Markets View - April 2022

Welcome to the latest edition of Markets View!  This month, we look at how responses to the Russian invasion of Ukraine have impacted FMIs and market participants, HM Treasury's response to its Wholesale Markets Review consultation, ESMA's call for evidence on climate stress testing for central counterparties, the report on central counterparty financial resources from FSB, CPMI and IOSCO, and HM Treasury's response to its consultation on an expanded resolution regime for CCPs.

Implications arising from the Russia-Ukraine war for FMIs and market participants

The fallout from the Russia-Ukraine war has had profound consequences for financial market infrastructures (FMIs) and market participants, largely from sanctions and disruptions to trading. Financial measures taken by the international community have included sanctions against Russian and Belarusian assets, businesses and key individuals. Partly in response to the volatility caused by sanctions, the Russian central bank closed the Moscow Exchange on 28 February, partially reopening it on 24 March. Western trading venues have also been affected. Since March, major trading venues, such the London Stock Exchange, the New York Stock Exchange and NASDAQ, suspended trading in securities of most Russian companies. In addition to disruption to trading linked to securities in Russian companies, increased volatility has impacted trading in commodities on trading venues, see eg., the London Metal Exchange suspended Nickel trading in March and retrospectively cancelled a number of trades.

These issues have affected FMIs and market participants in a variety of ways:

• Investment managers - Some firms are exposed to "stranded" Russian or Belarusian assets, ie., assets subject to sanctions prohibiting dealing with such assets and/or counterparties that own them. Given the difficulty of valuing such assets, some firms have marked stranded assets down to zero and closed funds to withdrawals.
• Central securities depositories (CSDs) - EU CSDs have ceased certain activities related to Russian securities and the Russian rouble (RUB) as well as Russian residents, so, eg., Clearstream has ceased accepting the RUB as a settlement currency, ceased providing FX services in RUB, closed the settlement of Russian domestic and Russian-related securities, and blocked the account of Russia's National Settlement Depository.
• Central clearing parties (CCPs) - Especially in relation to energy and commodities market segments, CCPs are closely monitoring volatility and margin developments. The main impact for clearing members and their clients of spiralling energy and commodity prices has been a record-high spike in margin calls in derivatives markets.

Industry bodies have responded by publishing guidance to help firms navigate some of these key issues. ISDA issued a guidance note for parties to OTC transactions affected by the closure of markets and the cessation of trading in certain securities. In order to mitigate market risk and promote orderly settlement, the guidance illustrates the consequences of market closure and cessation events based on the default provisions in ISDA documentation. ICMA issued a guidance note to address questions from firms affected by cash bond and repo trades that have not settled due to sanctions. While noting that professional legal advice should be obtained, resolving unsettled trades may require commercial negotiation with other parties to take action such as to cancel trades or wait until settlement is possible.

More agile, less prescriptive regulation for wholesale financial markets...when parliamentary time allows

HM Treasury's response to the Wholesale Markets Review consultation included its first set of changes to remove "unwieldy" rules as part of its post-Brexit review of UK capital markets.  We suggest key changes for trading venues, FMIs and market participants to focus on are:

• Equity markets - Entrenching the suspension applied in early 2021, the government will remove the double volume cap, which respondents viewed as an arbitrary limit doing little to improve price formation. The government will also remove the share trading obligation, freeing firms to trade in the most liquid market and obtain best execution for clients. In addition, the government will remove the requirement for algo firms to enter into market making strategies to simply liquidity provision.
• Fixed income and derivatives markets - Correcting the misalignment caused by the EMIR Refit in 2019, the government will align the counterparties in scope of the derivatives trading obligation (DTO) with those subject to the clearing obligation. The government will also expand the exemption from the DTO beyond portfolio compression to all post-trade risk reduction services to incentivise the uptake of such services.
• Commodity derivatives - To simplify the regime and remove unnecessary restrictions, the government will limit the scope of the position limits regime to physically settled and agricultural contracts, formalising the FCA's suspension of supervisory and enforcement action last year, and exclude economically equivalent OTC contracts from being automatically captured, given the difficulty of identifying such contracts.
• Trading venue perimeter - The current definition of multilateral systems has created uncertainty about what type of firms need to be authorised as an MTF, especially given the emergence of platforms facilitating the bringing together of parties. The FCA will consult on guidance to resolve the uncertainty in the definition of multilateral systems.
• Market outages - To resolve ambiguity regarding the role of market operators and participants in such circumstances, the FCA will consult on what should happen in a market outage. The government also plans to delegate the pre-trade equity waivers regime to the FCA and allow trading venues that rely on a reference price waiver to use reference prices from any trading platform that offers the best execution result, whether that was the market of first admission (currently as required under MiFIR) or not.  Being able to choose from several venues should also help trading venues address market outages.
• Systematic internalisers (SIs) - The government will revert to a qualitative definition of SIs so that firms do not have to carry out complex calculations that are costly to comply with and which have resulted in many firms opting out of the regime. The government will also allow SIs to execute client orders at the midpoint between the best bid and offer, bringing the UK into line with other global markets.

The industry has welcomed these changes but, in the wider European context, there are concerns about the continuity of cross-border services and market fragmentation. The EU is conducting its own MiFIR review and will tighten rather than ease regulatory requirements: for instance, it announced new regulations to drive volumes back onto lit markets.

Developing an approach to climate risk stress testing for EU CCPs

ESMA issued a call for evidence ahead of its consultation on the introduction of climate stress tests (STs) for CCPs. CCPs should review the proposed framework for categorising climate risks and the issues flagged for modelling such risks as they will inform internal approaches taken to this still-developing field.

• Physical risk - The impact of extreme weather events on the operations of CCPs and associated parties combined with price movements in markets affected by such events. Firms were invited to comment on the main challenges of modelling physical risks, ie., identifying what weather events are relevant, how to formulate scenarios for testing, and if only energy/commodity prices assets would be impacted.
• Rapid transition risk - The risk to CCPs that financial/reputational issues faced by companies as part of policy, legal, technological and market changes from efforts to mitigate/adapt to climate change cause sudden spikes in volatility combined with defaults by members. To determine whether such risks are appropriate in the context of CCP STs, firms were invited to comment on if investors would plausibly react to such changes in the time the CCPs require to liquidate the positions of a defaulting member.
• Business risk - The risk that if clearing activities linked to "brown" assets or activities decline over time and are not replaced by new "green" activities, a CCPs' earnings will decline. ESMA itself flags that this may be a risk monitored more generally outside a specific climate risk framework, but firms were invited to comment on whether only certain sectors and/or asset types would need to be considered (such as the oil and gas sector/oil futures contracts).
• Collateral replacement risk - The impact on the market and participants of potential changes in collateral eligibility if (i) new climate-related eligibility constraints were applied or (ii) assets lost value such that investors required increasing risk premia to hold or they became more volatile. Firms were invited to comment on what information is needed to identify assets to be replaced, whether a commitment to replacing a certain number of assets would be an appropriate outcome, and an appropriate time horizon for the analysis.

Several industry bodies have provided responses to the call for evidence. Amongst other things, ISDA flagged that it did not consider the time horizons of business or collateral replacement risks to be relevant to CCP STs, while this theme was picked up by CCP12 and EACH in relation to rapid transition risks, which suggests that there is divergence in the industry even on headline issues. The EACH response also recorded that some members had already taken part in group-wide exercises assessing physical risk-type issues as part of general group-wide ESG reviews.

Further work for CCPs on financial resources and tools for recovery and resolution

The FSB, CPMI and IOSCO published a joint report assessing if the tools and financial resources for recovery and resolution currently available to CCPs are adequate and effective. The report concludes that the current resources and tools are lacking in some key respects and particularly when it comes to recovery following non-default loss events. CCPs should have regard to the following insights from the report in their recovery and resolution planning.

• Non-default loss events - All surveyed CCPs were able to address their liquidity needs following a loss of access to an institution holding assets on behalf of the CCP, but fewer than a third were able to cover their losses following a modelled cyber theft of assets. Considering how widely non-default loss events can vary in nature, the mixed results are perhaps not surprising, but the sheer inadequacy of resources in the face a cyber threat may imply that current tools do not sufficiently equip CCPs to respond to certain types of loss event.
• Impact of tools on financial stability - The impact on the wider market of CCPs' use of cash calls, variation margin gains haircutting (VMGH), initial margin haircutting (IMH), forced allocation, tear-ups and write down of liabilities in resolution (positive or negative) ultimately depends on which tools a CCP has used and the degree to which it applies them. The impact can vary widely, from affecting participants' choice of CCP to disrupting operations between CCPs and linked FMIs. While all tools aim to smooth disruption following CCP loss or failure, all carry risks for the market, so CCPs should be able to demonstrate that their choice of tool was carefully considered and tailored to specific loss events.
• Use of VMGH and cash calls - The analysis indicates that using cash calls and VMGH has very minimal positive impact on CCP liquidity and solvency, even when these tools are used to the maximum extent possible. Use of these tools however can negatively impact individual clearing members' liquidity, leading to potential knock-on effects for the wider market that CCPs should consider.
• Default loss events - The surveyed CCPs were generally well positioned to handle default loss events as modelled, with only half of all service lines requiring use of any recovery tools at all and only a small number of service lines requiring complete exhaustion of pre-funded and committed financial resources.

CCPs should keep a watching brief on this issue, as the FSB will continue to review the sufficiency of the existing CCPs' resolution toolkits, with work on examining potential alternative financial resources and tools for CCP resolution to commence later this year.

HM Treasury proposes to expand CCP resolution regime

In the same month as the joint report discussed above, HM Treasury published a response to its consultation on an expanded resolution regime for CCPs. The proposal is to give the Bank of England additional powers to resolve a CCP, including:

• excluding resolution as a basis for terminating contracts with CCPs and a power to stay termination rights along the lines of the provisions that apply to banks and investment banks in the Banking Act;
• the power to tear up contracts with clearing members, thereby returning a CCP to a matched book. The intention is that this power will be applied to the smallest number of contracts and that cancelled contracts will be cash settled at a commercially reasonable price;
• loss allocation tools - both variation margin haircutting and cash calls - with limits of twice default fund contribution for default losses and three times default fund contribution for non-default losses; and
• an ability to write down default fund contributions.

These and the other resolution tools will be subject to the no creditor worse off safeguard, so clearing members should not be left worse off in a resolution than if the CCP were to enter insolvency. HM Treasury also proposes to impose a second "skin-in-the-game" tranche in CCPs' default waterfall, to follow the default fund but precede cash calls, so that it is used before any resources which are not pre-funded. The Bank will be able to set its quantum and will take relevant factors such as the CCP's risk-based capital requirements into account when doing so. Timing for these changes is to be confirmed.