[Federal Register Volume 87, Number 161 (Monday, August 22, 2022)]
[Notices]
[Pages 51471-51473]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2022-17946]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-95503; File No. SR-LCH SA-2022-004]


Self-Regulatory Organizations; LCH SA; Order Approving Proposed 
Rule Change Relating to the Clearing of Markit iTraxx[supreg] Australia 
Indices and the Associated Single-Name Constituents and Remediation of 
WWR Margin Instability

August 16, 2022.

I. Introduction

    On June 30, 2022, Banque Centrale de Compensation, which conducts 
business under the name LCH SA (``LCH SA''), filed with the Securities 
and Exchange Commission (``Commission''), pursuant to Section 19(b)(1) 
of the Securities Exchange Act of 1934 (``Act''),\1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to amend its the Methodology 
Services Reference Guide: Credit Default Swap (``CDS'') Margin 
Framework (``CDSClear Risk Methodology'') and its CDS Clearing 
Supplement (the ``Clearing Supplement'') to permit the clearing of 
Markit iTraxx[supreg] Australia indices and the associated single-name 
constituents. The proposed rule change was published for comment in the 
Federal Register on July 13, 2022.\3\ The Commission did not receive 
comments regarding the proposed rule change. For the reasons discussed 
below, the Commission is approving the proposed rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Self-Regulatory Organizations; LCH SA; Notice of Filing of 
Proposed Rule Change Relating to the Clearing of Markit 
iTraxx[supreg] Australia Indices and the Associated Single Name 
Constituents and Remediation of WWR Margin Instability; Exchange Act 
Release No. 34-95207 (July 7, 2022); 87 FR 41788 (July 13, 2022) 
(File No. SR-LCH SA-2022-004) (``Notice'').
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II. Description of the Proposed Rule Change

    LCH SA is proposing to amend its CDSClear Risk methodology and its 
Clearing Supplement to allow LCH SA to clear Markit iTraxx[supreg] 
Australia indices and the associated single-name constituents. The 
proposal would apply LCH SAs' current risk management processes to the 
management of risks posed by such products. Additionally, LCH SA 
proposes changes to its rules to remediate the recommendation of an 
independent model validation regarding the wrong-way risk (``WWR'' or 
``Wrong-Way Risk'') margin instability.\4\
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    \4\ The description that follows is substantially excerpted from 
the Notice. Capitalized terms not otherwise defined herein have the 
meanings assigned to them in the LCH SA CDSClear Risk methodology, 
CDS Clearing Supplement or LCH SA rules, as applicable.
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A. Amendments to the Clearing Supplement

    The proposed rule change would amend the Clearing Supplement in 
order to include the relevant provisions to allow the clearing of the 
new Markit iTraxx[supreg] Australia indices and the associated single-
name constituents. The proposed rule change would amend Part B of the 
Clearing Supplement, Section 1.2 (Terms defined in the CDS Clearing 
Supplement) to include a new sub-paragraph (a) to the definition of an 
``Index Cleared Transaction Confirmation'' in order to make a reference 
to the form of confirmation which incorporates the iTraxx[supreg] Asia/
Pacific Untranched Standard Terms Supplement. As a consequence, the 
sub-paragraphs (a), (b), (c), and (d) have been re-lettered as (b), 
(c), (d), and (e), respectively.
    Further, Section 2.2 (Index Cleared Transaction Confirmation) of 
Part B of the Clearing Supplement would be amended to make appropriate 
references to any Index Cleared Transaction that is a Markit 
iTraxx[supreg] Australia Index in paragraphs (a)(i), (b)(i), (c)(i) and 
(f)(i).

B. Proposed Amendments to the CDSClear Risk Framework

    The proposed rule change would amend Section 2.1.1.1 (Interest Rate 
Curve) of the CDSClear Risk Methodology by removing the specific 
interest rate curve name used with the International Swaps and 
Derivatives Association, Inc. (ISDA) standard model pricer (used as a 
converter between upfront cash and quoted spread in basis points, as 
described on www.cdsmodel.com). The proposal would instead refer to the 
ISDA website such that when the standard model moves to using new 
benchmark interest rates instead of LIBOR (such as the Secured 
Overnight Financing Rate and the Sterling Overnight Index Average) 
(collectively, the ``Risk Free Rates''), the CDSClear Risk Methodology 
will continue to refer to current information without risking becoming 
outdated.
    For clarity, the proposal would remove ``through a CDS index'' 
under the provisions of Section 3.2 (Self-referencing margin risk) 
because the Self-Referencing Margin would apply as soon as a clearing 
member sells protection on itself regardless of the financial 
instrument used.
    The proposed rule change would also add iTraxx[supreg] 
Australia to the list of indices on which index basis packages can be 
cleared under Section 3.4.5 (Portfolio Margining).
    Because there are financial single-name constituents in the 
iTraxx[supreg] Australia index family, LCH SA proposes to 
subject positions on this index to a wrong-way risk margin requirement, 
which aims at capturing the potential contagion effect off the default 
of a clearing member (that is a financial institution) on instruments 
with open positions in the defaulter's portfolio (``Wrong Way Risk'' or 
``WWR''). Specifically, the application of wrong-way risk margin is 
designed to address the risk that Australian financials credit spreads 
may widen following the default of a clearing member to an extent that 
goes beyond the spread move already covered by the spread margin. 
Because of this requirement, coupled with the need to address a 
recommendation raised by the independent risk model validation on the 
instability of the Wrong Way Risk margin component, the proposal would 
amend the provisions under Section 3.8 of the CDSClear Risk Methodology 
about the Wrong Way Risk margin to introduce the following updates:

--the introduction of the shocks applied to Australian entities in 
Section 3.8.1.1 (Spread parallel moves), alongside the shocks applied 
to existing products.
--a generalization of the calculation to all indices under Section 
3.8.1.4 (Index Shocks) instead of specifically referring to Senior 
Financial or its parent index Main as is currently the case in Section 
3.8.1.3.
--a description of the way the shocks on indices are defined in Section 
3.8.1.4 (Index Shocks) as being derived directly from the shocks 
applied on constituents as a spread and CS01 weighted average.\5\
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    \5\ The new definition would apply to iTraxx[supreg] 
Australia as well as other indices containing financial names; 
however, LCH SA states that no financial impact is expected since 
index shocks are currently calibrated as the average shock of their 
constituents. Notice, 87 FR at 41789.

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[[Page 51472]]

--a specification that the contribution to the spread margin used to 
derive the spread_SM under Sections 3.8.1.5 (Wrong-Way/Right-Way P&L) 
and 3.8.1.6 (Instrument level Expected Shortfall) would now consider 
the contribution of a single tenor, instead of the joint contribution 
of all tenors on a given product, to address the WWR margin instability 
observed with curve trades.\6\
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    \6\ LCH SA states that such specification is required to address 
the recommendation raised by the Independent Model Validation. 
Notice, 87 FR at 41789. Specifically, curve trades are trades 
involving long or short positions on the same index but along a set 
of [?] different maturity points. LCH SA calculates the WWR charge 
by converting positions into an equivalent 5-year notional position. 
This conversion can, in certain limited circumstances for curve 
trades, result in a WWR that is unreasonably high.
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--the introduction of iTraxx[supreg] Australia alongside 
other regions under Section 3.8.1.8 (Trigger) when aggregating Wrong-
Way and Right-Way risk across regions.
--Some of the existing provisions under Sections 3.8.2 (Offsets inter-
region) and 3.8.3 (Final WWR Margin) would be moved to the general 
Section 3.8.1 explaining the overall WWR calculation. Specifically, LCH 
SA proposed moving (i) the shocks defined when extending to CDX 
products are now part of the table inside Section 3.8.1.1 (Spread 
parallel moves) and the relevant provision would be moved at the end of 
this same section. Further, ta provision in Section 3.8.2 regarding Sub 
Financials would be moved to the Section 3.8.1.2 (Sub Financials) as a 
subsection of 3.8.1 (WWR: Parallel Move).

    In addition to the changes to Section 3.8, LCH SA proposes to 
update the provisions of Section 4 on Additional Margin for the 
Liquidity and Concentration Risk Margin under paragraphs 4.1.2 (Macro 
Hedging Phase) and 4.1.4.1 (Diversification Ratio) to specify that 
iTraxx[supreg] Australia index would be used for hedging and 
would define an additional sub-portfolio when considering liquidation 
costs.
    Finally, the proposed changes would, for consistency purposes, 
remove any reference to LIBOR curves in Section 2.1.1.1 of the CDSClear 
Risk Methodology, and refer instead to the cdsmodel.com website, which 
details the pricer used by all market participants to convert from 
quoted spreads to upfronts in parallel to the cessation of LIBOR and 
the transition to Risk Free Rates. The proposed changes would also 
clarify in Section 1, Introduction that the short charge can cover 1 or 
2 credit events, as the CDX.HY component does cover 2 defaults.

III. Discussion and Commission Findings

    Section 19(b)(2)(C) of the Act directs the Commission to approve a 
proposed rule change of a self-regulatory organization if it finds that 
such proposed rule change is consistent with the requirements of the 
Act and the rules and regulations thereunder applicable to such 
organization.\7\ For the reasons discussed below, the Commission finds 
that the proposed rule change is consistent with Section 17A(b)(3)(F) 
of the Act \8\ and Rule 17Ad-22(e)(6)(i) thereunder.\9\
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    \7\ 15 U.S.C. 78s(b)(2)(C).
    \8\ 15 U.S.C. 78q-1(b)(3)(F).
    \9\ 17 CFR 240.17Ad-22(e)(1) and (e)(6)(i).
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A. Consistency With Section 17A(b)(3)(F) of the Act

    Section 17A(b)(3)(F) of the Act requires, among other things, that 
the rules of LCH SA be designed to promote the prompt and accurate 
clearance and settlement of securities transactions and, to the extent 
applicable, derivative agreements, contracts, and transactions.\10\
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    \10\ 15 U.S.C. 78q-1(b)(3)(F).
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    As noted above, the proposed rule change would amend the Clearing 
Supplement and the CDSClear Risk Methodology to allow and account for 
the clearing of the new Markit iTraxx[supreg] Australia indices and the 
associated single-name constituents. The Commission has reviewed the 
terms and conditions of the additional new Markit iTraxx[supreg] 
Australia indices proposed for clearing and has determined that those 
terms and conditions are substantially similar to the terms and 
conditions of the other indices LCH SA currently clears, with the key 
difference being the constituents. Moreover, after reviewing the Notice 
and LCH SA's policies and procedures, the Commission understands that 
LCH SA would clear Markit iTraxx[supreg] Australia indices and the 
associated single-name constituents pursuant to its existing clearing 
arrangements and related financial safeguards, protections, and risk 
management procedures. The Commission also understands that LCH SA 
would revise its existing margin methodology to accommodate the 
clearing of iTraxx Australian indices and the associated single-name 
constituents, but that LCH SA would not change its existing default 
management policies and procedures and operational process because the 
proposed product does include new risk factors not already addressed 
with regard to the Corporates and Financials indices or single-names 
that LCH SA currently clears.
    In addition, based on its own experience and expertise, including a 
review of data on expected volume, market share, and the number of LCH 
SA Clearing Participants (``CPs'') expected to trade in Markit 
iTraxx[supreg] Australia indices and the associated single-name 
constituents as well as certain model parameters for Markit 
iTraxx[supreg] Australia indices, the Commission believes that LCH SA's 
rules, policy, and procedures, including as amended by the proposed 
rule change, are reasonably designed to (i) price and measure the 
potential risk presented by Markit iTraxx[supreg] Australia indices and 
the associated single-name constituents, (ii) collect financial 
resources in proportion to such risk, and (iii) liquidate these 
products in the event of a CP default. The design of LCH SA's rules, 
policies, and procedures should, therefore, help ensure LCH SA's 
ability to maintain sufficient financial resources to support its 
critical services and function as a central counterparty, thereby 
promoting the prompt and accurate settlement of the additional Markit 
iTraxx[supreg] Australia indices and other transactions. Further, as 
noted above, LCH SA would apply its existing margin methodology, 
including its Wrong Way Risk margin framework noted above, to the new 
iTraxx[supreg] Australia Index, which are similar to the European 
indices currently cleared by LCH SA. The Commission believes that this 
will, in turn, strengthen LCHS SA's ability to calculate margin 
requirements sufficient to cover its credit exposure to its clearing 
members.
    Additionally, LCH SA is proposing a number of clarifying changes. 
Specifically, the proposed rule change would remove ``through a CDS 
index'' under the provisions of Section 3.2 (Self-referencing margin 
risk) of the CDSClear Risk Methodology as needlessly specific. The 
proposal would also remove the interest rate curve name used with the 
ISDA standard model pricer.\11\ because it does not need to be 
specified in this risk documentation. Instead, the proposal would refer 
to the original website when the market moves to the new Risk Free 
Rates, so that the CDSClear Risk Methodology always automatically 
refers to the latest state in

[[Page 51473]]

the market without risking becoming outdated. The Commission believes 
that such changes would strengthen LCH SA's risk documentation by 
ensuring it is clear and current, which, in turn, would support LCH 
SA's ability to manage risk and maintain financial resources to 
promptly and accurately clear and settle trades.
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    \11\ Used as a converter between upfront cash and quoted spread 
in basis points, as described on www.cdsmodel.com.
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    For these reasons, the Commission believes the proposed rule 
changes are consistent with Section 17A(b)(3)(F) of the Act.\12\
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    \12\ 15 U.S.C. 78q-1(b)(3)(F).
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B. Consistency With Rule 17Ad-22(e)(6)(i)

    Rule 17Ad-22(e)(6)(i) requires that LCH SA establish, implement, 
maintain, and enforce written policies and procedures reasonably 
designed to cover its credit exposures to its participants by 
establishing a risk-based margin system that, at a minimum considers, 
and produces margin levels commensurate with, the risks and particular 
attributes of each relevant product, portfolio, and market.\13\
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    \13\ 17 CFR 240.17Ad-22(e)(6)(i).
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    As noted above, because there are financial single-name 
constituents in the iTraxx[supreg] Australia index family and positions 
on this index will therefore be subject to the Wrong Way Risk margin, 
the proposed rule change would apply LCH SA's existing margin 
methodology, including its Wrong Way Risk margin framework, to the new 
iTraxx[supreg] Australia Index. The Commission believes that by 
proposing to include the new iTraxx[supreg] Australia Index in LCH SA's 
existing margin methodology, the proposed rule change supports LCH SA's 
ability to have a risk-based margin system that considers, and produces 
margin levels commensurate with the risks and particular attributes of 
each relevant product, including the iTraxx[supreg] Australia Index and 
the associated single-name constituents. As noted above, the Commission 
has reviewed the terms and conditions of the additional new Markit 
iTraxx[supreg] Australia indices proposed for clearing and has 
determined that those terms and conditions are substantially similar to 
the terms and conditions of the other indices LCH SA currently clears, 
with the key difference being the constituents. Because of this 
similarity, LCH SA would apply its existing margin methodology, with 
the revisions discussed above, to the new iTraxx[supreg] Australia 
Index.
    For this reason, the Commission believes that the proposed rule 
change is consistent with Rule 17Ad-22(e)(6)(i).\14\
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    \14\ 17 CFR 240.17Ad-22(e)(6)(i).
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IV. Conclusion

    On the basis of the foregoing, the Commission finds that the 
proposed rule change is consistent with the requirements of the Act, 
and in particular, with the requirements of Section 17A(b)(3)(F) of the 
Act \15\ and Rule (e)(6)(i) thereunder.\16\
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    \15\ 15 U.S.C. 78q-1(b)(3)(F).
    \16\ 17 CFR 240.17Ad-22(e)(6)(i).
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    It is therefore ordered pursuant to Section 19(b)(2) of the Act 
\17\ that the proposed rule change (SR-LCH SA-2022-004) be, and hereby 
is, approved.\18\
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    \17\ 15 U.S.C. 78s(b)(2).
    \18\ In approving the proposed rule change, the Commission 
considered the proposal's impact on efficiency, competition, and 
capital formation. 15 U.S.C. 78c(f).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\19\
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    \19\ 17 CFR 200.30-3(a)(12).
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Jill M. Peterson,
Assistant Secretary.
[FR Doc. 2022-17946 Filed 8-19-22; 8:45 am]
BILLING CODE 8011-01-P