This is the third report prepared by the Task Force on Securities Settlement Systems, which was jointly established by the Committee on Payment and

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Committee on Payment and Settlement Systems Technical Committee of the International Organization of Securities Commissions Recommendations for Central Counterparties Consultative Report March 2004 Organización Internacional de Comisiones de Valores International Organization of Securities Commissions Organisation internationale des commissions de valeurs Organização Internacional das Comissões de Valores

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Copies of publications are available from: Bank for International Settlements Press & Communications CH-4002 Basel, Switzerland E-mail: Fax: +41 61 280 9100 and +41 61 280 8100 This publication is available on the BIS website ( and the IOSCO website ( © Bank for International Settlements and Internatio nal Organization of Securities Commissions 2004. All rights reserved. Brief excerpts may be reproduc ed or translated provided the source is stated. ISBN 92-9197-663-6 (online)

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Consultative Report on Recommendations for CCPs iii Foreword This is the third report prepared by the Task Forc e on Securities Settlement Systems, which was jointly established by the Committee on Payment and Settlement Systems (CPSS) of the central banks of the Group of Ten countries and the Techni cal Committee of the International Organization of Securities Commissions (IOSCO) in December 1999. Recommendations for Central Counterparties aims to set out comprehensive standards for risk management of a central counterparty (CCP). CCPs occupy an important place in securities settlement systems (SSSs). A CCP interposes itself between counterparties to financial transactions, becoming t he buyer to the seller and the seller to the buyer. A well designed CCP with appropriate risk management arrangements reduces the risks faced by SSS participants and contributes to the goal of financial stability. CCPs have long been used by derivatives exchanges and a few securities exchanges. In re cent years, they have been introduced into many more securities markets, including cash market s and over-the-counter ma rkets. Although a CCP has the potential to reduce risks to market participa nts significantly, it also concentrates risks and responsibilities for risk management. Therefore, the effectiveness of a CCP™s risk control and the adequacy of its financial resources are critical aspects of the infrastructure of the markets it serves. In the light of the growing interest in developing CCP s and expanding the scope of their services, the CPSS and the Technical Committee of IOSCO concluded that internat ional standards for CCP risk management are a critical element in prom oting the safety of financial markets. The present consultative report includes 14 headline recommendations and accompanying explanatory text that cover the major types of risks CCPs face. The report also includes a methodology for assessing implementation of the re commendations, which identifies key issues and key questions and provides guidance on assignment of an assessment category. The CPSS and IOSCO are now releasing the recommendat ions in this report for consultation, and are seeking public comments from all interested parties by 9 June 2004. We believe that wide participation in the public consultation process would be benef icial, and we therefore encourage any interested parties to submit their comments to the Task Force. The Task Fo rce will review the comments and develop the final recommendations based upon the in formation gained in the consultative process. The CPSS and the Technical Committee of IOSCO are grateful to the member s of the Task Force and its Co-Chairmen, Patrick Parkinson of the Board of Governors of the Federal Reserve System and Shane Tregillis of the Monetary Authority of Singapor e, for their excellent work in preparing this consultative report in a timely manner. We are looking to them to take the lead in completing this important initiative. Tommaso Padoa-Schioppa, Chairman Committee on Payment and Settlement Systems Andrew Sheng, Chairman Technical Committee, IOSCO

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iv Consultative Report on Recommendations for CCPs Note to readers The consultation period will last until 9 June 2004 (inc lusive). Interested parties are invited to comment on any aspect of the report. However, views and suggestions on the topics set out below are particularly welcome: Do the Recommendations adequately cover all the relevant topics? Please describe any issues which you feel have been missed and should be addressed in the report. Does the explanatory text for each Recomme ndation provide an adequate rationale for the Recommendation and elaborate its implications su fficiently clearly? Please indicate any areas which you think deserv e further clarification. Does the assessment methodology concerning each Recommendation in the report address the relevant issues in such a way as to enable an accurate evaluation of whether the recommendations have been implemented? In several particular areas, the Task Fo rce solicits the reac tions of reviewers: The Task Force concluded that the recommendations should be applied to guarantee arrangements as well as CCPs. Do reviewers agree? Should all or a subset of the recommendations be applied to these arrangements? In further considering the scope of the reco mmendations, the Task Force discussed their application to clearing participants that serv e as intermediaries allowing other market participants to access the CCP™s services. T he Task Force concluded that individual national authorities should make judgments about the appl ication of particular recommendations to clearing participants that clear for substantia l numbers of market participants, but that the recommendations need not be applied to such participants in every jurisdiction. Do reviewers agree with this judgment? If not, should some or all of the recommendations be applied to such clearing participants in every jurisdiction? Or should the recommendations not be applied to clearing participants in any jurisdiction? Recommendation 3, Collateral Requirements, covers both derivatives and cash markets. Is this approach appropriate for both types of ma rket? If not, what is the rationale for differential treatment? Do reviewers agree that a minimum coverage ratio should be set for collateral requirements? The Task Force has made a distinction between a CCP™s steps to protect itself in the event of losses in normal market conditions (Rec ommendation 3, Collateral Requirements) and its potential need for resources in more extr eme market conditions (Recommendation 4, Financial Resources). Is this distinction clear and useful? If not, how should the Task Force distinguish these different risk management needs? Do CCPs currently meet thes e recommendations? If not, are they too stringent or is there a need for CCPs to strengthen their practices and pr ocedures in order to attain appropriate levels of safety and efficiency? Comments in English are invited by 9 June 2004 (inclusive) from all interested parties. They may be sent to: Secretariat to the CPSS-IOSCO Task Forc e on Securities Settlement Systems Bank for International Settlements CH-4002 Basel, Switzerland Fax: +41 61 280 9100 E-mail: (please mention fiRecomme ndations for CCPsfl in the subject line of the message) We strongly recommend that you send comments by e-mail (or fax) first, to avoid possible delays in postal delivery; the Secretariat will send an ac knowledgment immediately upon receipt. Please note that it may not be possible to give consider ation to comments received after the deadline.

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Consultative Report on Recommendations for CCPs v Contents Foreword.. ..iii Note to readers. iv 1. Introduction. ..1 Exhibit 1: CPSS-IOSCO Technical Committee Recommendations fo r Central Counterpar ties (CCPs)3 2. Scope of application of the recomme ndations .5 3. Overview of a CCP™s ri sks and risk ma nagement..6 4. Recommendations. .11 Recommendation 1: Legal risk .11 Recommendation 2: Partic ipation requirements..14 Recommendation 3: Colla teral require ments.16 Recommendation 4: Finan cial resources.19 Recommendation 5: De fault procedures.22 Recommendation 6: Custody and investment risks26 Recommendation 7: O perational risk .27 Recommendation 8: M oney settlements..30 Recommendation 9: Phys ical deliveries..32 Recommendation 10: Risks in links between CCPs..35 Recommendation 11: Efficiency.. 37 Recommendation 12: Governance.39 Recommendation 13: Transparency..41 Recommendation 14: Regula tion and oversight..42 Annex 1: Glossary.. ..45 Annex 2: Members of the CPSS-IOSCO Task Force on Securities Settlement Systems48

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2 Consultative Report on Recommendations for CCPs Systemsfl . Key issues that need to be evaluated to determine the extent of observance of each recommendation and the key questions corresponding to those key issues are identified. Guidance is then provided on how to translate the answers to the key questions into the assignment of an assessment category. This guidance on the assignment of rating categories is not intended to be applied in a purely mechanical fashion. In some instances, a CCP may not strictly meet the assessment criteria for observance of a recomme ndation but may successfully address the safety or efficiency objectives that underlie the recommendation and the key issues and key questions. Nonetheless, the guidance is intended to establish a presumption as to what the appropriate rating should be, given the circumstances indicated by th e answers to the key questions. This approach is intended to foster discipline in the ratings process while allowing some flexibility to deal with special circumstances. The guidance also includes explanatory notes to clarify certain issues that seem likely to arise in the course of an assessment. 1.9 A glossary is provided in Annex 1. Annex 2 is a list of the members of the Task Force.

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Consultative Report on Recommendations for CCPs 3 Exhibit 1: CPSS-IOSCO Technical Committee Recommendations for Central Counterparties (CCPs) 1. Legal risk A CCP should have a well founded, transparent and en forceable legal framework for each aspect of its activities in all relevant jurisdictions. 2. Participation requirements A CCP should require participants to have suffici ent financial resources and robust operational capacity to meet obligations arising from participation in the CCP. A CCP should have procedures in place to monitor that participation requirements ar e met on an ongoing basis. A CCP™s participation requirements should be objective, publicly disclosed, and permit fair and open access. 3. Collateral requirements A CCP should calculate its credit exposures to particip ants on a daily basis and hold collateral that in normal market conditions covers its potential losses from closing out positions held by a defaulting participant. 4. Financial resources A CCP should maintain sufficient financial resources to withstand a default by the participant to which it has the largest exposure in extreme but plausibl e market conditions that produces losses not fully covered by collateral requirements. 5. Default procedures A CCP™s default procedures should be clear and tr ansparent, and they should ensure that the CCP can take timely action to contain losses and liquidi ty pressures and to continue meeting its obligations. 6. Custody and investment risks A CCP should hold assets in a manner whereby risk of loss or of delay in its access to them is minimised. Assets invested by a CCP should be held in instruments with minimal credit, market and liquidity risks. 7. Operational risk A CCP should identify sources of operational risk and minimise them through the development of appropriate systems, control and procedures. Syst ems should be reliable and secure, and have adequate, scalable capacity. Business continuity plans should allow for timely recovery of operations and fulfilment of a CCP™s obligations. 8. Money settlements A CCP should employ money settlement arrangements that eliminate or strictly limit its settlement bank risks, that is, its credit and liquidity risks from the use of banks to effect money settlements with its participants. Funds transfers to t he CCP should be final when effected.

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4 Consultative Report on Recommendations for CCPs 9. Physical deliveries A CCP should clearly state its obligations with res pect to physical deliveries. The risks from these obligations should be identified and managed. 10. Risks in links between CCPs CCPs that establish links either cross-border or dome stically to clear trades should design and operate such links in ways that observe the other recommendations in this report. 11. Efficiency While maintaining safe and secure operations, CCPs should be cost-effective in meeting the requirements of users. 12. Governance Governance arrangements for a CCP should be effective, clear and transparent to fulfil public interest requirements and to support the objectives of owners and users. In particular, they should promote the effectiveness of the CCP™s risk management procedures. 13. Transparency A CCP should provide market participants with suffici ent information for them to identify and evaluate accurately the risks and costs asso ciated with using its services. 14. Regulation and oversight A CCP should be subject to transparent and effect ive regulation and oversight. In both a domestic and an international context, central banks and securities regulators should cooperate with each other and with other relevant authorities.

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Consultative Report on Recommendations for CCPs 5 2. Scope of applicati on of the recommendations 2.1 A CCP is typically defined as an entity that interposes itself between counterparties to contracts in one or more financial markets, becom ing the seller to every buyer and the buyer to every seller. In some markets a CCP extends an fiopen offe rfl to act as counterparty to market participants and is interposed between participants at the ti me trades are executed. In other markets, the participants themselves initially are the counterparti es. Subsequently the trades may be submitted to a CCP, which is substituted as the seller to the buy er and the buyer to the seller. Substituting a CCP discharges the original obligations between market participants. 2.2 CCPs were first introduced for trading on exchanges. Exchange rules often require that trades be executed at the best bid or offer, regardle ss of the creditworthiness of the party making the best bid or offer. Market participants in such ex changes cannot effectively manage their counterparty credit and liquidity risks with other participants. The use of a CCP makes such bilateral risk management unnecessary because the CCP is counterpart y to every trade. In over-the-counter (OTC) markets, in which CCP services have been introduced more recently, use of thos e services is typically optional. Counterparties may agree to submit their trades to a CCP, thereby substituting the CCP as counterparty, or they may not agree to do so, in which case they must mana ge their counterparty risks with each other. Whether it serves an exchange or OTC markets, a CCP typically concentrates risks and risk management responsibilities. Even where use of a CCP is optional, its services are often used intensively by the largest market participants. 2.3 On many securities exchanges, a CCP has not yet been introduced. Participants on such exchanges remain the counterparties to the trades. However, in many such markets, especially in eastern Europe and Latin America, performance of t he trades is guaranteed by the stock exchange or some other entity (a guarantor). The guarantor typically establishes a fund (a guarantee fund) that would be used to compensate non-defaulting participant s from losses they may suffer in the event that one or more participants default on their obligations as counterparties. (Aggregate compensation is typically limited to the value of the assets in the gua rantee fund.) The guarantor typically relies on its participation requirements to limit potential losses, although some guar antors also impose collateral requirements on participants. Although such arra ngements do not involve a CCP, they do create a concentration of responsibility for risk management. A risk management failure by the operator of such a guarantee fund would have effects similar to thos e of a risk management failure by a CCP – the liquidity of the markets for which it guarantees tr ades would be disrupted, and possibly the payment and settlement systems used to settle trades in those markets. Therefore, the Task Force concluded that these recommendations should be applied to g uarantee arrangements as well as CCPs. In what follows the term CCP should be understood to include guarantee funds as well as true CCPs. 2.4 In many cases only a subset of market parti cipants are also participants (counterparties) of the CCP. Other participants (usually but not excl usively smaller participants) access the CCP™s services through an intermediary (a ficlearingfl participant of the CCP). Where many market participants rely on the same clearing participant , counterparty risk and responsibility for risk management may be concentrated to a significant degree in that clearing participant. Thus, a risk management failure by such a clearing participant could have effects similar to a risk management failure by a CCP. In some jurisdictions, such cl earing participants are subject to capital requirements and other regulations that explicitly address the risks arising from cl earing. Where such regulations are not in place, authorities may wish to consider whether such clearing participants™ policies and procedures are consistent with certain of thes e recommendations, notably those addressing collateral requirements, investment and custody risk, operational risk and physical deliveries.

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