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Company Circular No:

LCH.Clearnet Limited Circular No 3391

Date:5 December 2013
To:All LCH.Clearnet Ltd Clearing Members (excluding FCM Clearing Members)

LCH.Clearnet Rulebook: Notification of proposed rule amendments in relation to margin-taking, payment netting and close-out netting

Background

LCH.Clearnet Limited (ďLCH.ClearnetĒ) proposes to make a number of clarificatory amendments to certain of its Rulebook provisions dealing with, or impacting on, margin-taking, payment netting and close-out netting. These changes follow feedback from LCH.Clearnet Clearing Members and industry bodies.

The intention is to increase transparency as to how the LCH.Clearnet collateralisation mechanics work with the benefit that the relevant provisions would support the giving of robust legal and accounting opinions by Clearing Membersí external advisers for accounting and regulatory capital purposes (particularly in relation to SwapClear). This would support Clearing Members in continuing to net their positions where they have previously done so. Clearing Members are reminded that they should take their own professional advice on these matters.

The intention is for the new wording to be included in the current LCH.Clearnet Rulebook before 31 December 2013 (subject to the relevant regulatory consent being obtained).

The clarifications will not lead to any change in practice at LCH.Clearnet (operational or otherwise) and are intended to clarify LCH.Clearnetís legal rights or obligations as they are generally understood in a manner which allows for greater legal certainty and which will therefore improve the provision of the legal and accounting opinions noted above.

Many of the clarifications are relevant only to the SwapClear service. However, some will be of more general relevance.

LCH.Clearnet is continuing to work with market participants in order to determine whether equivalent or similar changes are desirable for FCM Clearing Members.

Relevant Amendments

TopicBackgroundScope
Legal basis on which margin is providedThe amendments will clarify, in the case of SwapClear Business, that variation margin is provided as collateral for a Clearing Memberís obligations under its trades with LCH.Clearnet by means of a conventional title-transfer collateral arrangement (as opposed, for instance, to being provided in daily settlement of the trades). This clarification is useful since, whilst both types of arrangement give rise to a commercially similar result, the legal efficacy of each such type of arrangement depends on a very different legal analysis.SwapClear
The amendments will conform the terms used to describe the assets provided as collateral, the act of providing collateral and the amount of collateral which is required to be provided, to reduce the likelihood of the opinions having to include assumptions as to how the margining mechanics do in fact operate.General
In order to support a robust netting analysis in the legal opinions, the amendments will clarify that a partyís obligation to return any cash provided to it as collateral is accelerated so as to become due at the point at which it is to be netted against the obligations for which it acts as collateral. The maturity of such a return obligation is necessary for a robust netting analysis.General
The amendments will clarify that all collateral which has been provided to LCH.Clearnet and which has not been applied in or towards discharge of a Clearing Memberís obligations to LCH.Clearnet will be returned to that Clearing Member upon LCH.Clearnet being satisfied that the Clearing Member has no further obligations to LCH.Clearnet.General
Two-way provision of variation marginAlthough it has always been the case that LCH.Clearnet provides collateral to Clearing Members in respect of variation margin obligations, to date this practice has not been fully documented in the LCH.Clearnet Rulebook. In order to reduce the likelihood of the opinions having to assume the relevant mechanics in the absence of express contractual provisions, the Relevant Amendments will introduce provisions to document this existing practice expressly, including describing the concept of collateral balances being held by LCH.Clearnet and Clearing Members.SwapClear
Business as usual payment nettingThe amendments will include more detailed drafting to document the basis on which payment netting will occur in the ordinary course of business. In particular, the new drafting will clarify that a partyís obligation to return variation margin is netted against amounts owed to that party on settlement of the relevant trades with the result that settlement of the relevant trades does not involve the exchange of gross payments between the parties. The inclusion of express wording to this effect is an important element of the revised IAS 32 accounting requirements.SwapClear
Close-out netting on LCH defaultThe close-out netting provision applicable on LCH.Clearnetís default in the existing LCH.Clearnet Rulebook had applied in respect of obligations under the trades, with netting of cash collateral held against those obligations being addressed implicitly under a separate provision. The amendments will consolidate both concepts into a single provision which expressly refers to netting between the trades and related cash collateral. This will reduce the likelihood of the opinions having to assume which obligations are subject to close-out netting on LCH.Clearnetís default.General
The amendments will clarify that a Clearing Memberís default fund contributions may not be included in any set-off following an LCH.Clearnet default. This will ensure that a Clearing Member may not obtain value through effecting a set-off of any net termination amount owed by it to LCH.Clearnet against its default fund contribution in circumstances where its default fund contribution may be required to manage LCH.Clearnetís losses in connection with the default of another Clearing Member.General
The amendments will clarify the interaction between the close-out netting provision applicable on LCH.Clearnetís default and the default management process applicable on a Clearing Memberís default. In particular the amendments will provide that a defaulting Clearing Member may close-out against LCH.Clearnet provided that LCH.Clearnet is also in default and LCH.Clearnet has failed to instigate the default management process in relation to that Clearing Member within a specified time period following that Clearing Memberís default.General
Clearing Member default provisionsThe amendments will clarify the interaction between the Default Rules (those providing for LCH.Clearnetís general remedies following a Clearing Member default) and the SwapClear Default Management Process by stating expressly that the SwapClear DMP is mandatory, but that LCH.Clearnet may take any of the actions contained in the Default Rules if they are not inconsistent with the SwapClear DMP. This will reduce the likelihood of the opinions having to assume which set of default management provisions prevails.SwapClear
The amendments will clarify the interaction between the Default Rules (providing for cross-product netting) and the SwapClear DMP by stating expressly that the SwapClear DMP operates prior to the relevant Default Rule. This will reduce the likelihood of the opinions having to assume the order in which the default management processes occur.SwapClear
The amendments will clarify that the purpose of the SwapClear DMP is to establish the amount of any LCH.Clearnet losses as a result of a Clearing Memberís default which are then discharged in the manner contemplated by the Default Rules. This will reduce the likelihood of the opinions having to assume the linkage between the outcome of an auction process under the SwapClear DMP and the Default Rules.SwapClear

LCH.Clearnet is currently completing the required regulatory approval process. Once a CFTC submission is made (which is expected to be mid-December) the proposed rule amendments together with a detailed description of the changes will appear here:

http://www.lchclearnet.com/rules_and_regulations/ltd/proposed_rules.asp

If you would like earlier sight of the proposed rule changes please contact rulebook@lchclearnet.com and indicate which services you are interested in.