82 FR 26721 - Self-Regulatory Organizations; LCH SA; Order Approving Proposed Rule Change Relating to LCH SA's CDS Margin and Extreme Credit Spread Curves

SECURITIES AND EXCHANGE COMMISSION

Federal Register Volume 82, Issue 109 (June 8, 2017)

Page Range		26721-26722
FR Document		2017-11865
Federal Register, Volume 82 Issue 109 (Thursday, June 8, 2017)
[Federal Register Volume 82, Number 109 (Thursday, June 8, 2017)]
[Notices]
[Pages 26721-26722]
From the Federal Register Online  [www.thefederalregister.org]
[FR Doc No: 2017-11865]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-80849; File No. SR-LCH SA-2017-004]


Self-Regulatory Organizations; LCH SA; Order Approving Proposed 
Rule Change Relating to LCH SA's CDS Margin and Extreme Credit Spread 
Curves

June 2, 2017.

I. Introduction

    On April 4, 2017, Banque Central de Compensation, which conducts 
business under the name LCH SA (``LCH SA''), filed with the Securities 
and Exchange Commission (``Commission''), pursuant to Section 19(b)(1) 
of the Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change (SR-LCH SA-004) to amend its CDS 
margin framework to replace an algorithm-based approach to pricing 
credit default swaps (``CDS'') in the event extreme spread curves cause 
the International Swaps and Derivatives Association Standard Model for 
pricing credit default swaps (``ISDA Pricer'') to fail with an 
approximation-based method.\3\ The proposed rule change was published 
for comment in the Federal Register on April 19, 2017.\4\ The 
Commission received no comment letters regarding the proposed change. 
For the reasons discussed below, the Commission is approving the 
proposed rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ For additional information regarding the ISDA Standard 
Model, see www.cdsmodel.com. The Commission is providing this link 
solely for informational purposes.
    \4\ Securities Exchange Act Release No. 34-80451 (April 13, 
2017), 82 FR 18515 (April 19, 2017) (SR-LCH SA-2017-004) 
(``Notice'').
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II. Description of the Proposed Rule Change

    LCH SA has proposed to amend its CDS margin framework. The proposed 
change would alter the approach used by LCH SA when the ISDA Pricer, 
used in pricing CDS, fails as a result of extreme spread curves. Under 
its current CDS margin framework, LCH SA uses the ISDA Pricer to 
calibrate credit spread curves as part of its spread margin component. 
According to LCH SA, the ISDA Pricer cannot be used to calibrate credit 
spread curves where ``extreme'' credit spread curves exist.\5\ In the 
event that the ISDA Pricer fails due to the existence of extreme credit 
spread curves, LCH SA has established a dichotomy-based algorithm that 
it uses to adjust the inputs and calibrate the spread curves 
iteratively until it identifies the tenor causing the calibration to 
fail, and the closest spread to that tenor that will allow the curve to 
appropriately calibrate.\6\
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    \5\ Notice, 82 FR at 18515.
    \6\ Id.
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    LCH SA represented that this dichotomy-based algorithm can consume 
significant amounts of time to process because of the number of 
repetitions that may be necessary for the process to produce the 
appropriate results, which could result in delays in calculating margin 
requirements.\7\ To ameliorate the potential for these delays, LCH SA 
has proposed to amend its approach by replacing the dichotomy-based 
algorithm described above with an approximation-based approach under 
which LCH SA would, in the event that the ISDA Pricer fails, construct 
a piecewise hazard rate curve and a piecewise constant interest rate 
curve, and then apply average hazard and interest rates for the 
relevant period to price the relevant CDS.\8\
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    \7\ Id.
    \8\ Id.
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    LCH SA represents that it has performed quantitative analysis, 
which indicates that the revised approach to calculating margin 
requirements in the event that the ISDA Pricer fails is a reliable 
pricing tool.\9\ Therefore, this revised approach is not likely to 
result in significant changes to CDS prices and margin requirements 
calculated using LCH SA's current approach.
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    \9\ Notice, 82 FR at 18516.
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III. Discussion and Commission Findings

    Section 19(b)(2)(C) of the Act directs the Commission to approve a 
propose rule change of a self-regulatory organization if it finds that 
such proposed rule change is consistent with the requirements of the 
Act and the rules and regulations thereunder applicable to such 
organization.\10\ Section 17A(b)(3)(F) of the Act requires, among other 
things, that the rules of a registered clearing agency be designed to 
promote the prompt and accurate clearance and settlement of securities 
transactions and, to the extent applicable, derivative agreements, 
contracts, and transactions.\11\ Rule 17Ad-22(e)(17) requires, in 
relevant part, that each covered clearing agency establish, implement, 
maintain, and enforce written policies and procedures reasonably 
designed to manage a covered clearing agency's operational risk by 
identifying the plausible sources

[[Page 26722]]

of operational risk, both internal and external, and mitigating their 
impact through the use of appropriate systems, policies, procedures and 
controls, as well as to ensure that systems have a high degree of 
security, resiliency, operational reliability, and adequate, scalable 
capacity.\12\ Rule 17Ad-22(b)(1) requires, in relevant part, a 
registered clearing agency that performs central counterparty services 
to establish, implement, maintain and enforce written policies and 
procedures that are reasonably designed to measure the registered 
clearing agency's credit exposures to its participants at least once 
daily and limit its exposures to potential losses from participant 
defaults under normal market conditions.\13\ Rule 17Ad-22(b)(2) 
requires, in relevant part, a registered clearing agency that performs 
central counterparty services to establish, implement, maintain and 
enforce written policies and procedures that are reasonably designed to 
use margin requirements to limit its credit exposures to participants 
under normal market conditions and use risk-based models and parameters 
to set margin requirements.\14\ Rule 17Ad-22(e)(6) requires, in 
relevant part, a covered clearing agency that provides central 
counterparty services to cover its credit exposures to its participants 
by establishing a risk-based margin system that, at a minimum, 
considers and produces margin levels commensurate with the risks and 
particular attributes of each relevant product, portfolio and market, 
and marks participant positions to market and collects margin, 
including variation margin or equivalent charges if relevant, at least 
daily.\15\
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    \10\ 15 U.S.C. 78s(b)(2)(C).
    \11\ 15 U.S.C. 78q-1(b)(3)(F).
    \12\ 17 CFR 240.17Ad-22(e)(17).
    \13\ 17 CFR 240.17Ad-22(b)(1).
    \14\ 17 CFR 240.17Ad-22(b)(2).
    \15\ 17 CFR 240.17Ad-22(e)(6)(i) and (ii).
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    The Commission finds that the proposed rule change is consistent 
with Section 17A(b)(3)(F) of the Act and the relevant provisions of 
Rule 17Ad-22 thereunder. The Commission believes that the proposed rule 
change will reduce the risk that the process for determining spread 
margin requirements will require excessive time to process in the event 
that extreme spread curves cause the ISDA Pricer to fail; the proposed 
rule change thereby will improve LCH SA's operational ability to 
calculate its margin requirements promptly without sacrificing 
accuracy. Because it will facilitate the calculation of margin 
requirements in a timely fashion, the proposed rule change is 
consistent with the prompt and accurate clearance and settlement 
requirement of Section 17A(b)(3)(F) of the Act and with operational 
risk requirements of Rule 17Ad-22(e)(17).
    The Commission also believes that the proposed rule change provides 
for an approach that takes into consideration relevant risks (including 
hazard rates and interest rates) in order to provide for appropriate 
method for calculating CDS prices, and consequently the measurement of 
LCH SA's credit exposures and margin requirements, in the event that 
the ISDA Pricer fails. As a result, the proposed rule change is 
consistent with requirements of Rules 17Ad-22(b)(1) and (2), and Rule 
17Ad-22(e)(6).

IV. Conclusion

    It is therefore ordered pursuant to Section 19(b)(2) of the Act 
that the proposed rule change (SR-LCH SA-2017-004) be, and hereby is, 
approved.\16\
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    \16\ In approving the proposed rule change, the Commission 
considered the proposal's impact on efficiency, competition, and 
capital formation. 15 U.S.C. 78c(f).

    For the Commission by the Division of Trading and Markets, 
pursuant to delegated authority.\17\
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    \17\ 17 CFR 200.30-3(a)(12).
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Eduardo A. Aleman,
Assistant Secretary.
[FR Doc. 2017-11865 Filed 6-7-17; 8:45 am]
 BILLING CODE 8011-01-P
Federal Register / Vol. 82, No. 109 / Thursday, June 8, 2017 / Notices 26721

stated in the application. Such terms SECURITIES AND EXCHANGE to adjust the inputs and calibrate the
and conditions are designed to, among COMMISSION spread curves iteratively until it
other things, help prevent any potential identifies the tenor causing the
[Release No. 34–80849; File No. SR–LCH
(i) undue influence over an Underlying calibration to fail, and the closest spread
SA–2017–004]
Fund that is not in the same ‘‘group of to that tenor that will allow the curve to
investment companies’’ as the Fund of Self-Regulatory Organizations; LCH appropriately calibrate.6
Funds through control or voting power, SA; Order Approving Proposed Rule LCH SA represented that this
or in connection with certain services, Change Relating to LCH SA’s CDS dichotomy-based algorithm can
transactions, and underwritings, (ii) Margin and Extreme Credit Spread consume significant amounts of time to
excessive layering of fees, and (iii) Curves process because of the number of
repetitions that may be necessary for the
overly complex fund structures, which June 2, 2017. process to produce the appropriate
are the concerns underlying the limits
I. Introduction results, which could result in delays in
in sections 12(d)(1)(A), (B), and (C) of
calculating margin requirements.7 To
the Act. Applicants assert that On April 4, 2017, Banque Central de ameliorate the potential for these delays,
permitting a Section 12(d)(1)(G) Fund of Compensation, which conducts LCH SA has proposed to amend its
Funds to invest in Other Investments as business under the name LCH SA (‘‘LCH approach by replacing the dichotomy-
described in the application would not SA’’), filed with the Securities and based algorithm described above with
raise any of the concerns that section Exchange Commission (‘‘Commission’’), an approximation-based approach under
12(d)(1) of the Act was intended to pursuant to Section 19(b)(1) of the which LCH SA would, in the event that
address. Securities Exchange Act of 1934 the ISDA Pricer fails, construct a
4. Section 12(d)(1)(J) of the Act (‘‘Act’’) 1 and Rule 19b–4 thereunder,2 a piecewise hazard rate curve and a
provides that the Commission may proposed rule change (SR–LCH SA–004) piecewise constant interest rate curve,
exempt any person, security, or to amend its CDS margin framework to and then apply average hazard and
replace an algorithm-based approach to interest rates for the relevant period to
transaction, or any class or classes of
pricing credit default swaps (‘‘CDS’’) in price the relevant CDS.8
persons, securities, or transactions, from
the event extreme spread curves cause LCH SA represents that it has
any provision of section 12(d)(1) if the
the International Swaps and Derivatives performed quantitative analysis, which
exemption is consistent with the public Association Standard Model for pricing indicates that the revised approach to
interest and the protection of investors. credit default swaps (‘‘ISDA Pricer’’) to calculating margin requirements in the
Section 17(b) of the Act authorizes the fail with an approximation-based event that the ISDA Pricer fails is a
Commission to grant an order method.3 The proposed rule change was reliable pricing tool.9 Therefore, this
permitting a transaction otherwise published for comment in the Federal revised approach is not likely to result
prohibited by section 17(a) if it finds Register on April 19, 2017.4 The in significant changes to CDS prices and
that (a) the terms of the proposed Commission received no comment margin requirements calculated using
transaction are fair and reasonable and letters regarding the proposed change. LCH SA’s current approach.
do not involve overreaching on the part For the reasons discussed below, the
of any person concerned; (b) the Commission is approving the proposed III. Discussion and Commission
proposed transaction is consistent with rule change. Findings
the policies of each registered Section 19(b)(2)(C) of the Act directs
II. Description of the Proposed Rule
investment company involved; and (c) the Commission to approve a propose
Change
the proposed transaction is consistent rule change of a self-regulatory
with the general purposes of the Act. LCH SA has proposed to amend its organization if it finds that such
Section 6(c) of the Act permits the CDS margin framework. The proposed proposed rule change is consistent with
Commission to exempt any persons or change would alter the approach used the requirements of the Act and the
transactions from any provision of the by LCH SA when the ISDA Pricer, used rules and regulations thereunder
Act if such exemption is necessary or in pricing CDS, fails as a result of applicable to such organization.10
appropriate in the public interest and extreme spread curves. Under its Section 17A(b)(3)(F) of the Act requires,
current CDS margin framework, LCH SA among other things, that the rules of a
consistent with the protection of
uses the ISDA Pricer to calibrate credit registered clearing agency be designed
investors and the purposes fairly
spread curves as part of its spread to promote the prompt and accurate
intended by the policy and provisions of margin component. According to LCH clearance and settlement of securities
the Act. SA, the ISDA Pricer cannot be used to transactions and, to the extent
For the Commission, by the Division of calibrate credit spread curves where applicable, derivative agreements,
Investment Management, pursuant to ‘‘extreme’’ credit spread curves exist.5 contracts, and transactions.11 Rule
delegated authority. In the event that the ISDA Pricer fails 17Ad–22(e)(17) requires, in relevant
Robert W. Errett, due to the existence of extreme credit part, that each covered clearing agency
Deputy Secretary. spread curves, LCH SA has established establish, implement, maintain, and
[FR Doc. 2017–11924 Filed 6–7–17; 8:45 am]
a dichotomy-based algorithm that it uses enforce written policies and procedures
reasonably designed to manage a
asabaliauskas on DSKBBXCHB2PROD with NOTICES

BILLING CODE 8011–01–P 1 15 U.S.C. 78s(b)(1). covered clearing agency’s operational
2 17 CFR 240.19b–4. risk by identifying the plausible sources
3 For additional information regarding the ISDA

Standard Model, see www.cdsmodel.com. The 6 Id.
Commission is providing this link solely for
7 Id.
informational purposes.
4 Securities Exchange Act Release No. 34–80451 8 Id.
9 Notice,82 FR at 18516.
(April 13, 2017), 82 FR 18515 (April 19, 2017) (SR–
LCH SA–2017–004) (‘‘Notice’’). 10 15 U.S.C. 78s(b)(2)(C).
5 Notice, 82 FR at 18515. 11 15 U.S.C. 78q–1(b)(3)(F).

VerDate Sep<11>2014 17:24 Jun 07, 2017 Jkt 241001 PO 00000 Frm 00065 Fmt 4703 Sfmt 4703 E:\FR\FM\08JNN1.SGM 08JNN1
Document Created: 2018-11-14 10:06:20
Document Modified: 2018-11-14 10:06:20
Category		Regulatory Information
Collection		Federal Register
sudoc Class		AE 2.7: GS 4.107: AE 2.106:
Publisher		Office of the Federal Register, National Archives and Records Administration
Section		Notices
FR Citation		82 FR 26721