FINANCIAL INSTITUTIONSENERGYINFRASTRUCTURE, MINING AND COMMODITIESTRANSPORTTECHNOLOGY AND INNOVATIONPHARMACEUTICALS AND LIFE SCIENCES

Break out session: Client clearing explainedMIG SeminarFinancial Services TeamNorton Rose LLPApril 2013

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EU: client clearing in EMIR CCPs and clearing members must offer both:– Omnibus client segregation: Separate records / accounts distinguishing between clearing

member's assets and positions and assets and positions of its clients– Individual client segregation: Separate records / accounts distinguishing between assets

and positions of each client of clearing member and any excess margin posted to CCP CCPs must allow clearing members to open further accounts Requirement to distinguish involves recording in separate accounts, not netting

across accounts and not exposing assets in one account to losses in another CCPs and clearing members must disclose levels of protection and costs - must

be reasonable commercial terms CCPs must commit to trigger procedure for porting - if clearing member defaults

and client requests, transfer client positions and assets to another clearing member that has agreed to step in - omnibus and individual accounts

CCPs can actively manage their risks by liquidating positions and assets if this cannot be done within a pre-defined timeframe

Client collateral can only be used to cover positions held for relevant client account and any surplus on a clearing member default should be returned to client or, if not possible, to clearing member for relevant client account

Neutrality on principal to principal versus agent model: domestic issues are separate

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Client clearing

Clearing Member

CCP

Client

Alternative Clearing Member

Back off contracts, clearing agreement, security interest in favour of the client,

collateral

Cleared contract, CCP rules, collateral

OTC Counterparty

OTC derivative trade, non-clearing master

agreement

Porting of positions and assets takes place on clearing member default

Account structures – Omnibus and Individual Segregation

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Omnibus Segregation

Client 1

Client 2

Client 3

Clients 1, 2 +3 Clients, 1, 2 + 3

Clearing Member (books + records)

CCP (books + records)

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Omnibus segregation Records and accounts kept at CCP which distinguish the assets

and positions of the clients within the omnibus account from assets and positions within either the clearing member’s house account or any other client account

Positions can be netted within an omnibus account but not across accounts

Assets covering positions in an omnibus account are not exposed to losses on positions recorded in any other account but within the account, one client’s assets may be used to cover another client’s positions – so fellow client risk will exist

Excess collateral can be held at the clearing member level

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Individual Segregation

Client 1

Client 2

Client 3

Clearing Member (books + records)

CCP (books + records)

Client 1

Client 2

Client 3

Client 1

Client 2

Client 3

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Individual Segregation Positions and assets distinguished from the positions and assets

of any other client and the clearing member’s house account Positions within the account can be netted but positions cannot be

netted across accounts Assets covering positions recorded in the account cannot be used

to cover losses connected to positions recorded in any other account, so no fellow client risk

Any collateral called by the clearing member which is in excess of that called by the CCP must be passed to the CCP and not held by the clearing member

Legal documentation in Client Clearing structures

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A typical client clearing documentation map

CCP

Clearing MemberSecurity Trustee

OTC derivative counterparty

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CC

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Trust Deed

Client

Execution standard terms

Non-clearing Master AgreementT

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Cle

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Impact of default – Omnibus AccountsOmnibus segregation

Party Is the Client exposed to losses arising from that party’s default?

How does the exposure arise?

Clearing Member (to the extent any excess collateral is posted to the Clearing Member by the Client: a big caveat on protection)

Clearing Members may hold excess collateral posted by Clients who have selected omnibus segregation. Such excess collateral will not be part of the porting process at the CCP.

Other Clients of the Clearing Member

If another Client in the same omnibus account defaults, the loss may have to be borne by all of the Clients in that account.

CCP Clearing Members are likely to make their obligations to Clients conditional on CCP performing its obligations (in both BAU and default situation).

CCP default is a risk for Clients.

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Impact of default – Individual AccountsParty Is the Client exposed to

losses arising from that party’s default?

How does the exposure arise?

Clearing Member X Client clearing protections under EMIR should protect Client against Clearing Member default.

Other Clients of the Clearing Member

X N/A

CCP Clearing Members are likely to make their obligations to Clients conditional on CCP performing its obligations (in both BAU and default situation).

CCP default is a risk for Clients: “full segregation” options being looked at to deal with this

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Documentation checklist The types of issues that we would be looking at in the clearing

documentation are:– What is each document doing – there are usually a number of documents, you

need to understand what each one is doing and your obligations, rights and risks under each

– Porting mechanism – what are the mechanics of this at each relevant CCP? What exactly will be ported or returned to the client on the default of the clearing member? Can the CCP claim any costs and expenses from the client’s assets? Are there any registration requirements? When does the client need to appoint an alternative clearing member? Is there a security trustee involved?

– Impact on existing OTC master agreements – how do the documents relating to cleared OTC derivatives interact with any existing master agreements relating to non-cleared OTC derivatives? E.g. are there any cross netting and set-off provisions? How will a default or termination under one of the agreements impact on the other?

– Termination rights - in what circumstances can the client exercise its rights to terminate a cleared derivative or the back to back contract? What events at CCP and clearing member level will trigger termination of the client’s contracts? What rights does the client have in each case?

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Documentation checklist cont/d– Liability and indemnity - is the client being asked to accept liability for anything

which is really the clearing member’s responsibility? What indemnities is the client being asked to give?

– Security, title transfer and the risks for the client - what quality of security is being provided to the client, on what terms are the securities transferred and what risks might these arrangements pose for the client?

– Client money – does the client have client money protection? How does the client money regime interact with the client clearing structure being entered into?– Arguably the client money issue makes most difference either in relation to

transfer risk in individual seg account or in relation to moneys held by the clearing member in the omnibus account

– Structure is more complex as there are different documentation packages across the various clearing houses with varying degrees of discretion and mandating of terms

– However, these are the key issues to be asking about

Indirect client clearing

Indirect clearing: The world of the second tier banks

At clearing member’s request, CCP must keep separate records and accounts showing indirect client’s position and assets

No requirement to offer indirect clearing but if it does then must be on reasonable commercial terms: may include minimum operational terms for clients who participate

Must give client choice between individual and ominous segregation options for indirect clients in its books and records Must have procedures to transfer indirect client’s position and assets to a new client or clearing member or liquidate them if original client

defaults: back up client or clearing member mechanism to be included

Must be credit institution, investment firm or equivalent in third country Must keep records and accounts distinguishing its assets and positions from those of indirect clients Must offer indirect clients choice of account and disclose risks Must request clearing member to open segregated account at CCP for indirect clients Contract with indirect client must be consulted on with clearing member Must provide sufficient information to clearing member to identify, monitor and manage any risks. In event of default all information to be provided

to clearing member. Politics of this compromise is to balance the interest of the second tier banks who do not wish to lose their client base against systemic stability issues

CCP

Clearing Member

Client

Indirect client

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Indirect client clearing

CCP

Clearing Member

Client

Indirect Client

Cleared contract, CCP rules, provision of

collateral

Adopting ClientBack off contract, clearing agreement,

CCP mandated documentation,

provision of collateral

Possible for indirect client to move into position of client upon

client default (subject to agreement with clearing

member)

Porting of positions and assets takes

place on client default

OTC derivative counterparty

Back off contract, indirect clearing agreement,

clearing member mandated documentation

provision of collateral

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OTC Oracle: our EMIR online technical resource

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Disclaimer

The purpose of this presentation is to provide information as to developments in the law. It does not contain a full analysis of the law nor does it constitute an opinion of Norton Rose LLP on the points of law discussed.

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