Central Counterparty for Equities

Guidance Note

December 200003/00

Agency and riskless principal trading

1Introduction

This guidance note is intended to explain to market participants how agency business can be transacted on SETS following the introduction of the central counterparty (“CCP”) service in February 2001. In addition, it explains the main differences between trading agency business and handling the same business as a riskless principal on SETS in the CCP environment.

The purpose of this note is to clarify the issues surrounding the capacity in which firms deal so that they can take a decision on their preferred way to trade on SETS. It includes brief details of some of the SFA issues involved, though such firms (and those that are not SFA authorised) are encouraged to contact their supervision team to discuss individual circumstances.

2Agency trading & LCH rules

Although firms can trade on SETS as agent or principal, the relationship between clearing members of the London Clearing House (“LCH”) and LCH in respect of business cleared (as distinct from settled) by such clearing members must be on a principal to principal basis. This means that a firm wishing to trade as an agent must clear its agency business through a general clearing member (“GCM”), which must be a separate legal entity to the trading firm (it can be within the same group of companies, however). The trading firm will be treated as a non-clearing member (“NCM”) for this business.

Further details on this issue can be found in the Service Implementation Guide, the LCH rules, the three party (LCH/GCM/NCM) agreement and the consultation notice on revisions to the Rules of the London Stock Exchange.

3Agency vs riskless principal

When the London Stock Exchange introduced SETS in October 1997, a number of firms decided to trade for clients as a riskless principal, rather than as an agent. One of the reasons for this was to protect customers from trading with unknown counterparties on SETS. A riskless principal transaction (sometimes called principal brokerage) does not involve the firm taking a position in a security, but entering into back to back principal trades between itself, its counterparty and its customer, all on the same terms.

Any member firm of the Exchange can choose whether to transact on a riskless principal or agency basis. The Exchange imposes no restrictions, as long as the firm is appropriately authorised.

4Default

This section sets out how CCP positions will be handled under LCH and Exchange rules in the event of default. All non-CCP positions will be dealt with under the Exchange’s default rules in the normal way.

Clearing member default

LCH’s powers in the event of a default are described in its Default Rules. In general, in the event of a default, LCH is able to either close-out, settle or transfer the outstanding positions of the defaulting clearing member. LCH’s responsibility, in the event of a default, is to its non-defaulting clearing members, however, wherever possible, LCH’s preference is to either settle with non-defaulting NCMs and clients or to transfer their positions to another solvent clearing member, in which case the Exchange’s default rules will not be applied.

If LCH does close out any trades with a clearing member under its rules, the Exchange’s default rules will apply to any onward positions with NCMs or customers. These contracts, which are all on a principal basis, will be hammered (closed out at the market price at the time of default) under the Exchange’s rules, producing a net credit/debit for each of the clients/customers with the clearing member.

Non-clearing member default

Agency

In the case of a default of an NCM conducting agency business, the NCM’s clearer is responsible for the NCM’s position with LCH and also is put in touch with the customers of the NCM to either settle or close out – at the GCM’s discretion – each individual outstanding position.

Principal

In the case of a default of an NCM conducting principal business (including riskless principal), the NCM’s clearer is responsible only for the NCM’s position with LCH. Any non-LCH positions held by clients/customers are hammered as above, producing a net credit/debit for each of the clients/customers with the NCM.

Customer default

In the case of the default of an NCM’s customer, the responsibilities of the NCM are set out in Exchange rule 2.20(a), which states:

A member firm shall, in its on Exchange transactions with other member firms and its dealings with the Exchange, be bound as a principal, notwithstanding that it may be acting for a client.

Therefore in the case of the default of an NCM's customer, the NCM is responsible for completing the trade, whether it was acting as agent or principal.

5Provision of clearing services for NCMs

Due to the exposure to end clients in the event of the default of an NCM acting as agent and the potential additional administration and risk that this would entail, GCMs may impose additional controls and/or charge more for clearing agency business than for riskless principal. Some GCMs may also be reluctant to provide agency clearing services altogether. In order to avoid these extra burdens, agency NCMs may wish to consider trading as riskless principals.

6Regulatory treatment

The Exchange has discussed the different regulatory treatment of agency and riskless principal business with the FSA, which supervises SFA-authorised firms on behalf of SFA. The FSA has stated that firms who wish to conduct riskless principal business and need to amend their business profile and Investment Services Directive (“ISD”) category to do so, should apply to their supervision team in the normal way.

To conduct riskless principal transactions, SFA rules require firms to be at least category B authorised under the ISD, with an initial capital requirement of €125,000. This compares to the minimum category C authorisation required for dealing as agent, with an initial capital requirement of €50,000 (under existing definitions). Category B firms are subject to more stringent financial reporting requirements than Category C firms. Riskless principal trades themselves attract the same capital treatment as agency trades, being subject to counterparty risk requirement, as opposed to position risk requirement.

Firms should also examine whether their current client agreements allow them to deal as principal.

As set out above, firms should contact their supervision team to discuss individual circumstances.

7Transaction reporting

As set out in the Exchange’s rules consultation for the CCP in Notice N54/00, the underlying buying and selling parties to a central counterparty transaction will be required to transaction report as today. There will be no requirement for other intermediary parties involved in central counterparty transactions to submit transaction reports, except where they are providing these services on behalf of the trading parties.

The Exchange’s current requirements are set out in the guide to transaction reporting through CREST, available on the Exchange’s website at For riskless principal transactions, firms should report both the market and client legs and submit them to both the Exchange and SFA (for SFA-authorised firms), through using the appropriate flags in CREST.

List of guidance notes

The project has published a number of guidance notes. The others published to date, or in production, are listed below, please contact the project for any later guidance notes.

01/00Disclosure of shareholdings

02/00UK Stamp Duty Reserve Tax

03/00Agency and riskless principal trading

04/00Irish Stamp Duty (to be published)

05/00Impact of late settlement (to be published)

Contact points

The CCP for Equities project can be contacted on 020 7849 0510 or via email at . Members of the Exchange, LCH or CRESTCo can also make use of their usual contacts in these organisations.

Information about the service is also available on the following websites:


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