Central Counterparty for Equities
Guidance Note
December 200004/00
Balance sheet reporting
1Background
Although the principal-to-principal structure of the central counterparty model was established in the early stages of the project, some prospective General Clearing Members (GCMs) have only recently appreciated that the structure has implications for their balance sheet accounting and credit risk information systems. This is an issue both for GCMs in relation to their business with NCMs; and for GCMs and ICMs in relation to business with clients which is currently labelled ‘agency’ business.
The issues were raised bilaterally with LCH by three firms and discussed in a broader forum with LIBA’s Settlement Working Party. LCH was asked, and agreed, to re-examine the principal-to-principal structure built into the proposed LCH-GCM-NCM agreement and its Regulations to see whether it could make changes that would obviate the need for the balance sheet reporting. It was suggested that a structure in which the GCM gave an irrevocable commitment to assume the NCM/client’s settlement obligations in the event of the latter’s non-performance would relieve the need for reporting.
2Conclusion of re-examination
LCH has reviewed the contractual-legal structure with its advisers and concluded that it cannot make the suggested change to a hybrid agency-principal structure. The basis of the conclusion is that such a structure would be ambiguous and would fall outside the statutory insolvency protection offered to LCH under Part VII of the Companies Act 1989. The effectiveness of that protection is of fundamental importance to the security of LCH’s central counterparty arrangements, and at the same time to the clearing members who of course provide the default backing of the company. The effect of the removal of Part VII protection would be to introduce uncertainty as to LCH’s right to apply the initial margin of a defaulting member to offset default losses. The Default Fund contributions of non-defaulting members would therefore be more at risk.
The contractual structure will thus remain as shown in the diagram below:
3Accounting treatment
Contact with prospective GCMs has revealed a range of views on what needs to be reflected on their balance sheet:
- It is not necessary to reflect the NCM/client business on balance sheet
- Mark-to-market value should be shown
- Total trade consideration should be shown
- Individual trade values should be shown.
LCH has spoken to accountants and been told that contract values should be shown (FRS5 debtor-creditor entries) and that knowledge of client exposures will also be required under FSA/SFA reporting and credit risk requirements. But the situation is complex, particularly in the case of multi-national firms, and firms should of course seek their own advice in the light of their own group and legal structures.
4Regulatory capital requirements
The FSA has advised that whether or not client-related exposures are on- or off-balance sheet is not a factor in the applicable regulatory requirements. The SFA Rules and FSA Guide to Bank Supervision, although detailed, seem relatively clear on this issue, but firms should of course seek advice from their relevant Supervision Team or Complex Groups Division, Policy at the FSA if they are uncertain.
5Calculation of balance sheet positions
GCMs may require net receivables/payables by NCMs, by trade date, in order to meet balance sheet reporting requirements.
The information can be derived fromLCH’s PC margin calculation tool, PC ERA. In addition to PC-ERA’s existing reports, LCH could, if members wish, develop a new report to provide details of variation margin and consideration by trade date for balance sheet reporting purposes. Whilst PC ERA has been specifically developed for use in a testing environment, LCH will , if there is member demand, provide additional support for the PC tool in an interim period for members whose systems will not provide this functionality by 26 February 2001.
Questions pertaining to this guidance note should be directed to:
Name / Number / E-mailChristopher Jones / +44 20 7426 7103 / mailto:
Andrew Lamb / +44 20 7426 7055 / mailto:
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
04/00Balance sheet reporting
05/00Impact of late settlement (to be published)
06/00Irish Stamp Duty (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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