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In this Issue

Dear Members of ACSDA,

In the third edition of this Newsletter, we are pleased to present you with three articles about very relevant topics in today’s financial market landscape.

First, Chris Cononico, President of GCSA LLC , shares with us a reflection about the insurance, which has become an important topic for a Financial Market Infrastructure for its use as a form of credir risk mitigation and as a possible recovery tool.

Additionally, Clearstream gives us insight on how the Liquidity Alliance can help CSDs in their effort to set in motion collateral management services quickly and economically.

Finally, The final article of this newsletter deals with Mexico’s Financial Reforms Initiatives and the modifications regarding electronic custody.

We invite you to participate with any issues of interest, suggestions or comments to our Risk Committee.

Best wRegards,

Gerardo Gamboa Ortiz Jorge Hernán JaramilloHead of the Risk Committee of ACSDA ACSDA President

Is Insurance Suitable for the Default Waterfall of Central Counterparties?

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Collateral Management Out of Box for CSDs

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Electronic Custody: ReducingOperational Risk Through its Implementation P9

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The concept of insurance as a loss absorption layer in the default waterfall of central counterparties (“CCPs”) has existed for decades. Our Chairman, David Hardy, who was CEO of LCH.Clearnet for nearly twenty years, recalls structuring an insurance policy for International Commodities Clearing House (a predecessor to London Clearing House Ltd.) as far back as 1988. While insurance has had its fits and starts as a risk-transfer partner to CCPs since ICCH, traditionally it had been relegated to a niche product for a handful of exchange groups. Until now, no coordinated attempt at a true partnership between the insurance and clearing industries has ever occurred, no matter how advantageous and symbiotic the potential relationship might have become.

Since the recent financial crisis and subsequent G20 mandate to clear OTC derivatives, insurance has once again become an important topic at financial market infrastructure (“FMI”) related conferences around the world for its use as a form of credit risk mitigation (CPSS-IOSCO – Principles for Financial Market Infrastructure (“PFMIs”) – Principle 4) and as a possible recovery tool. At the same time, the insurance industry, as a whole, is now taking more interest in the once esoteric clearing industry as insurers have become more familiar with the growing importance of central clearing and CCPs look to further bolster their waterfall resources. Are the insurance and clearing industries finally ready to partner for the benefit of the default waterfall? Can insurance meet the needs of end clients, FMIs, regulators, and central banks as a dedicated risk transfer partner?

A Consortium – No More Single Name Counterparty Risk

We believe that one of the key lessons of the financial crisis and a basic tenet of sound risk management is diversification of counterparty risk. Not only should policies be written by a diversified consortium of insurers, but there should be mechanisms built within the consortium itself to offer the best prices to its clients. There should also be a mechanism within the policy to replace insurers who are downgraded below threshold ratings (such as A3/A-) and the coverage provided by each participating insurer should be sized in advance relative to its own claims paying ability. Finally, the participants in the consortium should themselves be multiline insurers with diversified business models and domiciled in highly rated countries.

April, 2014

Is Insurance Suitable for the Default Waterfall of Central Conuterparties?

By Chris Cononico, President of GCSA LLC

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Unambiguous Policy Wording

Oftentimes, poor underwriting by insurers is compounded with ambiguous policy wording, which has hurt the reputation of the insurance industry as a whole. For an insurance consortium to partner with CCPs, the triggers for coverage set forth in the policy must be very clear and mirror the functioning of the default fund itself as closely as possible – i.e. once a member defaults and losses reach a defined threshold, the policy will pay the claim.

Designated Program and Claims Managers Insurers, by and large, are not experts regarding the daily operations of CCPs. Traditionally, this has limited their understanding of margin systems, default waterfalls, legal issues, and the need by CCPs for intraday liquidity. The GCSA Consortium handles this dilemma by relying upon the expertise of a specialized group of professionals (the GCSA team) to underwrite, perform surveillance, communicate with key regulators, and manage claims on behalf of its consortium. We’ve successfully brought together people with legal, clearing, markets, regulatory, and insurance expertise under one organization for the specific purpose of providing a coherent product for financial market infrastructure.

Insurance and Principle 7 (Liquidity)

Insurance, when structured properly, can be an excellent tool for credit loss absorption (PFMI -Principle 4) and there is also an opportunity for it to work within the existing liquidity framework of the CCP (PFMI - Principle 7) to meet demands for immediate funds. Some regulators, such as the US Commodity Futures Trading Commission (CFTC), permit the coupling of insurance with unsecured liquidity facilities, so that the combination of tools can work together to meet financial resource requirements– i.e. the liquidity facility provides immediate funds and the insurance ultimately pays back the liquidity facility and absorbs the losses. Other regulators have more stringent “prefunded” requirements for their default resources, which require collateral that could ultimately be posted to committed secured liquidity facilities. We think there exists an opportunity for an insurance consortium to post collateral to an independent trust in conjunction with the

coverage afforded by the policy, which can be immediately released upon the submission of a claim. This form of insurance would allow CCPs to have immediate access to collateral that could be posted to their secured credit facilities, committed repurchase agreements, or ultimately sold in the marketplace for liquidity. GCSA has dubbed this alternative “Contingent Convertible (CoCo) Insurance” and it represents an innovation in the way insurance could potentially support CCPs.

The Cost of Insurance

When GCSA prices the cost of insurance for a default waterfall, the premium varies by CCP because the risk of loss is dependent on the risk management practices, historical performance of the margin system, the credit quality of the member base, and other underwriting factors such as our analysis of the legal and regulatory regime.

Quantitatively, statistical tools such as extreme value theory can be applied to analyze the frequency and severity of breaches of the margin system, which helps our understanding of catastrophic scenarios. GCSA also complements its quantitative work with its own assessment of each CCP’s compliance with the 24 principles of the PFMIs. As such, the risk to the insurance policy can be very different from the senior unsecured credit quality of the CCP itself; hence the cost is independent of the prices of other capital market instruments.

For example, an insurance policy that sits in the Cover 2 portion of the waterfall (or beyond) would be priced well below the average cost of capital of both the CCP and its members. Insurance is also able to augment its offering with reinstatement features that act as “replenishment tools” for recovery that can effectively double the available capacity offered to the CCP for a fraction of the premium cost.

As such, we believe that a properly structured insurance package can be very cost-effective for market participants.

April, 2014

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Conclusion: So, Is “Insurance” Suitable for the Default Waterfall?

With the right partners, the right policy wording, the right structure, and the right placement in the default waterfall, the answer is “yes.” We think the right insurance program could meet the needs of CCPs and comply with CPSS-IOSCO PFMIs, EMIR, and a myriad of other local regulations. Bringing together the enormous claims paying ability of the insurance industry could make the financial system stronger. It holds the possibility of reducing pro-cyclicality and reliance upon member assessments for replenishment, while also encouraging a more efficient use of capital, which could allow CCPs to hold larger buffers against catastrophe.

We estimate that clearinghouses hold approximately $30 billion in default funds across the word, which supports millions of derivative transactions and helps to backstop many hundreds of trillions of dollars of notional exposure against counterparty defaults that could generate losses in excess of margin collateral. Initiatives like the GCSA Consortium would provide further default protection to the industry, while bringing diversification of resources, independent surveillance, and facilitate a true long-term partnership between the insurance industry and FMIs.

April, 2014

“We believe this relationship will ultimately prove to be an important agent for strengthening the fabric of the financial system.”

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Collateral management out of a box for CSDs

By Clearstream

Across the industry and around the world, banks and other financial institutions are scrambling to come up with answers to the causes of the so-called “credit crunch” of 2007-08, and a widely anticipated shortage of collateral stemming from regulatory measures taken to deal with that initial shortage of credit. Those measures, which include the Basel III capital adequacy regime, the Dodd-Frank Act, the European Market Infrastructure Regulation (EMIR) and the Capital Requirements Directive (CRD IV), were adopted in the aftermath of the

financial crisis, and are now being translated into national legislation and regulations.

Banks and other financial institutions naturally turn to a market infrastructure such as a central securities depository (CSD) for support in dealing with challenges. Developing a workable collateral management offering for their underlying clients to avert a shortage of collateral is therefore essential for CSDs to remain competitive.

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With regulatory measures fuelling expectations of a global shortage of eligible collateral, CSDs are under pressure from local market participants to help them manage and move collateral. Gerd Hartung, senior vice president, client relations, global securities financing and broker-dealers at Clearstream, explains how the Liquidity Alliance can help CSDs put sophisticated collateral management services in place quickly and economically.

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As the implementation dates of the various regulatory measures draw closer, it is becoming urgent for banks and other financial institutions to optimise their collateral management systems and to pool their collateral in order to avoid the much-feared collateral crunch.

While these concerns are now well known throughout the industry, it is also important to think beyond the operational details of the problem to find a sustainable, global solution to the looming collateral shortage.

Market infrastructures such as central counterparties (CCPs), trade repositories and CSDs are appreciated for the vital role they played in stabilising markets during and after the crisis. It is therefore natural that regulators have decided to strengthen their role - for example, by requiring standardised OTC derivatives to be centrally cleared. But while the discussion rightly centres around the risk-mitigating elements of the CCPs, we should not forget that the CSDs also played a vital role in guaranteeing stability during the financial crisis. They achieved this by the provision of liquidity to the market as confidence dropped and inter-bank lending almost ground to a halt. Tri-party agent services in particular experienced a boom as they allowed banks to better manage and cover their exposures through a neutral infrastructure provider.

CSDs are therefore particularly well placed to help the market overcome the potential collateral shortfall by optimising collateral pools. Clearstream, for example, has longstanding experience in providing collateral management and securities lending services via its Global Liquidity Hub. It can leverage this knowledge to help other organizations overcome collateral fragmentation.

However, while CSDs around the world are feeling the mounting pressure of the upcoming regulations through increased client expectations and demands, not all CSDs have the funding, resources or international experience to develop collateral management services of their own within the required timeframe. It is therefore vital for CSDs to collaborate, and to adapt already existing services and technologies to their individual market requirements.

In this spirit, five CSDs formed the Liquidity Alliance in January 2013 to adapt a common approach to the collateral shortage. Instead of each CSD having to embark on costly and lengthy IT developments, they will use a common collateral management platform. The Liquidity Alliance also serves as a forum for sharing experiences, identifying common needs and promoting collateral research. In other words, the Liquidity Alliance aims to go beyond the purely technical aspects of the problem. It seeks, through collaboration, to create a pool of useful knowledge about how to cope with the global collateral sourcing and servicing challenge.

The Liquidity Alliance uses the Liquidity Hub GO solution from Clearstream as its common collateral management platform. It is currently the only service available which allows assets to remain in custody in a domestic market while the system is white-labelled by the local CSD to perform sophisticated collateral management tasks such as allocation, optimisation and substitution.

It is vital that the services do not entail moving assets out of the domestic market, as local custody is a legal requirement in

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“Market participants want services that reduce collateral fragmentation and lower inefficient collateral buffers, as well as improving the accessibility and mobility of assets useable as collateral. The ultimate goal is to improve the capital base and liquidity flow of the institution.”

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many jurisdictions. Staying in the domestic market also means that the assets are governed by local laws, and the contractual arrangements between the CSDs and their customers can remain unchanged.

In addition to sharing collateral management technology, members of the Liquidity Alliance come together on a regular basis to discuss current market developments, partnership plans and business opportunities in collateral management, while also investing resources in studies and industry research. Since the members of the Alliance are drawn from all over the world, they form a valuable pool of local insights and expertise that can be used on a global scale. They also act as a trusted source of information. In this way, the Alliance adds value to what could easily remain a purely operational and technical subject.

However, the Liquidity Alliance is much more than a talking shop. It is already in action. The Brazilian CSD, CETIP, has gone live with the common collateral management service. ASX (Australia), Iberclear (Spain) and Strate (South Africa) are expected to follow suit in the course of this year.

The most valuable aspect of the Liquidity Alliance for these organizations is that it enables them to develop collateral management services for their local markets much faster and more efficiently than on their own. It allows domestic markets to develop services to customers, while simultaneously enabling them to meet regulatory requirements within the tight timeframes set by both domestic and international regulators.

The Liquidity Alliance is now fielding requests from market participants to extend the offering to include the use of offshore assets to cover domestic exposures, in addition to mobilising domestic assets for the coverage of offshore exposures. Members of the Alliance have already developed ways of using collateral held offshore for domestic purposes.

The ultimate aim of the Liquidity Alliance is to come up with effective and cost-efficient answers to the anticipated collateral shortage by using domestic collateral to cover international exposures, and vice versa. To attain this objective will not be the work of a moment. The Liquidity Alliance aims to enhance its services, and add to its membership.

April, 2014

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As part of Mexico’s Financial Reform initiatives, modifications and additions where contemplated to allow certain securities to be issued electronically.

The modifications to the Mexican Securities Market Law represent for Indeval a major change, who has to provide the technological infrastructure to process the securities registry, the actual issuance and storage of these electronic securities.

On the legal front, participants have to adhere to the new Internal Rules of the CSD, Operational Manual and strictly follow the outline of a new contract model. In addition, the new operation model needs to be analyzed, designed and documented in alignment to the general rules issued by the Central Bank.

This new system will be available to issue any type of security, although its use will be enacted gradually.

Modifications to the Mexican Securities Market Law regarding electronic custody

Article 282. The securities stored in Central Securities Depositories may be represented in multiple issued securities or into one that covers part or all of the securities issued. Such securities may be issued electronically in the form of a data message with advanced electronic signature in accordance with the Commercial Code and the general provisions issued by the Central Bank, including, among other aspects, securities that can be issued by electronic means, as well as specific security features needed for such purposes.

For those securities issued in print media (physically), may be replaced electronically under the terms of this paragraph in accordance with the general provisions issued by the Central Bank.

Article 283. Deposit service referred to in this Chapter, shall be constituted by the delivery of securities to the Central Securities Depository, which will open accounts for the depositors. Additionally, in the case of securities deposited by electronic, optical or other technological means, will be received under the provisions contained in the Commercial Code.

April, 2014

Electronic Custody: Reducing Operational Risk Through its Implementation

By Custody Area, Indeval

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PARTICIPATE IN OUR NEXT ISSUEIf you want to give us some feedback or sharing us information for the next edition, do not hesitate to contact us to:nbarajas@indeval.com.mx

April, 2014