019-005).
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II. Description of the Proposed Rule Change

A. Subordinated Financials

    To introduce clearing of Subordinated Financials,\5\ the proposed 
rule change would make changes to (i) the Reference Guide: CDSClear 
Margin Framework and CDSClear Default Fund Methodology (together the 
``CDSClear Risk Methodology''); (ii) the CDS Clearing Supplement 
(``Supplement''); and (iv) the CDS Clearing Procedures 
(``Procedures'').\6\
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    \5\ The following description is substantially excerpted from 
the Notice. See Notice, 84 FR at 39386. For further explanation on 
the background and creation of Subordinated Financials, see Notice, 
84 FR at 39386.
    \6\ Capitalized terms not otherwise defined herein have the 
meanings assigned to them in the LCH SA rulebook, the CDSClear Risk 
Methodology, Supplement, or Procedures.
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i. Changes to the CDSClear Risk Methodology
    LCH SA's existing Total Initial Margin Framework is comprised of 
the following components: Self Referencing Margin; Spread Margin; WWR 
Margin; Short Charge Margin; Interest Rate Risk Margin; Recovery Rate 
Margin; Vega Margin; and certain additional margins, including 
Liquidity and Concentration Risk Margin. The proposed rule change would 
apply LCH SA's existing margin methodology to the clearing of 
Subordinated Financials, and in doing so, would adapt certain 
components of that margin methodology for the clearing of Subordinated 
Financials. Specifically, the proposed rule change would adapt the 
Spread Margin, WWR Margin, Short Charge Margin, and Liquidity and 
Concentration Risk Margin components to the clearing of Subordinated 
Financials.
    With respect to the Spread Margin, LCH would use the historical 
data available for Subordinated Financials and would consider 
Subordinated Financials to be a different instrument than senior debt 
for purposes of portfolio margining.
    With respect to WWR Margin, the proposed rule change would cover 
Subordinated Financials with specific shocks calibrated from available 
historical data.
    With respect to the Short Charge, the proposed rule change would 
apply to Subordinated Financials the existing global short charge that 
covers non-financials, but would consider shocks in the recovery rates 
to ensure that the short charge covers the different recovery rates for 
Subordinated Financials. With respect to calculating the short charge 
for portfolios containing Subordinated Financials, LCH believes that 
considering shocks in the recovery rates without modifying the number 
of defaults would lead to overly conservative margins where jump-to-
default would outweigh other components of the margin methodology.\7\ 
To avoid this outcome the proposed rule change would decrease the 
number of expected credit events in the five days following the default 
of a Clearing Member from two to one, by moving the second credit event 
to the ``extreme market conditions'' category as opposed to the 
``normal market conditions'' category. The proposed rule change would 
also calculate the exposure the portfolio has to each underlying 
reference entity and the probability of each combination of defaults, 
to define the maximum amount that could be lost with a 99.7% confidence 
due to default events. The proposed rule change would then retain the 
greater of this calculated amount and the top exposure with a shifted 
recovery rate as the Short Charge margin.
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    \7\ See Notice, 84 FR at 39387.
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    Finally, the proposed rule change would make similar changes with 
respect to the stressed short charge and global short charge, and a 
specific change for CDX.HY names, by taking the stress short charge as 
the maximum of the sum of the top two exposures and the average across 
the ten riskiest entities.
    With respect to Liquidity and Concentration Risk Margin, the 
proposed rule change would apply the existing liquidity charge to 
Subordinated Financials as a new instrument but would consider 
Subordinated Financials jointly with Senior CDS for purposes of the 
concentration charge component of the margin charge.
ii. Changes to the Supplement
    The proposed rule change would amend the Supplement, which 
establishes the legal terms for CDS transactions cleared by LCH SA. The 
proposed rule change would amend the Supplement to include relevant 
language needed for clearing Subordinated Financials. Specifically, 
with respect to defining Credit Events, the proposed rule change would 
change various references to ``Restructuring Credit Event'' to ``M(M)R 
Restructuring'' or add references ``M(M)R Restructuring'', to make 
clear that these provisions apply to a restructuring that is a ``M(M)R 
Restructuring.'' This change is needed because clearing Subordinated 
Financials would introduce transactions for which Restructuring is a 
Credit Event but where ``M(M)R Restructuring'' is not applicable, and 
thus, in specifying provisions that would apply to ``M(M)R 
Restructuring'' the proposed rule change would clarify that these 
provisions would not apply to a restructuring of Subordinated 
Financials. Moreover, a number of provisions of the Supplement, such as 
the defined terms, apply to all Cleared Transactions that refer to a 
Reference Entity, which would include Cleared Transactions involving 
Subordinated Financials. However, the clearing of Subordinated 
Financials would mean that a portfolio could contain CDS contracts that 
have the same underlying Reference Entity but which reference different 
seniorities of debt issued by that Reference Entity. Certain Credit 
Events or Succession Events with respect to a Reference Entity could 
apply or not apply to a CDS contract, depending on seniority and/or 
transaction type. Thus, where appropriate and necessary, the proposed 
rule change would add wording to the relevant provisions of the 
Supplement to clarify that that, depending on the Reference Entity, 
Transaction Type, or Reference Obligation, those provisions may apply 
or not apply to a specific transaction. In connection with this change, 
the proposed rule change would also add a definition for, and various 
references to, the term ``Component Transaction'' to distinguish 
further cleared transactions by Reference Entity

[[Page 61949]]

and Transaction Type. The proposed rule change would also make various 
modifications to use of the Physical Settlement Matrix to accommodate 
clearing of Subordinated Financials.
    Finally, unrelated to the clearing of Subordinated Financials, the 
proposed rule change would modify inaccurate references to the CCM 
Client account structure. Earlier this year, LCH SA amended its rules 
to permit Clearing Members to create multiple account structures for a 
single client and multiple trade accounts per client within a single 
omnibus account structure.\8\ In line with that change, the proposed 
rule change would update certain portions of the Supplement to make 
clear that Clearing Members may create multiple account structures for 
a single client and multiple trade accounts per client within a single 
omnibus account structure. LCH SA did not make these changes in the 
earlier amendment, and the proposed rule change would make these 
changes now to ensure consistency with the amendment from earlier this 
year. The proposed rule change would also make various typographical 
and technical corrections to the CDS Clearing Supplement and update 
references as needed.
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    \8\ Securities Exchange Act Release No. 86376 (July 15, 2019), 
84 FR 34955 (July 19, 2019) (SR-LCH-SA-2019-003).
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iii. Changes to the Procedures
    Consistent with the changes to the Supplement, the proposed rule 
change would modify Section 4 of the Procedures to treat transactions 
differently depending upon the Transaction Type and/or seniority of a 
transaction. Similarly, the proposed rule change would add a reference 
to seniority and Reference Entity, Transaction Type, and Reference 
Obligation in Procedure 4.3. As discussed above, the clearing of 
Subordinated Financials would mean that a portfolio could contain CDS 
contracts that have the same underlying Reference Entity but which 
reference different seniorities of debt issued by that Reference 
Entity. Thus, the proposed rule change would modify Section 4 of the 
Procedures to distinguish the Reference Obligation by seniority level, 
if applicable.

B. WWR Margin

    To address certain recommendations arising out of a recent model 
validation, the proposed rule change would make two changes to WWR 
margin designed to enhance the WWR margin's stability and decrease its 
volatility. First, the proposed rule change would calculate WWR margin 
as if it was inside the expected shortfall. Second, the proposed rule 
change would include the iTraxx Main index in the WWR margin 
calculation, with a dedicated shock defined separately from the iTraxx 
Senior Financials and iTraxx Subordinated Financials indices.

C. Modification to DFAM

    Independent of and unrelated to LCH SA's proposal to introduce the 
clearing of Subordinated Financials, the proposed rule change would 
also modify DFAM. LCH SA's intent in collecting DFAM is to ensure that 
LCH SA collects from a Clearing Member additional margin to account for 
the stress risk of that Clearing Member above a certain threshold 
(defined as a percentage of the size of the Default Fund and dependent 
on the internal credit score of the Clearing Member). In other words, 
DFAM gradually demutualizes a Clearing Member's stress risk above and 
beyond a certain threshold of the Default Fund by collecting additional 
margin from that Clearing Member (rather than covering such stress risk 
through the Default Fund). However, according to LCH SA, it does not 
intend to require Clearing Members to deposit a total amount of 
resources for a given clearing service higher than that Clearing 
Member's worst stress loss for that service. To ensure that the sum of 
all resources called from a Clearing Member, including DFAM, does not 
exceed the stress tested loss measured for that Clearing Member, 
consistent with LCH SA's intent in collecting DFAM,\9\ the proposed 
rule change would put in place a cap on the amount of DFAM to ensure 
that, in collecting DFAM, LCH SA does not unintentionally require a 
Clearing Member to contribute resources greater than the Clearing 
Member's worst stress loss. The proposed rule change would do so by 
amending the CDSClear Default Fund Methodology to ensure that DFAM 
could not exceed a Clearing Member's Stress Test Loss Over Additional 
Margin, which would be defined as a Clearing Member's Stress Test Loss, 
minus that Clearing Member's contribution to the Default Fund.
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    \9\ See Notice, 84 FR at 39387.
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III. Commission Findings

    Section 19(b)(2)(C) of the Act directs the Commission to approve a 
proposed rule change of a self-regulatory organization if it finds that 
the proposed rule change is consistent with the requirements of the Act 
and the rules and regulations thereunder applicable to the 
organization.\10\ For the reasons given below, the Commission finds 
that the proposed rule change is consistent with Section 17A(b)(3)(F) 
of the Act \11\ and Rules 17Ad-22(e)(1) and (e)(6)(i) thereunder.\12\
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    \10\ 15 U.S.C. 78s(b)(2)(C).
    \11\ 15 U.S.C. 78q-1(b)(3)(F).
    \12\ 17 CFR 240.17Ad-22(e)(1) and (e)(6)(i).
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A. Consistency With Section 17A(b)(3)(F) of the Act

    Section 17A(b)(3)(F) of the Act requires, among other things, that 
the rules of LCH SA be designed to promote the prompt and accurate 
clearance and settlement of securities transactions and, to the extent 
applicable, derivative agreements, contracts, and transactions, to 
assure the safeguarding of securities and funds which are in the 
custody or control of LCH SA or for which it is responsible, and, in 
general, to protect investors and the public interest.\13\
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    \13\ 15 U.S.C. 78q-1(b)(3)(F).
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    As described above, the proposed rule change would facilitate the 
clearing of Subordinated Financials by LCH SA, which, as discussed 
above, consist of the Markit iTraxx Subordinated Financials Index CDS 
and Related Single Name CDS Constituents. To do so, the proposed rule 
change would amend the CDSClear Risk Methodology to apply LCH SA's 
existing margin methodology to Subordinated Financials and, relatedly, 
amend the Supplement and the Procedures to add new terms and revise 
existing terms and references as necessary to ensure that Subordinated 
Financials are clearly and accurately defined and referenced throughout 
LCH SA's existing rulebook. By making these changes to facilitate LCH 
SA's clearance and settlement of these additional CDS contracts, the 
Commission believes the proposed rule change would promote the prompt 
and accurate clearance and settlement of securities transactions.
    Moreover, as described above, the proposed rule change would make a 
number of changes to LCH SA's margin methodology, which the Commission 
believes would improve the operation and effectiveness of the margin 
methodology. First, in adapting LCH SA's margin methodology to the 
clearance and settlement of Subordinated Financials, the Commission 
believes that the proposed rule change would help to ensure that LCH 
SA's margin system effectively deals with, and collects margin to 
cover, the risks associated with clearing these additional CDS 
contracts. Second, the Commission believes that, by incorporating the 
changes to the WWR

[[Page 61950]]

margin described above, the proposed rule change would help to ensure 
that WWR margin operates effectively and accurately captures and covers 
the wrong-way-risk associated with clearing certain portfolios. 
Finally, the Commission believes that in establishing a cap on DFAM the 
proposed rule change would help to ensure that LCH SA does not require 
Clearing Members to deposit a total amount of resources for a given 
clearing service higher than their worst stress loss for that service, 
consistent with LCH SA's intent in collecting DFAM.
    Given that an effective margin system is necessary to manage LCH 
SA's credit exposures to its Clearing Members and the risks associated 
with clearing security based swap-related portfolios, the Commission 
believes that the proposed rule change would help improve LCH SA's 
ability to avoid potential losses that could result from the 
mismanagement of credit exposures and the risks associated with 
clearing security based swap-related portfolios. Because such losses 
could disrupt LCH SA's ability to promptly and accurately clear 
security based swap transactions, the Commission believes that the 
proposed rule change, by improving the operation and effectiveness of 
LCH SA's margin system, would thereby help promote the prompt and 
accurate clearance and settlement of securities transactions. 
Similarly, given that such losses could threaten LCH SA's ability to 
operate, thereby threatening access to securities and funds in LCH SA's 
control, the Commission believes that the proposed rule change would 
help assure the safeguarding of securities and funds which are in the 
custody or control of the LCH SA or for which it is responsible. For 
both of these reasons, the Commission believes the proposed rule change 
would, in general, protect investors and the public interest. Finally, 
the Commission believes that in helping to ensure that LCH SA does not 
collect from a Clearing Member DFAM higher than its worst stress loss, 
the proposed rule change would leave a Clearing Member with additional 
liquidity to engage in CDS transactions, which would therefore promote 
the clearance and settlement of CDS transactions.
    Finally, as discussed above, the proposed rule change would correct 
typographical errors, make technical corrections, and update references 
as needed to the Supplement and Procedures, including modifying 
inaccurate references to the CCM Client account structure. The 
Commission believes that these changes would help to ensure that the 
Supplement and Procedures are clear and operate effectively, consistent 
with LCH SA's intent. The Commission further believes that clear and 
effective Supplement and Procedures are necessary for LCH SA to 
promptly and accurately clear and settle CDS transactions, and 
therefore that this aspect of the proposed rule change also would 
promote the prompt and accurate clearance and settlement of securities 
transactions.
    Therefore, the Commission finds that the proposed rule change would 
promote the prompt and accurate clearance and settlement of securities 
transactions, assure the safeguarding of securities and funds in LCH 
SA's custody and control, and in general, protect investors and the 
public interest, consistent with the Section 17A(b)(3)(F) of the 
Act.\14\
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    \14\ 15 U.S.C. 78q-1(b)(3)(F).
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B. Consistency With Rule 17Ad-22(e)(1)

    Rule 17Ad-22(e)(1) requires that LCH SA establish, implement, 
maintain, and enforce written policies and procedures reasonably 
designed to provide for a well-founded, clear, transparent, and 
enforceable legal basis for each aspect of its activities in all 
relevant jurisdictions.\15\ The Commission believes that the proposed 
rule change, in introducing new terms, as well as correcting 
typographical errors and updating references, would help to ensure that 
the Supplement and Procedures provide a consistent and enforceable 
legal basis for clearing Subordinated Financials. Therefore, the 
Commission finds that the proposed rule change is consistent with Rule 
17Ad-22(e)(1).\16\
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    \15\ 17 CFR 240.17Ad-22(e)(1).
    \16\ Id.
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C. Consistency With Rule 17Ad-22(e)(6)(i)

    Rule 17Ad-22(e)(6)(i) requires that LCH SA establish, implement, 
maintain, and enforce written policies and procedures reasonably 
designed to cover its credit exposures to its participants by 
establishing a risk-based margin system that, at a minimum, considers, 
and produces margin levels commensurate with, the risks and particular 
attributes of each relevant product, portfolio, and market.\17\
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    \17\ 17 CFR 240.17Ad-22(e)(6)(i).
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    The Commission believes that the proposed rule change, in adapting 
LCH SA's margin methodology to the clearance and settlement of 
Subordinated Financials, would help to ensure that LCH SA's margin 
system considers, and produces margin levels commensurate with, the 
risks and particular attributes of these additional CDS contracts. 
Moreover, the Commission believes that, by incorporating the changes to 
the WWR margin described above, the proposed rule change would help to 
ensure that LCH SA's margin system considers, and produces margin 
levels commensurate with, the wrong-way-risk associated with clearing 
certain portfolios. Finally, in capping DFAM to ensure that Clearing 
Members are not required to deposit a total amount of resources for a 
given clearing service higher than their worst stress loss for that 
service, consistent with LCH SA's intent, the Commission believes that 
the proposed rule change would help to ensure that LCH SA's margin 
requirement does not exceed the stress loss risk associated with a 
Clearing Member, and thus is set at a level commensurate with the 
stress risk posed by a particular Clearing Member's portfolio. Because 
the proposed rule change would not prevent LCH SA from collecting DFAM 
up to the stress loss risk associated with a Clearing Member, however, 
the Commission believes the proposed rule change would not interfere 
with LCH SA's ability to cover its credit exposures to Clearing Members 
through DFAM.
    Therefore, the Commission finds that the proposed rule change is 
consistent with Rule 17Ad-22(e)(6)(i).\18\
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    \18\ Id.
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IV. Conclusion

    On the basis of the foregoing, the Commission finds that the 
proposed rule change is consistent with the requirements of the Act, 
and in particular, with the requirements of Section 17A(b)(3)(F) of the 
Act \19\ and Rules 17Ad-22(e)(1) and (e)(6)(i) thereunder.\20\
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    \19\ 15 U.S.C. 78q-1(b)(3)(F).
    \20\ 17 CFR 240.17Ad-22(e)(1) and (e)(6)(i).
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    It is therefore ordered pursuant to Section 19(b)(2) of the Act 
\21\ that the proposed rule change (SR-LCH-SA-2019-005), be, and hereby 
is, approved.\22\
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    \21\ 15 U.S.C. 78s(b)(2).
    \22\ In approving the proposed rule change, the Commission 
considered the proposal's impact on efficiency, competition, and 
capital formation. 15 U.S.C. 78c(f).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\23\
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    \23\ 17 CFR 200.30-3(a)(12).
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Jill M. Peterson,
Assistant Secretary.
[FR Doc. 2019-24693 Filed 11-13-19; 8:45 am]
 BILLING CODE 8011-01-P


