1

Impact of the new Principles on Financial

Market Infrastructures

Workshop on payments systems oversight

Kingston, Jamaica

5 December 2012

Klaus Löber

CPSS Secretariat

Bank for International Settlements

1 * Views expressed are those of the author and not necessarily those of the BIS

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Outline

The financial crisis and OTC derivatives markets reform

Principles and the role of CPSS-IOSCO

The new principles for Financial Market Infrastructures

(PFMIs)

Other related CPSS initiatives

– Assessment methodology and disclosure framework

– Recovery and resolution of FMIs

– OTC Derivatives

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Financial Market Infrastructures (FMIs)

Facilitate recording, clearing and settlement of monetary and other financial

transactions

Strengthen the markets they serve

Mitigate systemic risk

FMIs play a critical role in fostering financial stability

On the other hand, FMIs also concentrate risk – not the least through

interdependencies.

If this risk is not properly managed, FMIs can be sources of:

Credit losses

Liquidity and collateral dislocations

Financial shocks

FMIs could be major channels through which shocks are transmitted

across domestic and international financial markets

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Experience during the financial crisis

FMIs generally proved resilient to the crisis due to the efforts of last 20 years

– No materialisation of systemic risk in FMIs

– Global efforts towards intraday finality were essential: RTGS, DvP and PvP

– Abnormally high settlement volumes managed during volatility

– FMIs could cope with the default of a large counterparty

– Beneficial role of CLS and CCPs were widely acknowledged

However the recent financial crisis also highlighted i.a.:

– Significant counterparty credit risk in OTC derivatives markets

– Severe lack of transparency in the OTC derivatives market and absence of infrastructure to mitigate risk

– Insufficient (cross-border) information flow

– Shortcomings in default and liquidity risk management

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OTC Derivatives Market Reforms

G20 recommendations - Pittsburgh communiqué of September 2009

Trading and Clearing: All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties (CCPs) by end-2012 at the latest

Reporting: OTC derivative contracts should be reported to trade repositories (TRs)

Non-centrally cleared contracts should be subject to higher capital requirements

The FSB and its relevant members should assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse

Standard setting bodies should strengthen their risk

management standards

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Key international standards Financial Stability Board

Macroeconomic policy and data transparency

1 Monetary and financial policy transparency IMF

2 Fiscal policy transparency IMF

3 Data dissemination IMF

Financial regulation and supervision

4 Banking supervision BCBS

5 Securities regulation IOSCO

6 Insurance supervision IAIS

Institutional and market infrastructure

7 Crisis resolution and deposit insurance BCBS/IADI

8 Insolvency World Bank

9 Corporate governance OECD

10 Accounting and auditing IASB/IAASB

11 Payment, clearing and settlement CPSS/IOSCO

12 Market integrity (money laundering etc) FATF

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Role of CPSS and IOSCO

CPSS and CPSS-IOSCO standards are increasingly becoming

the foundation of FMI related oversight and regulatory activities

CPSS is recognised by the FSB as one of the relevant standard

setting bodies (SSBs). The PFMIs are among the key standards

for sound financial systems

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Old standards

CPSS Core principles for systemically important payment

systems (CPSIPS)(2001)

CPSS-IOSCO Recommendations for securities settlement

systems (RSSS) (2001)

CPSS-IOSCO Recommendations for central counterparties

(RCCP) (2004)

New standards

CPSS-IOSCO Principles for financial market infrastructures

(PFMI) (2011)

International standards for payment, clearing

and settlement systems

9 9

New Principles for the Financial Market Infrastructures:

The new principles are designed to be applied holistically because of their

significant interaction

Replace former three standards with one single, comprehensive set

of principles for all FMIs:

CPSIPS (2001), RSSS (2001), RCCP (2004)

Incorporate the lessons drawn from recent crisis experiences

– more demanding requirements in many areas

– new principles that were not or not fully addressed by the existing

standards

Ensure consistency among requirements to different FMIs while

reflecting the specific role of certain types of infrastructure (e.g.

CCPs, TRs)

Provide revised responsibilities of relevant authorities in regulating,

supervising and overseeing FMIs

Development of the PFMIs

A comprehensive review of the old standards was launched in February

2010 to

– support G-20 and FSB objectives to strengthen core financial

infrastructures and markets by strengthening existing standards and

broadening their coverage

– incorporate lessons learned from the recent financial crisis to adapt to

greater uncertainties and risks in financial markets

– promote consistent global enforcement across different FMI types,

different FMI designs, and different jurisdictions

CPSS and IOSCO issued a consultative draft of the PFMI in March 2011

and conducted extensive market consultation

A final version of the PFMI published in April 2012 incorporated the results

of the market consultation

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Status of the principles

CPSS and IOSCO members should strive to adopt the principles in the

PFMI by the end of 2012 and put them into effect as soon as possible;

FMIs are expected to observe the principles as soon as possible

“Binding” on members of relevant committees (CPSS, IOSCO, FSB) - not

directly legally binding but they enjoy the status of “soft law” because of:

– power of the arguments they contain

– membership of the committees

(increased legitimacy thanks to wider membership of CPSS)

Domestic regulation frequently based on them

(sometimes the basis of legislation too by way of incorporation)

Compliance of CCPs with the PFMIs is a condition for banks to benefit

from lower capital requirements (see Capitalisation of bank exposures to

central counterparties, BCBS, 2012)

Basis of assessments by IMF and World Bank for financial sector

assessment programmes (FSAPs)

Guiding philosophy in drafting

Express standards as broad principles in recognition that FMIs differ

significantly in organization, function, and design

Recognize that FMIs can achieve a particular result in different ways

Incorporate minimum requirements where appropriate to ensure a

common base level of risk management across FMIs

Adopt a functional approach to the applicability of the principles in the

PFMI to different types of FMIs

Adopt a holistic approach to the principles in the PFMI by having them

build upon and complement each other

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Interaction between the principles

The principles have significant interaction with each other and, as

previously noted, must be read holistically

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FMIs covered by the PFMIs

FMIs are sophisticated multilateral arrangements among participating financial institutions that handle significant transaction volumes and sizable monetary values

FMIs facilitate the recording, clearing and settling payments, securities, derivatives, or other financial transactions

These FMIs are regarded as systemically important because of the

critical roles in the markets they serve:

Systemically important (large value and retail) payment systems (SIPS)

Central counterparties (CCP)

Central securities depositories (CSD) and Securities settlement systems (SSS)

Trade repositories (TR) (newly included)

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General

organisation

Credit and liquidity risk

Settlement

CSDs and Exchange

Value Settlements

Default Management

General business and

operational risk management

Access

Efficiency

Transparency

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Responsibilities of Authorities

• Responsibility A: FMIs should be subject to appropriate and effective

regulation, supervision, and oversight by a relevant authority

• Responsibility B: Authorities should have the powers and resources to carry

out effectively their responsibilities in regulating, supervising, and overseeing

FMIs

• Responsibility C: Authorities should clearly define and disclose their

regulatory, supervisory, and oversight policies with respect to FMIs

• Responsibility D: Authorities should adopt and consistently apply the PFMI

• Responsibility E: Relevant authorities should cooperate, both domestically

and internationally, as appropriate, in promoting the safety and efficiency of

FMIs

Key differences between old and new standards

Unifies the set of standards for payment systems that are systemically

important, CSDs, SSSs, CCPs, and TRs (a new type of FMI)

Focuses requirements on its safety and efficiency to limit systemic risk and

foster transparency and financial stability

Introduces more-demanding requirements and provides greater guidance

when compared with previous standards

Addresses a number of important issues across several principles

– financial resources

– recovery or orderly wind down

– fair and open access

– tiered participation arrangements

– interdependencies, including interoperability

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New requirement Key discussion issues

Principle 4:

Credit risk

• Distinction between current exposures

and PFEs

• Full coverage of all exposures with high

degree of confidence

• Specific requirements for DNS with

and without settlement guarantee

• Greater emphasis on crisis scenarios

especially for CCPs

• Reference to exposure of all affiliated

entities of same group

• Contingency planning for uncovered

credit losses

• Does the FMI have enough

collateral?

• How to estimate potential

future losses?

• What stress scenarios?

• Normal versus extreme

condition: margins versus

other resources?

• Separate default funds?

Principle 7:

Liquidity risk

• Greater clarity on range of eligible

funding arrangements

• Greater emphasis on crisis scenarios

• Reference to different roles of

defaulter including as liquidity provider

• What funding arrangements

are eligible (only committed or

more)?

• Multiple roles of participants

• Role of central bank facilities?

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Current vs. potential future exposures

• Current exposure is the loss an FMI would face immediately if a participant

were to default

– Technically, the greater of zero or the market value of a transaction with a

counterparty that would be lost upon the default of the counterparty

• A PS or SSS faces current exposure when it extends intraday credit to a participant

• A CCP faces current exposure equal to the difference between the current market value of

open positions and the value of the positions when the CCP last marked them to market

• Potential future exposure is an estimate of credit exposure than an FMI

could face at a future point in time

– Technically, the maximum exposure expected to occur at a future point in time at a

high level of statistical confidence; arises from potential fluctuations in the market

value of positions and/or collateral

• A PS or SSS faces potential future exposure if the value of collateral securing an

extension of intraday credit could fall below the amount of credit extended, leaving a

residual exposure

• A CCP faces potential future exposure from potential fluctuations in the market value of

open positions with a defaulting customer between the last time they were marked to

market value and the time that they are liquidated or hedged

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PS and SSS requirements

Cover exposures to each participant fully with a high degree of

confidence

– This means that a PS or SSS must strive to collect collateral or maintain other resources with

values equal to or greater than the current and potential future exposures to each participant

– PS and SSS generally collect collateral to mitigate current exposure and apply haircuts to that

collateral to mitigate potential future exposure

– Note: “high degree of confidence” is not explicitly defined

– Exception to requirement: DNS PS and DNS SSS where there is no settlement guarantee

• A settlement guarantee may be provided either by the FMI itself or by the participants

For DNS systems where there is no settlement guarantee but where

participants face credit exposures arising from the FMI’s PCS processes, the

FMI should maintain resources to cover the exposures of the two participants

and their affiliates that would create the largest aggregate credit exposure in

the system

– A higher level of coverage should be considered for a PS or SSS that creates large exposures

or that could have a significant systemic impact if more than two participant families were to

default

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CCP requirements

• Cover exposures to each participant fully with a high degree of confidence

– This means that a CCP must collect margin or maintain other resources with values equal to or

greater than the current and potential future exposure to each participant

– CCPs generally collect variation margin (cash) to cover current exposure and initial margin

(cash and securities) to cover potential future exposure

– “High degree of confidence” is defined (in principle 6 on margin) as the 99% confidence level

(single-tailed) of the estimated distribution of future exposure

• In addition, collect additional resources to cover the default of one or two

participants and their affiliates in extreme but plausible market conditions

– Intended to cover a subset of “tail risk” (or beyond the 99 confidence level)

– CCPs generally collect additional collateral as margin or as contributions to a mutualized pool

of resources

• Document supporting rationale for and have appropriate governance

arrangements relating to the amount of total financial resources held

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Cover 1 or cover 2 for “extreme but plausible”

• Whether a CCP maintains sufficient resources to cover one or cover two

depends on the risk profile of its activities and its systemic importance

– Activities with a more-complex risk profile include clearing financial instruments that

are characterized by discrete jump-to-default price changes or that are highly

correlated with potential participant defaults

– Determinants of systemic importance in specific jurisdictions include consideration

of

• location of the participants

• aggregate volume/volume of transactions that originate in each jurisdiction

• proportion of its total volume/value of transactions that originate in each

jurisdiction

• range of currencies in which the instruments it clears are cleared or settled

• any links it has with FMIs located in other jurisdictions

• extent to which it clears instruments that are subject to mandatory clearing

obligations in multiple jurisdictions

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Key highlights in liquidity risk

Requirements are similar to those for credit risk, with a few key differences

– The likelihood that an FMI would have to cover two for liquidity is lower than for

credit

– PSs and SSSs in addition to CCPs are required to perform stress testing of liquid

resources

Strengthened as compared to previous standards

– Requires maintenance of sufficient liquid resources to effect settlement of payment

obligations same-day (for PS and SSS) or on time (for CCPs) with a high degree of

confidence

– Requires maintenance of sufficient liquid resources to withstand at least the default

of the participant and its affiliates that would generate the largest aggregate

liquidity obligation for the FMI in extreme but plausible market conditions

However, the PFMI expands the types of qualifying liquid resources as

compared to previous standards

New requirement Key discussion issues

Principle 6:

Margin

• Initial margin to cover not only

“normal” market conditions

• From quarterly to monthly

sensitivity analysis, daily back-

testing, annual methodology

testing

• Does the FMI have the „right‟

margining methodology?

• What and how frequent back

testing, stress testing, model

testing?

• Initial margin also to cover

extreme losses?

Principle 5:

Collateral

• Avoid concentration risk

• Avoid procyclicality

• Avoid wrong-way risks

• Higher quality

• What type of collateral, e.g.

government debt?

• How to reconcile trade off as

regards procyclicality?

• Does the FMI have the „right‟

collateral?

• How much can/should wrong-way

risk be avoided?

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Initial margin requirements

Initial margin is collateral collected to cover potential changes in the value of

each participant’s position (that is, potential future exposure) over the

appropriate close-out period in the event the participant defaults

– Meet an established single-tailed confidence level of at least 99% with respect to

the estimated distribution of future exposure (at the portfolio, sub-portfolio, or

product level)

– Have an initial margining system that takes into account the product characteristics

such as complexity, close-out period length, price volatility and correlation, jump-to-

default risk, and hedging strategies

– Use an appropriate close-out period that considers anticipated close-out times in

stressed market conditions and an appropriate historical period for each product

type

– Identify and mitigate any credit exposure that may give rise to specific wrong-way

risk

– Address procyclicality by adopting a forward looking and relatively stable and

conservative margin requirements

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Variation margin requirements

Variation margin is funds that are collected or paid out to reflect current

exposures resulting from actual changes in market prices

– Collect variation margin daily (and intraday where appropriate) to mitigate current

exposure

– Have the authority and operational capacity to make scheduled and unscheduled

intraday variation margin calls and payments

– Have highly reliable price information for marking positions to market; sources of

price information include

• market

• third-party pricing services

• CCP valuation models

• participants

Testing margin coverage

• Backtesting is an ex-post comparison of actual outcomes with outcomes

derived from the margin model

– Performed daily

– The CCP should have clear procedures to deal with instances where the model did

not perform as expected and determine whether a recalibration is warranted

– Backtesting does not evaluate effectiveness against forward-looking risks

• Sensitivity analysis tests how the margin coverage might be affected by a

wide set of scenarios designed to reflect potential market conditions

– Performed at least monthly

– Scenarios should include both historical and hypothetical situations

• Validation of the margin methodology should be conducted at least annually

by qualified and “independent” individuals

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Key highlights in collateral

An FMI should establish prudent valuation practices to have adequate

assurance of its collateral’s value in the event of its liquidation

– Mark-to-market collateral daily

– Ensure haircuts reflect potential values and liquidity to decline over the interval

between their last revaluation and the time by which an FMI can reasonably

assume that the assets can be liquidated

– Incorporate assumptions about collateral value during stressed market conditions

(including extreme price moves and changes in market liquidity)

An FMI should disclose its policies on the reuse of collateral (that is, the use

of collateral that has been provided by participants in the normal course of

business)

– Do not rely on the reuse of collateral to increase or maintain profitability

– May, however, invest any cash collateral received from participants on their behalf

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Principle Purpose Key discussion points

Principle 14:

Segregation and

portability

• Protect indirect participants;

• Increased importance

following mandatory clearing

• What model of segregation, at the

level of CCP or participant? Other

equivalent models?

• What form of portability (relevant

for capital requirements)?

Principle 15:

Business risk

• Recognise the fact that FMIs

may fail and create systemic

disruptions not only as a

result of member default, but

also as a result of non-default

related risks

• What types of non-default related

business risks?

• What ongoing quantitative

requirement (at least 6 months)?

• What liquid composition?

Principle 19:

Tiered

participation

• Identify and address any risks

that that the FMI may face

from indirect participants

• How far down the chain of tiering?

• FMIs as quasi-regulators?

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Key highlights in segregation and portability Segregation and portability arrangements must have a strong legal basis and

have a high degree of legal certainty under applicable law

A CCP should protect customer assets through the use of individual or

omnibus customer accounts

– Individual account structures and the collection of margin on a gross basis

provide flexibility in how a customer’s portfolio may be ported to another

participant, but are operationally and resource intensive

– Omnibus account structures are less operationally intensive and can be

more efficient when porting positions and collateral for a group of

customers, but may expose customers to fellow-customer risk and under-

margined positions with net margining

In certain jurisdictions, a cash market CCP may have alternative approaches

to protecting customers

– For example, laws that subject participants to explicit and comprehensive

financial responsibility or customer protection requirements

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Key highlights in general business risk

An FMI should maintain liquid net assets funded by equity equal to at least six

months of current operating expenses

– Actual amount held should be determined by the FMI’s general risk profile and the

length of time required to achieve a recovery or orderly wind-down of its critical

operations and services (and projected in its recovery or orderly wind-down plan)

– Actual amount held should be reviewed periodically using a variety of scenarios

– Calculation of operating expenses for these purposes may exclude depreciation

and amortization expenses

Liquid net assets held for these purposes cannot be used for any other

purpose

– However, equity held under international risk-based capital standards should be

included where relevant and appropriate to avoid duplicate capital requirements

An FMI’s capital plan should specify how it would raise new capital if its equity

capital were to fall close to or below the amount needed

– The capital plan should consider such factors as ownership structure and any

insured business risks 31

Risks from tiered participation

• Operational dependencies between direct and indirect participants could

affect the smooth functioning of the FMI, such as in the case of

– An FMI with a few direct participants and many indirect participants

– A large indirect participant operating though a small direct participant

• Credit and liquidity risks between direct and indirect participants may affect

the FMI

– The failure of an indirect participant may affect the credit and liquidity needs of

the direct participant

– A CCP may face exposures to indirect participants upon the failure of a direct

participant (at least until such time that customer positions are ported or closed

out)

• Default scenarios can create uncertainty about whether indirect

participants’ transactions have been settled or will be settled and whether

settled transactions can be unwound

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Principle Purpose

Principle 3:

Comprehensive risk

management

• Need for a holistic risk management view

• FMIs should address risks to and from other FMIs

Principle 18:

Access and participation

requirements

• Facilitate expanded direct access without

compromising the safety of the FMI (CGFS report)

Principle 20:

FMI links

• More specific and demanding requirements on different

types of links

Responsibility E:

Cooperation between

authorities

• Strengthening the need for cross-border cooperation

between authorities

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Elements of a risk-management framework

Types of risks that should be addressed

• Legal

• Credit

• Liquidity

• Settlement

• General business

• Custody and investment

• Operational

• Reputational

• Tiered participation

• Other

Potential sources of risks

• Participants and their customers

• Other FMIs

• Settlement and custodian banks

• Liquidity providers

• Service providers

Components of a risk-management framework to address these risks

• FMI design

• Policies (including participant incentives)

• Procedures

• Information and control systems

• Internal controls

• Recovery and orderly wind-down plans

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• A sound risk-management framework should identify the range of risks that an FMI faces and should appropriately address these risks

Key requirements by FMI type

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CSD-CSD Links

• Cover fully all extensions of

credit between CSDs with high-

quality collateral

• Place limits on extensions of

credit between CSDs

• Prohibit provisional transfers of

securities between linked CSDs,

or prohibit retransfer of

provisionally transferred

securities prior to the transfer

becoming final

• Ensure the link arrangement

provides protection for the rights

of participants

• Robust reconciliation procedures

are needed to ensure accurate

records

• Manage risks associated with the

use of an intermediary to access

another CSD

• Identify and manage potential

spillover effects from linked CCPs

• Cover current and potential future

exposures to the linked CCP and its

participants fully with a high degree

of confidence

• Financial resources used to cover

inter-CCP current exposures should

be prefunded with highly liquid

assets that exhibit low credit risk

• Financial resources provided by

one linked CCP to another should

be ring fenced from other resources

and should be at the bottom of the

waterfall

• Losses in a particular financial

product should be contained to

those participants clearing the

products

• Linked CCPs should consider

harmonizing their risk-management

frameworks

• Carefully assess additional

operational risks related to

links to ensure scalability and

reliability of IT and related

resources

• Ensure that changes in a

linked FMI will not inhibit the

smooth functioning of the link,

risk-management

arrangements, and non-

discriminatory access to the

link

CCP-CCP Links TR Links

Note: Links to payment systems are not addressed by this principle, but rather by principle 9 on money settlements.

Assessment Methodology

• Provides guidance for assessing observance of the 24 principles and 5

responsibilities defined in the PFMI

– Provides guidance for determining the scope of an assessment,

gathering facts, developing conclusions, and assigning a rating of

observance for each principle

• Intended primarily for external assessors at the international level, such

as the World Bank and the International Monetary Fund

• May also be used by national authorities, either as written or as an input

to their own methodologies

• Intended to promote objectivity and comparability across the

assessments of observance in different jurisdictions

• Consultative period on the Assessment Methodology ended June 2012

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Disclosure Framework Outlines basic information that an FMI should disclose to increase

transparency of its governance, risk-management, and operations in

order to provide participants, authorities, and the public with a

comprehensive understanding of the FMI and to facilitate comparisons

across FMIs

– The FMI’s organization, markets served, and key metrics

– Any recent changes to the FMI’s design and services

– The FMI’s approach to or method for observing each of the

applicable principles in the PFMI

Principle 23 of the PFMI requires FMIs to complete the Disclosure

Framework on a regular basis and disclose their answers publicly

Prepared in connection with the Assessment Methodology to ensure a

consistent framework for disclosure and assessment

Consultative period on the Disclosure Framework ended June 2012 37

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PFMI related follow-up

December 2012 Publication of final Assessment

methodology and disclosure framework

End 2012/early 2013 Starting of monitoring of implementation

by CPSS-IOSCO:

Reviews are considered to be carried out in three levels, assessing

(i) whether a jurisdiction has completed the process of adopting the

required legislation and other policies;

(ii) whether the content of new legislation and policies is complete

and consistent; and

(iii) whether there is consistency in the outcomes of implementation

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PFMI related follow-up work

Recovery and resolution of FMIs

- Following the work undertaken by the FSB in respect of

resolution and recovery regimes for financial institutions

- Outlines the issues to be taken into account for different types

of FMIs when putting in place effective recovery plans and

resolution regimes consistent with the FSB Principles and Key

Attributes

- CPSS-IOSCO consultative report published in July 2012

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OTCD related follow-up work

OTCD Data reporting and aggregation requirements

– Laying out minimum data reporting requirements and standardised

formats, and the methodology and mechanism for data aggregation on

a global basis

– CPSS-IOSCO paper outlining considerations for data requirements for

Trade Repositories published in January 2012

Legal Entity Identifier

– Establishing a scheme for the issuance of unique legal entity identifiers

– FSB report published in June 2012

Access by authorities to trade repository data

– Guidance on the level of access by authorities having different

mandates (supervision, oversight, financial stability, etc.) to data stored

in TRs

– CPSS-IOSCO task force to prepare further guidance

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OTCD related follow-up work

Capital requirements for bank exposures to central counterparties

– Introducing the interim framework for determining capital

requirements for bank exposures to CCPs via additions and

amendments to “Basel II” (indicating that a PFMIs compliant CCPs

will receive a preferential capital treatment)

– BCBS document published in July 2012

Margining requirements for non-centrally-cleared derivatives

– Laying out a set of high-level principles on margining practices and

treatment of collateral, and proposing margin requirements for non-

centrally-cleared derivatives with the objectives of reducing systemic

risk and promoting central clearing

– BCBS-IOSCO consultative paper published in June 2012

Coordination of OTCD related regulatory activities

– Aiming to address gaps and overlaps of standard setting bodies

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What is next?

Globalisation and regional integration

Consolidation

Innovation

Interdependencies

…

Continued and enhanced global cooperation among authorities

is essential in promoting global financial stability