1: Introduction
1.1 The Bank of England (the Bank) published a consultation paperfootnote [1] in July 2024, outlining its proposed approach to determining commercially reasonable payments to clearing members whose contracts are subject to a statutory tear up in resolution under Schedule 11 of the Financial Services and Markets Act 2023 (Schedule 11).
1.2 The Bank received written and verbal feedback on the consultation paper from UK central counterparties (CCPs) and representatives of users of UK CCPs. The Bank's policy development has also been informed by engagement in international policy discussions with other CCP resolution authorities, and from our observation of arrangements in other jurisdictions.
1.3 Respondents were generally supportive of the proposals in the consultation paper, while recognising the challenging circumstances in which a statutory tear up may occur. Respondents provided suggestions and identified areas where further clarity would be helpful. This paper summarises the feedback received and provides the Bank’s responses to the points raised, noting those areas where the Bank is making a change to the proposals outlined in the consultation paper.
2: Feedback to consultation responses
2.1 The following sections summarise the feedback received on the Bank’s consultation paper and outline the Bank’s response.
CCPs’ role in proposing prices for torn up contracts
2.2 The Bank’s consultation paper proposed that, when the Bank executes a statutory tear up, it would in the first instance instruct the CCP in resolution to use its own rules and arrangements to propose prices to the Bank for contracts being torn up. Several respondents welcomed the approach of utilising CCPs’ existing approaches to generating prices, noting that CCPs have particular expertise in the markets they clear. One respondent noted that using CCPs’ existing arrangements to generate proposed prices would help promote transparency and predictability in the valuation of torn up contracts.
2.3 The consultation paper noted, however, that determining prices in a statutory tear up scenario (in which a CCP has been placed into resolution and other attempts to match the CCP’s book have failed) may be challenging. Several respondents noted that pricing may be more difficult if markets are stressed and liquidity is poor.
2.4 One participant raised concerns that the proposed approach could result in placing too much reliance on CCPs’ own rules and arrangements. The respondent suggested that the Bank examine CCPs’ rules and arrangements for generating prices in a tear up as part of future assessments of UK CCPs’ resolvability.
2.5 The Bank considers that CCPs are best placed to propose initial prices to the Bank for torn up contracts in a fast-moving tear up scenario, as they price these contracts daily using pre-established methodologies that clearing members have signed up to.
2.6 Notwithstanding the above, if the Bank were to consider that an initial price proposed by the CCP did not appear 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 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.
2.7 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. If the Bank considers that there are sufficient grounds to determine that the relevant price is manifestly not commercially reasonable, the Bank will use another method to generate a commercially reasonable price for the contract in question.
2.8 More broadly, it is important for CCPs and resolution authorities to ensure that clear and robust arrangements are in place to facilitate a successful resolution. The Bank has indicated its intention to develop an approach to assessing the resolvability of UK CCPs,footnote [2] consistent with the Financial Stability Board’s international standard for the Key Attributes of effective resolution regimes. Development of the Bank’s approach – and any findings from the Bank’s assessment of the resolvability of UK CCPs – will inform the Bank’s continued policy thinking on statutory tear up. The Bank will engage with stakeholders on the scope and nature of CCP resolvability assessments in due course. The Bank also has the power to direct CCPs to address impediments to resolvability under paragraph 2 of Schedule 11.
Responsibility for determining a commercially reasonable price
2.9 If the Bank decides to execute a statutory tear up under Schedule 11, it will be responsible under the legislation for determining ‘commercially reasonable’ prices at which contracts would be torn up. The consultation paper outlined that the Bank would first instruct the CCP to propose to the Bank commercially reasonable prices for contracts being torn up, after which the Bank would assess whether it considered the CCP’s prices to be commercially reasonable.
2.10 One respondent suggested that the Bank should remove the stipulation in the consultation paper that the CCP would be responsible for proposing prices that are considered ‘commercially reasonable’. The respondent noted that the Bank would be the sole arbiter under Schedule 11 of whether a price would be considered commercially reasonable or not, rather than the CCP. The Bank’s decision would be based on careful judgement considering the facts and circumstances at the time. As such, it may be difficult for a CCP to anticipate the Bank’s decision as to what would be considered commercially reasonable. Additionally, the respondent noted that the consultation paper sets out the Bank’s intention for CCPs to generate prices using their own rules and arrangements, rather than for CCPs to generate prices that the CCP anticipates may be considered commercially reasonable by the Bank.
2.11 The Bank confirms its intention for CCPs to generate proposed prices using their existing arrangements and acknowledges that the Bank is solely responsible for determining whether a price is commercially reasonable or not under Schedule 11. Consequently, the Bank has removed the reference in the updated statement of policy requiring prices proposed by the CCP to be ‘commercially reasonable’. The Bank will, however, require CCPs to provide supporting data and information to accompany their proposed prices, to facilitate the Bank’s analysis of whether these prices appear commercially reasonable to the Bank (as noted in the consultation paper and restated in the statement of policy).
Definition of a commercially reasonable price
2.12 Several respondents welcomed the Bank’s statement in the consultation paper that statutory tear up is not intended to be used as a means to allocate losses to members. 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 any losses that have crystallised and are outstanding in the resolution scenario, including as a result of the use of the tear up power.
2.13 As stated above, Schedule 11 requires the Bank to tear up contracts at commercially reasonable prices. The Bank noted in the consultation paper that it expects that mark-to-market mid-prices used by the CCP for margining purposes will generally reflect commercially reasonable prices.
2.14 One respondent noted that clearing members that wish to replace their torn up contracts in the market would bear ‘replacement costs’ if they are unable to replace the contract at the same or better price than the tear up price. For instance, a clearing member with a long position that is torn up at the mark-to-market mid-price would suffer costs if it replaces the position at a higher ask price.
2.15 The Bank acknowledges that clearing members with torn up contracts that choose to replace them in the market may experience an effective replacement cost of the spread between the tear up price and the replacement price. On balance, however, the Bank considers that its approach of tearing up at mark-to-market prices is preferable to an approach that seeks to compensate clearing members for contract replacement costs.
2.16 There is no certainty that all clearing members with torn up contracts will wish to replace those contracts, nor that replacement will be possible (or possible at a commercially reasonable market price) in stressed market conditions. Clearing members that would be compensated post-transaction for replacement costs would have little incentive to transact at a reasonable price. Alternatively, tearing up contracts at the ask price or bid price (depending on the individual position being torn up) rather than the mark-to-market mid-price would result in losses to the CCP, which would be allocated according to the CCP’s default waterfall.
2.17 In cases where UK CCPs have tear up powers in their default rules, contracts subject to a tear up under a CCP’s rulebook would be torn up at mark-to-market prices. In this way, the Bank’s approach to using mark-to-market prices in a statutory tear up would mirror the approach taken by a UK CCP in a counterfactual CCP rulebook tear up. Similarly, treatment of clearing members for the purposes of the No Creditor Worse Off counterfactual would not include consideration of potential replacement costs. In summary, the Bank considers that tearing up at a commercially reasonable mark-to-market price is a more practicable, clear and consistent approach.
CCPs’ incentives when proposing prices
2.18 Two respondents suggested that, given that the CCP would be a party to the contracts being torn up, CCPs may have incentives to propose prices that favour the CCP.
2.19 Under Schedule 11, the Bank is responsible for determining commercially reasonable payments to clearing members in a statutory tear up. The Bank would review the prices proposed by the CCP for contracts being torn up to assess whether 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 the statement of policy. Schedule 11 also provides the Bank with the power to take control of the CCP in resolution.
Access to pricing information in stressed market conditions
2.20 The Bank is responsible for determining commercially reasonable prices at which contracts would be torn up. The consultation paper noted that, 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 other potential price indicators.
2.21 Respondents generally deemed the Bank’s proposed approach to undertaking this assessment to be sensible and pragmatic, but highlighted several potential challenges that the Bank may face in gathering pricing data to assess commercial reasonability in stressed or illiquid markets. One respondent contended that a failed auction may represent the absence of a market price at that time for the specific portfolio or contract in question. Another noted that prices derived from exchanges or other venues that are based on trades in small quantities may not accurately reflect the value of larger positions within a tear up portfolio. The Bank acknowledges that the applicability of market prices for small volume transactions would need to be considered, alongside other factors, at the time of a tear up.
Benefits to the high bar for deviating from CCPs’ proposed prices
2.22 The consultation paper proposed that there should be a ‘high bar’ for the Bank to depart from a CCP’s proposed price and that there would be limited circumstances in which the Bank would step in to make judgements on granular pricing issues. One respondent welcomed this statement and suggested that setting a price consistent with CCPs’ own rulebooks would help ensure transparency and predictability in the valuation of contracts. The respondent suggested that the Bank should only depart from a CCP’s proposed price as a last resort and only where the Bank is able to substantiate that the CCP’s methodology would not produce a commercially reasonable price.
Determining an alternative price
2.23 If the Bank reviews a price proposed by the CCP and determines that the relevant price is manifestly not commercially reasonable, the Bank may use an alternative method to generate a commercially reasonable price for the contract in question. The consultation paper notes that the Bank would determine the appropriate pricing method at the time based on careful assessment of the stress scenario. The paper proposed that the Bank would consider a range of potential inputs and data sources to establish, test and corroborate the price it determines. These potential price indicators may include current and/or recent prices for the same/very similar contracts and/or modelled prices calculated by a third party.
2.24 Several respondents concurred with the Bank’s assertion that the Bank would need to consider carefully the applicability and reliability of different information sources depending on the scenario, market conditions and contract(s) in question.
2.25 One respondent suggested that the Bank should base any alternative price discovery methods on criteria that are as objective as possible, to help promote clarity and certainty around the valuation of torn up contracts. Two respondents contended that, where current prices are unavailable, it would be preferable to use the last available settlement prices to determine the tear up price to provide reliability, transparency and to reflect prevailing market pricing (as far as possible). One of these respondents suggested these prices could be modified on an ad-hoc basis for the purpose of the resolution, if warranted by the specific circumstances.
2.26 In scenarios where alternative market prices are available, one respondent recommended that the Bank remain cognisant that prices relating to smaller trades may not correspond to prices for much larger positions. Another noted that there may not be credible alternative pricing venues for some specific markets or contracts.
2.27 Feedback to the consultation suggested that modelled prices could be helpful if the calculation was straightforward (such as pricing interest rate swaps using interest rate curves based on futures prices) but may be less useful where models rely on estimates (such as those using volatility estimates for pricing swaptions).
2.28 The Bank acknowledges that several factors will affect the applicability and reliability of pricing information in a statutory tear up and is grateful to respondents for flagging potential challenges in sourcing appropriate pricing data. The Bank recognises that different pricing approaches may be appropriate in different situations, depending on the scenario, wider market backdrop and contract(s) in question, and will seek to use the best and most relevant available data at the time.
2.29 The Bank also received wider feedback during the consultation period on matters related to tear up and resolvability more broadly, which are addressed below.
Scope of a statutory tear up
2.30 The Bank is responsible under Schedule 11 for selecting the contracts that would be subject to a statutory tear up. One respondent noted that it would welcome additional clarity on how the Bank would decide which contracts would be in scope of a tear up.
2.31 HM Treasury’s Central Counterparties Special Resolution Regime Code of Practice documentfootnote [3] 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’. The Bank will develop policy on how to determine the scope of contracts subject to a tear up in due course.
The Bank’s approach to CCP resolution
2.32 One respondent welcomed the Bank’s consultation paper on statutory tear up in CCP resolution and noted that it would welcome a broader publication by the Bank on its general approach to CCP resolution. The Bank intends to publish a document setting out its approach to CCP resolution in due course.
3: Conclusion and implementation
3.1 The Bank has considered all feedback received and has produced a statement of policy consistent with the consultation paper and the Bank’s views as described above. That document fulfils the legislative requirement under paragraph 31(5) of Schedule 11 of the Financial Services and Markets Act 2023 to prepare a statement of policy setting out the Bank’s approach to determining commercially reasonable payments in a statutory tear up. The final statement of policy will enter into effect from 19 December 2024.
3.2 The Bank will keep the statement of policy under review and update it where appropriate to reflect policy developments or changes in the Bank’s approach.