82 FR 18515 - Self-Regulatory Organizations; LCH SA; Notice of Proposed Rule Change, Security-Based Swap Submission, or Advance Notice Relating to CDS Margin and Extreme Credit Spread Curves

SECURITIES AND EXCHANGE COMMISSION

Federal Register Volume 82, Issue 74 (April 19, 2017)

[Federal Register Volume 82, Number 74 (Wednesday, April 19, 2017)]
[Notices]
[Pages 18515-18516]
From the Federal Register Online  [www.thefederalregister.org]
[FR Doc No: 2017-07873]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-80451; File No. SR-LCH SA-2017-004]


Self-Regulatory Organizations; LCH SA; Notice of Proposed Rule 
Change, Security-Based Swap Submission, or Advance Notice Relating to 
CDS Margin and Extreme Credit Spread Curves

April 13, 2017.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on April 4, 2017, Banque Centrale de Compensation, which conducts 
business under the name LCH SA (``LCH SA''), filed with the Securities 
and Exchange Commission (``Commission'') the proposed rule change 
described in Items I, II, and III below, which Items have been prepared 
primarily by LCH SA. The Commission is publishing this notice to 
solicit comments on the proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Clearing Agency's Statement of the Terms of Substance of the 
Proposed Rule Change

    LCH SA is proposing to amend its CDS margin framework, in order to 
promote operational efficiency and improve operational risk management, 
to provide for an approximation-based method to replace the algorithm 
that is currently used in the event that the International Swaps and 
Derivatives Association (``ISDA'') standard model for pricing (``ISDA 
Pricer'') credit default swaps (``CDS'') fails as a result of extreme 
spread curves, as further described herein.

II. Clearing Agency's Statement of the Purpose of, and Statutory Basis 
for, the Proposed Rule Change

    In its filing with the Commission, LCH SA included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. LCH SA has prepared summaries, set forth in sections A, 
B, and C below, of the most significant aspects of these statements.

A. Clearing Agency's Statement of the Purpose of, and Statutory Basis 
for, the Proposed Rule Change

1. Purpose
    Spread margin is a component in LCH SA's margin methodology. LCH SA 
currently uses the ISDA Pricer to calibrate credit spread curves. In 
the case of ``extreme'' credit spread curves, however, it is not 
possible to calibrate credit spread curves using the ISDA Pricer. 
Currently, in the event that the ISDA Pricer fails, LCH SA uses a 
dichotomy-based algorithm to adjust the spread input and to perform 
repeated calibration of the spread curve between two tenors until it 
identifies (x) the tenor which has caused the calibration to fail and 
(y) the level of the spread closest to input for the tenor that allows 
the curve to calibrate. In practice, applying this algorithm is time 
consuming and may lead to lengthy system processing, because it 
necessitates repetition of a dichotomy analysis until the tenor that is 
responsible for the failure is identified. This, in turn, could result 
in delay in performing LCH SA's margin calculation. In addition, 
because the spread curve will be replicated in subsequent simulation 
runs as part of the spread margin calculation, it is very likely that 
the calibration failure that occurs when obtaining the mark-to-market 
price for a CDS contract will also occur in subsequent simulation runs, 
which means that the dichotomy algorithm would need to be used many 
times, which accounts for significant processing time in CDSClear's 
overnight batch. Therefore, to promote operational efficiency and 
improve operational risk management while maintaining a sound pricing 
mechanism, LCH SA is proposing to replace its existing dichotomy-based 
algorithm with a new approximation-based method to price CDS contracts 
in the event of extreme spread curves that cause the ISDA Pricer to 
fail.
    Text is added to Section 2.2 ``CDS Pricing'' in ``Reference Guide: 
CDS Margin Framework'' to describe the new approximation-based method, 
which specifies that in the event the ISDA Pricer fails, LCH SA would 
use an approximation-based method to calibrate credit spread curves. 
The new method consists of three steps: (i) Constructing a piecewise 
constant hazard rate curve, (ii) constructing a piecewise constant 
interest rate curve, and (iii) defining the average hazard rate and 
average interest rate over the period considered and applying them to 
price the CDS using the usual mark-to-market pricing formula in any 
market conditions, under the assumption of continuous coupon payment.
    LCH SA has performed analysis comparing its approximation method to 
the ISDA Pricer and the results indicate that its approximation method 
provides a reliable pricing estimate. The proposed rule change would, 
therefore, simplify LCH SA's margin methodology and would significantly 
reduce operational risk while simultaneously providing a sound pricing 
method for extreme curves.
2. Statutory Basis
    LCH SA believes that the proposed rule change is consistent with 
the requirements of the Act and the rules and regulations thereunder 
applicable to LCH SA. Specifically, in accordance with Section 
17(A)(b)(3)(F),\3\ LCH SA believes that the proposed rule change will 
promote the prompt and accurate clearance and settlement of securities 
transactions, derivatives agreements, contracts, and transactions and 
to assure the safeguarding of securities and funds which are in the 
custody or control of the clearing agency or for which it is 
responsible, in that the proposed rule change is designed to promote 
operational efficiency and reduce operational risk caused by the 
existing dichotomy-based algorithm, which is used in the event of 
extreme spread curves that cause the ISDA Pricer to fail, while 
maintaining a sound pricing mechanism for LCH SA's margin calculation. 
In addition, the proposed rule change is consistent with the relevant 
requirements of Rule 17Ad-22(d)(4), which requires a clearing agency to 
establish and maintain policies and procedures that identify sources of 
operational risk and to minimize such risk through development of 
procedures that are reliable,\4\ as well as Rule 17Ad-22(e)(17), which 
requires a covered clearing agency to establish and maintain policies 
and procedures reasonably designed to manage the covered clearing 
agency's operational risks by identifying the plausible sources of 
operational risk and mitigating their impact through the use of 
appropriate systems, policies, procedures and controls.\5\ LCH SA has

[[Page 18516]]

identified its current dichotomy-based algorithm as a source of 
operational risk, based on its observation of the algorithm as an 
operationally intensive and time consuming practice. LCH SA believes 
that the new pricing method as described in the proposed rule change is 
reasonably designed to minimize operational risk and eliminate possible 
delays existing in the current overnight batch process as a result of 
the dichotomy-based algorithm in the event of extreme spread curves 
that cause the ISDA Pricer to fail. In addition, LCH SA has performed 
analysis comparing its approximation method to the ISDA Pricer and the 
results indicate that its approximation method provides a reliable 
pricing estimate. Therefore, LCH SA believes that the proposed rule 
change is reasonably designed to minimize or mitigate the operational 
risk identified by LCH SA through the use of appropriate systems and 
policies, consistent with Rule 17Ad-22(d)(4) and Rule 17Ad-22(e)(17). 
The proposed rule change is also consistent with Rule 17Ad-22(b)(1) and 
(2),\6\ which require a clearing agency to maintain margin and limit a 
clearing agency's exposures to potential losses from participants' 
defaults under normal market conditions, and Rule 17Ad-22(e)(4),\7\ 
which requires a covered clearing agency to manage credit exposures to 
participants by maintaining sufficient financial resources to cover its 
credit exposure to each participant fully with a high degree of 
confidence. LCH SA has performed analysis to support the new pricing 
method for extreme spread curves as a reliable pricing tool to use in 
its margin methodology in the event of extreme spread curves that cause 
the ISDA Pricer to fail, and, therefore, believes that the proposed 
rule change would continue to cause LCH SA to maintain margin to cover 
its credit exposure to, and to limit its exposures to potential losses, 
each Clearing Member's defaults [sic] under normal market conditions 
with a high degree of confidence.
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    \3\ 15 U.S.C. 78q-1(b)(3)(F).
    \4\ 17 CFR 240.17Ad-22(d)(4).
    \5\ 17 CFR 240.17Ad-22(e)(17).
    \6\ 17 CFR 240.17Ad-22(b)(1)-(2).
    \7\ 17 CFR 240.17Ad-22(e)(4).
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B. Clearing Agency's Statement on Burden on Competition

    Section 17A(b)(3)(I) of the Act requires that the rules of a 
clearing agency not impose any burden on competition not necessary or 
appropriate in furtherance of the purposes of the Act.\8\ The proposed 
rule change is part of the spread margin calculation, which will 
uniformly apply across all participants and, as noted above, is 
consistent with the applicable requirements of the Act, eliminates 
operational risk and provides reliable pricing of CDS in the event that 
the ISDA Pricer fails. Therefore, LCH SA does not believe the proposed 
rule change will impose any burden on competition that is not necessary 
or appropriate in furtherance of the purposes of the Act.
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    \8\ 15 U.S.C. 78q-1(b)(3)(I).
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C. Clearing Agency's Statement on Comments on the Proposed Rule Change 
Received From Members, Participants or Others

    Written comments relating to the proposed rule change have not been 
solicited or received. LCH SA will notify the Commission of any written 
comments received by LCH SA.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 45 days of the date of publication of this notice in the 
Federal Register or within such longer period up to 90 days (i) as the 
Commission may designate if it finds such longer period to be 
appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    (A) by order approve or disapprove such proposed rule change, or
    (B) institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Comments may be submitted by any of 
the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an email to [email protected]. Please include 
File Number SR-LCH SA-2017-004 on the subject line.

Paper Comments

     Send paper comments in triplicate to Secretary, Securities 
and Exchange Commission, 100 F Street NE., Washington, DC 20549-1090.

All submissions should refer to File Number SR-LCH SA-2017-004. This 
file number should be included on the subject line if email is used. To 
help the Commission process and review your comments more efficiently, 
please use only one method. The Commission will post all comments on 
the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). Copies of the submission, all subsequent amendments, all 
written statements with respect to the proposed rule change that are 
filed with the Commission, and all written communications relating to 
the proposed rule change between the Commission and any person, other 
than those that may be withheld from the public in accordance with the 
provisions of 5 U.S.C. 552, will be available for Web site viewing and 
printing in the Commission's Public Reference Room, 100 F Street NE., 
Washington, DC 20549, on official business days between the hours of 
10:00 a.m. and 3:00 p.m. Copies of such filings will also be available 
for inspection and copying at the principal office of LCH SA and on LCH 
SA's Web site at http://www.lch.com/asset-classes/cdsclear.
    All comments received will be posted without change; the Commission 
does not edit personal identifying information from submissions. You 
should submit only information that you wish to make available 
publicly. All submissions should refer to File Number SR-LCH SA-2017-
004 and should be submitted on or before May 10, 2017.

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\9\
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    \9\ 17 CFR 200.30-3(a)(12).
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Brent J. Fields,
Secretary.
[FR Doc. 2017-07873 Filed 4-18-17; 8:45 am]
BILLING CODE 8011-01-P