The Bank of England’s approach to determining commercially reasonable payments for contracts subject to a statutory tear up in CCP resolution

1: Overview

1.1. Central counterparties (CCPs) play an important role in financial markets, increasing efficiency and reducing risks in bilateral trades by interposing themselves between buyers and sellers. Where a financial contract is centrally cleared, the CCP becomes the buyer to every seller and the seller to every buyer, providing assurance that the obligations under those contracts will be fulfilled.

1.2. Given the key role that CCPs play in the financial system, CCPs and resolution authorities must maintain clear and robust recovery and resolution arrangements to respond effectively to periods of significant stress.

1.3. Schedule 11 of the Financial Services and Markets Act 2023 (FSMA 2023) introduced a new regime for resolving CCPs that are deemed to be failing or likely to fail. The regime provides the Bank of England (the Bank) and His Majesty’s Treasury (HMT) with several stabilisation options to resolve CCPs effectively, protecting financial stability, taxpayers and the economy while maintaining the critical functions of the CCP. The regime consists of eight stabilisation options:

a. transfer to a private sector purchaser;
b. transfer to a bridge central counterparty;
c. transfer of ownership;
d. terminating clearing member contracts (ie ‘tear up’);
e. making a cash call;
f. reducing variation margin payments;
g. writing down liabilities; and
h. taking control of the CCP.

1.4. The fourth stabilisation option allows the Bank to ‘tear up’ (or terminate) one or more contracts cleared by the CCP in the affected clearing service. Tearing up contracts allows the CCP to return to a ‘matched book’^{footnote [1]} in a scenario in which one or more clearing members have defaulted on their payment or delivery obligations to the CCP. Rather than tearing up all contracts cleared by the clearing service in question, the Bank’s intention would typically be to conduct a ‘partial tear up’, limiting the number of contracts affected. References throughout this paper to the statutory tear up stabilisation option should be read as applying equally to both a full and partial tear up as the situation requires.

1.5. Depending on the value of each contract being torn up, the Bank would either (i) require the CCP to make a commercially reasonable payment representing the value of the terminated contract to the clearing member who is a party to the terminated contract, or (ii) require the clearing member to make a commercially reasonable payment representing the value of the contract to the CCP. Should more than one contract be torn up for a given clearing member, these payments will be made on a net basis.

1.6. FSMA 2023 established a statutory requirement for the Bank to publish, within 12 months of Schedule 11 of FSMA 2023 (Schedule 11) coming into force, a statement of policy as to how it would determine what a commercially reasonable payment is.^{footnote [2]}

1.7. This consultation paper sets out the Bank’s proposed approach to determining the commercially reasonable value of contracts subject to a statutory tear up in a CCP resolution. Section 2 sets out the background and context in which the statutory tear up stabilisation option may be used. Sections 3 to 5 outline the Bank’s proposed approach to determining a commercially reasonable valuation of contracts subject to a statutory tear up. Section 6 sets out the questions on which the Bank is consulting. Responses to the consultation will inform the Bank’s thinking ahead of publication of its statement of policy later in 2024.

2: Background

2.1. As noted above, FSMA 2023 provides the Bank and HMT with several stabilisation options to resolve CCPs effectively.

2.2. The Bank may use a stabilisation option only if it is satisfied that all the conditions set out in paragraph 17 of Schedule 11 (the ‘resolution conditions’) have been met.

2.3. If the Bank determines that it is necessary to use a stabilisation option, it will need to consider which option to use, having regard to its legal obligations and the special resolution objectives set out in Schedule 11. The special resolution objectives are as follows and are unranked:

• Objective 1 is to protect and enhance the stability of the UK financial system, including in particular by (a) preventing contagion (including contagion to market infrastructures) and (b) maintaining market discipline.
• Objective 2 is to protect and enhance public confidence in the stability of the UK financial system.
• Objective 3 is to maintain the continuity of central counterparty clearing services.
• Objective 4 is to protect public funds.
• Objective 5 is to avoid interfering with property rights in contravention of a Convention right (within the meaning of the Human Rights Act 1998).

3: Use of the tear up stabilisation option in a default loss scenario

3.1. The nature of the stabilisation options available to the Bank under FSMA 2023 depends on whether the failure of the CCP has occurred in the context of a ‘default loss scenario’, a ‘non-default loss scenario’ or a combination of the two. A default loss means a loss arising as a result of a clearing member defaulting on its obligations to the CCP, while a non-default loss means a loss arising as a result of something other than a clearing member defaulting on its obligations to the CCP. Statutory tear up is one of the stabilisation options provided for under Schedule 11 in a default loss scenario (but not a non-default loss scenario). The remainder of this paper refers to a tear up under Schedule 11 as a ‘statutory tear up’.^{footnote [3]}

3.2. CCPs act as the seller to every buyer and buyer to every seller, meaning that in business-as-usual conditions they clear a matched book. In a default loss scenario, one or more clearing members fails to meet their payment or delivery obligations to the CCP as they fall due, leaving the CCP with an unmatched book. This exposes the CCP to market risk – and thus potential losses – on its unmatched positions. For example, the CCP will no longer receive variation margin from the defaulting clearing member but remains obliged to meet any variation margin payments that fall due to non-defaulting clearing members.

3.3. A CCP is likely to seek to liquidate most or all of the defaulting clearing member’s positions as part of its default management processes, to return to a matched book.^{footnote [4]} There could be extreme scenarios, however, in which the CCP is unable to liquidate some or all of the defaulting clearing member’s positions using the tools available under the CCP’s rulebook – for instance if markets are stressed and liquidity is thin.

3.4. If the Bank determines that it is necessary to use one of the stabilisation options in such a scenario, the Bank may decide to use the stabilisation option to tear up contracts to return the CCP to a matched book, having regard to the special resolution objectives. The Bank may use the statutory tear up option before, after or alongside any unexhausted powers in the CCP’s rulebook and the statutory stabilisation options for loss allocation, as necessary.

3.5. The Bank would determine the scope of any statutory tear up (ie which contracts would be torn up) at the time of resolution. The scope of any tear up would be a scenario-specific judgement considering a range of factors, including the special resolution objectives (which include, among other things, the protection and enhancement of UK financial stability and the protection of property rights).^{footnote [5]} HMT’s Central Counterparties Special Resolution Regime Code of Practice document^{footnote [6]} notes that ‘The Bank would seek to make the scope of a tear-up as narrow as possible to minimise the impact of the tear-up on the CCP’s surviving members and the broader financial markets’. This consultation paper is focussed on the Bank’s approach to determining a commercially reasonable price for contracts that are subject to a tear up and does not address the Bank’s process for setting the scope of a tear up.

3.6. When contracts are torn up, either the CCP or the clearing member who is a party to the contract will be required to make a commercially reasonable payment representing the value of the terminated contract to the other party. The Bank is responsible under FSMA 2023 for determining what a commercially reasonable payment would be. The remaining sections set out the Bank’s proposed approach to determining the commercially reasonable value of contracts subject to a statutory tear up.

4: The Bank’s proposed approach to determining commercially reasonable prices in a statutory tear up

4.1. Resolution scenarios, by their nature, represent tail risk events. The scenario in which the Bank may consider executing a statutory tear up in CCP resolution may well be an extreme, fast-moving stress.^{footnote [7]} As a result, the Bank’s approach to determining commercially reasonable prices in a tear up needs to be practicable and executable in a tight timeframe, as well as clear and transparent.

4.2. When the Bank executes a statutory tear up, it would expect in the first instance to instruct the CCP to use its own rules and arrangements to generate commercially reasonable prices for contracts being torn up. The CCP would propose these prices to the Bank, supported by relevant data and information to illustrate how these prices have been derived. The Bank will engage with UK CCPs in due course to discuss the data that it may request from CCPs to support their proposed prices. Commercially reasonable prices in this case should be representative of the mark-to-market prices that the CCP would use for margining purposes. Prices should reflect those in an orderly market, disregarding any short-term market dislocations that represent disorderly trading.

4.3. The Bank would review the prices proposed by the CCP for contracts being torn up to confirm that they are commercially reasonable. The Bank may consider a range of inputs when assessing whether prices are commercially reasonable, including (but not necessarily limited to) the supporting data and information provided by the CCP and any of the alternative pricing indicators listed in paragraph 5.4 below.

4.4. Statutory tear up is not intended to be used as a means to allocate losses to members (eg by tearing up contracts at an artificially lower or higher price than is commercially reasonable). Using tear up to allocate losses could risk undermining netting provisions and would focus losses on counterparties whose positions are being torn up. Instead, the Bank would generally envisage using the loss allocation tools available to it in a default loss scenario - such as cash call or variation margin gains haircutting - to absorb losses that have crystallised, including as a result of the use of the tear up power.

4.5. In most circumstances, the Bank expects that the prices generated by the CCP will represent a commercially reasonable valuation of each contract. CCPs are well placed to perform this role. CCPs price all open positions on a daily basis for margin purposes. They have a range of methodologies and procedures to generate commercially reasonable prices in a variety of scenarios, which clearing members have signed up to and which are reviewed periodically.

4.6. It is, however, conceivable (although unlikely) that a situation could arise in which one or more prices initially proposed by the CCP appear manifestly not commercially reasonable to the Bank. For instance, liquidity may have dried up in the trading of the given cleared contract, making it difficult to price reliably. In assessing whether prices appear commercially reasonable, the Bank would consider a range of potential inputs and data sources, including supporting data and information provided by the CCP and the potential price indicators listed in paragraph 5.4 below.

4.7. In cases where initial prices proposed by the CCP do not appear to the Bank to be commercially reasonable, the Bank would expect in the first instance to query the price with the relevant CCP, to exchange views about the pricing of the contract(s) in question. The Bank would instruct the CCP in resolution to review the pricing of the contract based on the information exchanged, to consider whether the proposed price should be amended.

4.8. If, following its review, the CCP determines that its initial proposed price should be amended, the CCP would propose a new price to the Bank for consideration. If the CCP considers that its original proposed price remains appropriate, it will notify the Bank of its view, outlining the rationale for the proposed price. The Bank would consider any updated prices or information provided by the CCP in relation to the contracts in question and make a final assessment of whether it considers each proposed price to be commercially reasonable.

5: Alternative pricing approaches in a statutory tear up

5.1. The Bank’s view is that the bar for the Bank to deviate from a price proposed by the CCP should be high, and there would be limited circumstances in which the Bank would step in to make judgements on granular pricing issues. As outlined above, CCPs are experienced at pricing contracts and have a variety of methodologies that are designed to be used in both normal and stressed market scenarios. Members of a CCP are already exposed on a daily basis to prices generated by the CCP’s existing methodologies and are sighted on the CCP’s business-as-usual approach to setting daily settlement prices.

5.2. If the Bank reviews a price proposed by the CCP in the light of other pricing information (including as set out in paragraph 5.4 below) and considers that there are sufficient grounds to determine that the relevant price(s) is manifestly not commercially reasonable, the Bank will use another method to generate a commercially reasonable price for the contract(s) in question.

5.3. The Bank would determine the appropriate alternative pricing method for generating a commercially reasonable price at the time, based on careful assessment of the specifics of the stress scenario. Different pricing approaches may be appropriate in different situations, depending on the scenario, wider market backdrop and contract(s) in question.

5.4. Where the Bank decides to use an alternative pricing method, it would use the best available data at the time to inform its decision on an appropriate alternative price. The Bank would consider a range of potential inputs and data sources to establish, test and corroborate the price it determines, including one or more of the below potential price indicators:

a. Current prices relating to the same or very similar contract(s): If the CCP is unable to produce a commercially reasonable price for a contract, current prices provided by other pricing sources for the same or very similar contracts may help indicate a commercially reasonable price of the contract(s) in question. Current price information may be available from other CCPs, other trading locations, third-party providers or market-makers. Careful judgement would be required to reflect potential pricing variances between alternative price sources and the CCP and contract(s) in question.

If current prices for the same or similar contracts are unavailable or are not considered by the Bank to be commercially reasonable, prices of correlated contracts^{footnote [8]} cleared by the CCP or by other CCPs may provide insight into a commercially reasonable price for the contract(s) in question. Case-by-case judgement will be required to assess the extent to which any potential correlation exists and continues to be relevant, particularly in a stress.

b. Recent prices relating to the same or very similar contract(s): If current prices for the contract(s) in question are unavailable or are not considered by the Bank to be commercially reasonable, recent historical price levels may help indicate a commercially reasonable price for the contract(s) in question. If current market activity in the contract(s) in question does not appear to be orderly, the Bank may look to the last period of orderly market activity in the contract(s) in question to help inform its thinking on commercially reasonable prices.

c. A modelled price calculated by a third party: A modelled price calculated by a third party may help inform the Bank’s thinking on a commercially reasonable price for the contract(s) in question.

5.5. Once the Bank has either (i) accepted prices proposed by the CCP or (ii) used an alternative pricing method to determine a commercially reasonable price for each contract subject to the statutory tear up, the Bank will communicate these prices to the CCP. The Bank will then require the CCP to calculate the commercially reasonable payments to be made between the CCP and each of the relevant clearing members, and to communicate and initiate these payments to and from the relevant parties, representing the value of the terminated contract.

6: Questions being consulted on

6.1. The Bank would welcome responses to the following consultation questions:

• Do respondents have any views on the Bank’s proposed approach of using the CCP’s existing arrangements to determine a commercially reasonable valuation for contracts subject to a statutory tear up (unless the Bank considers it necessary to use an alternative pricing approach)?
• Do respondents have any views on the Bank’s proposed approach to assessing whether it considers the CCP’s proposed prices to be commercially reasonable?
• Do respondents have any views on the Bank’s proposed approach to generating alternative prices in circumstances in which the Bank concludes that one or more prices proposed by the CCP are not commercially reasonable?

6.2. The Bank would welcome written responses to these questions, or any other relevant observations, by Friday 4 October 2024. Please provide those responses by email to: CCP.Resolution@bankofengland.co.uk. Alternatively, please address any comments or enquiries to: Resolution Directorate, Bank of England, Threadneedle Street, London, EC2R 8AH.