2 Key dates February 2014: March 17 2014: April 2014: Market testing on an end-to-end LCH.Clearnet/CREST test platformMarch :Euroclear UK & Ireland launch underpinning settlement changes to the CREST system.April 2014:LCH.Clearnet launch their new Term £GC service and start the transition from the current Sterling GC service.
3 AGENDA Term DBV: a perspective from the Bank’s front office Andrew Hauser: Head of Sterling Markets DivisionThe case for changeToby Davies: Head of Market Services DivisionKey features of the new Cleared Term DBV serviceCREST system enhancements: David Nicholas, Euroclear UK & Ireland.New Term £GC product: Nigel Bradley, LCH.Clearnet.Sub-group update, and member actions requiredIan Fox: Chair, MMLG sub-group for Cleared Term DBV.Q&A (Panel session)Closing remarksIan Mair: Chair, London Money Market Association
7 ...secured flows now dwarf unsecured Average daily turnover in sterling money market (Nov 2012)
8 Gradual shift to secured: a global trend Secured transactions as share of total turnover
9 Improving market resilience Repo reduces (though not eliminates!) counterparty riskBut highly collateralised world increases macroprudential risks – some of which crystallised during the financial crisisGlobal response overseen by Financial Stability Board:Main focus on ‘procyclicality’But mitigating operational risk also importantUK challenges not on same scale as eg US triparty - but mismatch between daily DBV settlement unwind and term of underlying deals does pose operational and liquidity risks
11 The Bank’s front office interests Broad interest in stability of the market: key transmission channel for monetary policyDBV central to Bank’s own operations:Peak daily value during crisis = £85bnFrom July 2011, Bank counterparties have had option of using Term DBV in OMOs and OSFs......and we made it clear that we were ‘minded to discontinue use of Rolling Overnight DBV’MMLG oversight
12 “The system may be safer, but what’s in it for me?” Safer system benefits everyone, but also...Settlement costs and exposures (Toby Davies will cover)Margin costs (LCH.Clearnet will cover)
13 “The system may be safer, but what’s in it for me?” Safer system benefits everyone, but also...Settlement costs and exposures (Toby Davies will cover)Margin costs (LCH.Clearnet will cover)Front office engagement crucial to success of the exerciseGood practice guidelines (Toby/Ian will cover)
15 The case for change Toby Davies Head of Market Services Division 23 July 2013
16 Current DBV mechanism Current overnight DBV model is tried-and-tested low cost easy way of delivering market-defined baskets of GCno substitutions or mark-to-market needed because collateral is returned every morningreliableBut it masks hidden issuesan inefficient and risky churn of daily return and reissuedependency on provision of central bank liquidity through auto collateralised repo to fund intraday positions
18 RisksIn the event of a counterparty or system-wide outage intraday between morning unwind and afternoon re-input:DBV counterparties would be left holding the ‘wrong’ assetcounterparties would be required to manage liquidity dislocationDBV counterparties and their CREST settlement banks would be left with credit exposuresthe Bank would be left with intra-day liquidity extension to settlement banks that might need to be converted into overnight facilitiesThe values are substantial
19 11 November 2011Severe SWIFT outage on 11 November 2011 meant many of the day’s DBVs (including LCH’s) could not be submitted until very late in the dayDBV value input after the outage was resolved was £159bnOutstanding IDL (a large proportion of which is normally repaid automatically in afternoon DBVs) was at £82bn at the point of failure
20 The challenge The Bank has been exercised by the risks for many years Objective is to align the settlement arrangements with the underlying economic terms of the reponot to change the fundamental form of the tradeThe challenge is to reduce risks while retaining the benefits of the DBV basket collateral mechanism.The introduction of Term DBV within CREST in 2011 provided an underlying mechanismbut could not gain sufficient traction without being cleared through LCH.C which accounts for ~40% of DBV value settled.
21 Key characteristicsPrincipal exchanged on term basisDaily mark-to-marketAutomatic and manual substitution
22 Benefits From reduction in daily cash and collateral settlement flow in aggregate, less credit needed for settlementreduced position management ahead of DBV settlement windowreduced reliance on central bank liquidity provisionTail riskreduced risk from operational interruptiononly overnight and new business exposed to intraday interruptionreduced potential dislocation of liquidity
23 Good market practice is essential collateral giverto maintain pool of eligible collateral to feed mark-to-market and substitutionscollateral takerto ensure substitutions do not fail by keeping received collateral available for substitution and returnCREST is able to manage substitutions because it recognises a closed loop of collateral given/received in DBV. This breaks down if you deliver away received stock other than as DBV.Two approaches:Hold stock in segregated accountCareful position management
24 Summary Focus today is LCH introduction of a cleared Term GC product. The issue is to align the settlement process with the economic terms of the repowithout fundamentally changing the latterThe objective is to reduce potentially significant risk in the event of a counterparty or system-wide outage that prevents DBV settlementThe change will need to be carefully coordinated.Over to David Nicholas to describe the EUI changes, before Nigel Bradley sets out the LCH product changes.
26 Clearing Term DBV Bank of England Seminar 23 July 2013
27 Functional Overview Input and selection Mark to Market Uses existing DBV algorithm (basket based and size first)Return date (1 day – 2 years)Settling between 3:00pm and 4:10pmMark to MarketOvernight: identifies DBVs that are incorrectly collateralised (based on closing price)Intraday: Generates transaction to rebalance collateral levels to cover cash value of transactionGenerated (in full or partial) if stock is availableLinks across multiple transaction legs (even where position is flat)
28 Functional Overview Substitutions (Eligibility & Giver Recall) Automatic recall based on Corporate Action or settlement needDelivery versus deliveryRuns throughout the day to support settlement failsRecall/substitution possible over a wide chain/array of transactionsAdjustmentsAbility to adjust the value of collateral sought, consideration or length of term during the term of the DBVInterest CalculationInterest accrued daily for length of term (TDI)
29 Recall Substitution Simple Substitution (Bilateral model) Day 1: delivers £100m DBV (UBG) 7 day termDay 2: Party A delivers £25m gilt 1 to Party CDBV £100m UBGParty AParty B7 day term£50m Gilt 1£50m Gilt 2£100m Gilt 3Party AParty BSub (TDG) £25m Gilt 3£75m Gilt 3Sub (TDG) £25m Gilt 1£25m Gilt 1£50m Gilt 2£25m Gilt 3DEL £25mGilt 1Party C
30 Recall Substitution Complex Substitution Mbr F Mbr H Mbr X Mbr A Mbr B CCP is less vulnerable to subs fails given the large number of counterparty holdingsTDG £5m Gilt 2Mbr FMbr HDEL £30mMbr XMbr ATDG £5m Gilt 1Gilt 1TDG £10m Gilt 2TDG £30m Gilt 2TDG £10m Gilt 1Mbr BTDG £30m Gilt 1Mbr GLCHTDG £20m Gilt 2Mbr CTDG £20m Gilt 1Mbr HMbr DMbr IMbr E
31 Cleared Term DBV Enhancements Direct input of Term DBVs and Term DBV Adjustments from LCH.CSupport settlement of Giver Recall Substitutions, Term DBV Maturity Returns and Own Account Transfers alongside DBV settlement in order to satisfy settlement efficiency/minimise failsSupport early closing of a open term DBV via LCHSubstitutions triggered by Term DBV Amendment (during DBV settlement)Removal of diary time slicing (full availability of substitutions)Support of negative interest rates
32 Market PracticeSuccessful operation of substitution functionality – dependant on collateral being maintained within collateral arrangements (no onward Delivery of Collateral other than by Term DBV)Substitution not possible where collateral moved outside collateral arrangementsNo enforcement toolsNo Settlement Discipline regimeRequires adherence to good market practiceOptions to avoid unintentional delivery of collateral outside of collateral arrangements:Account Segregation - Main Trading and Collateral AccountsSingle Account – inventory management challenge
33 Account SegregationDBVs ‘Collateral Account’ separate from Main Trading AccountAdvantages:no possibility of unintentional delivery of collateral outside of collateral arrangementsClear view of Available Balance (securities available to trade/deliver)DisadvantagesAccount rebalancing necessary (top up/draw downs)Own Account Transfers in DBV settlement windowMovements in individual lines of securities
34 Single AccountSingle account for all activity (DBVs and Main Trading Account)Advantages:Maximum flexibilityDisadvantagesRequires accurate management of positionsClear view of what is held as collateralWhat is available for deliveryTo support a single account:Addition of ‘non Collateral Balance’ to CREST GUI and FT DEX messages (derived) – visibility of unencumbered balanceAvailable Balance – Collateral Balances
35 DBV Reporting Tools To support the market: Report per participant Highlighting any inadvertent breaches of good practiceNil Return Report – confirming non-breachesMonthly summary reportsNo participant detailsPersistent breaches – highlighted to participants individually
36 Testing AvailabilityTest Environment available for testing Term DBV functionalityBlock Booking – Nov/Dec 2013No charge for testing during this period
39 Term £GC Product Overview Bank of England23 July 2013
40 Term £GC Overview Term £GC Sterling GC Trading TDBV Settlement GB00B1347K44GB00BC7H8L40TDBV SettlementDBV SettlementTerm £GCProduct DefinitionSterling GCProduct DefinitionFeatures of cleared productSettlement mechanismTerm £GC Key BenefitsReduced operational risk and settlement credit needs due to the elimination of the requirement for daily return of cash and collateral compared to the current Sterling GC product.Introduction of margin offsets between trades relating to specific bonds e.g. the existing cleared Gilts market, and allocations resulting from Term £GC trades.
41 Term £GC OverviewSterling denominated repo trades based on the CREST Unstripped British Government (“UBG”) Delivery by Value (“DBV”) class.Term £GC will be made available for trading via electronic trading platforms and anonymous trading will be available.Bilateral and voice brokered trades will also be supported.Overnight trades and term trades (up to 374 day term) accepted.Settlement, using Euroclear UK & Ireland’s (“EUI”) Term DBV (“TDBV”) settlement platform, isinstructed by RepoClear and automatically matched via the Direct Input facility.Collateral allocated as part of a Term £GC trade can be substituted in the same manner as anyother collateral utilised within the TDBV environment.Participants’ positions will be maintained in CREST utilising standard Mark to Market functionalityaugmented with LCH.Clearnet Risk management processes.
43 Trade RegistrationTrade registration supported from to (all times are London time)Cut off for registration of trades for same day settlement: 14.30Fixed term tradesFixed repo rate (positive, negative or zero)Cash fill basis (defined in GBP)Based on EUI’s definition of Unstripped British Gilt (“UBG”) classConsistent with Sterling GCLCH.Clearnet retains ability to exclude specific ISINsOvernight to 374 day terms will be supportedForward start periods of up to 374 daysISIN listed n Bloomberg.
44 Risk Management Initial Margin Term £GC trades will be margined both intra-day and at end of day.For trades received on a same day settlement basis, IM will initially be calculated based on a synthetic allocation of bonds.Once the settlement allocations are known, positions will be margined based on the actual allocations as part of all subsequent margining processes.Initial margin offsets will be supported between Term £GC trades and trades executed against specific collateral cleared via the existing Gilts market.Variation MarginVariation Margin will be called to reflect the change in the net present value of the repo interest only.Delivery MarginDelivery Margin will not be applicable to Term £GC (as per Sterling GC).
45 Risk Management Intra-day Risk Management Term £GC will utilise the standard CREST TDBV functionality which adjusts collateral levels on a daily basis to ensure that the value of collateral appropriately covers the cash value of the transaction.This will be augmented with an additional level of market risk management by LCH.Clearnet
46 Settlement NettingThe settlement netting process for Term £GC will be run as two independent steps: “Term Netting” and “End Date Netting”Term Date NettingThe Term Netting process will seek to offset trades for which settlement willbe instructed “Today” (Day1 in the graphic) where trades have the same start and end date.As per the graphic, in the Day 1 Term Netting process, trades 1 and 2 are netted to produce a settlement instruction for +£30mnEnd Date NettingThis process examines the positions that have been instructed for settlement in CREST previously anddetermines whether those existing positions can be increased or decreased in size, or potentially terminated in order to minimize the level of open positions within the TDBV settlement platform for the participant.On Day 1 there are no positions that have been previously instructed for settlement, so no End Date netting takes place.
47 Settlement NettingTDBV Settlement Position in CREST following Day 1 nettingAs a result of the netting and settlement instruction which took place on Day 1, there is now a settlement position in place in CREST for +£30mn which has an end date of day 7.On day 2, there is only a single trade for the counterparty so no Term Date netting can take place.However the trade for -£20mn with an end leg settlement date of the day 7 must be considered for End Date netting.Thus, the new trade and the existing position are End Date netted and the existing TDBV position in CREST is reduced from £30mn to £10mn.TDBV Settlement Position in CREST following Day 2 nettingMention that there are multiple possible outcomes of this end date netting process.Existing value canIncreasedecrease or be cancelled.
48 Settlement Netting Repo Interest A separate netting process is utilised with respect to repo interest payments such that, on a daily basis, a single net repo interest payment in respect of all closing trades is instructed to CREST for settlement as a cash-only payment .This mirrors the process that is used in the current Sterling GC product.Settlement InstructionLCH.Clearnet submits all settlement instructions using the CREST Direct Input facility so that participants do not need to instruct or match in CREST themselves as a “business as usual” activity.This facility is used for all settlement instruction including the amendment of the size/early termination of settlement positions.
49 Substitution of Collateral The use of collateral substitution within the Term £GC product is twofold:In line with the bilateral market, substitution will be used by collateral givers where a specific bond is required in relation to a participant’s Delivery vs. Payment or Free of Payment transaction.In relation to the Term £GC product specifically, substitution transactions will be automatically generated to support the return of the correct collateral to its original giver as part of the end leg settlement process.The volume of substitution transactions which could be generated as a result of collateral return process may be significant:On any given day there are likely to be multiple givers of collateral to LCH.Clearnet and multiple recipients of collateral from LCH.Clearnet.Collateral delivered to LCH.Clearnet on an overnight basis may be allocated to a collateral taker on a term basis. It is essential that collateral which is allocated to participants as a result of the settlement of Term £GC trades is available for substitution using standard CREST Term DBV functionality.Any costs incurred by LCH.Clearnet as a result of substitution failure in these circumstances will be charged to the member who fails to support the requested substitution.
50 Tariff Structure Registration Fees Registration fees for Term £GC trades will be charged on an ad-valorem basis as per the below table using a 360 day count convention:The first 1-7The next 8-90TheIn addition, a processing fee of £0.70 is levied per registered trade.This fee structure is the same as that which is currently in place for Sterling GC.Settlement FeesSettlement related costs incurred by LCH.Clearnet in settling participants’ Term £GC positions in the EUI Term DBV settlement system will be recovered from participants.
51 Programme Timeline What is available now? Clients wishing to clear Term Sterling GC will need to interact directly with the CREST TDBV system. The CREST TDBV test environments are already available for Clients to utilise in their internal development processes.The Term £GC product description is published which can be used as a basis for Participants internal development processes.Additional technical specifications will be available from both LCH.Clearnet and EUI in September 2013.EUI are developing additional functionality for LCH.Clearnet to support Term £GC, which is scheduled to go live on 17 March 2014.LCH.Clearnet Member testing scheduled to commence February/March 2014.Term £GC will go live in April 2014, following a period of around a month of the CREST changes running in the production environment.What is available now?Implementation timeline
52 Transition of Liquidity to Term £GC Following the go-live of Term £GC, the current Sterling GC product will be continue to be available for a period of time and the two products will be supported in parallel.Whilst pragmatic as a short term solution, this approach is likely to lead to an undesirable split of liquidity across the two products.Will seek to create an environment where a high proportion of existingSterling GC users are able to trade the new Term £GC product fromlaunch such that there is a natural transfer of liquidity into Term £GC.At a point in time three months after the launch of Term £GC it isproposed to withdraw the Sterling GC product such that new tradescan no longer be registered.Based on the current maturity profile of Sterling GC, 99% of all open trades would mature within the 3 month period leaving only a small proportion of trades to be transferred across to the new product.
53 Contacts and Additional Information For further information on the Term £GC product, please contact: Manisha Mistry Tel: Or Nick Maggs Tel:
55 Cleared Term DBV Sub-group Update Member Actions Required Ian Fox 23 July 2013
56 PROGRESS SO FARInitiative launched by Chris Salmon 24th Jan 2013 – speech to LMMASub-group of MMLG created to co-ordinate the work required to introduce and adopt the new productSub-group includes representatives from EUI, CREST, LMMA, DMO, ISLA, Bank of England, major repo trading banksProduct design proposed by LCH / EUI and agreedImplementation timelines drawn upChanged cost impacts assessedMarket discipline regime agreed
57 MARKET ADOPTION IS KEYObjective has always been to get widespread support to ensure good market liquidityAim of the sub-group is therefore ensuring that the product is fit for purpose for market participants and they are ready to use it – this is key to finalising the implementation processSub-group has been widened to ensure greater representationCommunication of CTDBV plans through:MMLGSLRCLMMAISLABBAMajor market traders
58 MEMBER ACTIONS REQUIRED Expectation that new CTDBV product will be introduced in mid 2014 – so preparations should begin now if not already started:Full understanding of product design, settlement routine changesAsses impact on existing business / trading habitsScope changes to existing processes / habitsModel cost impactsEngage with LCH / EUI as necessary (detailed documentation available on websites)Ensure suitable collateral position monitoring and managementTimely focus on IT changes (if required)Commit resources to market testing of both BAU and migration processExisting LCH DBV product will be discontinued after a short period of parallel running (EUI o/n DBV product will continue)
59 LLOYDS – PREPARATIONS UNDERWAY Front Office and Back Office have been engaged on the project since January.Full understanding of product and changed trading and settlement requirements.Little technical IT changes required.Main action is to segregate CTDBV from trading inventory – separate CREST accounts and enhanced Front Office MI.Modelling of settlement / trading cost impacts has been performed.Review of policy and procedure documents – including second line oversight review.Will be fully engaged in testing. Counterparty engagement to follow.
60 NEXT STEPSSub-group will continue to steer through CTDBV – particular focus on testing outcomesContinued communication as wide as possibleComments / issues welcomedBank of England will write to market participants in September to get confirmation of market readinessNew product could be used to term out current large o/n DBV positions used to collateralise stock borrowing transactions
61 GOOD PRACTICE FRAMEWORK Fails – not acceptable, but no financial penalties beyond recharge of costs incurredExploring feasibility of daily fails reportingExploring feasibility of system flags to avoid stock being removed from the CTDBV cycleExisting EUI / LCH rules to apply, updated as requiredBank of England to update 2011 “TDBV Good Market Practice” documentEventual update to Gilt Repo Code of ConductDefault position is that “trading to fail” is unacceptable, accidental fails should be avoided