Project launching OTC derivative and repo clearing in KDPW_CCP using novation

Project Environment

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Adverse impact of the financial crisis• Adverse impact of the crisis on the stability of the financial sector• Reduced liquidity on the OTC market• Increased volaility of trade values• Rising awareness of credit risk in the ‘world after Lehman’

New regulations• UE: EMIR – Regulation on OTC derivatives, central counterparties and

trade repositories – pending approval of the European Parliament• USA: Dodd-Frank Act - implemented 21/07/2010• Basel III, CRD IV – in market consultation

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Identifying the Legal Environment

EMIR - Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on OTC derivative transactions, central counterparties and trade repositories.

• Central clearing of tradesmandatory clearing via a CCP (central counterparty) of all standard derivatives traded outside the regulated market

• Reporting to trade repositoriesmandatory reporting of all trades, both cleared centrally and bilaterally, to trade repositories

• Rules for CCPs and trade repositories- authorisation and supervision of CCPs- capital requirements- organisational requirements- precautionary requirements (risk guarantee system)- interoperability

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Identifying the Legal Environment

Basel Committee on Banking Supervision

Consultative Document Capitalisation Of Bank Exposures To Central

Counterparties

• Exposures to CCPs in respect of MtM and margins subject to low (2% risk weight) capital requirements owing to multilateral netting of liabilities and loss protection mechanisms offered by CCPs

• Bank exposure to the default fund determined on the basis of the current financial resources of the CCP in relation to hypothetical capital requirements. CCP hypothetical capital determined under CEM (Current Exposure Method).

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List of Active and Planned CCP Services for OTC Derivatives

Country Service Scope Status

Germany Eurex Clearing IRS Planned

Japan JSCC IRS Planned

Poland KDPW_CCP IRS, FRA Planned

Sweden Nasdaq OMX IRS Active

UK CME Clearing E. IRS Planned

UK LCH.Clearnet Ltd IRS Active

France LCH.Clearnet SA IRS Active

USA CME IRS Active

USA IDCG IRS Active

USA NYPC IRS Planned

Bank for International Settlement, CGFS Papers No 46

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• Experience in clearing: new clearing guarantee model of the

clearing house KDPW_CCP spun off from KDPW in July 2011

• Technical and technological infrastructure and existing

communication infrastructure with participants

• KDPW_CCP’s neutral position as a counterparty to market

participants

• Clearing Model accepted by the Banking Expert Team

• Relations with PFSA, NBP, market participants

• KDPW_CCP ability to use collateral in securities, which greatly

reduces the cost of collateral

• Own capital of KDPW_CCP

Why KDPW_CCP?

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Consultations with the Banking Expert Team

The Banking Expert Team has approved:

• Clearing model• Scope of cleared instruments• Instrument valuation model• Staged implementation of the project• Use of confirmation platforms• Risk management

All banks have been invited to participate in KDPW_CCP consultations;

64 representatives of 17 banks took part in the consultations.

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Proposed OTC Clearing Model

Trading Member A

C l i e nt External trading platform

MarkitWire SWIFT Accord• Trade validation• Trade affirmation• Trade matching

Trading Member B

C l i e nt

KDPW_CCP

•Trade clearing•Trade repository•Clearing risk and position management•Clearing guarantee system•Processing settlement in third-party systems

KDPW (CSD)•Cash settlement•Collateral in securities

Clearing Member B

KDPW Member A

NBP Settlement in PLN

Payer Bank A

PF

SA

Clearing Member A

Termination Platform(TriOptima)

KDPW Member B additionally in payer bank function

Thomson Reuters•market data transfer

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KDPW_CCP Clearing Model: Key Functionalities

P r o w a d z e n i e r o z l i c z e ńFormal and substantive check of instructions

Interpositioning KDPW_CCP as legal counterparty

Calculating interest payments and MtM

Contributions to the clearing guarantee system(margins and fund)

Risk management

•Defining and calculating risk parameters•HVar •Price monitoring•Back testing•Stress tessting•Exposure limits

Collateral administration

•Securities register•Collateral valuation

Trade repository

Early termination (Auction) (Tri Optima – automatic termination)

C l e a r i n g

Sending instructions for settlement

Reporting Backloading

Accepting trades for clearing

Third-party trading platformMarkitWire SWIFT Accord

KDPW_CCP

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Collateral Processing Model

Member

Credits and debits in respect of

contributions to the clearing

guarantee fund

NBP KDPW_CCP settlement in PLN

Collateral processing

SECURITIES

KDPW

COLLATERAL REGISTER

Transfer of ownership in KDPW_CCP account with KDPW

CASH

Accepting collateral in securities:a) Treasury bondsb) W20 index shares

Collateral valuationDetermining the haircut

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Instruments: List Approved with Banks

Phase 1 – 01 January 2013• Forward Rate Agreements • Interest Rate Swaps• Overnight Index Swaps• Basis Swaps• Repos

Phase 2 – 01 January 2014• Cross Currency Interest Rate Swaps• Options• Other

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Proposed Introduction of Clearing Novation to Regulations

Clearing novation means that the clearing house takes over the rights and obligations of a counterparty to a trade. Once a trade has been accepted for clearing, the rights and obligations arising from the trade expire in the relations between the trade counterparties and are replaced by new legal relations.

Clearing novation will be used on the organised market and outside the organised market.

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Novation

If a counterparty to a trade is a clearing member and has committed itself to the clearing house to perform obligations arising from the clearing of its trades, it is entitled to receive or liable to provide a benefit resulting from the clearing of the trade vis-a-vis KDPW_CCP.

Member A Member B Trade #1

KDPW_CCP

BUY SELL

BUYSELLTrade #2 Trade #2

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Consequences of Clearing Novation to KDPW_CCP

• Rights and obligations arising from the trade expire while new legal relations arise, to which the clearing house is a party.

• The clearing house is entitled to claim the benefits arising from the trade with regard to the trade counterparty (if it is a member) or a member which is a party to clearing.

• Once a trade has been accepted for clearing, a member which is a party to clearing and the clearing house may only raise claims arising from the legal relations which have replaced the original trade.

• A member which is a party to clearing cannot raise claims against the clearing house arising from the legal relation between the member and the entity which concluded the trade.

• Collateral established by the entity concluding the trade subject to clearing by the CCP is excluded from the liquidation assets of the member.

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Legislative Amendments

As a result of consultations initiated by KDPW with market institutions (PFSA, NBP, WSE, Chamber of

Brokers, Polish Banks Association, BondSpot, Custodian Banks Council), a draft has been submitted to

the Finance Ministry, requesting an amendment of the Act on Trading in Financial Instruments. Key

amendments include:

• Act on Trading in Financial Instruments:

Art. 45b - amendment of the definition of trade clearing: addition of the clearing house as entitled to

receive or liable to deliver cash and non-cash benefits arising from concluded trades;

Art. 45e - amendment excluding collateral established by the entity concluding the trade outside of

organised trading subject to clearing by the clearing house from the liquidation assets of the member

Art. 45g-45i - amendment introducing clearing novation.

Art. 50, Art. 68b - amendment adding new functionalities in the clearing house and KDPW regulations

Art.68 - amendment concerning guarantee funds, including establishment of guarantee funds for

trades concluded outside the organised market

• Harmonising amendments of the Act on Public Offering (Art. 67,90) and the Act on Civil Law Transaction

Tax (Art. 9).

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KDPW_CCP Clearing Guarantee System

Participant requirements

Price monitoring

Monitoringexposures / concentratio

n

Margins

MTM

Default fund + additional margins

Back Testing

Stress Testing

CCP capital

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State-of-the-art Risk Management System

• Valuation – instrument valuation model customised to market specificity

• Calculating risk based on HVaR (historical VaR)

• 5-day risk calculation horizon

• Confidence level – 99.9%

• 500 days – look back period

• Default fund – covers stress-test risk

• Additional margins – cover individual participant exposure between default fund

updates

• Stress-tests – test the adequacy of resources pooled in the clearing guarantee

system

• Back-tests – test the adequacy of the risk estimation model and its parameters

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Guarantee System Resources

I. Individual margins

II. Default fund

III. Additional margins

IV. KDPW_CCP capital

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Staged Project Implementation

1.Establish co-operation with Banking Expert Team2.Jointly develop OTC trade clearing model3.Approve standards of OTC instruments covered by phase 14.Develop risk management methodology and valuation rules5.Develop functional and technical specification of the new IT solution6.Select IT solution vendor7.Initiate Design Study with selected vendor

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8.Implementation work Jan-Jun 20129.Present technical documentation and draft regulations to participants Mar 2012 10.Expected introduction of novation to Polish regulations

Apr-Jun 201211.Amendment of KDPW_CCP regulations Jan-Jun 201212.Signing agreements with participants Dec 201213.Testing the system with participants Aug-Nov 201214.Increase of KDPW_CCP capital Q2-3 201215.Production rollout Jan

2013

PLANNED

DONE