CDS Settlement Services Risk Model Version June CDS Risk Management

CDS Settlement Services Risk Model Version 3.2.1 June 25th, 2003 CDS Risk Management CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 Table of Contents Introduction ............................................................................................................................1 1.1 Purpose..............................................................................................................................1 1.2 Background and Overview of the Risk Model ....................................................................1 2 CDS Risk Management Principles.........................................................................................2 3 Definition and Sources of Financial Risk in Securities Settlement ........................................3 3.1 Payment Risk .....................................................................................................................4 3.2 Replacement Cost Risk......................................................................................................4 4 Risk Controls .........................................................................................................................4 4.1 Membership Standards ......................................................................................................4 4.2 Trade Settlement in CDSX.................................................................................................6 4.2.1 CNS/BNS Settlement Process ....................................................................................7 4.2.2 Real Time TFT Settlement..........................................................................................9 4.2.3 Certificated Based Settlement (CBS)..........................................................................9 4.2.4 “Free Deliveries” .........................................................................................................9 4.2.5 Intra-day CNS Settlement ...........................................................................................9 4.2.6 Payment Exchange...................................................................................................10 4.3 Payment Risk Controls.....................................................................................................10 4.3.1 Extenders of Credit (including Federated Participants and Settlement Agents) and Receivers of Credit ..............................................................................................................11 4.3.2 CDSX Payment Risk Edits........................................................................................11 4.3.2.1 The Funds Edit ..................................................................................................12 4.3.2.2 ACV Edit ............................................................................................................13 4.3.2.3 Haircut Rates on Securities Used to Calculate Current ACV.............................14 4.3.2.4 Sector Limits for ACV Applied to “Family” Members..........................................18 4.3.3 Initial ACV and Cap...................................................................................................18 4.3.3.1 Initial ACV and Cap for Extenders of Credit, Settlement Agents and Federated Participants ......................................................................................................................18 4.3.3.2 Initial ACV and Cap for Receivers of Credit.......................................................19 4.3.4 Design of the RCP ....................................................................................................20 4.3.4.1 RCP Liquidity .....................................................................................................22 4.3.4.2 Calculation of the RCP Caps and ACV..............................................................22 4.3.4.2.1 “Top-up” Contributions to an RCP..................................................................24 4.3.4.3 Impact of a Default on the RCP .........................................................................24 4.4 Replacement cost Risk Controls ......................................................................................25 4.4.1 Daily Mark-to-Market.................................................................................................25 4.4.2 Daily Mark-to-Market in CNS and ACCESS..............................................................25 4.4.3 CDSX CNS Participant Fund ....................................................................................25 4.4.3.1 Calculation of the CDSX CNS Participant Fund ................................................26 4.4.3.2 Mark-to-Market Component ...............................................................................27 4.4.3.3 CNS Outstanding Positions Component............................................................28 4.4.3.4 CDSX CNS Participant Fund .............................................................................29 4.4.3.5 Timing of Calculations .......................................................................................29 4.4.3.6 VaR Calculations ...............................................................................................29 4.4.3.7 Advantage of the VaR Approach .......................................................................30 4.4.4 DetNet Participant Fund............................................................................................31 4.4.5 Capping Counterparty Services ................................................................................31 4.5 US Dollar Risk Model .......................................................................................................32 4.5.1 Size of USD Settlement Values ................................................................................33 4.5.2 Summary of the USD Risk Model .............................................................................33 1 CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 4.5.3 U.S. Banker Risk.......................................................................................................34 4.5.4 USD Caps .................................................................................................................34 4.5.5 USD Receivers’ Collateral Pool ................................................................................34 4.5.5.1 USD-RCP Liquidity ............................................................................................35 4.5.5.2 Calculation of the USD-RCP Caps ....................................................................35 4.5.6 ACV Edit for USD transactions .................................................................................35 4.5.7 New York Link Participant Fund................................................................................36 4.5.8 ACCESS Participant Fund ........................................................................................36 4.5.9 DTC Direct Service ...................................................................................................37 4.5.10 Proposed Co-ordination of CDS and NSCC Risk Models.........................................37 4.5.10.1 New York Link....................................................................................................38 4.5.10.2 5099/ACCESS ...................................................................................................39 4.5.10.3 Workplan for Coordination of CDS and NSCC Risk Models..............................40 4.6 Default of a Participant.....................................................................................................41 4.6.1 Replacement of a Defaulter’s Payment Obligation ...................................................41 4.6.2 Sources and Use of Collateral ..................................................................................42 4.6.3 Legal Foundations and Perfection of Security Interests in Collateral .......................43 4.7 Surveillance Practices......................................................................................................44 4.7.1 Monitoring of Participant Obligations ........................................................................44 5 Collateral Management........................................................................................................45 5.1 Centralization ...................................................................................................................46 5.2 Eligible Collateral .............................................................................................................46 6 Management of the Transition Period..................................................................................46 Appendices CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 1 1 1.1 Introduction Purpose Version 3 of the CDSX Risk Model was published in October 2002. Since that time there has been considerable discussion on the changes that need to be made to this version of the Risk Model to satisfy the requirements of both the Receivers and Extenders of Credit. All parties have agreed to a 12-month Transition Period1 to move from Version 3 of the CDSX Risk Model to a version that more fully addresses the issues that have been raised. The objective of this paper is to provide an update to Version 3 of the CDSX Risk Model based upon the work that has been completed to-date to both identify and address outstanding issues. The format of this paper is the same as Version 3 of the CDSX Risk Model but without the appendices2. All changes have been highlighted to allow the reader to easily determine what has been changed3. Where there have been changes to what was defined in Version 3, the current status of the discussions to-date, including any options that are being considered, are fully defined. All questions on the content of this paper should be addressed David Stanton, Senior Risk Manager at (416) 365-8489 or e-mail to dstanton@cds.ca. 1.2 Background and Overview of the Risk Model CDS has developed and implemented CDSX4 which is a single system for the clearing and settlement of all securities transactions. Upon its implementation on March 31st, 2003, CDSX replaced the Debt Clearing System (DCS) and will shortly be used to replace the current Securities Settlement Service (SSS). The underlying philosophy of the risk model is a combination of “defaulter pay” and “survivor pay”. In summary: • CDSX applies its inherent risk mechanisms to all Participants rather than to only the Banks and their families, the Settlement Agents and Federated Participants as was previously the case in DCS. This means that Receivers who were previously excluded from the Aggregate Collateral Value (ACV) and net debit cap controls are now subject to these controls and are required to collateralize all credit in the CDSX system. The “leakage edit”, which ensured that transaction prices were within an “acceptable” range has been removed as a risk control measure. The application of the ACV edit to all Participants provides a better means of ensuring collateralization of negative funds balances than the “leakage edit”. Whereas DCS controls were applied only to debt and money market securities, CDSX extends similar controls to all security types. • • 1 The Transition Period starts after the conversion of the vast majority of equities into CDSX. Currently, the Transition Period is scheduled to commence at the end of August 2003. 2 Changes to the Appendices attached to Version 3 of the CDSX Risk Model have been incorporated in the body of this update to the CDSX Risk Model. As later versions of the Risk Model are implemented, the Appendices will be formally updated. 3 Version 3.1 of the CDSX Risk Model was the original update to Version 3. This version of the CDSX Risk Model (i.e., Version 3.2.1) contains corrections and further clarifications to Version 3.1 based on feedback from the various Participant groups. 4 The CDSX software was successfully implemented on March 31st, 2003. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 • • 2 CDSX introduces additional payment risk controls for USD transactions including a maximum net debit cap. A Continuous Net Settlement (CNS) service forms part of the CDSX environment. When equities are moved to the CDSX platform, CNS and ACCESS (American and Canadian Connection for Efficient Securities Settlement) Participants will be required to collateralize the risks they bring to the clearing system to support CDS as the central counterparty (CCP). This is already a CDS requirement, but the calculations will be refined and the process advanced to more precisely reflect the risks and associated collateral requirements. Figure 1 illustrates the transition from the current risk model to the new risk model following the full implementation of CDSX. Figure 1 – Summary of Transition to the CDSX Risk Model Payment Risk DCS - ACV, Proactive TFT - Fund, Post-fact CNS - Fund, Post-fact ACCESS - Fund, Post-fact Payment Risk NY Link - Fund, Post-fact DTC Direct - Fund, Post-fact Today Future Settlement Risk DetNet - Fund, Proactive not applicable Payment Risk CDSX Risk Model Future Settlement Risk CDSX - ACV, Pool/Ring Proactive DetNet - Fund, Proactive not applicable CNS - Fund, Proactive ACCESS - Fund, Proactive Outside CDSX Risk Model Future Settlement Risk NY Link - Fund, Post-fact DTC Direct - Fund, Post-fact Implementation of the risk model also requires changes to how risks are currently managed at CDS: 1. An internal risk management system (IRMS) has been being built to proactively evaluate replacement cost risk in the CNS and ACCESS services. This system will be in place coincident with the conversion of equities into CDSX. 2. A Collateral Management System (CMS) has been built to more efficiently and effectively manage the collection and return of collateral across all settlement services. 3. Surveillance processes will be extended to proactively evaluate Participant settlement activity to ensure that risks being brought to the system are adequately managed (for further details please see Section 4.7). 4. Additional staffing is being put in place within the CDS Risk Management Department and the department is being reorganized to better respond to the changing and everincreasing demands of risk management in the clearing, settlement and depository environment. 2 CDS Risk Management Principles CDS bases its risk management practices on a number of core principles which give weight to avoiding risks and limiting potential losses due to risks. These principles are: CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 3 1. Identify the risks associated with the clearing and settlement process and the parties responsible for the potential losses that those risks might create. 2. Measure the identified risks. • Use industry standard risk measurement understandable and comprehensive. techniques that are accurate, 3. Design and implement controls to address the risks that: • Provide an adequate and known level of coverage against losses for system Participants while maintaining the efficiency and competitiveness of the Canadian securities markets. Require Participants to bear responsibility for the risks that they bring to the system. Contain losses within individual settlement services and Participant Collateral Pool/Credit Rings to eliminate the potential for risk “spill-over”. • • 4. Meet internationally recognized minimum standards for securities settlement systems5, including: • • • • Having a well-founded, clear and transparent legal basis in the relevant jurisdictions. Rigorously controlling the risks when assuming the role of central counterparty. Eliminating principal risk by linking securities transfers to funds transfers in a way that achieves Delivery Versus Payment (DVP) (See Section 3.1). Using a combination of collateral requirements and limits, ensure timely settlement in the event of the default of any Participant up to and including the Participant with the largest payment obligation. Establishing minimum standards for participation that also permit fair and open access. Providing market Participants with sufficient information for them to identify and accurately evaluate the risks and costs associated with using CDS services. • • This paper describes how these risk management principles are implemented in CDS’ settlement services within CDSX. 3 Definition and Sources of Financial Risk in Securities Settlement Securities settlement systems are subject to the risk of significant potential loss. Settlement risk is the risk of financial loss in the event of the failure of a Participant to fulfill its settlement obligations. There are two sources of risk associated with the default of a Participant. The first of these sources is the principal or payment risk which is the risk that a seller will deliver securities and not receive payment or that a buyer will make payment and not receive the purchased securities. The other source of risk is the replacement cost risk which is the risk of The list of the relevant minimum standards is summarized from the Bank for International Settlements and the International Organization of Securities Commission’s Recommendations for Securities Settlement Systems, November 2001. 5 CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 4 loss resulting from the change in value of unsettled trades from the original trade price6 to the price at which replacement trades are executed. 3.1 Payment Risk Payment risk exists during the period of time where a seller has delivered securities for which they have not received payment or when a buyer makes payment and has not yet received the purchased securities. Payment risk is eliminated through the use of a delivery versus payment (DVP) mechanism whereby the funds payment and security transfer of a trade are linked. While the DVP mechanism may eliminate payment risk, depending on the specific means of achieving DVP, credit risks of the same magnitude as payment risk may be created. For example, the transfer of securities and funds to settle a trade may result in a negative balance in the buyer’s funds account. While DVP has been achieved, the negative funds balance in the buyer’s account represents a credit risk equal to the original payment risk. The party that is supporting the negative funds balance in the buyer’s account is exposed to this credit risk. 3.2 Replacement Cost Risk Replacement cost risk exists in all trades processed by CDS regardless of service, security type or nature and timing of trade guarantee. This is because there is some amount of time between the moment that the trade is executed between two counterparties and the time that the trade is ultimately settled. During this period of time, there is a chance that one of the two counterparties (or perhaps one of the CDS Participants representing one of the two counterparties) will default. If this default occurs, the surviving counterparty to the trade, upon recognizing the default, will need to execute a trade to replace the original trade with the defaulting Participant. The price at which the surviving counterparty executes the replacement trade may be higher or lower than the original price. The difference between the original trade value and the replacement trade value can result in either a gain or loss for the surviving counterparty. 4 Risk Controls CDS has developed the following controls to mitigate payment and replacement cost risks in its settlement services. 4.1 Membership Standards CDS has established minimum standards for eligibility as a Participant in its settlement services and also requires Participants to be subject to regulation and to be a member in good standing of an industry Self Regulatory Organization, if applicable. These minimum standards vary depending upon the type of Participant and the service(s) in which the Participant operates. The membership standards are described in CDS’ Participant Agreement and Service Rules and are summarized below. CDS requires that all Participants be able to demonstrate that they meet basic standards, including the financial ability to meet their obligations to CDS and that they have in place sufficient personnel and capabilities. Participants are classified into one of the following categories: In the situation where a trade is marked to market and the mark has been paid, the replacement cost risk is the difference between the “mark” price and the replacement price. 6 CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 5 1. Regulated Financial Institution: a Participant that is created and regulated under Canadian laws and is a Financial Institution, a broker or dealer trading in securities, an insurance company or a securities clearing corporation or depository. The Participant must be in compliance with all applicable regulatory requirements including minimum capital requirements and financial stability standards. 2. Foreign Institution: a Participant that is created or regulated under laws other than Canada including brokers or dealers trading in securities, banks or savings banks, loan companies or corporations, insurance companies, securities clearing corporations or depositories, central banks or any other body trading in securities. The Participant must be in compliance with any applicable regulatory requirements including minimum capital requirements and financial stability standards. In addition, the Participant must have minimum capital of $1,000,000 and provide CDS with a letter of credit or guarantee from a Regulated Financial Institution that is a CDS Participant. 3. Government Body: The government of Canada or the government of any province or territory of Canada or any municipality in Canada, or any of their agencies. 4. Bank of Canada: The central bank of Canada. As is evident from the above, CDS bases its minimum standards on the minimum standards that have been put in place by the regulatory bodies that are responsible for oversight of the various Participant groups. CDS does not propose to develop independent minimum standards for entry into the various services that it offers to its Participants. Although it will continue to be CDS’ policy to leverage off the compliance work executed by its Participants’ regulators7, CDS accepts the proposition that it needs to strengthen its credit risk management capabilities. To this end, CDS will hire a credit risk manager to be in charge of the credit assessment of new Participant applications and the continual monitoring of Participant credit worthiness through liaisons with the various regulatory authorities. Participants are further classified into one of the following groups carried forward from DCS, some of which have additional membership standards. 1. Extender of Credit: A Participant that is a Financial Institution, is a direct clearer or group clearer member of the Canadian Payments Association, has capital of not less than $1 billion and is a direct participant in LVTS. 2. Federated Participant: A Participant that is a Financial Institution, is a group clearer (“Active Federated Participant”) or is an indirect clearer member of the Canadian Payments Association and is a member of the group for which the Active Federated Participant acts as the group clearer or has appointed the Active Federated Participant as its clearing agent, has capital of not less than $1 billion when aggregated with other members of the group described previously and is a direct participant in LVTS (if it is the Active Federated Participant). 3. Settlement Agent: A Participant that is a Financial Institution, is a direct clearer or group clearer member of the Canadian Payments Association or is an indirect clearer member and has a clearing account with a direct clearer or a group clearer member and has capital of not less than $100 million. 4. Bank of Canada. 7 CDS will continue to work to strengthen the MOUs that it has in place with the various regulatory bodies. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 6 5. Receiver of Credit: A Participant that is not classified into one of the previous categories. 4.2 Trade Settlement in CDSX CDS offers two types of trade settlement, trade-for-trade settlement and Central Counterparty (CCP) settlement. Trade-for-trade settlement (TFT) is offered for debt and equities and provides no risk protection or guarantee prior to settlement. During the actual settlement of TFT trades, the potential credit exposure arising from the settlement is compared to the maximum allowed exposure and the collateral to cover that exposure. This process is described below. Prior to settlement, each of the original counterparties to each TFT trade is exposed to risk resulting from the default of the counterparty. CCP settlement is offered through the following CDS settlement services: (i) CNS (ii) DetNet (iii) ACCESS. In these services, CDS substitutes itself as the counterparty for each trade through a netting and novation process. CDSX will have three distinct trade settlement processes: (i) CNS/Batch Net Settlement (CNS/BNS) (ii) Real Time Trade for Trade Settlement (TFT); and (iii) Intraday CNS Settlement. Trades in CNS are settled in either the CNS/BNS process or the intraday CNS process. TFT trades are settled in either the CNS/BNS process or the TFT process. A trade is considered “available for settlement” if it has reached value date and is confirmed. Trades that are available for settlement by the time the CNS/BNS process is initiated (e.g. at approximately 4:00 a.m. EST) will be processed through the batch CNS/BNS. Trades and CNS Outstandings that do not settle in the CNS/BNS process and trades that become available for settlement after the CNS/BNS process started, will be processed through the Real Time TFT and the Intra-day CNS Settlement processes. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 7 Figure 2 – Settlement Process Flowchart CNS / BNS Process: 4:00am New CNS trades New TFT Trades Net and Mark CNS/BNS Perform risk edits Fail CNS outstanding / BNS pending trades Pass Settle CNS outstanding Real Time TFT Process (7am-8pm) BNS pending trades Newly confirmed trades "Available" trades and positions Perform risk edits Fail Pass Settle Payment exchange Triggers (increase in funds or securities) Intraday CNS Process New CNS trades CNS outstanding Fail Pass Settle Mark Net and Mark Perform risk edits 4.2.1 CNS/BNS Settlement Process The CNS/BNS process will be run once per day in the early morning (e.g. at approximately 4:00 a.m. EST) and is designed to increase netting efficiency by combining the settlement of CNS trades and TFT transactions. The CNS part of the process addresses the CNS trades while the BNS part of the process addresses the TFT transactions. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 8 The goal of the combined process is to allow CNS and TFT activity to net against each other and to reduce a Participant’s requirements for security positions, funds/cap/credit and collateral while still satisfying the appropriate risk controls. The CNS process allows CNS Participants to “fail” to settle some or all of a net amount of CNS trades. For example, if a Participant sold 100 shares of security A and bought 80 shares of security A, the Participant would have a net CNS-to-deliver for 20 shares of security A. If the Participant did not have the 20 shares to complete the net delivery to CDS, the CNS process would create a “CNS Outstanding-to-Deliver” for 20 shares. This CNS Outstanding for 20 shares would be carried forward into the next CNS settlement and/or CNS netting process, which may not occur until the next business day. The combined CNS/BNS uses the following steps: 1. The system will extract all of the eligible trades that are targeted to settle CNS as well as all of the eligible trades that are targeted to settle Trade-for-Trade (Batch Net Settlement). 2. The system will calculate a "Mark-to-Market" (see Mark to Market section 4.4.1) payment for each CNS outstanding and for each CNS trade. Once the individual marks have been calculated, the "price" on each CNS trade and CNS Outstanding position will be changed to the latest available price (i.e. usually the previous day’s closing price). Each Participant’s net mark-to-market payment will be entered into the Participant’s Funds Account. 3. For each Participant, for each account, for each security, the system will calculate a "provisional" net security position by adding together new CNS trades, previous CNS Outstandings, new BNS trades, and the Participant’s ledger position in the security. 4. The system will also net together all of the funds amounts from the CNS activity and the BNS trades to arrive at a “provisional” net Funds position. 5. The system will find all of the negative provisional security positions and "exclude" (remove) transactions to eliminate the “provisionally” negative position. First, the system will create a CNS outstanding position up to a maximum of the net of the starting CNS Outstanding and the new trades. If necessary, the system will next exclude Trade-forTrade transactions until the provisional negative position is eliminated. 6. The system will perform the same "exclusion" routine for any funds position that does not fall within the Participants' cap/credit or collateral limits (see Section 4.3). 7. Once the system has completed all of the exclusions necessary to remove any negative provisional security positions and all funds accounts are within the Participant’s cap/credit and collateral (ACV) limits, the system will mark all of the CNS trades as settled, mark the non-excluded BNS trades as settled and mark the excluded BNS trades as pending. 8. All of the pending BNS trades will be re-considered for settlement in the real time, Tradefor-Trade settlement process. All of the CNS Outstandings will be re-considered for settlement in the Intra-day, CNS Settlement process. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 4.2.2 Real Time TFT Settlement 9 The Real Time TFT process will run continuously from approximately 12:30 a.m. EST to about 4:00 a.m. EST, when it stops while the CNS/BNS process executes. The TFT process runs again from approximately 7:00 a.m. EST through to 4:00 p.m. EST when settlement stops briefly to calculate each Participant’s final net payment obligation to or from CDS for Payment Exchange. Once the calculations are completed, settlement starts again and runs through to 8:00 p.m. EST, during which period only security positions can be settled. Any trade in any security will be eligible for TFT. When both parties to a transaction have agreed to the details and the transaction is available for settlement, the TFT process will attempt to settle the transaction. If the transaction passes all of the risk edits described in section 4.3.2, the TFT process will settle the transaction. If any of the risk edits cannot be satisfied, CDSX will put the transaction into a “pending” status and reattempt settlement later when a change occurs to the Participant’s funds, securities or collateral positions. 4.2.3 Certificated Based Settlement (CBS) CDSX no longer contains a Certificated Based Settlement (CBS) process. This feature was removed as a pre-condition to the implementation of the CDSX software. 4.2.4 “Free Deliveries” CDSX allows Participants to execute “free deliveries” of securities. CDSX does not allow Participants to execute “free deliveries” of funds8. A free delivery of securities is simply a trade with a Net Amount of zero. A free delivery of funds is simply a trade type with a quantity of zero or a Funds Transfer. Free deliveries of securities and funds9 are subject to all of the usual CDSX risk edits, including the Funds Edit and the ACV Edit. As part of the implementation of the CDSX software, CDS implemented a surveillance report detailing those settlements that are taking place at “inappropriate” values. CDS acts upon the incidence of any such settlements in accordance with the procedures that have been reviewed and approved by the SDRC Risk Sub-committee. During the Transition Period, there will be further discussion on limiting the “free delivery” of securities as well as revisiting the restrictions on the “free delivery” of funds. 4.2.5 Intra-day CNS Settlement The Intra-day CNS settlement process will be run at scheduled times during the business day. Only CNS Outstandings, left over from the early morning CNS/BNS process, are eligible for settlement by the Intra-day CNS Settlement process. Changes to a Participant’s ledger positions could occur between the time that the early morning CNS/BNS is completed and when the Intra-day CNS Settlement process is executed. For example, a Participant could move securities from a Segregated Account to a General Account. The Intra-day CNS Settlement process compares a Participant’s current ledger positions (both securities and funds) with their CNS Outstandings and, where possible, settles the CNS Outstandings either fully or partially. 8 “Free deliveries” of funds transactions are allowed from certain sources (e.g., ATON, NCS, Exchanges) but not directly as non-exchange trades entered by Participants. 9 To the extent that free deliveries of funds are allowed. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 10 All of the usual risk edits (Funds and ACV Edits) are applied during the Intra-day CNS Settlement process. CDSX also has the capability of running an Intra-day CNS Netting Process. This may be used if new CNS-eligible trades are input to the system during the business day, or if CDS wants to remark the CNS Outstandings during the business day using new or updated prices. Intra-day CNS settlement will occur each business day. However, the Intra-day CNS netting process (and its associated re-marking of CNS Outstandings with updated prices) will not normally be used each business day. The Intra-day CNS netting process will be executed only when necessary, such as when there have been significant changes to market prices. 4.2.6 Payment Exchange The CNS/BNS Settlement, TFT Settlement and Intraday CNS Settlement processes will generate entries to the Participant’s funds account that can result in negative funds account balances10 (the process of limiting the maximum size of these negative funds account balances is described in section 4.3.2). The payment exchange process ensures that these negative funds balances are satisfied at the end of each business day. CDSX will have one Payment Exchange each day for each currency (CAD and USD). For CAD, at approximately 4:00 p.m. EST each day, CDSX will stop the TFT process and finalize the funds positions of each Participant. Shortly after the funds positions have been finalized, the TFT process will be available again for securities only (no funds movements will be allowed). USD payment exchange timing will be determined based on the timing of payment exchange at DTCC. Participants will have their payment obligations (negative or positive) rolled up to their Designated Banker. Designated bankers will pay CDS and receive payment from CDS using the Large Value Transfer System (LVTS). For Receivers of Credit who have drawn on their line of credit, the amount for which a line of credit is drawn is automatically rolled up to the Extender of Credit. Any positive funds balances are rolled up to the Designated Banker identified for the Receiver’s ledger, and any negative funds supported by a cap will be rolled up to the Designated Banker. Payment exchange obligations in CAD are paid using LVTS and for USD using FedWire. 4.3 Payment Risk Controls CDS achieves Delivery versus Payment (DVP) by linking securities transfers in Participants’ ledgers with transfers in Participants’ CDS funds accounts. These security and funds transfers are final and irrevocable, and therefore settlement of trades and CNS Outstandings has occurred when these security and funds transfers are entered in the Participant’s accounts in CDSX. During the course of trade settlement processing, funds transfers may result in a negative funds balance in a given Participant’s funds account. Payment of Funds Balances is completed at the end-of-day via Payment Exchange when Participants are required to provide payment to cover any negative funds balance. In essence, the principal risk eliminated in the DVP process has been transformed into credit risk exposure represented by the negative funds balance. CDSX addresses this credit risk by ensuring that these negative funds balances are 10 CDSX can create negative funds balances through a number of other processes including entitlement adjustments, funds transfers, funds ledger adjustments, mark-to-market payments, and pledges. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 11 collateralized at all points of time11. CDSX also applies a limit on the size of these collateralized credit risk exposures. This process is described below. 4.3.1 Extenders of Credit (including Federated Participants and Settlement Agents) and Receivers of Credit In the current CDSX, the Participants are categorized as either Extenders of Credit, Settlement Agents, Federated Participants (i.e. the Caisse Centrale) or Receivers of Credit. The “credit granters” (i.e. the Extenders and Federated Participant) may grant credit to other CDSX Participants. Credit granters are responsible for assuming the credit risk exposures represented by the drawn lines of credit used to support the negative funds balances described above. Credit granters are responsible for both the negative funds balances in their own funds accounts as well the lines of credit drawn for those Participants to which they have extended credit. Credit granters are only obligated to cover the negative funds balances of their credit receivers up to the amount of the line of credit that is actually drawn. 4.3.2 CDSX Payment Risk Edits The payment risk edits in CDSX are applied to all transactions settled at CDS including both CCP net positions (such as CNS, ACCESS and DetNet trades) and trade-for-trade transactions. As described previously, transactions can settle through the CNS/BNS, TFT or Intraday CNS settlement process. In TFT settlement, the payment risk edits are applied to each individual trade. In CNS/BNS and Intraday CNS, payment edits are applied to the projected net amounts from a group of trades and positions. Although the risk edits for CNS/BNS settlements are performed on these projected net amounts, the actual settlement of each TFT transaction occurs individually, but simultaneously, at the end of the batch process. In order for a trade to settle, the following payment risk edits are applied to all CAD transactions: 1. The seller must have sufficient securities in their securities account to complete the delivery, or a portion of the delivery in CNS (known as “partials”). 2. The buyer must have sufficient available funds, unused cap (see the next section for a definition of “cap”) and/or unused lines of credit to cover their funds obligation after the settlement (the “Funds Edit”). 3. The buyer and the seller must have sufficient Aggregate Collateral Value (“ACV”) after the settlement to cover the resulting funds obligation (the “ACV Edit”) 12. In CDSX, lines of credit and ACV are denominated in CAD only. As a result, settlement of USD transactions is subject to the following payment risk edit process (the details of the USD risk controls are provided in section 4.5): With the exception of negative funds balances due to entitlement adjustments, ledger adjustments and mark-to-market payments. The risk from these negative funds balances is addressed by the Collateral Pool/Credit Rings of which the defaulter is a member. Participants that choose not to join one of the Collateral Pool/Credit Rings will be required to be a member of another uncollateralized credit ring established for this purpose. 12 ACV is denominated only in Canadian dollars and is used to ensure adequate collateralization of a CAD debit funds position. Not all securities contribute towards a Participant’s ACV. For example, securities issued by a Participant do not count as ACV for that Participant. 11 CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 12 1. The seller must have sufficient securities in their securities account to complete the delivery. 2. The buyer must have sufficient available USD funds or unused USD cap to cover their funds obligation after the settlement. 3. The seller must have sufficient ACV after settlement to continue to be able to collateralize its CAD obligation. Participants have requested CDS to reconsider the payment risk edit process for settlements denominated in USD. Participants would like to see: • ACV equivalency being granted to a positive balance in the USD funds account. • The ability to have a USD line of credit in the system rather than only being able to have a cap based on a survivor pay pooling arrangement. • The ability for CDS to grant ACV for positions that are being held by Participants at DTCC in their respective New York Link accounts. CDS agrees that these changes would be valuable additions to CDSX functionality. At the present time, these changes have not been factored into the proposed 12-month Transition work plan prepared by CDS and shown in this paper. However, there will be opportunity through the approval process for this work plan to revisit the assumption made by CDS that it will not be possible to address these issues until after the Transition Period. If all of these edits are satisfied, CDSX settles the trade by: 1. Subtracting the securities from the seller’s account and adding them to the buyer’s account. 2. Subtracting the funds from the buyer’s account and adding them to the seller’s account. 3. Updating both the buyer’s and the seller’s ACV. There has been concern expressed by Participants that, during the initial conversion of equities to the CDSX system, “gridlock” may occur in the settlement process as a result of these edits. CDS has undertaken to identify contingencies that can put in place to identify and resolve any gridlock situations that may occur. These contingencies will be documented and approved by the SDRC Risk Sub-committee prior to implementation. 4.3.2.1 The Funds Edit All Participants’ Funds Accounts have a limit on the size of negative funds balances (essentially a limit on the maximum amount that the Participant can owe at payment exchange). The size of this limit is based on two factors: 1. Caps: A cap is an amount assigned to a Participant pursuant to a formula in the Rules and Procedures. Some Participants are assigned a cap of zero. Only Participants that are members of a CDSX collateral pool/credit ring receive a cap. The amount of the cap is determined by the rules and formulae of the Participants’ collateral pool/credit ring as explained below. Extenders of Credit, Settlement Agents and the Federated Participants must be members of their respective collateral pool/credit rings. Receivers of Credit receive cap when they are members of the Receivers’ Collateral Pool/Credit Ring (RCP). CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 13 2. Lines of Credit: In CDSX, credit granters grant lines of credit to other Participants. Participants may receive multiple lines of credit from multiple credit granters, although this is not typically the case. Some Participants may have both a cap and a line of credit. In this case, the effective limit on the Participant’s negative funds balance is the sum of the cap and the line of credit. The system will always use up a Participant’s cap before drawing on a line of credit. The limit on each Participant’s negative funds balance meets CDS’ risk management principle of limiting the potential exposure created by a Participant. When the system performs the Funds Edit on the buyer in a trade, it will calculate the buyer’s projected funds account balance by subtracting the net settlement amount of the trade from the buyer’s current funds account balance. If this projected balance is positive or zero, the Funds Edit is satisfied. If the projected funds account balance is negative, the Funds Edit will compare this projected negative amount to the Participant’s limit (i.e. the sum of the Participant’s cap and lines of credit). If the projected balance is within the limit, then the Funds Edit is satisfied. If the projected balance is not within the limit the trade will not be settled (the trade would be placed in a pending state and settlement would be re-attempted later). 4.3.2.2 ACV Edit The ACV Edit ensures that a negative CAD funds balance in a Participant’s CAD funds account is collateralized. ACV is a calculated value of the collateral that could be realized if the Participant failed to pay their payment obligation. CDSX maintains a current ACV balance for each Participant. A Participant’s current ACV is the sum of an “Initial ACV” and the “haircut” value of the securities in the Participant’s “risk” accounts (essentially the Participant’s general and restricted collateral accounts). The current ACV fluctuates as securities are moved into or out of a Participant’s risk accounts. 1. Initial ACV: Initial ACV is an amount of ACV assigned to the Participant. Participants that are members of a CDSX collateral pool/credit ring receive initial ACV automatically. The amount of initial ACV is determined by the size and rules of the Participant’s collateral pool/credit ring as described below. To facilitate the implementation of the CDSX software and the application of the ACV edit to Participants who had previously been exempt from this edit, the Credit Extenders agreed to provide 10% initial ACV to their respective Receivers. The 10% initial ACV is calculated based on a Receiver’s established lines of credit from the Receiver’s primary granter of credit. This provision of 10% initial ACV is to be progressively eliminated as equities are made eligible for processing in CDSX. 2. Risk Accounts / Haircut Value: If a Participant fails to pay an amount owed to CDS then CDS may invoke its Default Rules and Procedures. These procedures allow CDS to take certain securities as collateral from the defaulting Participant. CDS is entitled to take all of the securities in the defaulting Participant’s “risk” accounts. CDSX constantly maintains an ACV value of these securities. In calculating this value, CDSX takes the latest market value (using the previous day’s closing price or the most recent closing price if the previous day’s closing price is not available) of the securities and deducts a margin or “haircut” to arrive at the ACV value assigned to the securities in the Participant’s risk accounts. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 14 CDSX performs an ACV edit on both the buyer and seller for all transactions that involve ledger changes. For the buyer, the system first calculates the buyer’s projected funds balance. If the buyer’s projected funds balance is zero or positive, the buyer’s ACV edit is automatically satisfied since there is no negative funds balance to collateralize. If the projected funds balance is negative, CDSX then calculates the buyer’s projected ACV by adding the ACV value of the securities being purchased to the buyer’s current ACV. If the projected ACV is greater than or equal to the buyer’s projected negative funds balance, then the ACV edit is satisfied. If the buyer’s projected ACV is less than the buyer’s projected negative funds balance, then the buyer’s ACV edit is not satisfied and the trade would not be settled (the trade would be placed in a pending state and settlement would be re-attempted later). For the seller, CDSX first calculates the seller’s projected funds balance (the current funds account balance plus the net settlement amount from the trade). If the seller’s projected funds balance is zero or positive, the seller’s ACV edit is satisfied. If the seller’s projected funds balance is negative, the system then calculates the seller’s projected ACV by subtracting the ACV value of the securities being sold from the seller’s current ACV. If the seller’s projected ACV is greater than or equal to the seller’s projected negative funds balance, then the seller’s ACV edit is satisfied. If the seller’s projected ACV is less than the seller’s projected negative funds balance, then the seller’s ACV edit is not satisfied and the trade would not be settled. Some transactions are not subject to the ACV edit. For example, a Participant selling securities directly out of one of its non-risk accounts (e.g. a Segregated Account) would not be subject to the ACV edit. However, the buying Participant would still have to satisfy the ACV edit for its side of the transaction. 4.3.2.3 Haircut Rates on Securities Used to Calculate Current ACV The purpose of applying haircuts to securities in a Participant’s risk account to determine current ACV is to ensure that the value of securities in these risk accounts will be at least as large as the negative funds balance they are intended to cover. The haircut represents the amount that the securities could decline in value from the time of default to the time that the collateral securities are liquidated. Therefore, the size of the haircut depends on the “riskiness” of the securities. For equities, CDS will use a Value-at-Risk13 (VaR) based margining methodology similar to the methodology used to measure this risk in the CNS and ACCESS Participant Funds described below. This methodology takes into account the “riskiness” of the security as well as the impact of market liquidity over the potential liquidation period. Securities issued by the Participant themselves or their subsidiaries are given no value for ACV purposes in their own ledgers. Specific equity haircut rates as calculated by the CDSX VaR model are available upon request from CDS. Each of the security-specific haircut rates used for ACV purposes for equities will be backtested on a weekly basis for each of the days in the previous week. CDS will apply the same backtesting methodology as recommended by the BIS for the purposes of backtesting VaR models of banks to measure market risk in their trading portfolios14. This methodology attributes VaR is an industry-standard measure of market risk that quantifies the maximum loss that a given position would sustain with a given confidence level over a set period of time. For example, VaR could be calculated based on a 99% confidence level over a 1-day holding period. This means that the VaR measure would account for 99% of 1-day changes in value of this position. In other words, we would expect that daily losses would exceed the VaR measure 1 day out of 100. 14 Bank for International Settlements, Supervisory framework for the use of “back-testing” in conjunction with the internal models approach to market risk capital requirements, (January 1996) 13 CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 15 either a green, yellow or red zone to each calculation meaning that the calculated haircut rate is covering the risk sufficiently (the green zone) or there may be concerns about the degree of risk coverage (the yellow and red zones). Based on the results of the backtesting, individual security haircut rates will be adjusted as required. Since the use of VaR for calculating haircut rates for equities is very dependent on price data, Version 3 of the risk model introduced a number of edits into the haircut calculation process which examined the price history. If the price history was less than the full 261-day price history required by the calculation, then a minimum haircut rate of 15% was applied. If there were any periods of 10 consecutive days within the price history with no price change, a default rate of 100% was applied. As a result of discussions with Participants, this edit will be revised for the commencement of the Transition Period. A temporary adjustment of the 10-day “static price” period to 20 days and a reduction of the default haircut rate from 100% to 75% is proposed for implementation, followed by a more thorough review and development of a robust approach that will take into account whether there are periods of no trading activity. Final agreement is required from the Bank of Canada on this proposal. At the present time, the Bank continues to express concern over the default haircut rate of 75% where there is “static price” data for more than 20 days. The final price history edit in Version 3 required that, if the price history was less than 20 days, a default rate of 100% would be applied, subject to consideration of relevant factors for new issues. CDS and Participants have begun discussions on refinements to this price history edit for new issues. Although further discussions and analysis are required, it has been proposed that a standard haircut rate in the range of 15% to 25% be used for most new equity issues. CDS will monitor new issues of securities and will change the standard haircut rate as necessary to reflect any material deviation in pricing behaviour from the standard haircut rate. Procedures will be developed to define when the standard haircut rate will apply and when CDS may use its discretion to adjust the haircut rate (e.g. possibly by using the haircuts from an issuer’s existing issues as the basis for a new issue’s starting haircut value). Currently, the haircut rates for fixed income instruments are derived from a table that is maintained within CDSX. The haircut rates for fixed income instruments are based upon the Issuer, rating of the security and the length of time to maturity. A haircut rate of 100% is given to all corporate debt with a rating of less than A. In the lead-up to the implementation of the CDSX software, the issue of having a haircut rate of less than 100% for BBB bonds, public sector entities and unrated municipal bonds became a major issue. At the insistence of several Receivers and the CVMQ, CDS agreed that it would lead an initiative to determine the viability of providing ACV value in the system for these debt instruments. Of the categories of corporate debt for which a 100% haircut rate is currently assigned for the purpose of providing ACV within CDSX, it is proposed that only BBB-rated debt should be given a haircut rate below 100%. Given that BBB-rated debt represents investment grade but that the category includes a wide range of trading activity and price information, debt rated below BBB would continue to receive a haircut rate of 100%. It is proposed that further analysis be conducted in the months following equities conversion to refine the assessment of the default and liquidity risks associated with BBB debt as it relates to higher-rated debt. At that point, further consideration can be given as to whether any revisions should be made to any of the debt haircut rates. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 16 Debt issued by public sector entities, such as hospitals, universities and school boards, typically receive provincial government support through grants and a guarantee of the financing corporations that support the financing of the PSEs’ obligations, subject to renewal in the annual provincial budget. Based on the level of government support but given the absence of an explicit government guarantee for the full term of the debt, CDS is proposing to apply haircut rates in a range of 15% - 20%, subject to confirmation of the support arrangements by the main provinces. There continues to be major disagreement on what constitutes an appropriate haircut rate for these types of securities. The Bank of Canada continues to believe that a 100% haircut is the appropriate level whereas a number of participants believe that the proposed 1520% haircut level is excessively high. Discussions between the various involved parties will need to continue in order to resolve the disagreement and arrive at a mutually acceptable position. Debt issued by municipalities that are rated by a recognized rating agency receives haircuts equivalent to corporate debt. CDS does not propose to change this approach until such time as it may use a VaR model to determine the haircuts for debt similar to the approach used for equities15. Currently, debt issued by unrated municipalities is treated as other unrated debt and assigned haircuts of 100%. Based on the analysis to date, it is proposed that unrated munis receive haircut rates as shown in the table below. This proposal is based on a number of factors that help to reduce the probability of default, such as municipalities’ power to raise revenue through taxation, provincial government financial support and constraints to support effective fiscal management. Also, preliminary analysis of market experience and practice has provided guidance on the extent to which these instruments are subject to liquidity risk. Similar to the issues surrounding an appropriate haircut rate for debt issued by public sector entities, there continues to be major disagreement on what constitutes an appropriate haircut rate for unrated municipal debt. Discussions to resolve these issues are on-going. The proposed haircut rates for the three categories of debt just described are provided in the following table16. Current and Proposed Debt Haircut Rates Term to Maturity (Years) Issuer Type 0 to 1 1 to 3 3 to 5 5 to 10 1.0% 1.0% 1.5% 2.0% Government of Canada 1.5% 2.0% 2.5% 3.0% Federal Guaranteed 2.0% 3.0% 3.5% 4.0% Provincial 3.0% 4.0% 4.5% 5.0% Provincial Guaranteed 4.0% 5.0% 5.5% Corporate AAA 7.5% 8.5% 9.0% Corporate AA 12.0% 13.0% 13.5% Corporate A 15.0% 16.0% 17.0% 18.5% Public Sector Entities/ Government Grants (proposed) 20.0% 21.0% 22.0% 23.5% Unrated Munis (proposed) 15 >10 2.5% 3.5% 4.5% 5.5% 6.0% 10.0% 15.0% 20.0% 25.0% The application of a VaR methodology to the calculation of debt haircuts is not included in the work plan for the 12-month Transition Period. As in the case of the issues surrounding ACV and USD, CDS’ assumptions on the exclusions from the work plan can be revisited during the work plan confirmation process. 16 Please refer to previous comments concerning the disagreements over the proposed haircut rates for PSEs/Government Grants and for Unrated Munis. Further discussions are required to finalize these haircut rates. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 Current and Proposed Debt Haircut Rates Term to Maturity (Years) 0 to 1 1 to 3 3 to 5 5 to 10 30.0% 32.0% 33.0% 100.0% 100.0% 100.0% 17 Issuer Type Corporate BBB Corporate BB Corporate B Corporate C >10 35.0% The Bank of Canada has indicated that, because of systemic risk concerns, it has reservations about allowing the Extenders and their family members to generate unlimited ACV for equities or for any debt instruments rated below A. The Bank has also indicated that there may need to be a distinction made between the equities that can be granted ACV in the system for Extenders and their family members versus what can be granted to non-affiliated Receivers. Essentially, the Bank is suggesting that the Extenders and their family members would only receive ACV in the system for those equities issued by companies with a rating of BBB or higher. CDSX is not currently able to make this distinction when granting ACV for equities. The system changes required to make this distinction are not currently included in the work plan for the 12-month Transition Period. The Bank has indicated that it does not have an issue with the absence of limits on ACV for non-affiliated Receivers for these securities given the lack of systemic risk concerns should one of the non-affiliated Receivers default. In order to make the distinction between affiliated and non-affiliated Receivers of Credit when granting ACV from the various forms of high yield types of securities, the ACV generated from high yield types of securities needs to be segregated from other higher grade securities through the introduction of sector limits specifically for each of these types of high yield debt. CDS has indicated that the system changes to accommodate sector limits for high yield debt can be implemented in January 2004. Once the sector limits are available in the CDSX system, it is CDS’ intention to implement the haircut rates shown in the above table subject to the revisions that will take place for unrated municipal debt and public sector debt17. Until such time as CDS is able to make the distinction between affiliated and non-affiliated Receivers when granting ACV for high yield, public sector and unrated municipal debt and to allow more time to resolve the haircut issues for public sector and unrated municipal debt, CDS has proposed continuing with the 100% haircut rate for these types of security instruments. In order to ensure that there is sufficient ACV in the system to continue the settlement of trades in these types of securities CDS has also proposed that the 10% initial ACV proposal from the Extenders continue in effect until January 2004. The Extenders have not yet indicated their acceptance of this proposal. The Extenders have indicated that they need to review the ACV data provided by CDS before being in a position to decide on the continuation of the 10% initial ACV currently being provided to their respective Receivers. The non-affiliated Receivers have indicated that they need to analyze the ACV data that have been provided to them from CDS before being in a position to agree to the continuation of the 100% haircut values until January 2004 (i.e., when the new sector limits are in place and the revised haircut values can be implemented). The Receivers have also suggested that there may be interim solutions other than the continuation of the initial 10% ACV, if needed. 17 There would not appear to be any disagreement with the haircut rates that have been negotiated for BBB debt. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 4.3.2.4 Sector Limits for ACV Applied to “Family” Members 18 CDSX currently places limits on the amount of certain types of collateral that can count towards ACV. These “sector limits” are placed on the Extenders of Credit, Settlement Agents, the Federated Participants and their “family” members (i.e. subsidiaries). These limits are known as “Sector Limits” and apply to Private sector-issued securities (Private Sector Limit or “PSL”) and Non-federal government sector-issued securities (Government Sector Limit or “GSL”)18. Once a Participant has accumulated, within a given sector, a value of ACV collateral equal to the sector limit, the system stops accumulating ACV when further securities are acquired. For example, if a Participant had a PSL of $100, the system would stop counting, as ACV, the value of any other private sector security above $100 that was acquired by the Participant. There is no limit on the amount of ACV that can be made up of federal government securities. The sector limits ensure that a Participant’s ACV is not overly concentrated in a certain type of securities. For CDSX, an Equity Sector Limit, or “ESL”, is in place for the Extenders, Settlement Agents and Federated Participants. Additional sector limits will be added by January 2004. Receivers of Credit that are not members of a “family” of an Extender, Settlement Agent or Federated Participant, are not subject to Sector Limits, of any kind. 4.3.3 Initial ACV and Cap All Participants must have a settlement cap/line of credit and initial ACV or a positive funds balance in order to effect settlements in CDSX. Initial ACV and Cap is provided for all Participants that are members of a Credit Ring/Collateral Pool as described below. The securities residing in the Participant’s risk accounts will be valued, using the appropriate haircut, at the beginning of each business day and this value will be added to the starting ACV for the Participant. There is one amount of Initial ACV that is entered by CDS into the system for each Participant. There is one amount of Cap for each currency that is entered by CDS into the system for each Participant. 4.3.3.1 Initial ACV and Cap for Extenders of Credit, Settlement Agents and Federated Participants There are two groups of Participants who can extend credit in CDSX: Extenders of Credit and the Active Federated Participant (the Caisse Centrale). Each of these credit granting groups has a separate collateral pool/credit ring that creates initial ACV and a cap for each of its members. In some cases, a credit granter may allocate a portion of its initial ACV to a related Receiver of Credit known as a “family member” (i.e. a subsidiary). In addition there is a third CDSX collateral pool/credit ring called the Settlement Agents (these Participants are not permitted to grant credit in the system). An issue has been raised with CDS concerning the relevance of the GSL given the expansion of eligible collateral for LVTS that has taken place since the GSL was first introduced. Initial discussions with the Bank of Canada indicate a receptivity towards further discussions on the need for this sector limit. These discussions will continue during the 12-month Transition Period with the goal of reaching a decision co-incident with the expansion of collateral in the various participant funds (i.e., mid-way through the Transition Period). 18 CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 4.3.3.2 Initial ACV and Cap for Receivers of Credit The CDSX risk model applies the Funds Edit and ACV Edit to all Participants. 19 Prior to the implementation of the CDSX software, there was a concern if the non-affiliated Receivers: (a) Will have sufficient credit and/or cap to satisfy the Funds edit to execute their business. (b) Will have sufficient ACV to satisfy the ACV edit to execute their business. To facilitate the implementation of the CDSX software, the Extenders agreed to provide 10% initial ACV to their respective Receivers. The 10% initial ACV was calculated based on a Receiver’s established lines of credit from the Receiver’s primary granter of credit. Initially, the “10% initial ACV” proposal from the Extenders included a decrease in the provision of initial ACV by 2 ½% per quarter and the proposal was only applicable if there were no equities in the CDSX system. Since the initial 10% ACV proposal was tabled, the Extenders have agreed to retain the 10% ACV in the system during the Pilot conversion of equity securities. How the 10% will be reduced to zero once other equities are converted to CDSX is currently under discussion. CDS has proposed that the 10% be maintained in its totality until high yield and municipal debt can be given collateral value in the system (i.e., until January 2004) or an acceptable alternative arrangement for the provision of ACV can be implemented. The Extenders have not yet indicated their acceptance of this proposal. CDS has proposed the creation of an additional collateral pool/credit ring as an alternative means of addressing the issues of funds and ACV adequacy outlined above. This additional collateral pool/credit ring is referred to as the “Receiver’s Collateral Pool/Credit Ring” (RCP). There are a number of alternatives for the non-affiliated Receivers in terms of providing sufficient cap, credit and ACV: 1. Arrange for a line of credit with an Extender of Credit (or multiple lines of credit with multiple Extenders of Credit) and manage the securities in their risk accounts to ensure that sufficient ACV is available to cover their settlement requirements. In this case, a Participant would have a negative funds balance limit equal to their lines of credit and ACV equal to the haircut value of the securities in their risk accounts plus any initial ACV. Arranging a line of credit does not provide a means of providing initial ACV. However, Participants may leave securities in their risk accounts overnight which will generate initial ACV equal to the haircut value of those securities. 2. Participate in the Receivers’ Collateral Pool (RCP). Members of the RCP provide collateral to CDS that is pooled with other members’ individual contributions. Each individual contribution generates initial ACV and a cap based on the formula described in Section 4.3.4. Members of the RCP share risk with other members with the result that the default of one or more members of the RCP may result in losses to the surviving members once the defaulter’s contributions to the RCP have been exhausted. 3. A combination of alternatives 1 and 2. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 4.3.4 Design of the RCP 20 The design of the RCP has been based on the design of the three existing DCS collateral pools/credit rings (e.g. the Extender of Credit Collateral Pool/Credit Ring). The main features of the RCP may be summarized as follows: • Participation in the RCP will be mandatory during the Transition Period but voluntary thereafter, and will be open to any Receiver of Credit, including Receivers that are members of an existing CDSX “family”. Participants in the RCP will receive a Cap and Initial ACV from the RCP. Participation in the RCP will involve risk sharing with the other members of the RCP. Risk sharing is one of the means of reducing the cost of providing a cap and initial ACV to the members of the RCP. The RCP-generated Cap and ACV can be used to cover any type of settlement in CDSX (i.e. CNS settlement or Trade-for-Trade Settlement). The RCP-generated Cap will not be used to cover CNS mark-to-market payments or the risk on CNS outstanding positions (see the section 4.4.3 on the CNS Participant Fund). The RCP will be designed to cover the default of the single Participant with the largest RCP-generated cap. The RCP-generated cap and ACV that is assigned to each RCP member will be proportional to both the individual contribution of an RCP member as well as the aggregate size of the RCP Collateral Pool. • • • • • • Receivers of Credit that want to eliminate risk exposure to any other Participant would obtain a line of credit from a credit extender. Receivers that use only a line of credit and their own securities (as ACV) to address the Funds and ACV edits do not share risk with any other Participant. For Participants that want to lower their costs, and are willing to share some amount of risk with other Participants, the RCP will be an alternative means of addressing the Funds and ACV Edits. The RCP is not intended to address all of the cap/credit and ACV requirements of all Participants. For some Participants, the use of the RCP may provide them with sufficient cap/credit and ACV to execute all of their business. For other Participants, the use of the RCP may be in addition to a line of credit and their own securities (as a source of ACV). Some rare transactions (e.g. entitlement adjustments) can create a negative funds balance that exceeds the Participant’s cap/line of credit. The risk from these negative funds balances is addressed by the Collateral Pool/Credit Rings of which the defaulter is a member. Participants that choose not to join one of the Collateral Pool/Credit Rings will be required to be a member of another uncollateralized credit ring established for this purpose. The Extenders have recently proposed an alternative mechanism for providing adequate ACV into the system, referred to as the Receivers ACV Pool (RACVP). The proposed mechanism is similar to the concept of the Receivers Collateral Pool but with some significant differences: CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 21 Extenders’ Proposal (RACP) Participation would be mandatory for Receivers. The contribution to the pool would be the same for each Receiver and losses would be allocated equally amongst all Participants in the pool. Each Receiver would receive as Initial ACV an amount equal to 50% of the value of the pool. The absolute size of the pool should not need to exceed $50 million. CDSX would continue to calculate ACV as proposed if a Participant had drawn on a credit facility. In the event of a default, the Credit Extender would rely first on the securities acquired in the account to cover the outstanding balance. The Credit Extender would have a claim on the RACVP for any shortfall to the extent that the RACVP had been utilized to settle the transactions. Receivers’ Collateral Pool (RCP) Participation would be voluntary once the Transition Period was completed. Contribution to the pool is based on individual Participant need for cap and initial ACV. Losses are allocated according to the contribution to the pool. Each Receiver receives ACV equal to the Receiver’s contribution to the pool times a standard leverage factor. The size of the pool is dependent upon the total contributions to the pool as determined by the Participants. Caps and ACV provided through the RCP are drawn down before a line of credit from an Extender. If an RCP member defaults in making their dayend payment to CDS, the RCP will be responsible for paying the portion of the defaulter’s obligation that was covered by the RCP Cap. In the event of a default against a line of credit, the Credit Extender would rely first on the securities acquired in the account to cover the outstanding balance. If there was a surplus from the defaulter’s contribution to the RCP, this would also be made available to the Credit Extender. RCP operates in the same way as the proposal from the Credit Extenders. The RCP does not allow Participants to exit until quarterly revaluation points. Participants that join between quarterly revaluation points will inherit the leverage factor and limits that current exist. Any claim on the pool would require Participants to top up their contribution to maintain the pool for the survivors. The addition of new Receivers or the loss of a Receiver would require a change in the value of the individual contribution if the pool is to be maintained at a fixed amount. There would be no Cap or Credit attached to There is cap attached to the RCP. The cap is set this pool. equal to the Participant’s contribution to the RCP times the computed leverage factor for the pool. Although there are possible advantages to the Extenders’ proposal, there are also enough uncertainties in the proposal (e.g., the co-existence with an RCP, the haircut rates for BBB bonds and equities priced below $2 and the effect of significant contribution levels to small Participants) to preclude quick acceptance on the part of either CDS or the Receivers. Both CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 22 CDS and the Receivers have indicated a willingness to negotiate the Extenders’ proposal through the Transition Period. 4.3.4.1 RCP Liquidity Each member of the RCP will contribute collateral to the RCP. The collateral will be in the form of securities that are pledged to CDS. In time, CDS expects to accept any security that is eligible for use for advances at the Bank of Canada or within the LVTS payment system19. CDS will use the aggregate amount of collateral in the RCP to obtain a standby line of credit from one or more commercial liquidity providers (CDS does this today with the current SSS Participant funds). As a backstop to these liquidity arrangements, CDS has the ability, as a last resort, to obtain liquidity from the Bank of Canada. In the event of a default by an RCP member, CDS will convert the collateral in the RCP into funds in order that CDS could complete the payment of the defaulter’s payment obligation. The RCP would be responsible for only the portion of the defaulter’s obligation that was covered by the defaulter’s RCP-generated cap. No other CDS Participant (i.e. non-RCP members) would be responsible for any portion of a defaulter’s payment obligation that was covered by an RCP-generated cap. 4.3.4.2 Calculation of the RCP Caps and ACV Members of the RCP will receive a Cap and Initial ACV from their participation in the RCP. The Cap and Initial ACV assigned to each RCP member will be determined by the formula outlined below. That is, if the formula generates a cap for an RCP member of $10 million then that RCP member will also receive an Initial ACV of $10 million. The formula that determines an RCP member’s cap and initial ACV will be proportional to: • • The RCP-member’s individual collateral contribution to the RCP The aggregate amount of collateral contributed by all members to the RCP. The RCP has been designed to address the default of the RCP member with the single largest cap. This means that no member of the RCP would receive a cap larger than the total amount of collateral in the RCP (i.e. the RCP collateral alone would be sufficient to cover the largest cap). In contrast, the existing CDSX collateral pool/credit rings contain collateral that covers only a portion of the members’ largest caps. 19 For the CDSX participant funds, including the RCP, the forms of collateral that are currently eligible for the various participant funds in CDSX will remain as currently defined. At the midway point of the Transition Period (i.e., 6 months after all equities are transferred to CDSX) the eligibility criteria will be expanded. A number of operational and legal issues have been raised with respect to the expansion of eligible collateral for the various participant funds. The first six months of the Transition Period is deemed to be sufficient time to resolve these legal and operational issues. The Collateral Management System (CMS) built by CDS to facilitate the expansion in eligible collateral will be introduced into production prior to the expansion taking place. It should be noted that letters of credit and letters of undertaking are not acceptable as collateral in any of the CDSX participant funds. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 23 The difference in the cap and initial ACV formula for the RCP and, for example, the Extenders of Credit, reflects the different profiles (e.g. capital base) and capabilities (e.g. access to Bank of Canada lender-of-last resort facility) of the Extenders versus the potential RCP members. Each member’s RCP-generated cap and initial ACV will be calculated as follows: 1. CDS will determine the Maximum RCP Cap equal to the aggregate value of all RCP collateral. 2. CDS will determine the RCP leverage factor equal to the maximum RCP cap divided by the largest individual member’s collateral contribution. 3. Each member’s RCP-generated cap will be equal to the value of the member’s individual collateral contribution times the RCP Leverage Factor. 4. Each member’s RCP-generated initial ACV will be equal to their RCP-generated Cap. One of the impacts of the formula outlined above is that each member’s RCP-generated Cap and Initial ACV is dependent, to some extent, on the amount of collateral contributed to the RCP by the other members. For the creation of the CAD RCP, CDS originally proposed transferring all existing TFT Pool contributions of all Receivers of Credit in BBS/SSS. It has recently been determined that a more effective approach is to offer a conversion option to all members of the CAD RCP. Each Participant required to contribute to the CAD RCP can choose to transfer either 25% or 100% of its current required contribution to the BBS/SSS TFT Pool over to the CDSX CAD RCP. This tiered contribution level proposal maintains the agreed upon mandatory membership in the CAD RCP for all Receivers while allowing Receivers that would have elected not to be members of the RCP (if the CAD RCP were voluntary during the 12-month Transition Period) to reduce their exposure in the CAD RCP. Given the size of existing contributions to the TFT Pool from various Receivers of Credit, this proposal has the added benefit of a significant potential increase in the leverage factor. During the 12-month Transition Period, all of the Receivers of Credit will be members of the “Credit Ring for RCP Receivers making Canadian dollar Settlements” under the CDSX Rules. After the 12-month Transition Period, Receivers may choose to remain in the CAD RCP or withdraw from the CAD RCP and become members of the “Credit Ring for Non-Contributing Receivers making Canadian dollar Settlements”. The amount transferred from the TFT Pool to the CAD RCP for each Receiver of Credit will become the minimum contribution requirement that must be maintained during the 12-month Transition Period. Members of the CAD RCP may elect to provide more collateral than the minimum requirement in order to generate additional cap and initial ACV. CDS will allow additional contributions to the CAD RCP at regular intervals during the 12-month Transition Period and will recalculate the resulting leverage ratio. The following schedule for CAD RCP recalculations and collateral additions has been proposed20: • 20 Immediately prior to the conversion of 5,000 equities; Please note the section describing a participant’s ability to “top up” its contribution to the RCP to immediately obtain additional cap and ACV. The ability to “top up” could be used to handle “spikes” in settlement requirements. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 • • • 24 Immediately prior to the conversion of the remaining 35,000 equities; Monthly for the first three months following the conversion of the remaining 35,000 equities; Quarterly thereafter. The RCP provides an equal amount of initial ACV and cap to the Participants that are members of the RCP. The amount of initial ACV is determined by multiplying the Participant’s contribution to the RCP by a calculated leverage factor. Participants need to know if the RCP will provide sufficient ACV and cap to meet their increased settlement requirements in CDSX. Consequently, CDS has provided estimates of the amount of ACV and cap that Participants would have required to satisfy BBS/SSS settlement activity over a three-month period. CDS estimates that a USD RCP of USD 10 million will be sufficient to meet the vast majority of USD cap requirements for Receivers of Credit. However, CDS recognizes that there will be occasions when USD 10 million is not sufficient to satisfy the settlement requirements for certain participants and is actively exploring ways in which this limit can be quickly and cost effectively increased to deal with intra-day “spikes” that may occur in a Participant’s USD business. The USD RCP will operate during the Transition Period in the same manner as designed for the post-transition phase, that is, with voluntary membership of Receivers of Credit who require USD cap. The value of the required collateral contribution for each member will be based on each Participant's requirement for a USD cap, using the leverage ratio determined from the information already provided by CDS to all Participants. Any Receivers who choose not to join the USD RCP will be required to fund USD settlement requirements by maintaining a positive USD funds account balance. New USD collateral to support the USD RCP will be required. This represents a change from the original transition plan which contemplated ACCESS Participants using their USD collateral in the BBS/SSS ACCESS Participant Fund to fund the USD RCP in CDSX. The ongoing collateral requirements of the USD RCP will be reviewed and recalculated on the same schedule as the CAD RCP described above. 4.3.4.2.1 “Top-up” Contributions to an RCP An RCP member that would like a larger cap/initial ACV than the one the RCP formula generates for them may decide to “top-up” their collateral contribution. An RCP member that decides to “top-up” would be required to pledge collateral, “dollar-for-dollar”, to increase their cap/initial ACV. For example, if an RCP member requested an increase to their cap/initial ACV by $3 million, then the RCP member would have to pledge collateral to the RCP with a value (after haircuts were applied) of $3 million. These requests for top-up may be made at any time (i.e. RCP members do not need to wait for the quarterly re-calculations) and these top-ups may be used for temporary increases in cap/ACV. CDS’ liquidity arrangements for the RCP will take into account the potential for these top-up requests. 4.3.4.3 Impact of a Default on the RCP If an RCP member defaults in making their day-end payment to CDS, the RCP will be responsible for paying the portion of the defaulter’s obligation that was covered by the RCP Cap. For example, if the defaulter’s total payment obligation to CDS was $15 million, $5 million CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 25 of which had been drawn against the defaulter’s RCP Cap and the remaining $10 million drawn against a line of credit, the RCP would be responsible for paying only the $5 million. The Default Section 4.6 provides further details on the allocation of the defaulter’s obligations and the use of collateral obtained from the defaulter. 4.4 Replacement cost Risk Controls CDS provides three central counterparty (CCP) services: CNS, ACCESS and DetNet21. In all of these services CDS becomes the counterparty to each of the Participants’ trades at some point in the clearing and settlement process. The legal mechanism used in all of these services to place CDS as central counterparty is called “novation”. For example, a trade originally between Participant A and Participant B could be “novated” to become two separate trades; one between Participant A and CDS and the other between Participant B and CDS. In the CNS process, CDSX will net and novate all of the trades that a Participant has in a given security down to a single “to-deliver” (i.e. the Participant sold more than they bought) or “to-receive” (the Participant bought more than they sold) position between the Participant and CDS. 4.4.1 Daily Mark-to-Market CDS will mark-to-market all trades and outstanding positions in its CCP services. This mark-tomarket process addresses the potential loss from the original trade price to the current price. CDS marks trades for the first time at netting and novation (e.g., the evening of T+2 for equities in CNS and on the evening following confirmation for DetNet) and continues to mark daily until the position is settled or the outstanding position cleared. 4.4.2 Daily Mark-to-Market in CNS and ACCESS CDS will mark-to-market all CNS and ACCESS trades and Outstandings in each security based on the closing price available for that security as of the day prior to value date (typically the closing price on T+2). The daily mark-to-market payment exchange is included in the daily processes of CDSX. In a T+3 environment where CDS nets and novates CNS trades on the evening of T+2, the mark-to-market payment can represent as much as three days of price movement. 4.4.3 CDSX CNS Participant Fund The time at which the novation occurs is different in each of the three central counterparty services. In CDSX, CNS trades are novated early (i.e. 4:00 a.m. EST) on the morning of their settlement date (currently T+3). From a risk perspective, the key issue is that after novation has occurred, CDS must settle the transactions for which it is the counterparty, regardless of whether or not any other Participant fulfills their settlement obligations. For example, Participant A sells 100 shares, at a price of $1.00 to Participant B in a CNS-eligible transaction. If CDS becomes the counterparty to all CDSX transactions (even Trade-for-Trade transactions) through novation. The main (legal) distinction between the processing of transactions in CDS’ three CCP services (CNS, ACCESS, DetNet) and the processing of TFT transactions is the timing of when novation occurs and CDS becomes the counterparty. In the CCP services, novation occurs and CDS becomes the central counterparty as soon as the transactions are netted, which can occur prior to the settlement date of a transaction in some CCP services (i.e. DetNet). For TFT transactions, novation occurs and CDS becomes the counterparty to the resulting security and fund positions only when the TFT transaction is actually settled in CDSX. Settlement of TFT transactions can never occur before the transactions’ settlement date and may occur after the original settlement date (e.g. in the case of a fail). 21 CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 26 Participant B goes out of business prior to CDS novating this trade on the morning of settlement date, then Participant A must find another buyer for its shares. If the price of the shares had dropped to $0.90 in the meantime, Participant A would suffer the $10 loss themselves. However, if Participant B went out of business after CDS novated this trade on the morning of settlement date, then CDS must take receipt of the 100 shares from Participant A and pay $100 (the originally contracted amount). In this example, CDS would suffer the loss $10 that was generated when CDS sold the 100 shares into the market at a price of $0.90 per share. A CNS Participant Fund will be established to cover the risks to CDS that are generated by CDS’ central counterparty role. The CDSX CNS Participant Fund is designed to cover only the replacement cost risk that CDS must face as the central counterparty to all CNS positions. This is different from the current, SSS-CNS Participant Fund. The current SSS-CNS Participant Fund covers both the “CNS payment risk” from a payment default by a CNS Participant as well as the replacement cost CNS risks (i.e. the risks from the CNS mark-to-market payments and the CNS outstanding positions). In the CDSX risk model, the CNS Participant Fund covers only the “replacement cost” risks (a line of credit or a cap would cover the “payment risks”). For example, a CNS Participant might take delivery of 100 shares in CNS and owe CDS $100 for this settlement. In addition the Participant might owe $10 for a CNS mark-to-market payment and have a CNS Outstanding for another 25 shares. In CDSX, if the Participant were to default, the $100 owed by the Participant for the settlement of the CNS settlement would be covered by their line of credit and/or cap. The $10 owed by the Participant for their mark-to-market payment would be covered by the CDSX CNS Participant Fund, as would any losses generated when CDS replaced, in the market, the CNS Outstanding for 25 shares. In SSS, all three items (the $100 owed for the settlement, the $10 owed for the marks and any loss on the CNS Outstanding for 25 shares) would be covered by the SSS-CNS Participant Fund. 4.4.3.1 Calculation of the CDSX CNS Participant Fund CDS is using the current DetNet Participant Fund structure as the basis for the development of the CDSX CNS Participant Fund. As with DetNet, the CDSX CNS Participant Fund is designed to be a primarily “defaulter-pay” model. That is, in the vast majority of cases, the replacement cost risk that each CNS Participant generates through their CNS activity should be covered by the Participant’s own contributions to the CNS Participant Fund. In rare circumstances, the surviving CNS Participants might be required to cover a residual loss generated by the default of a CNS Participant. However, the contribution formula for the CNS Participant Fund has been designed such that each CNS Participant would cover their own risk “99 times out of 100”. In the event of a CNS Participant default, there are two amounts that a Participant’s CNS Participant Fund contributions are designed to cover: 1. A CNS mark-to-market payment that was owed by the Participant on the day of default. 2. Any loss that CDS might incur when it “closes out” the CNS Participant’s CNS outstanding positions. CDSX has been designed not to draw on lines of credit or caps to cover mark-to-market payments and a mark will not use up any of the Participant’s ACV. Although the marks will be posted to the Participant’s CDSX Funds Accounts, they will not draw on the lines of credit or caps. This arrangement means that mark-to-market amounts are covered only by the CNS Participant and not by a Participant’s line of credit and/or cap. In the event of a CNS CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 27 Participant’s default, the CNS Participant Fund would cover the portion of the defaulter’s payment obligation that was generated by the mark-to-market payment. Because the CNS Participant Fund covers the marks, neither the caps/credit nor ACV is needed to cover these amounts. The main features of the CNS Participant Fund may be summarized as follows: • • • • Participation in the CNS Participant Fund will be mandatory for all CNS Participants. The CNS Participant Fund is designed to be primarily “defaulter-pay”. Participants in the CNS Participant Fund will not receive cap or initial ACV from the CNS Participant Fund. The calculation of each CNS Participant’s contribution will be based on the following factors: • • • • • • mark-to-market payment for the current day; the history of the Participant’s mark-to-market payments over the previous 50 business days; the estimated market risk on the Participant’s CNS outstanding positions; the recent history of the market risk on the Participant’s CNS outstanding positions over the previous 20 business days. Contributions to the CNS Participant Fund will be in the form of acceptable collateral, subject to appropriate haircuts. CDS will calculate each CNS Participant’s required contribution each day and request any “top up” required should the currently available collateral be insufficient. The CNS Participant Fund contribution will be the sum of two components: 1. The Mark-to-Market Component which is the largest of the Participant’s mark-tomarket payments paid to or received from CDS in the last 50 business days, including the current day for which the calculation is being made, plus 2. The CNS Outstanding Positions Component which is the larger of: (a) The VaR calculated on the current CNS Outstanding positions (see below for more details), or (b) The Average VaR for the previous 20 business days, including the current day for which the calculation is being made. CDS will perform these calculations for each CNS Participant each morning (i.e. after the CDSX early morning batch settlement process has been completed). Participants will receive notice of their required contribution early each morning as part of their Collateral Management report (see the Collateral Management section). 4.4.3.2 Mark-to-Market Component The Mark-to-Market Component of the CNS Participant Fund calculation is designed to cover the potential that a Participant that owes a mark-to-market payment to CDS will default and not CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 28 pay that amount. Since a Participant’s CNS mark is calculated and applied to the Participants’ funds accounts during the early morning batch settlement process in CDSX (i.e. at around 5:00 a.m. EST), the entry to a Participant’s funds account will occur prior to CDS having an opportunity to receive additional collateral from the Participant. To address the risk that a default occurs prior to the Participant delivering their required contribution to CDS, the calculation uses the largest of either the marks paid to CDS or received from CDS in the last 50 business days for each Participant. Since the marks are based on the Participant’s CNS outstanding positions and the movements in market prices, a Participant is just as likely, on a given day, to owe CDS a mark as to be owed a mark. If, during the past 50 business days, a Participant was owed a mark of $100 by CDS, the mark-to-market component of the calculation assumes that the Participant would be just as likely to have owed CDS a mark of $100. Therefore, CDS uses the absolute value of the mark-to-market receipts or payments. 4.4.3.3 CNS Outstanding Positions Component The CNS Outstanding Positions Component of the CNS Participant Fund calculation is designed to cover the risk that CDS would face if a CNS Participant went out of business with CNS outstanding positions. In this circumstance, CDS must enter the market and either sell or buy securities to “close-out” the Participant’s CNS outstanding positions. For example, if the Participant had a CNS outstanding-to-deliver position for 50 securities, CDS would have to buy 50 securities in the market to close-out that position. If the Participant had a CNS outstandingto-receive position for 80 securities, CDS would have to sell 80 securities in the market to closeout that position. The difference between what CDS pays/receives in the marketplace for these close-out transactions and what CDS receives/pays for the original CNS positions represents the loss (or gain) that CDS needs to cover through the CNS Participant Fund. CDS will use an industry-standard VaR technique to estimate the risks to CDS from a Participant’s CNS outstanding positions. The VaR analysis looks at each of a Participant’s individual CNS outstanding positions, as well as the history of price movements for each of those positions over the most recent 20, 90 and 260 trading days. Based on these factors, the VaR analysis estimates how much the value of each of the Participant’s outstanding positions might change over the number of days that CDS estimates it might take it to execute the “closeout” transactions outlined above. During the Transition Period, CDS has agreed to the implementation of a portfolio diversification process. Rather than only looking at the aggregate risk associated with individual outstandings, CDS will analyze the overall risk associated with the “portfolio” of outstandings held by a single Participant in a given CCP service. By taking this approach it is expected that there will be “offsets” that will tend to reduce the overall collateral requirement. CDS expects to introduce a portfolio diversification approach in May 2004. Also during the Transition Period, CDS has agreed to design and implement additional collateral requirements on individual outstandings based on a concentration within a particular security or issuer, the relative liquidity of a particular security or the amount of time that an outstanding has remained in the system (i.e., aging). These changes are also expected to be implemented in the May 2004 time period. Any adjustments to the collateral requirement calculations will be subject to thorough backtesting, both historical and ongoing, in order to ensure that the required degree of risk CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 29 protection and “defaulter-pay” collateralization is being maintained. Backtesting results will be shared with all participants on a regular basis. 4.4.3.4 CDSX CNS Participant Fund At the commencement of the Transition Period the contributions to the CNS Participant Fund in CDSX will be based on the current required contributions to the CNS Participant Fund in BBS/SSS. Initially, the amount contributed to the CDSX CNS Participant Fund by an individual Participant may not be sufficient to cover the risk presented by that Participant’s outstanding positions and mark-to-market obligations (i.e., the CDSX CNS Participant Fund will initially be more of a survivor pay model than a defaulter pay model). During the course of the Transition Period, it is intended to move towards full implementation of the collateral requirements calculated by the CDSX Risk Model (i.e., as reflected in IRMS). However, this transition will be staged to be co-incident with the implementation of the changes to the calculation of risk related to outstandings as described above and the backtesting results that have been collected. Consequently, the transition will commence after the implementation of the May release of the system (see section on “Management of the Transition Period”). At the end of the Transition Period all Participants will be required to meet the full collateral requirement as determined by IRMS and verified through backtesting. 4.4.3.5 Timing of Calculations CDS will execute its VaR calculations after the CDSX early morning batch settlement process has been completed. If the VaR calculations were done before the early morning settlement had completed, the CNS outstanding positions could be much larger. During the batch settlement process, CNS outstanding positions will be reduced due to a number of factors including: netting with trade-for-trade transactions, settlements due to existing ledger positions and settlement of ACCESS positions. For example, a Participant might have a net CNS todeliver position of 1,000 shares. The Participant might have a ledger position of 200 shares, have a trade-for-trade buy transaction for 500 shares and have an ACCESS settlement that would deliver a further 100 shares. Since the VaR calculations will be executed after the batch settlement process is completed, the calculation would use the actual CNS outstanding-todeliver position of 200 (1,000 - 200 - 500 - 100) as the basis for the calculations. After the processing of the CDSX batch settlement, CDS would only be exposed to the replacement cost risk on the remaining 200 share outstanding-to-deliver position. The 800 shares that were settled would be covered by the Participant’s cap/line of credit and ACV. Participants have suggested examining alternative times for calculation of the CNS Participant Fund collateral requirements to account for the fact that intra-day settlements of CNS outstanding positions could change the risk of the positions and hence the collateral requirements. CDS has been calculating CNS and ACCESS Participant Fund collateral requirements from IRMS using outstanding positions in SSS following Cycle 2 to estimate the potential impact of delaying the timing of the collateral calculation. This is an issue that will be further examined during the Transition Period. 4.4.3.6 VaR Calculations The VaR method of estimating market risk is an industry-standard methodology. CDS currently uses this approach to calculate the DetNet Participant Fund contributions. The VaR methodology employed is also used by the IDA to calculate the margin rates for securities in CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 30 their “Equity Margin Project” proposal. CDS will adopt a VaR methodology similar to the one that underlies the proposed IDA Margin Guidelines. Since the IDA Margin Guidelines were developed for use by broker/dealers for their individual margin accounts, there will be some differences in CDS’ implementation. The major differences are: • The IDA Guidelines “band” the margin rates for ease of use. For example, if the IDA’s calculations result in a 5% haircut for a given security, the guidelines use 15% (i.e. any calculated haircut between 0% and 15% are scaled up to 15%). CDS will use the calculated amount instead of the assigned “banded” amount. The IDA proposal assigns different holding periods and a “liquidity factor” to security margin rates based on the liquidity of the security. The guidelines assume that it might take 2 days to liquidate a position in a “higher-than-typical” security and up to 4 days in a “less-than-typical” security. CDS will apply a minimum standard 3-day holding period to all securities. Securities with less than average liquidity will be applied a 5-day or 10-day holding period. The details of the treatment of liquidity are under review. CDS will be conducting daily surveillance of Participants’ CNS and ACCESS outstanding positions to identify any situations that fall outside these parameters (e.g. CNS outstanding positions that represent an unusually large proportion of the daily trading volume of a security). CDS may use its discretionary authority to request more collateral from a Participant if the surveillance identifies cases that are not addressed by the standard calculations. The IDA Margin Guideline are intended to cover three standard deviations of price risk, meaning that the margin rates that are calculated in the model expect to cover the portfolio value changes in excess of 99% of the time. CDS will use a 99% confidence interval in its calculations (which is approximately 2.3 standard deviations). • • CDS will conduct on-going reviews of the VaR models using back-testing of the risks from the CNS Outstandings and the adequacy of the collateral in the Participant funds. The backtesting of collateral requirements will be conducted for each Participant in each CCP service. These backtesting results will be made available to Participants. To the extent that the backtesting indicates that the collateral would have been insufficient, CDS may request additional collateral in order to maintain the required 99% confidence factor. 4.4.3.7 Advantage of the VaR Approach The use of the VaR methodology for estimating replacement cost risk that must be covered will have an important benefit for the CNS (and ACCESS) Participants. In the current SSS, a Participant’s contribution to the SSS-CNS Participant fund is based upon the gross value of the Participant’s (un-netted) trades (i.e. the formula is 2.5% of the value of a Participant’s buys plus sells). However, since CDS is exposed to risk from only a Participant’s CNS Outstandings, this gross-value-based formula does not reflect the actual risk that CDS must address. For example, CNS Participant A might have gross CNS trades worth $100 that result in a CNS Outstanding worth $100. CNS Participant B might have gross CNS trades worth $100 that result in no CNS Outstanding (i.e. the Participant bought 50 shares and sold 50 shares of the same security). Both Participants would make the same contribution to the SSS-CNS Participant fund, even though the second Participant presented no risk to CDS (since they had no CNS Outstanding). Part of the reason for this approach in SSS is that the SSS-CNS Participant Fund is designed to cover both the payment risk on the settlements that do occur as well as the future risk on the CNS Outstandings. In CDSX, both Participants would be required to have sufficient cap/line of credit to cover the settlement amounts of these transactions. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 31 In the CDSX VaR-based approach to the CNS Participant fund, Participants will contribute to the fund based on their CNS outstanding positions and mark-to-market payments only. In the example above, Participant A would make a contribution to the CDSX-CNS Participant fund based on their $100 CNS Outstandings. Participant B would not be required to make a contribution, since they had no CNS Outstandings. Participants that carry no or small CNS Outstandings will make small contributions to the CDSX-CNS Participant Fund. Participants that carry large CNS Outstandings will make larger contributions to the CDSX-CNS Participant Fund. The same approach will be used for the CDSX ACCESS Participant Fund. Another example of the advantage of the CDSX VaR-based approach can be seen in the ACCESS service. In the current SSS/ACCESS services, a Participant that buys $100 worth of shares in ACCESS and sells the same $100 worth of shares in CNS must contribute both to the ACCESS Participant Fund (based on the $100 bought through ACCESS) and the CNS Participant Fund (based on the $100 sold in CNS). In CDSX, these two transactions would be completed in the CDSX early morning CNS/BNS process and the Participant would have no ACCESS Outstandings and no CNS Outstandings. Since both the CDSX ACCESS Participant Fund and CNS Participant Fund contributions will be based on the value of the Outstandings, the Participant, in this example, would not need to contribute collateral to either Participant Fund. 4.4.4 DetNet Participant Fund The existing design of the DetNet Participant Fund will remain unchanged. 4.4.5 Capping Counterparty Services A minimum requirement from the Extenders for the CDSX Risk Model was that there must be agreement among all parties on an approach and implementation timeframe to limit the overall exposure in counterparty services caused by the existence of outstandings. Two proposals have been presented by CDS to the Extenders and the Receivers. While important details remain to be fully determined and documented, both the Extenders and Receivers have agreed to go forward with a solution combining both proposals. One solution focuses on the options available to the survivors in a pool where a loss has occurred whereas the other solution introduces a system-wide “hard” cap on the risk that any Participant can bring to the system. The remainder of this section describes the current thinking on the details of implementing the capping proposal. However, these details have not been formally agreed between the parties and further negotiations continue to take place. The survivor focused solution allows the non-defaulting Participants in a pool to decide to withdraw from the service that is supported by the pool when there is a default in the service that goes beyond the collateral payments made to the pool by the defaulting Participant. However, prior to withdrawal, a surviving Participant who wants to withdraw from the service must increase its current contribution to the pool by 300% and must clear all outstanding trades from the service that is supported by the pool. The system-wide “hard” cap solution gives all Participants, regardless of capital size, the same cap. The cap will be set to 7.5% of the average Net Allowable Assets (NAA) for the largest 3 CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 32 broker/dealers rounded up to the higher $5 million22. The system-wide cap will take effect at the end of the Transition Period. When the calculated risk reaches or exceeds 100% of the systemwide cap and remains that way by Payment Exchange on the same day, the Participant’s eligibility will immediately23 be removed from the counter-party service exhibiting the highest risk profile for that Participant. The Participant will not be allowed back into this counter-party service until the Participant’s total risk profile drops below 75% of the system-wide cap. The Participant’s netted and novated trades will remain in the counter-party services until settled (i.e., there will be no “force out” of previously netted and novated trades into a trade-for-trade format). On a daily basis, CDS will provide a report on the ten highest aggregate risk profiles to all Participants in the central counterparty services. The amount of collateral being held for each Participant will also be shown on the report. In this way, the risk departments within the various Participant organizations can use their own internal processes to arrive at an estimate of the risk being taken by CDS in relation to the counter-party services. 4.5 US Dollar Risk Model The US Dollar Risk Model addresses both payment and replacement cost risks in USD that occur within CDSX as well as the services outside of CDSX (i.e. New York Link and DTC Direct). The US Dollar Risk Model for CDSX has been defined taking into account the current USD values and volumes that CDS is processing through its various services. Should these values and volumes materially change over time, CDS will revisit the methodology of the US Dollar Risk Model. CDSX will be capable of settling transactions in either CAD or USD for every type of service (e.g. TFT, CNS or ACCESS). In addition, CDS’ ACCESS service has a CNS settlement component that settles in USD. The settlement of any of these transactions could be done in USD. For example, two Participants can settle a Canada bond transaction for USD, or a Canadian Participant could settle the “Canadian” side of an ACCESS settlement in USD. The USD funds account balances that result from these settlements will be covered by a USD cap in CDSX. The US Dollar Risk model is based upon the equivalent components of the Canadian dollar risk model. There are some differences between the CAD and USD risk models to account for the significantly lower values processed in USD as well as some of the constraints on CDS in processing USD (i.e. CDS does not have access to the Federal Reserve Bank as a lender of last resort for USD as it does with the Bank of Canada for CAD). The main similarity between the CAD and USD risk models is that a Funds Edit will be performed on both types of transactions. The main difference in the two models is that the ACV edit will not be performed on the buyer in a USD transaction (see the ACV Edit section below). 22 23 Bank participants will be subject to the same system-wide cap as the broker/dealers. Discussions within the Central Counterparty Cap Working Group have identified certain instances (e.g., large transactions that are tied up during a holiday where one market is closed and the other is open, entitlement payments, corporate actions, delayed deposits, etc) that could result in a participant exceeding the cap on a temporary basis. The working group will decide whether CDS should be given the discretion to determine whether or not a participant should be removed from a counter-party service and in what situations this discretion can be used. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 4.5.1 Size of USD Settlement Values 33 The value of USD activity in CDSX is significantly lower than the value of the CAD activity. For example, on a given day, CDSX is expected to process the following: • • • • Approximately $100 billion to $125 billion CAD in gross settlements of debt/money market transactions. Approximately $3 billion to $5 billion CAD in gross settlements of Canadian equity exchange transactions. Approximately $5 billion to $10 billion CAD in gross settlements of Canadian “nonexchange” (mostly custodial deliveries) equity transactions Approximately $0.1 billion to $0.2 billion USD in gross settlements of USD transactions. In summary, the value of gross CAD settlements on a given day in CDSX are expected to be about $140 billion CAD while the USD settlements are expected to be about $0.2 billion USD ($0.3 billion CAD). Therefore, the gross value of the USD settlements will be about 0.2% of the value of the CAD settlements. The net, day-end payments to CDS in USD will be similarly small. The ACCESS service will generate the largest net payments to CDS in USD. Currently, the largest net payments to CDS from ACCESS are about $20 million USD. 4.5.2 Summary of the USD Risk Model The USD Risk Model may be summarized as follows: • • All Participants that have a negative USD balance in their funds accounts must have a USD cap. All USD caps will be generated from a collateral pool/credit ring. The existing Extender, Settlement Agent and Federated collateral pool/rings will be modified to generate a USD cap for their Participants. A separate RCP for USD will be established to generate a USD cap for those Participants that want one and do not belong to the former category. A Participant’s USD cap may be used for any type of USD settlement (CNS, ACCESS or Trade-for-Trade). There are currently no USD lines of credit granted within CDSX. An ACCESS Participant Fund will be established similar to the CNS Participant Fund. The ACCESS Participant Fund will only cover the replacement cost risks associated with the ACCESS mark-to-market payments and any ACCESS Outstandings (this will be subject to the minimum collateral required by DTCC). Values in the ACCESS Participant Fund will be highly influenced by what is demanded by NSCC through the application of its Risk-Based Margining (RBM) approach which is scheduled to be implemented on August 18th, 2003. • • • In addition to the USD-denominated transactions that will be processed through CDSX, CDS also offers its Participants the ability to settle USD transactions directly at the Depository Trust and Clearing Corp (DTCC) through the New York Link (NYL) service. New York Link transactions do not settle in CDSX (they settle in DTCC’s systems) and, technically, the risk control mechanisms for NYL are not part of the CDSX risk model. However, a description of the NYL Participant Fund is included in this paper for completeness. DTCC calculates each New CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 34 York Link (NYL) Participant’s required collateral contribution. NSCC’s RBM approach will also be applied to New York Link Participants beginning August 18, 2003. CDS and NSCC have proposed to cover their respective exposures to a default (by a Participant in CDS’s case and by CDS in NSCC’s case) by requiring NYL Participants to contribute collateral to a jointly accessible fund based on the gross RBM calculations of Participants’ risk (see section 4.5.10.1 below for further details). 4.5.3 U.S. Banker Risk CDS will make arrangements with two U.S. commercial banks to act as primary and back-up liquidity providers for USD. Either of these two U.S. banks will be able to provide the full liquidity requirements on an individual basis. 4.5.4 USD Caps CDSX will perform a Funds Edit on all USD transactions, just as it will do for CAD transactions. A Participant will not be allowed to have a negative USD balance in their USD funds account that exceeds their USD cap. All USD transactions (Trade-for-Trade or CNS) will use this USD cap. Extenders are not able to grant USD lines of credit in CDSX. No Participant is expected to require a USD cap that is larger than $50 million USD. The terms of the existing Extender of Credit, Settlement Agent and Federated Participant collateral pool/credit rings will be changed to generate a USD cap for each Participant within those rings. The relatively insignificant size of the required caps will not require significant changes to the design of those rings (i.e. the CAD cap formula could be slightly reduced to generate a small USD cap for each pool/ring member). In the event of a default by a member of one of these three existing collateral pool/credit rings, the surviving members of the collateral pool/credit ring would be responsible for paying the defaulter’s USD obligation to CDS. 4.5.5 USD Receivers’ Collateral Pool A USD Receivers’ Collateral Pool (USD-RCP) will be established for those other Participants that require a USD cap. The design of this USD-RCP will be identical to the RCP for CAD activity. The main features of the USD-RCP may be summarized as follows: • • • Participation in the USD-RCP will be voluntary, but open to any Receiver of Credit. Participants in the USD-RCP will receive a cap (but no initial ACV) from the RCP. Participation in the USD-RCP will involve risk sharing with the other members of the USD-RCP. Risk sharing is one of the means of reducing the cost of providing a cap to the members of the USD-RCP. The RCP-generated cap may be used to cover any type of USD settlement in CDSX (i.e. CNS settlement or Trade-for-Trade Settlement). The USD-RCP Cap will not be used to cover ACCESS mark-to-market payments or the risk on ACCESS outstanding positions (see the section on the ACCESS Participant Fund). The USD-RCP will be designed to cover the default of the Participant with the largest USD-RCP cap. • • • CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 • 35 The RCP-generated cap that is assigned to each RCP member will be proportional to both the individual contribution of an RCP member as well as the aggregate size of the RCP. 4.5.5.1 USD-RCP Liquidity Each member of the RCP will contribute collateral to the RCP. The collateral will be in the form of securities. CDS expects to accept any security that is eligible for use for advances at the Bank of Canada or within the LVTS payment system. CDS would use the aggregate amount of collateral in the RCP to obtain a standby line of credit from at least two commercial USD liquidity providers. The two providers are used to address any potential for a default by one of the liquidity providers. CDS cannot use the Bank of Canada as a backstop liquidity provider for USD. In the event of a USD default by an USD-RCP member, CDS would use either or both of its USD liquidity sources to convert the collateral in the USD-RCP into USD liquidity in order that CDS could complete the payment of the defaulter’s USD payment obligation. No other CDS Participant (i.e. non-USD-RCP members) would be responsible for any portion of a defaulter’s payment obligation that was covered by a USD-RCP cap. 4.5.5.2 Calculation of the USD-RCP Caps The same formula that is used to calculate the caps for the CAD-RCP will be used to determine the USD cap for USD-RCP member. The formula for the USD cap will be based upon the Participant’s collateral contribution to the USD-RCP as well as the total amount of collateral that is pledged to the USD-RCP. 4.5.6 ACV Edit for USD transactions The ACV Edit, as it has been described for the CAD transactions will not be applied to the USD transactions. The purpose of the ACV Edit in CDSX is to ensure that a Participant’s CAD funds obligation is collateralized. In CDSX, the amount of ACV that is recorded for a Participant is always denominated in Canadian dollars. When a Participant buys a security for CAD, their ACV is increased by the ACV value of the purchased securities. When a Participant sells a security for CAD, their ACV is decreased by the ACV value of the securities. The ACV edit itself would not allow a purchase or sale for CAD that would cause a Participant’s negative funds account balance to exceed their ACV. With US dollar transactions, the ACV edit is applied differently. When a Participant buys a security for USD, their (Canadian) ACV is increased by the CAD equivalent ACV of the purchased securities (if the purchased securities are targeted to one of the buyer’s risk accounts such as the General Account). The ACV edit itself is not applied to the USD purchase (i.e. the transaction could not fail to settle because of the ACV edit). When a Participant sells a security for USD, the Participant’s (Canadian) ACV is decreased by the CAD equivalent ACV of the securities (if the sale came out of one of the Participant’s risk accounts). The ACV edit could prevent this transaction from settling if the (Canadian) ACV after the settlement would be less than the Participant’s negative funds account balance in CAD. Since ACV is not needed to cover USD funds account balances, the value of those securities purchased for USD can be used to cover CAD funds obligations. If the original purchase of the securities for USD went into CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 36 one of the buying Participant’s non-risk accounts (such as a Segregated account) then the Participant’s ACV would not be updated. Similarly, if the sale of the securities for CAD also came out of a non-risk account, then the ACV edit would not be applied to the CAD sale of the securities. Securities purchased for USD and targeted for a risk account will be added to a Participant’s ACV. The value that is added to the Participant’s ACV will be based on a USD price for the security that is converted to CAD using a CAD-USD exchange rate. Sales of securities, for either USD or CAD will be deducted from a Participant’s ACV if the sale comes out of a risk account. However, positive balances of USD funds in a Participant’s funds account will not count as ACV. This is due to the expected timing of USD payment exchange. The only way that positive USD funds account balances could be used as ACV would be if CDS did not pay out those USD funds before the Participant paid CDS any CAD amounts owing. If that were the case, then CDS could use the USD funds owed to the Participant to collateralize the CAD obligation owed by the Participant. The timing of the USD payment exchange period in CDSX will be coordinated with DTCC’s payment exchange. DTCC will control the timing of this process. Therefore, USD funds could already have been paid to the Participant before CDS knew whether or not the Participant was going to pay their CAD obligation. If the Participant defaulted on their CAD obligation, CDS would no longer have the Participant’s USD funds to use as “collateral”. For this reason, positive USD funds account balances will not count as ACV24. 4.5.7 New York Link Participant Fund New York Link (NYL) transactions do not settle within CDS’ systems. All NYL settlements occur within DTCC’s systems. For this reason, there is no need for a NYL Participant to be given a cap or ACV within CDSX. Since NYL settlements do not occur in CDSX, the risk controls for NYL are not part of CDSX. However, the NYL Participant fund is described in this paper for completeness. 4.5.8 ACCESS Participant Fund The ACCESS service includes a CNS settlement capability that is the same as the domestic Canadian CNS service25. CDS is the central counterparty to all ACCESS settlements. ACCESS generates the same type of risks to CDS as the domestic CNS process (see the CNS Participant Fund section). These risks are the potential for an ACCESS Participant to not make their ACCESS mark-to-market payment to CDS and the risk that a loss will be generated when CDS closes-out a defaulter’s ACCESS outstanding positions. These risks in ACCESS will be addressed the same way as in CNS, through an ACCESS Participant Fund. The main features of the ACCESS Participant Fund can be summarized as follows: • Participation in the ACCESS Participant Fund will be mandatory for all ACCESS Participants. 24 This is an issue that CDS has agreed should be examined again. However, as previously indicated, this issue is not currently included in the work plan for the 12-month Transition Period. 25 CDSX has the capability of processing domestic CNS transactions denominated in USD. The replacement cost risks from these transactions would be covered by the CNS Participant Fund. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 • • • The ACCESS Participant Fund is designed to be primarily “defaulter-pay”. 37 Participants in the ACCESS Participant Fund will not receive a cap or initial ACV from the ACCESS Participant Fund. The calculation of each ACCESS Participant’s contribution will be based on the following factors: • • • • • an apportionment of the RBM collateral requirement calculated by NSCC for the 5099 account. the Participant’s ACCESS mark-to-market payment for the current day, the history of the Participant’s ACCESS mark-to-market payments over the previous 50-business days, the estimated market risk on the Participant’s ACCESS outstanding positions the recent history of the market risk on the Participant’s ACCESS outstanding positions over the previous 20-business days. • • Contributions to the ACCESS Participant Fund will be in the form of acceptable collateral, subject to appropriate haircuts. CDS will calculate each ACCESS Participant’s required contribution each day and request any “top up” required should the currently available collateral be insufficient. CDS will collect the ACCESS Participant Fund contributions from its Participants. This collateral will be pledged to a common fund that will be jointly accessible by CDS and NSCC under specifically prescribed conditions (see the following section on co-ordinating the CDS and NSCC risk models for more details on how the ACCESS Participant Fund will be shared between CDS and NSCC). 4.5.9 DTC Direct Service The DTC Direct service operates at DTCC (i.e. there are no settlements taking place at CDS). DTCC calculates the collateral required from DTC Direct Participants and these Participants will pledge the collateral directly to DTCC. 4.5.10 Proposed Co-ordination of CDS and NSCC Risk Models Beginning August 18, 2003, NSCC plans to apply its Risk-Based Margining (RBM) methodology to the NSCC accounts that CDS uses to sponsor its Participants’ settlement in New York Link (NYL) and the settlement of U.S. dollar transactions conducted by Participants in ACCESS (through the NSCC 5099 omnibus account). NSCC looks to CDS to complete settlement on behalf of these accounts and so, will apply RBM to each of these accounts to protect itself against the payment and market risk associated with non-settlement. In turn, CDS relies on its Participants to complete settlement of their transactions in order to ensure that its obligations to NSCC are satisfied. Through the course of negotiations between CDS and NSCC, it was mutually agreed that the concept of “super-netting” the obligations between the NYL accounts and the 5099 omnibus account should not be pursued. Although super-netting would have allowed NSCC to treat the obligations of CDS for the various NYL accounts and the 5099 omnibus account as a single netted amount, it was agreed that this approach would have blurred the distinction between the CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 38 two underlying cross-border services and could have led to some Participants bearing part of the risk created by other Participants in a different service. The proposed approaches for covering the risks in NYL and ACCESS treat the two underlying services distinctly. The following summarizes the proposal which CDS and NSCC are reviewing internally and which remains subject to approval for implementation. 4.5.10.1 New York Link In the case of NYL, each Participant is associated with a specific account. NSCC is therefore able to determine what each Participant’s settlement obligation is and to calculate the associated risk. However, it relies on CDS to pledge adequate collateral to cover the payment and market risks related to each Participant’s obligations. As CDS depends on its Participants to cover the risk that they create, it currently requires Participants to provide collateral to cover their exposures to CDS plus an equivalent amount to cover the risk that NSCC is exposed to CDS. NSCC’s move from an activity-based approach to a risk-based approach will result in a significant increase in collateral requirements. However, NSCC and CDS have agreed that Participants should not be required to double their collateral contributions under the new methodology, provided that their respective risks can be adequately covered. In order to accomplish this, CDS and NSCC propose to use a third party collateral agent to hold collateral that would dually serve to cover CDS’s calculated exposure to each individual firm using the NYL service as well as NSCC’s exposure to CDS in the event that CDS cannot complete settlement on behalf of the NYL Participants. The collateral agent will act in a custodian role. Liquidity will continue to be obtained, as needed, from other liquidity providers, further to other arrangements. The minimum amount of collateral held at the third party collateral agent will be the larger of the sum of the individually calculated requirements for the NYL firms (given CDS’s exposure to each Participant’s cumulative net value of its transactions) or CDS’s aggregate requirement to NSCC (as NSCC is exposed to CDS for a single netted value across all of the NYL members, since all NYL activity is mutualized). Therefore, there might be offsets between two NYL firms trading on opposite sides in the same security issue; on the other hand, some positions traded by multiple firms might cause CDS’s cumulative position to go over a more onerous special margin threshold. NSCC will calculate daily margin requirements, typically on a gross (i.e. by individual account) basis, and transmit these figures to the individual NYL firms as well as to CDS. While CDS will have ultimate responsibility for collecting the required amount, NSCC will also monitor receipt based on reports from the third-party collateral agent. NSCC’s Collateral Management System will be modified to look at, or receive a feed from the third party collateral agent and to display the correct collateral value for any securities held in the account (taking into account haircuts, currency, etc.). Use of this collateral will be pursuant to an agreement between NSCC and CDS outlining the conditions by which the collateral may be accessed by either party (i.e., CDS or NSCC). Prior to the use, by CDS, of any portion of the collateral deposited in respect of an individual Participant which would reduce the total collateral value in the account to a level below NSCC’s calculated exposure to CDS as a whole, CDS must demonstrate that it ultimately has, or will have, the means to replace the required funds. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 39 In the event that a NYL firm in a debit settlement position with NSCC (through CDS) is unable to settle, CDS will request that the funds held at the third party collateral agent initially be made available for its immediate liquidity needs, and ultimately to complete the close-out of the insolvent firm’s positions and to cover any resulting losses. It has been suggested that NSCC could act on CDS’s behalf in performing the close-out. Further discussion is required to determine the implications of such an approach. 4.5.10.2 5099/ACCESS As the daily 5099 omnibus account obligations reflect the netted USD settlements and outstanding obligations of the ACCESS Participants, CDS and NSCC agree that the ACCESS Participants should not be expected to doubly contribute collateral to satisfy both the CDSX IRMS requirements and the RBM Clearing Fund requirements. In order to ensure that both organizations can cover their risks without requiring ACCESS Participants to doubly collateralize their exposures, ACCESS Participants will contribute collateral to a jointly accessible fund lodged with the third party collateral agent to be used for the NYL service as described above. CDS will be responsible for collecting the collateral contributions from the ACCESS Participants and pledging the collateral to the joint fund. Until CDS’s IRMS is fully implemented in CDSX (i.e., by the end of the Transition Period), NSCC’s RBM will be the basis for calculating ACCESS Participants’ contributions to the joint fund. As the USD RCP cap and funds edit of the CDSX Risk Model will be in place upon completion of partial equities conversion, these risk-based edits would supplement coverage of the payment risk associated with ACCESS’s USD settlement obligations. RBM will be calculated on the basis of the 5099 omnibus account as a distinct calculation separate from the other, New York Link, accounts. CDS proposes that the respective shares of the RBM requirement be allocated to ACCESS Participants according to their individual IRMS calculations. This reflects the fact that IRMS calculates the respective risk brought by each Participant to ACCESS, which in turn generates the net 5099 obligation from CDS to NSCC. CDS will compare the IRMS test data currently being produced for ACCESS Participants with the RBM data to be produced by NSCC and allocated on the basis of the IRMS requirements, in order to assess the requirements that would be initially applied to Participants. CDS accepts that RBM is calculating the collateral requirements for both payment risk and replacement cost risk whereas in CDSX it is necessary to consider the collateral requirements from both the USD generation of cap (typically through the RCP) and IRMS to arrive at a comparative figure between the methods of calculation employed by the two organizations. However, CDS continues to believe that the IRMS calculations of Participant risk constitutes the best available proxy for dividing the RBM requirement among the ACCESS Participants. IRMS is calculating the risk posed by individual Participants whereas RBM (of necessity) is calculating the risk on a net basis which means that the level of risk brought to the system by one Participant is reflected across all Participants. By relying on the individual Participant calculations made by IRMS, CDS intends to minimize, if not eliminate, any cross subsidization between Participants in terms of the collateral to be put up against the risk brought to the system. Once CDS’s IRMS is in place for the ACCESS service, the larger of either CDS’s requirements (including any special margining) or NSCC’s RBM calculation will be the basis for determining each day’s requirement for the joint fund. This will ensure that the requirements determined by the two methodologies are satisfied. Using its backtesting process, CDS will, during the course of the Transition Period, analyze the differences in collateral requirements generated by RBM CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 40 and CDSX (through the USD generation of cap and IRMS) and ensure that it can properly explain any material differences that do occur. In the event that an ACCESS Participant defaults, CDS will seize the Participant’s contribution to the joint fund (and any contribution of other Participants as may be needed to make up any shortfall) to cover its risk. CDS will ensure that sufficient collateral remains in the joint fund to continue to cover NSCC’s RBM requirement during the day of default and that the value in the joint fund remains sufficient for subsequent days, by calling on ACCESS Participants to top up any shortfall. NSCC is prepared to consider accepting Government of Canada securities as acceptable collateral for the joint fund. At this point, the only other form of collateral that will be acceptable to both CDS and NSCC is U.S. cash. CDS is researching what would be required to allow US Treasury instruments to be accepted as collateral in CDSX for ACCESS Participants. CDS and NSCC will need to establish a reporting structure to: a. determine their respective methodological requirements, b. advise Participants of their contributions based on the requirements of the larger total calculation, c. keep both organizations informed of the level of the joint fund, and d. inform NSCC of any default, what part of the fund has been used and how CDS will ensure that coverage of the RBM requirement will be maintained. Also, CDS will need to be informed if NSCC draws on the fund. In the event that one of NSCC’s Participants fails and the 5099 omnibus account is required to cover part of any shortfall in NSCC’s Clearing Fund, NSCC will be able to access the joint fund to the extent required. ACCESS Participants will be required to proportionately top up any withdrawal from the joint fund so that the larger of the two calculations of collateral requirements continues to be maintained. 4.5.10.3 Workplan for Coordination of CDS and NSCC Risk Models At a high level, several key issues remain to be addressed for either NYL, the ACCESS omnibus account or both: a. What third party collateral agent will maintain the joint fund? b. Under what conditions will CDS and NSCC be able to access the contributions in either joint fund? These conditions will need to be clearly stipulated so that there is not a situation where both CDS and NSCC attempt to draw on the joint fund for the same circumstance. c. Formal agreement that the ACCESS Participants’ respective shares of the RBM requirement for the 5099 omnibus account will be based on the IRMS calculated requirements? d. What will be the reporting process for advising the two clearing corporations of the respective requirements that will apply each day for the 5099/ACCESS joint fund? e. How would the liquidity arrangements be put into effect to cover end-of-day payments and the replacement of outstanding long or short positions of a defaulting Participant? f. Demonstrate to the clearing organizations’ respective boards and regulators that they will be adequately covered for risk under the proposed approach. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 4.6 Default of a Participant 41 Rule 9 in the CDSX Rules details the processes to be followed in the event of a Participant default. In general, the default processes are designed to address three issues: 1. On the day of default, a defaulter’s payment obligation to CDS must be replaced by an alternative source of liquidity. 2. To obtain the “replacement” payment described in #1 above, CDS will deliver the collateral that it obtains from the defaulter, as well as collateral that is obtained from the defaulter’s collateral pool/credit rings and Participant Funds. Risk account collateral goes first to sureties to cover amounts drawn under authorized lines of credit, and then to survivors of the applicable category credit ring. In the event of a Receiver default, CDS will take possession of collateral pool and Participant fund contributions and pledge them as security to obtain liquidity. 3. If the defaulter was a Participant in a central counterparty service, CDS will execute, as soon as possible, any close-out transactions that are necessary to clear the defaulter’s outstanding positions. The following describes, in general terms, how each of these tasks will be accomplished. The detailed description of these processes will be found in the CDSX Rules and in the Procedures. 4.6.1 Replacement of a Defaulter’s Payment Obligation The payment obligation of any defaulter (i.e. Extender of Credit, Settlement Agent, Federated Participant or Receiver of Credit) must be satisfied on the day of default. The CDSX rules will not allow CDS to “unwind” any settled transaction nor to delay the payment of amounts that CDS owes to other Participants. On the day of default, an alternative source of funds must be available to “replace” the amount that was owed to CDS by the defaulter. The following describes the source(s) of the replacement liquidity. CDSX has been built such that a Participant cannot have a negative funds account balance unless that balance is covered by a cap or line of credit and ACV collateral. The only exceptions to this rule are mark-to-market payments covered by the respective Participant Fund for the service generating the mark and rare CDS-adjustment transactions (that have never been used in CDSX or in its predecessor, DCS) that do not go through the Funds or ACV edits. An example of a CDS-adjustment would be an entry to recover an entitlement payment that was previously paid in error. Because of the Funds Edit, all of a defaulter’s negative funds account balance should be covered by one or more alternative sources of liquidity26. Those sources are: Table 2 – Sources of Liquidity Alternative Liquidity Source Defaulter’s Collateral Pool/Credit Ring that generated the cap Amounts drawn under a line of credit Defaulter’s Extender(s) of Credit Mark-to-market payments Participant Fund(s) (i.e. CNS, ACCESS or DetNet) Portion of Funds Obligation Amounts drawn under a cap 26 CDS maintains stand-by lines of credit backed by the collateral in the pools. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 Table 2 – Sources of Liquidity Portion of Funds Obligation Alternative Liquidity Source Other amounts that exceed the cap or line of Defaulter’s Credit Ring. credit 42 For example, a defaulter might have a payment obligation of $175 (i.e. at Payment Exchange, their funds account balance was negative $175). In processing the default, CDS may discover that the defaulter had a cap of $100 that was fully used, a line of credit for $50 that was fully drawn and had made a mark-to-market payment for $25. In this example, CDS would look to the defaulter’s collateral pool/credit ring for $100; look to the defaulter’s Extender of Credit for $50 and would look to the defaulter’s Participant Fund for the remaining $25. 4.6.2 Sources and Use of Collateral There are several sources of collateral that can be obtained for use during the processing of a default. Some of this collateral will come from the defaulter itself and some collateral will come from the defaulter’s collateral pool/credit ring or Participant Fund. In general, the sources of collateral are: 1. The securities in the defaulter’s “risk accounts” (i.e. the General Accounts and Restricted Collateral Accounts). This is the so-called “ACV” collateral. 2. The securities pledged by the defaulter itself to a collateral pool/credit ring. 3. The securities pledged by the defaulter to a Participant Fund(s). 4. The securities pledged by other members of the defaulter’s collateral pool/credit ring 5. The securities pledged by other members of the defaulter’s Participant Fund(s) The following table outlines the sequence in which each of these sources of collateral will be used. In general, CDS maintains a policy of “no-spill-over” between services. For example, collateral pledged to the CNS Participant Fund must first be used to cover any CNS mark-tomarket amounts of the defaulter and any losses generated by the close-out of the defaulter’s CNS outstanding positions. After these two items have been addressed, any excess amounts of CNS collateral from the defaulter itself would be used by CDS to mitigate other losses. Table 3 – Sources and Uses of Collateral - Receiver of Credit Default Source of Collateral Sequence of Use 1. Defaulter’s ACV Extenders of Credit (if any). Any remaining collateral goes Collateral next to the CAD-RCP and next to the USD-RCP (if the defaulter was an RCP member). Any remaining collateral goes to CDS to mitigate other losses. 2. Defaulter’s RCP RCP. Any remaining collateral goes next to the extenders of contribution (if any) credit (if necessary). Any remaining collateral goes to CDS to mitigate other losses. 3. Defaulter’s Participant Participant fund to cover mark-to-market and close out fund contributions (if any) losses. Any remaining collateral goes to CDS to mitigate other losses 4. Securities pledged by Collateral pool/credit ring to cover the defaulter’s cap. This other members of the type of collateral is never used for any other purpose. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 43 Table 3 – Sources and Uses of Collateral - Receiver of Credit Default Source of Collateral Sequence of Use defaulter’s pool/ring 5. Securities pledged by Participant fund to cover the defaulter’s mark-to-market other members of the payments and any close-out losses. This type of collateral is defaulter’s Participant never used for any other purpose. fund(s) Table 4 – Sources and Uses of Collateral - Other Participant Default (Extender, Settlement Agent, Federated Participant) Source of Collateral Sequence of Use 1. Defaulter’s ACV Defaulter’s collateral pool/credit ring. Any remaining Collateral collateral goes next to the credit extenders (if any). Any remaining collateral goes to CDS to mitigate other losses. 2. Defaulter’s collateral Defaulter’s collateral pool/credit ring. Any remaining pool/credit ring collateral goes next to the credit extenders (if any). Any contributions (if any) remaining collateral goes to CDS to mitigate other losses. 3. Defaulter’s Participant Participant fund to cover mark-to-market and close out fund contributions (if any) losses. Any remaining collateral goes to CDS to mitigate other losses 4. Securities pledge by other Collateral pool/credit ring to cover the defaulter’s cap. This members of the type of collateral is never used for any other purpose. defaulter’s pool/ring 5. Securities pledged by Participant fund to cover the defaulter’s mark-to-market other members of the payments and any close-out losses. This type of collateral is defaulter’s Participant never used for any other purpose. fund(s) 4.6.3 Legal Foundations and Perfection of Security Interests in Collateral The grant by participants of security interests in collateral is central to the risk controls in CDSX. In order to be assured that these security interests are valid and enforceable against third parties (for instance, a trustee of an insolvent Participant), it is essential to comply with the applicable requirements for perfection of security interests. Ontario law is the contractual choice of law specified in the Participant Agreement entered into by CDS and its participants. Ontario is the location of CDS's system and records. Therefore, CDS concludes from its legal analysis that the collateral is located in Ontario and that Ontario law governs the pledging of collateral by participants to CDS. CDS relies first and foremost on its possession of collateral to perfect its security interests and, as an auxiliary mechanism, on registration of financing statements pursuant to the Ontario Personal Property and Security Act to reinforce the perfection of its security interests. Ontario law confers a superpriority on the security interests granted by participants to CDS, by virtue of the provisions of section 85 of the Ontario Business Corporations Act. Thus, under Ontario law the security interests granted under the CDSX Rules take precedence over any other security interests in the same collateral. In addition to perfecting its security interests by possession, CDS perfects by registration: to optimize its position as a secured creditor CDS uses all perfection mechanisms available to it. (Also, some security interests are not susceptible to perfection by possession, for example, the CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 44 security interest in dividends and other entitlements associated with securities.) The question therefore arises as to where these registrations should be made. If a dispute arose involving collateral pledged to CDS under the CDSX Rules, it is possible that a court would apply the laws of a province other than Ontario to determine who was entitled to the collateral. CDS is confident that Ontario law is the most likely choice of law that a court would apply to govern the interpretation of the Participant Agreement and Rules (including matters of validity, enforceability and priority of security interests). However, CDS also recognizes the possibility that a court might apply the laws of another jurisdiction, in particular if the dispute involved a third party not bound by the CDS Participant Agreement and Rules. As a matter of prudence, therefore, CDS will also be registering its security interests in other provinces. Choice of law under provincial PPSA legislation and the Quebec Civil Code is based on the jurisdiction where the collateral is located, or the jurisdiction where the debtor is located, depending on the nature of the collateral. CDS has already registered its security interests in Ontario (the location where the collateral is located) and, accordingly, the further registrations will be made where participants are located outside Ontario. The applicable legislation looks to either chief executive office or registered office as determinative of the location of a debtor. Therefore, where a participant has either its registered office or its chief executive office in a province other than Ontario, CDS will register in that province/those provinces. Quebec, being a civil law jurisdiction rather than a common law jurisdiction, has a different legal regime which utilizes different terminology. In recognition of that fact, and to the extent that Quebec law may be applicable, the Rules were amended and now make express provision for a grant of hypothec, in addition to referring to the grant of security interests by participants. 4.7 Surveillance Practices CDS surveillance practices are comprised of the following activities that address the risk management principle of preventing risk as well as recovering from losses that may occur: 1. The first of these is the financial surveillance of Participants through CDS’ Memorandum of Understanding with the self-regulatory organizations (SROs) with audit jurisdiction over CDS members. This agreement states “the financial soundness of a firm will be monitored by the self-regulatory organization with audit jurisdiction for itself and on behalf of CDS in accordance with the audit jurisdiction SRO’s own criteria, standards of measurements, procedures and practices”. Based on this monitoring, the SRO provides immediate notification to CDS as a result of receiving information in respect of a material concern relating to a firm. In addition to SRO surveillance, CDS receives and reviews on a regular basis the financial statements of its Extender and Settlement Agent Participants. The MOU is being updated in consultation with the SROs to reflect the risk coverage requirements under the CDSX Risk Model. 2. CDS monitors Participant obligations, activity levels, collateral and concentration of collateral in each of its settlement services and has the authority to require individual Participants to provide collateral in excess of the "normal” collateral requirements in cases where CDS deems it prudent, given the risk associated with the Participant’s obligations and activities. 4.7.1 Monitoring of Participant Obligations The monitoring and surveillance outlined below are subject to review and revision to take into account developments during the Transition Period, such as the adoption of additional collateral CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 45 requirements based on concentration, liquidity and aging of Participants’ outstanding positions, as described in section 4.4.3.3. CDS’ risk management includes the on-going surveillance of market Participants with respect to their financial standing and settlement activities. This ongoing surveillance is done by CDS in conjunction with the appropriate regulatory authorities and the exchanges. CDS will put a Participant on an active surveillance list and closely monitor its activities in a number of situations including where: 1. The Participant has a high concentration of pending or outstanding settlements, in particular securities that are illiquid and/or have experienced recent and significant price changes; 2. The Participant has a history of late settlement; 3. There appears to be unusual activity by the Participant, for example, the Participant has an outstanding position representing an unusually large proportion of the average daily volume of a security. In practical terms, CDS will establish a monitoring process to identify risk and use its risk management discretion to act in four levels of surveillance triggered by a ratio of outstanding obligations to Risk Adjusted Capital (RAC) as provided to CDS by industry regulatory bodies: • • Normal Monitoring: Where a Participant is considered within acceptable operating parameters. No additional risk management action. Level 1 – Advisory: Where a Participant’s Outstandings in all CCP services is considered to be above an appropriate threshold, provisionally estimated to be 3 times RAC. Additional collateral may be called. Level 2 – Remedial: Where a Participant is considered to be well outside of acceptable thresholds with regard to settlement activity as measured by the value of their Outstandings in CCP services, provisionally estimated to be 5 times RAC. Additional collateral and special margining of high-risk positions will be called sufficient to both cover the risks and discourage further high-risk activity. Level 3 – Final Notification: Where a Participant is considered to far exceed the acceptable parameters with regard to settlement activity relative to their financial situation or to be in chronic non-compliance. Additional collateral and extra margin will be called, mark-to-market credits may be withheld and suspension of service privileges may be initiated. • • 5 Collateral Management Each Participant that uses one of the three CDS central counterparty services will contribute collateral to each of the Participant Funds that are established to cover the replacement cost risk for those services. In addition, a Participant may be required to pledge collateral to CDS for other activities such as the Participant’s membership in a CDSX credit ring. Participants may be pledging collateral for one or more of the following: 1. Extender of Credit Collateral Pool/Credit Ring 2. Settlement Agent Collateral pool/Credit Ring CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 3. Federated Participant Collateral Pool/Credit Ring 4. Receiver’s Collateral Pool/Credit Ring (RCP) 5. USD-RCP Collateral Pool/Credit Ring (USD-RCP) 6. CNS Participant Fund 7. ACCESS Participant Fund 8. New York Link Participant Fund 9. DetNet Participant Fund 10. Special Collateral as determined by CDS’ Risk Management Department 5.1 Centralization 46 While the calculation of the collateral that is required for a given activity will be made on an individual security basis, the actual pledging and management of a Participant’s collateral will be done centrally (i.e. the Participant will pledge to CDS and manage a single set of collateral that covers all of their individual collateral requirements). In addition to the operational efficiencies that this will provide, it will also allow a Participant to “net” collateral requirements. For example, a decrease in collateral requirements for one service could be used to cover an increased collateral requirement from another service without the need to retrieve or pledge. Without this centralized approach to collateral management, Participants would be required to maintain excess collateral for each service or increase their level of collateral management. The centralization of collateral management will also prepare CDS to engage in crosscollateralization arrangements with other clearing and settlement organizations. Such arrangements will also increase the optimization of collateral for Participants. 5.2 Eligible Collateral CDS currently accepts Government of Canada Bonds and Treasury Bills, Cash and Letters of Credit as eligible collateral. Mid-way through the 12-month Transition Period, CDS will expand the range of collateral it will accept in certain pools to include other debt securities (such as Provincials, NHA/MBS, Bankers Acceptances, Commercial Paper etc). Letters of Credit are not acceptable as collateral in CDSX, since they are not eligible to be pledged to the Bank of Canada (CDS’ back-up liquidity provider). The expanded range of collateral will reduce the cost to the Participants of satisfying their various CDS collateral requirements. 6 Management of the Transition Period After its publication in October 2002, both the Extenders of Credit and the Receivers of Credit (represented by the independent investment dealers) expressed serious concerns about various aspects of Version 3 of the CDSX Risk Model. In certain cases, the concerns were consistent between the parties (e.g., handling of exceptions in the VaR model). In other cases, the concerns were in conflict with one side (the Extenders) believing that the Risk Model needs to be strengthened in certain areas with the other side (the Receivers) believing that the Risk Model is already overly conservative. In subsequent discussions between all parties involved in the approval of the CDSX Risk Model, it was agreed that a 12-month Transition Period would be used to move from Version 3 of the Risk Model to a version that adequately addresses the concerns that had been raised. It has CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 47 been agreed by all parties that at the end of the Transition Period, the CDSX Risk Model will be fully implemented as defined at that time (i.e., all transition measures that dilute the full effects of the Risk Model will be removed and all Participants will be expected to operate within the entire framework of the Risk Model). CDS will break the 12-month Transition Period down into a series of three time horizons and will address the outstanding issues through the implementation of an updated version of the CDSX Risk Model at the conclusion of each time horizon. The end dates for the three time horizons are January 2004, May 2004 and August 2004. The principal component in the January time horizon is the implementation of additional sector limits in CDSX to facilitate the use of high yield debt, public sector debt and unrated municipal debt for ACV purposes. CDS will also make changes in the management and governance of the CDS risk function during this time horizon period. The principal components to be fully addressed for the May time horizon are27: • Portfolio Diversification whereby IRMS will value the aggregate risk across all of a Participant’s outstanding trades rather than viewing the risk as an accumulation of the risk associated with individual outstanding trades. In effect, CDS will view a Participant’s outstanding trades as a portfolio of positions where the market risk associated with long positions can be offset by the market risk associated with short positions and vice versa. Collateral requirements to cover the outstanding trades will be based on the portfolio view rather than on the current accumulated view. The special margin requirements related to concentration. IRMS will examine trading activity, settlement activity, and outstanding trades to determine if a Participant has a dominant position relative to current trading volumes and/or float outstanding in one or more securities or industry groups. Where a level of concentration is found to exist, CDS will either restrict the amount of ACV that is given to the Participant for the security or securities or will demand additional collateral to cover replacement cost risk. The rudimentary processes put in place in version 3 of the CDSX Risk Model to deal with security liquidity will be refined to more accurately reflect the impact on the haircut rates that should be applied to illiquid securities. System and procedural changes designed to react to the aging of outstanding trades would be implemented, if required. Subject to further discussion and agreement, CDS would put in place procedures to buy-in against outstanding positions that have remained in the system beyond an agreed-upon number of days. IRMS would be amended to call for additional collateral if an outstanding trade remains in the system beyond the agreed-upon number of days. In light of the experience of operating in the CDSX environment for a period of time, CDS will facilitate discussions between its Participant groups on the need to restrict “free” security movements (i.e., security movements that are not on an acceptable • • • • 27 The level of detail being provided is based upon CDS’ current understanding of the issues and requirements in each area. This understanding will be expanded and probably altered once the detailed analysis phase is conducted for each of the issues. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 48 “value-for-value” basis) and to re-examine the effectiveness of the restrictions that are already in the system to govern the free movement of funds. • In light of the experience in setting the haircut rates for new issues of securities, CDS will refine its processes to be more efficient and to more accurately calculate appropriate haircut rates. Once the portfolio diversification processes as well as the special margin processes for concentration, liquidity and aging are implemented, CDS will be in a position to start the transition from a volume based measure of risk to a VaR methodology when dealing with outstanding trades. However, there will be a need for system support to ensure that the transition can be managed without undue operational impact. The refinement of the monitoring and surveillance procedures will be an on-going activity throughout the Transition Period. There will be a need for system support to extract data for input to the monitoring and surveillance process. • • The principal components to be fully addressed for the August time horizon are: • The capping of counter-party services. System support for the tracking and reporting of risk by Participant against the system-wide cap will be designed and implemented. Similarly, any required system support for the withdrawal from the counter-party services by a survivor in a default situation will be provided. The on-going need to provide initial ACV and cap in the system will be addressed. Initial ACV and cap are presently provided by the RCP. This exercise will determine if the RCP in its current form is viable on a long-term basis or if an approach based on the Extenders’ RACVP is more appropriate. System changes to support whatever decisions are made will be implemented. In the CGE&Y report there were recommendations on how to deal with price variability from the various pricing sources used by CDS. These recommendations will be analyzed in detail and acted upon as appropriate. CDS also will replace the static price exception with a no trading exception to determine price history gaps for assessing liquidity risk. The CGE&Y report made several recommendations on how stress testing should be done within CDSX. These recommendations will be analyzed in detail and acted upon as appropriate. The haircut and backtesting statistics report is a formal presentation of the results exhibited by the Risk Model over time in relation to the objectives that have been set for the Risk Model. This report will be designed and developed. The CGE&Y report recommended that haircut rates be calculated on a more regular basis than once a week which is the current calculation frequency. This recommendation will be analyzed in terms of benefit versus processing overhead and will be acted upon as deemed appropriate. • • • • • CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 • 49 The pricing table maintained within CDSX and used by IRMS for the calculation of haircut values is subject to distortion as a result of certain corporate actions (e.g., stock splits). Manual procedures will be put in place initially to deal with these distortions. However, a long-term automated solution needs to be put in place. As experience is gained with the operation of the CDSX Risk Model, more data will be required by the Risk Department to identify issues and trends. The project to aggregate risk information provides the system support to the Risk Department to “slice and dice” the risk information that is collected on an on-going basis by CDSX and IRMS. Once IRMS is fully implemented at the end of the Transition Period, the collateral requirement to cover the risk associated with outstanding trades in the ACCESS service will be the higher of RBM and the aggregate calculations made by IRMS. System support is required to decide on the level of collateral that has to be provided by each ACCESS Participant. • • CDS has prepared detailed plans for the first time horizon period of June 2003 through to January 2004. Higher level plans have been prepared for the remaining two time horizon periods (i.e., January 2004 to May 2004 and May 2004 to August 2004). In the December 2003 to January 2004 timeframe, CDS will prepare a detailed plan for the January to May 2004 timeframe. In April 2004, CDS will prepare a detailed plan for the May to August 2004 timeframe that deals with any remaining items. An overview project plan is attached as an Appendix to this paper. CDS Settlement Services Risk Model – Version 3.2.1, June 25th, 2003 Appendices CDSX Risk Model Delivery Schedule Jun-03 Jul-03 Aug-03 Sep-03 Oct-03 Nov-03 Dec-03 Jan-04 Feb-04 Mar-04 Apr-04 May-04 Jun-04 R R R R R D R R D D R D D D M D D R U,I M D L M,D D D D D U U U U U U U I,L I,L I,L I,L I,L Jul-04 Aug-04 1st Time Horizon (January 2004) Implement additional sector limits 2nd Time Horizon (May 2004) Portfolio diversification Concentration of positions Liquidity risk component Age of outstandings Revisit free movements of securities/funds Final solution for haircut values for new issues Transition from SSS/BBS collateral requirements to IRMS requirements. Provide system support for new monitoring and surveillance procedures. D D R D I,L U R R D D I,L L 3rd Time Horizon (August 2004) Limiting CCP exposures in Access, CNS, and DetNet Long term "RCP" for ACV Adequacy Pricing issues for haircut calculations Stress Testing Haircuts and collateral backtest statistic reports Increase frequency of haircut calculations Automated solution for identification and correction of price distortions due to corporate actions Aggregation of Risk Information Comparison of risk based margining to IRMS to determine Access participant collateral requirements Provide system support for additional monitoring and surveillance procedures. Legend R Requirements definition M Modeling D Development (includes FA, Code, Unit Test, System Integration Test) U User Acceptance Test P Performance, Volume, Stress Testing I Implementation L Live R D D D U R U M I,L I,L I,L M,L I,L I,L D D U I,L R R R R D D P,U R R D D D D D U U M P,U R D M U M M,L I,L R D U I,L