[Federal Register Volume 82, Number 160 (Monday, August 21, 2017)]
[Notices]
[Pages 39622-39629]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2017-17546]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-81399; File No. SR-LCH SA-2017-007]


Self-Regulatory Organizations; LCH SA; Notice of Filing of 
Proposed Rule Change Relating to Margin Framework and Default Fund 
Methodology for Options on Index Credit Default Swaps

August 15, 2017.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on August 1, 2017, Banque Centrale de Compensation, which conducts 
business under the name LCH SA (``LCH SA''), filed with the Securities 
and Exchange Commission (``Commission'') the proposed rule change 
described in Items I, II, and III below, which Items have been prepared 
primarily by LCH SA. The Commission is publishing this notice to 
solicit comments on the proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Clearing Agency's Statement of the Terms of Substance of the 
Proposed Rule Change

    LCH SA is proposing to amend its (i) Reference Guide: CDS Margin 
Framework (``CDSClear Margin Framework'' or ``Framework'') and (ii) 
CDSClear Default Fund Methodology (``Default Fund Methodology'') to 
incorporate terms and to make conforming and clarifying changes to 
allow options on index credit default swaps (``CDS Options'') to be 
cleared by LCH SA.\3\ A separate proposed rule change has been 
submitted concurrently (SR-LCH SA-2017-006) with respect to amendments 
to LCH SA's rule book and other relevant procedures to incorporate 
terms and to make conforming and clarifying changes to allow options on 
index credit default swaps (``CDS'') to be cleared by LCH SA. The 
launch of clearing CDS Options will be contingent on LCH SA's receipt 
of all necessary regulatory approvals, including the

[[Page 39623]]

approval by the Commission of the proposed rule change described herein 
and SR-LCH-SA-2017-006.
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    \3\ All capitalized terms not defined herein have the same 
definition as the Framework or Default Fund Methodology, as 
applicable.
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II. Clearing Agency's Statement of the Purpose of, and Statutory Basis 
for, the Proposed Rule Change

    In its filing with the Commission, LCH SA included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. LCH SA has prepared summaries, set forth in sections A, 
B, and C below, of the most significant aspects of these statements.

A. Clearing Agency's Statement of the Purpose of, and Statutory Basis 
for, the Proposed Rule Change

1. Purpose
    In connection with the clearing of CDS Options, LCH SA proposes to 
modify its CDSClear Margin Framework and Default Fund Methodology to 
manage the risk arising from clearing CDS Options and to streamline the 
descriptions in the existing CDSClear Margin Framework and Default Fund 
Methodology to take into account CDS Options and improve the 
organization and clarity of the CDSClear Margin Framework and Default 
Fund Methodology.
(i). CDSClear Margin Framework
    The CDSClear Margin Framework will be reorganized to include a new 
introductory section covering the overall new structure of the 
Framework, which will include a description of the CDSClear pricing 
methodology and margin methodologies for single-name CDS, index CDS, 
and CDS Options. The margin methodologies used to calculate total 
initial margin will consist of seven components, i.e., self-referencing 
margin, spread margin, short charge, wrong way risk margin, interest 
rate risk margin, recovery rate margin, and vega margin. In addition, 
the Framework will also cover liquidity margin to account for 
liquidation cost or potential losses as a result of concentrated or 
illiquid positions, credit event margin to account for the risk of 
recovery rate changes during the credit event processes, and variation 
margin to account for observed mark-to-market changes as additional 
margin charges. Finally, the methodology for FX rate adjustments that 
are necessary for U.S. dollar denominated products cleared by LCH SA is 
described in relevant sections of the Framework.
a. Pricing Methodology
    A new section on CDSClear pricing methodology is created as new 
Section 2 in the Framework to cover both CDS pricing (section 2.1) and 
CDS Options pricing (section 2.2). LCH SA does not propose any change 
to the methodology currently used to price CDS under Section 2.1 but 
because pricing is an input used by various margin components to 
calculate total initial margin, LCH SA believes it is appropriate to 
remove the CDSClear pricing methodology from the existing spread margin 
section and incorporate it under the new Section 2.
    New section 2.2 describes the methodology that will be used to 
price CDS Options. LCH SA proposes to adopt a market standard model 
which makes certain adjustments to address the limitations of the 
classic Black-Scholes model and that is made available on Bloomberg 
(the ``Bloomberg Model'') and is commonly used by both dealers and buy-
side participants in order to facilitate communication on index 
swaptions. The limitations of the classic Black-Scholes model include 
the inability to reflect the contractual cash flow exchanged upfront 
upon the exercise of the option. Neglecting the upfront cash flow 
exchange would have a significant impact for deeply in-the-money payer 
options because setting the underlying par spread curve flat at the 
strike level would considerably reduce the risk duration and, 
therefore, the potential profits and losses (``P&Ls'') resulting from 
the option exercise with respect to such options. In addition, if a 
credit event occurs with respect to the underlying index CDS after the 
option was traded but before its expiry, the resulting loss would be 
settled if and only if the option is exercised, and settlement would 
occur on the day of exercise. Finally, the strike and spot for price-
based CDS Options are expressed in price terms rather than in spread 
terms and, therefore, require price-to-spread conversion before using 
the Bloomberg Model. LCH SA proposes to incorporate the upfront cash 
flow amount to be exchanged upon exercise and the cash payment 
resulting from the settlement of credit events that would occur between 
the trade date and the expiry into the payoff amount at expiry in the 
CDS Option price definition. In addition, consistent with the Bloomberg 
Model, LCH SA also proposes to implement an adjusted spread in the log 
normal distribution by calibrating the spread to match the implied 
forward price, based on market quoted spreads, with certain assumptions 
made to improve the calibration in order to be able to price CDS 
Indices with a closed formula as the Bloomberg Model.
    Revised section 2.3 covers the market data for CDS and CDS Options. 
Section 2.3.1 describes the market data LCH SA uses to build the 
database for single-name CDS covering the 10-year look-back period, 
which is the same as the description in the existing CDSClear Margin 
Framework with very minor technical edits to improve headings and to 
correct typographical errors.
    New section 2.3.2 addresses implied volatility in the pricing of 
CDS Options. LCH SA proposes to rely on the stochastic volatility 
inspired or ``SVI'' model to construct volatility surfaces and to use 
the model to price or reprice a CDS Option as well as to interpolate 
the various implied volatilities obtained from the Bloomberg Model 
described above in a consistent manner. The choice of the SVI model is 
based upon considerations that the model is an appropriate fit with the 
historical data and that it guarantees a volatility surface free of 
static arbitrage (such as calendar and butterfly arbitrage) if the 
appropriate parameters are selected.
    New section 2.3.3 describes the sources of historical data for CDS 
Option prices used by LCH SA to construct the database covering the 10-
year look-back period. These sources consist of Markit's history of 
composite prices and specific dealers' history of prices. LCH SA will 
then use this data to extract historical implied volatility. In order 
to ensure that only SVI paramertizations that model the shape of the 
volatility curves well would be used in the construction of the time 
series, LCH SA would use a pre-defined coefficient of determination to 
measure how well the data fits the statistical model. Section 2.3.3 
also describes other data to be used for purposes of constructing 
historical implied volatility in the case of missing at-the-money 
(``ATM'') volatility and SVI data points in the historical time series. 
If an option price cannot be obtained through members' contribution (as 
described below) or Markit, LCH SA may use the price from the then on-
the-run series or use a proxy to determine the ATM volatility returns 
from other similar options or from the index spread returns.
    Finally, new section 2.3.4 provides the source of new daily pricing 
data for CDS Options that will be used to update implied volatility on 
a daily basis. Similar to the current end-of-day pricing mechanism for 
CDS, LCH SA will require members to contribute prices on options for 
all strikes that are a multiple of five bps for iTraxx Europe Main or 
25 bps for iTraxx Europe Crossover of a

[[Page 39624]]

given expiry when the members have at least an open position on one 
strike for that expiry. Members' contributed prices will be used for 
marking the options book if a quorum of three distinct contributions 
(underlying, expiry, strike) is recorded per option. Otherwise, LCH SA 
will fall back to Markit's composite prices or use pre-defined rules to 
fill in missing data.
b. Total Initial Margin
    A new Section 3 is created to provide the total initial margin 
framework. New section 3.1 provides a summary of the total initial 
margin framework, including a brief description of each of the seven 
components of the total initial margin.
    New section 3.2 provides an overview of the risks captured by each 
margin component and the additional margin charges, as well as cash-
flow specific considerations and adjustments made to the margin 
framework specific to U.S. dollar denominated CDS contracts. This re-
organized overview is substantively consistent with the description in 
existing section 3.1.1 of the CDSClear Margin Framework except for the 
addition of the new vega margin which is proposed in connection with 
the clearing of CDS Options.
i. Self-Referencing Margin
    New Section 3.3 sets forth self-referencing margin, a component of 
the total initial margin, for both CDS and CDS Options. In the case of 
CDS, self-referencing margin is designed to cover the specific wrong 
way risk relating to a Clearing Member selling protection on itself 
through a CDS index or a client selling protection on the Clearing 
Member. Self-referencing margin reflects the P&L impact resulting from 
the Clearing Member defaulting on a sold-protection position in CDS 
referencing its own name with zero recovery. In the case of CDS 
Options, the P&L impact resulting from a Clearing Member defaulting on 
a sold-protection position in CDS referencing its own name can be 
calculated by taking the difference between the current option value 
and the option value incorporating a loss amount in the underlying CDS 
index.
ii. Spread Margin
    New Section 3.4 sets forth spread margin for both CDS and CDS 
Options. There is no change proposed to the spread margin calculation 
for CDS, which would continue to be calculated using a value-at-risk 
model to build a distribution of potential losses from simulated 
scenarios based on the joint credit spread and volatility variations 
observed in the past. LCH SA then determines the expected shortfall 
based on a quantile of the worst losses that could happen in the case 
of unfavorable credit spread and volatility fluctuations within each 5-
day scenario and takes the difference in P&Ls of each portfolio between 
the average of the prices beyond the 99.7 percent quantile of the 
portfolio and the current mark-to-market price of the portfolio as the 
expected shortfall. In addition, because the European Market 
Infrastructure Regulation (EMIR) limits margin reduction from portfolio 
margining to no greater than 80 percent of the sum of the margins for 
each product calculated on an individual basis, LCH SA would determine 
the spread margin to be the maximum between the expected shortfall of 
the portfolio and 20 percent of the sum of the expected shortfalls 
across instruments.
    The methodology for calculating spread margin would be the same for 
CDS Options, with two adjustments. First, in addition to simulated 
credit spreads, simulated volatilities would be calculated by defining 
a shifted volatility curve for each option expiry date. Both simulated 
credit spreads and simulated volatilities would be used to produce 
simulated option values as an input in the value-at-risk model to 
generate the expected shortfall. Second, in order to properly account 
for the impact of CDS Options which expire within the 5-day margin 
period of risk, LCH SA proposes to add to the Section 3.4 spread margin 
provisions regarding an assessment of whether a CDS Option would be 
exercised on expiry by considering the present value of an option on 
the date of expiry. If the assessment determines that the option would 
be exercised, LCH SA would take the resulting index CDS position into 
account in the expected shortfall calculation for the following days 
within the margin period of risk.
    LCH SA is also proposing to move the discussion of margin impact 
related to clearing CDX IG/HY contracts to Section 3.4 without any 
substantive change and to delete the current Section 3 on ``CDX IG/HY 
Specificity'' in the CDSClear Margin Framework. This reorganization of 
the CDSClear Margin Framework is intended to streamline the 
presentation because the same spread margin methodology that applies to 
European CDS contracts would equally apply to U.S. dollar denominated 
contracts, with certain considerations given to the use of U.S. 
interest rate benchmarks, FX adjustment, use of shifted FX rate for 
computing historical expected shortfalls, and an FX haircut, as 
described in Section 3 of the current CDSClear Margin Framework.
iii. Short Charge
    New Section 3.5 sets forth short charge for both CDS and CDS 
Options, which replaces the former Section 4.1. As with the existing 
Framework, the purpose of the short charge is to address the jump-to-
default risk, i.e., the P&L impact, when liquidating a defaulting 
member's portfolio, as a result of one or more reference entities in 
the portfolio experiencing a default. The definition of the short 
charge remains the greater of (x) the ``global short charge,'' derived 
from the Clearing Member's largest, or ``top,'' net short exposure (in 
respect of any CDS contracts) and its top net short exposure amongst 
the three ``riskiest'' reference entities (in respect of any entity 
type) that are most probable to default in its portfolio, and (y) a 
``high yield short charge,'' (``HY short charge'') derived from a 
member's top net short exposure (in respect of high yield CDS) and its 
top two net short exposures amongst the three ``riskiest'' reference 
entities (in the high yield category) in its portfolio. In addition, 
because wrong way risk margin considers the P&L impact as a result of 
the Clearing Member's top two net short exposures in respect of senior 
financial CDS, it is relevant to calculate a financial short charge to 
reflect the jump-to-default P&L impact resulting from the default of 
the two financial entities with the largest net short exposures.
    The steps for determining the net short exposure and default 
probability per entity also remain the same with respect to CDS 
portfolios. LCH SA would define the net short exposure at the portfolio 
level, aggregating net notional by entity, applying a recovery rate and 
subtracting the variation margin already collected with respect to each 
entity, either as a single name or as part of an index. Because there 
are various transaction types and contract terms based on different 
ISDA definitions, LCH SA would calculate each reference entity's net 
exposure based on transaction types and contract terms across various 
possible scenarios, sum the exposures together according to the 
scenarios, and retain the worst scenario as the reference entity's net 
short exposure.
    With respect to the determination of the short exposure for CDS 
Options, LCH SA believes that it would be appropriate to consider the 
P&L impact of a credit event experienced by a constituent of an index 
CDS underlying the CDS Option on the value of the option. Rather than 
repricing the option each day based on the spread level of

[[Page 39625]]

the underlying index and the ATM volatility level, LCH SA proposes to 
adopt an approximation approach to define the change in the option 
price relative to the total loss in the underlying index so as to 
expedite the calculation. The amount of such change would represent the 
impact on the option premiums as a function of the loss amount to be 
delivered at the option expiry if the option is exercised. Such change 
in option price would then be calibrated on a loss interval for each 
eligible option as a polynomial function and the calculation of this 
loss function would be performed at the option instrument level.
    The total short exposures with respect to each reference entity 
would be the sum of (i) the net short exposure for the CDS contracts 
referencing such entity and (ii) the losses resulting from the CDS 
Options on index CDS with such entity as a constituent. A total short 
exposure will be calculated for each entity except for an entity 
experiencing a credit event or an entity that is a member or member's 
affiliate with respect to which a self-referencing margin is imposed. 
LCH SA will then be able to select the entity or entities for purposes 
of calculating the global short charge, HY short charge, and financial 
short charge.
    In order to accommodate the addition of CDS Options to CDSClear's 
clearing services, LCH SA proposes to make certain adjustments to the 
short charge calculation. First, when calculating the total short 
exposure for each reference entity, including an entity that is a 
constituent of an index CDS underlying an option, the total short 
exposure would be calculated for each day within the 5-day margin 
period of risk using a simulated credit spread and ATM volatility data 
for both CDS and CDS options, instead of using the current spread as is 
the case for CDS only in the existing Framework.
    Second, after entities are selected for calculating the global 
short charge, HY short charge and financial short charge, if a 
portfolio includes CDS Options, as a result of the non-linearity of 
options products, the total short exposure would not be the sum of the 
P&L impacts of each individual entity's default. Therefore, LCH SA 
proposes to calculate each of the global short charge, HY short charge 
and financial short charge by considering the combined P&L impacts of 
simultaneous defaults of the selected entities.
    Third, because the total short exposure for each reference entity 
would be calculated using a simulated credit spread and ATM volatility 
data for both CDS and CDS Options, the global short charge, HY short 
charge and financial short charge derived from the selected entities' 
total short exposures would represent the jump-to-default risk and the 
market risk (i.e., spread moves) from both the CDS contracts and the 
CDS Options contracts at the portfolio level on each day within the 5-
day margin period of risk in the simulated scenario. In order to 
calculate the short charge margin that reflects the P&L impact of the 
jump-to-default risk only at the portfolio level and the spread margin 
that reflects the P&L impact that comes from spread and ATM volatility 
moves, LCH SA would compare three expected shortfall amounts at the 
portfolio level: (i) The expected shortfall reflecting the P&Ls 
consisting of spread margin, the global short charge, the HY short 
charge and the financial short charge (ES<INF>1</INF>), (ii) the 
expected shortfall reflecting the P&Ls consisting of spread margin, 
global short charge and HY short charge (ES<INF>2</INF>), and (iii) the 
expected shortfall reflecting the P&Ls consisting of spread margin 
(ES<INF>3</INF>). If ES<INF>1</INF> exceeds ES<INF>2</INF>, the excess 
amount would be the result of the financial short charge, which is the 
jump-to-default component of the wrong way risk and should be allocated 
to the wrong way risk margin. If ES<INF>2</INF> exceeds ES<INF>3</INF>, 
the excess amount would represent the jump to default risk and should 
be allocated to the short charge margin. In addition, as stated above, 
EMIR limits the effect of margin reduction from portfolio margining to 
no greater than 80 percent of the sum of the margins for each product 
calculated on an individual basis. Thus, LCH SA would also calculate an 
expected shortfall reflecting the P&L impact of the spread and ATM 
volatility moves (ES<INF>4</INF>) at a product level and then use 20 
percent of ES<INF>4</INF> as the minimum floor for the spread margin.
    Finally, new Section 3.5 will also consider the impact of option 
expiry on the P&L as part of the short charge calculation. In this 
respect, LCH SA would consider two cases: (i) The option exercise 
decision occurs before the occurrence of two credit events, and 
therefore, the credit events would have no impact on the option 
exercise decision and would only impact the P&L if the option is 
exercised upon expiry; and (ii) the two credit events occur before the 
option exercise decision and therefore, would have impact on the option 
exercise. LCH SA would use the worst case in the short charge 
calculation.
iv. Interest Rate Risk Margin/Recovery Risk Margin/Wrong-Way Risk 
Margin/Vega Margin
    New Section 3.6 sets forth interest rate risk margin for both CDS 
and CDS Options, which replaces the former Section 7 in the existing 
CDSClear Margin Framework. The methodology for calculating interest 
rate risk margin remains the same, except to provide for repricing CDS 
Option positions using the same ``bump'' parameters up and down 
computed by taking the 99.7 quantile of the interest rate return based 
on the same sample of dates in the spread historical database.
    New Section 3.7 sets forth recovery rate risk margin for CDS, which 
replaces Section 6 in the existing CDSClear Margin Framework. The 
methodology for calculating recovery rate risk margin is the same as 
the existing Framework. Because recovery rate risk margin applies to 
only single-name CDS, no adjustment or change is necessary to 
accommodate the addition of CDS Options to the CDSClear services 
because the options are on index CDS.
    New Section 3.8 sets forth wrong way risk margin, which replaces 
Section 5 in the existing CDSClear Margin Framework. The methodology 
for calculating wrong way risk margin is the same as the existing 
Framework with minor revisions to streamline the description and to 
improve readability.
    New Section 3.9 sets forth a new margin component, i.e., vega 
margin, which would apply to CDS Options only. Because LCH SA uses ATM 
options to calculate volatility returns in all volatility scenarios, 
the derived expected shortfall would not fully capture the risk of 
volatility changes in the options premium relative to the strikes, 
i.e., the skew risk and the risk of changes in the volatility of 
volatility. Therefore, LCH SA is proposing to add vega margin to the 
total initial margin in order to capture the skew risk and the 
volatility of volatility risk. The vega margin would first calculate 
the risk of skew and volatility of volatility independently by 
estimating option premium changes when the skew is shifted by an 
extreme move, which is calibrated as a quantile of the distribution of 
each parameter in the historical data set gathered by LCH SA, for each 
time series of an available parameter. LCH SA would then define shifts 
of the skew by multiplying a standard deviation of the returns of 
historical skews by a percentile for a given probability threshold. 
Then, LCH SA would also consider similar shocks on the volatility of 
volatility alone. Finally, LCH SA would also consider

[[Page 39626]]

scenarios of combined risk of skew and volatility of volatility and 
choose the worst P&L for the index family produced in these scenarios 
as the total vega margin charge.
c. Additional Margins
    LCH SA proposes to create a new Section 4 in the CDSClear Margin 
Framework, which would cover (i) liquidity and concentration risk 
margin from Section 8 of the existing CDSClear Margin Framework, (ii) 
accrued coupon liquidation risk margin from Section 9 of the existing 
CDSClear Margin Framework, and (iii) credit event margin from Section 
10 of the existing CDSClear Margin Framework.
i. Liquidity and Concentration Risk Margin
    New Section 4.1 sets forth liquidity and concentration risk margin, 
which is moved from Section 8 of the existing CDSClear Margin 
Framework. Liquidity and concentration risk margin is designed to 
mitigate the P&L impact as a result of an illiquid or concentrated 
position in a defaulting member's portfolio. The methodology for 
calculating liquidity and concentration risk margin for CDS contracts 
is the same as the existing Framework with minor revision to streamline 
the description and to improve readability. In order to accommodate the 
addition of CDS Options to the existing clearing services, LCH SA 
proposes changes to the existing liquidity and concentration risk 
margin methodology to cover portfolios containing CDS Options.
    To calculate the liquidity charge for portfolios including CDS 
Options, LCH SA would consider the options separately from CDS in the 
portfolio. Given that the market will require options to be liquidated 
as a delta-hedged package, LCH SA would delta-hedge the positions 
underlying the options and most likely auction the options as a package 
separate from the remainder of the portfolio. LCH SA will attempt to 
source the hedges from the CDS part of the defaulting member's 
portfolio using a delta hedging algorithm to ensure minimal hedging 
costs before sourcing the hedges from the market.
    After the options package is delta-hedged, from the bidders' 
perspective, the pricing of the auction package would consist of 
hedging the vega of the delta-neutral options package at different 
resolutions consecutively until the portfolio is fully unwound. The 
cumulative costs incurred in the successive vega hedging would reflect 
the liquidity charge for the options.
    The liquidity charge for the entire portfolio will be the sum of 
the liquidity charge computed for the CDS component of the portfolio 
and the liquidity charge computed for the options component of the 
portfolio.
ii. Accrued Coupon Liquidation Risk Margin
    New Section 4.2 sets forth accrued coupon liquidation risk margin 
for both CDS and CDS Options. The accrued coupon liquidation risk 
margin with respect to CDS remains the same as section 9 of the 
existing CDSClear Margin Framework with minor edits to improve clarity 
and readability. In addition, changes are proposed to address the 
accrued coupon liquidation risk for CDS Options. Because accrued coupon 
liquidation risk margin is designed to cover the accrued coupon payment 
during the 5-day liquidation period, LCH SA would be exposed to a 
coupon payment risk for an option only if the option expiry falls 
within the 5-day liquidation period and the option is exercised. 
Therefore, accrued coupon for options contracts with an expiry more 
than 5 days away will be zero and accrued coupon for options contracts 
with expiry falling within the 5-day liquidation period will be the 
accrued coupon for 5 days if the options are exercised. LCH SA would 
consider the option exercise decision based on the current spread level 
+/- \1/2\ of the bid-offer on the underlying to reflect the cost of 
monetizing an in-the-money option.
iii. Credit Event Margin
    New Section 4.3 sets forth credit event margin, which is moved from 
section 10 of the existing CDSClear Margin Framework. The overall 
approach to the calculation of the credit event margin remains the same 
with certain revisions to streamline the presentation and to improve 
clarity and readability. With respect to ``hard'' credit events, 
because the recovery rate is unknown before the auction occurs, LCH SA 
would impose credit event margin to cover an adverse 25 percent 
absolute recovery rate move from the credit event determination date 
to, and including, the auction date. After the auction, when the 
recovery rate is known, Credit Event Margin is no longer required, and 
cash flows are exchanged in advance through the Variation Margin to 
extinguish any risk of the future payment not being made. However, 
because of the addition of CDS Options, LCH SA proposes a number of 
changes to the calculation of credit event margin. First, if several 
credit events occur, LCH SA proposes to calculate the credit event 
margin with respect to each affected CDS and CDS Option contract by 
considering adverse recovery moves that could be a combination of 
upwards, downwards and flat on the different entities depending on the 
portfolio, instead of summing the credit event margin covering adverse 
25 percent adverse recovery rate move for each reference entity as in 
the case of linear CDS. The aggregation of the P&L at the affected CDS 
and CDS Option contracts level would be the credit event margin at the 
portfolio level. After the credit event margin is calculated for each 
portfolio, the combination of adverse recovery rate moves retained for 
a particular Clearing Member's portfolio would also be used in the 
spread margin calculation in order to virtually shift the strikes of 
all option contracts experiencing the credit event. Second, currently, 
LCH SA separates credit event margin calculations with respect to the 
portfolio of a Clearing Member that is the protection seller of the CDS 
experiencing a credit event and the portfolio of a Clearing Member that 
is the protection buyer of the CDS experiencing a credit event. The 
protection seller would be required to pay a credit event margin and 
the protection buyer would pay a so-called ``IM Buyer'', which 
corresponds to a margin charged to the buyer in the event of a credit 
event and is calculated in the same way as the calculation of the 
credit event margin with the only difference being the change in the 
direction of the shocks. With the addition of CDS Options, LCH SA 
proposes to use one terminology ``credit event margin'' calculated 
using the same methodology as the existing credit event margin 
calculation with respect to a Clearing Member's portfolio containing a 
contract affected by the credit event regardless of whether the 
Clearing Member is a protection buyer or protection seller.
    Finally, with respect to restructuring events or so-called ``soft'' 
credit events, because different auctions may be held depending on the 
maturity of the contracts and therefore, the recovery rate could be 
different across all the contracts with various maturity dates, LCH SA 
proposes to consider each maturity separately instead of netting all 
positions with the same reference entity. For each given reference 
entity experiencing a restructuring event with respect to a given 
maturity, the calculation of the credit event margin is similar to that 
used for hard credit events.

[[Page 39627]]

d. Cash Flows, Contingency Variation Margin and Extraordinary Margin
    New Sections 5, 6 and 7 set forth cash flow exchanges (in the form 
of variation margin, price alignment interest, quarterly coupon 
payments or upfront payments), contingency variation margin, and 
extraordinary margin. These sections are moved from Sections 11, 12 and 
3.4 of the existing CDSClear Margin Framework without substantive 
change and with minor revisions to eliminate redundancy and improve 
clarity and readability.
e. Appendix
    The new Section 8 Appendix sets forth the settlement agent and FX 
provider, FX haircut and quanto with respect to CDX IG/HY contracts. 
These are moved from Section 3.1.2, 3.3.2 and 3.3.3 of the existing 
CDSClear Margin Framework without substantive change.
(ii). Default Fund Methodology
    LCH SA also proposes to modify its Default Fund Methodology to 
incorporate terms for CDS Options and to make certain clarifying and 
conforming changes to the Default Fund Methodology.
    Section 1 of the Default Fund Methodology, which outlines the 
stress risk framework, would be amended in Sections 1.1, 1.2, 1.3, and 
1.4 to make formatting changes and clarifying changes to the text for 
readability.
    Section 2 of the Default Fund Methodology sets forth the 
methodology used to calculate default fund, which is designed to cover 
the potential impact of the default of two or more Clearing Members in 
stressed market conditions in excess of initial margin held by LCH SA. 
Section 2.1 currently provides an overview of the framework for such 
methodology. The fundamental piece of the methodology is to identify 
stress testing scenarios to introduce market moves in so-called 
``extreme but plausible'' market conditions beyond those applied to the 
margin calculation. Such stress testing scenarios would then be applied 
to Clearing Members' portfolios to calculate the P&L impacts and the 
sum of the two highest stress testing losses over initial margin 
(``STLOIM'') across all Clearing Members' portfolios. From there, LCH 
SA adds a 10 percent buffer to be the size of the default fund. Because 
of the addition of CDS Options, LCH SA proposes to amend Section 2.1 to 
take into account the new vega margin designed to address the skew risk 
and volatility of volatility risk particular to CDS Options that are 
not covered in the spread margin calculation. As a result, a stressed 
vega margin (in addition to the existing stressed spread margin and 
stressed short charge) would be calculated under the stress test 
scenarios. LCH SA would then calculate stress test losses (i.e., the 
sum of the stressed spread margin, stressed short charge and stressed 
vega margin) over initial margin components designed to cover the 
market risk and default risk (i.e., the spread margin, short charge, 
wrong way risk margin and vega margin). Clarification changes are also 
made to the explanation of stressed spread margin and stress short 
charge.
    Section 2.2 of the Default Fund Methodology would be modified to 
separate the description of the methodology for calculating P&L from 
the description of the stress testing scenarios. The description of the 
stress scenarios would be retained in Section 2.2 with certain 
clarifying changes for readability, and the description of the 
methodology for calculating the P&L for purposes of spread moves and 
short charge would be removed from Section 2.2 and replaced with new 
Sections 2.3 and 2.4. The various scenarios considered for the Default 
Fund Methodology would also be renumbered under new subsections 2.2.1 
(Standard Scenarios), 2.2.2 (Dislocation Scenarios), 2.2.3 (SPAN 
Scenarios), 2.2.4 (2x Lehman Scenarios), 2.2.5 (Black Monday Scenario), 
2.2.6 (Theoretical Scenarios), 2.2.7 (Theoretical 4x Bear Sterns 
Scenario), and 2.2.8 (Correlation Breakdown). A new set of scenarios 
would also be added in Section 2.2.9 (Volatility Scenarios), which 
considers movements in the implied ATM volatilities of index families, 
in both historical and theoretical stress scenarios.
    New Section 2.3 of the Default Fund Methodology sets forth the new 
calculation of the stressed spread margin component of the STLOIM. 
Consistent with the changes made to the CDSClear Margin Framework, the 
new calculation of stressed spread margin would consider ATM implied 
volatility moves for options and the stressed spread margin would be 
calculated in two scenarios: (i) Historical scenarios covering credit 
spread moves and ATM implied volatility movements in combination, and 
(ii) theoretical scenarios covering credit spread movements and ATM 
implied volatility moves independently. For CDS, only scenarios 
covering spread moves would be considered.
    New Section 2.4 of the Default Fund Methodology would set forth the 
stressed short charge component of the STLOIM calculation and would 
incorporate terms to account for the addition of CDS Options. The new 
stressed short charge calculation would follow the methodology of the 
short charge calculation as part of the total initial margin to take 
into account the non-linear nature of options, except that the number 
of default entities assumed is higher for stressed short charge than 
the number of defaults assumed for normal short charge. As under the 
existing Default Fund Methodology, the stressed short charge will cover 
the greater of (i) a ``Global Stressed Short Charge,'' which considers 
the entity having the largest exposure and the two highest exposures 
among the three entities most likely to default in the Clearing 
Member's portfolio, (ii) a ``Financial Stressed Short Charge,'' which 
considers the two entities having the largest exposure among senior 
financial entities and the highest exposure among the three senior 
financial entities most likely to default in the Clearing Member's 
portfolio, and (iii) a ``High Yield Stressed Short Charge,'' which 
considers the two entities having the largest exposure among entities 
in the high yield index family and the two highest exposures among the 
three entities among the high yield entities most likely to default in 
the Clearing Member's portfolio.
    New Section 2.5 of the Default Fund Methodology would add a new 
stressed vega margin component to the STLOIM calculation. As noted 
above with respect to the CDSClear Margin Framework, vega margin is 
included with respect to CDS Options to address skew risk and 
volatility of volatility risk. The stressed vega margin component of 
the STLOIM calculation would be calculated in the same manner as the 
vega margin component of the CDSClear Margin Framework, but would use a 
higher quantile than the regular vega margin calculation.
    New Section 2.6 of the Default Fund Methodology, entitled Exercise 
Management, would account for the impact of CDS Options which expire 
within the 5-day liquidation period. If the time to expiry with respect 
to an option in a defaulting member's portfolio is less than or equal 
to five days, LCH SA would consider the impact of option exercise in 
four permutations for each stress scenario to account for the default 
and extreme spread moves occurring before or after option expiry. LCH 
SA would then select the permutation generating the largest loss for 
any particular scenario. Section 2.6.1 of the Default Fund Methodology 
then sets forth the calculations for the exercise decision in respect 
of CDS Options and 2.6.2 describes the impact of the exercise

[[Page 39628]]

decision. For options that are expiring, if the option is deemed 
exercised, the ``bumped'' price will not be calculated in respect of 
the CDS option, but on the underlying index into which the CDS option 
would be exercised. With respect to these options exercised and 
converted to index CDS contracts, Section 2.6.3 of the Default Fund 
Methodology then provides that the resulting index contracts will lead 
to a change in the consideration of net short exposures and therefore, 
the global, financial and HY stressed net short exposures need to be 
calculated, which would affect the determination of the stressed short 
charge.
    New Section 2.7 would set forth the P&L scenarios that are 
considered as part of the Default Fund Methodology. New Section 2.7.1 
would set forth the stressed spread margin calculation with respect to 
specific products. In the case of CDS Options, the product is 
identified with the index family and series of the underlying index, 
such that the option P&L for each product can be added to the P&L for 
linear contracts and offsets may be made between the two groups. If the 
P&L at the product level is positive, a haircut is applied. Sections 
2.7.2 then provides for a stressed short charge that is a component of 
the stressed initial margin calculation in Section 2.7.3. Under Section 
2.7.4, the stressed initial margin calculation is then compared across 
historical scenarios, theoretical spread scenarios, and theoretical 
implied volatility scenarios.
    Finally, the sections on Credit Quality Margin and Default Fund 
Additional Margin would be renumbered as new sections 3.1 and 3.2, 
respectively, and would be updated to incorporate terms for CDS Options 
and to account for the imposition of vega margin in respect of CDS 
Options.
2. Statutory Basis
    LCH SA believes that the proposed rule change in connection with 
the clearing of CDS Options is consistent with the requirements of 
Section 17A of the Act and the regulations thereunder, including the 
standards under Rule 17Ad-22.\4\ Section 17(A)(b)(3)(F) \5\ of the Act 
requires, among other things, that the rules of a clearing agency be 
designed to promote the prompt and accurate clearance and settlement of 
securities transactions and derivative agreements, contracts, and 
transactions and to assure the safeguarding of securities and funds 
which are in the custody or control of the clearing agency or for which 
it is responsible. As noted above, the proposed rule change is designed 
to manage the risk arising from the clearing of CDS Options and to 
streamline the description of the existing margin framework and default 
fund methodology for CDS to take into account CDS Options and improve 
the organization and clarity of the CDSClear Margin Framework and 
Default Fund Methodology.
---------------------------------------------------------------------------

    \4\ 17 CFR 240.17Ad-22.
    \5\ 15 U.S.C. 78q-1(b)(3)(F).
---------------------------------------------------------------------------

    LCH SA believes that the proposed changes to the CDSClear Margin 
Framework and the Default Fund Methodology satisfy the requirements of 
Rule 17Ad-22(b)(2), (b)(3), (e)(1), (e)(4) and (e)(6).\6\
---------------------------------------------------------------------------

    \6\ 17 CFR 240.17Ad-22(b)(2), (b)(3), (e)(1), (e)(4), and 
(e)(6).
---------------------------------------------------------------------------

    Rule 17Ad-22(b)(2) requires a clearing agency to use margin 
requirements to limit its credit exposures to participants under normal 
market conditions and to use risk-based models and parameters to set 
margin requirements.\7\ Rule 17Ad-22(b)(3) requires each clearing 
agency acting as a central counterparty for security-based swaps to 
maintain sufficient financial resources to withstand, at a minimum, a 
default by the two participant families to which it has the largest 
exposure in extreme but plausible market conditions (the ``cover two 
standard''). Rule 17Ad-22(e)(4) requires a covered clearing agency to 
effectively identify, measure, monitor, and manage its credit exposures 
to participants and those arising from its payment, clearing and 
settlement processes by maintaining sufficient financial resources,\8\ 
and Rule 17Ad-22(e)(6) requires a covered clearing agency that provides 
central counterparty services to cover its credit exposures to its 
participants by establishing a risk-based margin system that meets 
certain minimum requirements.\9\
---------------------------------------------------------------------------

    \7\ 17 CFR 240.17Ad-22(b)(22).
    \8\ 17 CFR 240.17Ad-22(e)(4)(i).
    \9\ 17 CFR 240.17Ad-22(e)(6)(i).
---------------------------------------------------------------------------

    As described above, LCH SA proposes to amend its margin framework 
to manage the risks associated with clearing CDS Options. Specifically, 
the proposed rule change amends the existing spread margin and short 
charge components of the total initial margin to take into account 
implied volatility in the calculation of the spread margin and short 
charge as well as updating interest rate risk margin, recovery rate 
risk margin and wrong-way risk margin components of total initial 
margin to incorporate CDS Options. In addition, the proposed rule 
change adds the new vega margin to account for the skew risk and 
volatility of volatility risk specific to CDS Options. These changes 
are designed to use a risk-based model to set margin requirements and 
use such margin requirements to limit LCH SA's credit exposures to 
participants in clearing CDS and/or CDS Options under normal market 
conditions, consistent with Rule 17Ad-22(b)(2). LCH SA also believes 
that its risk-based margin methodology takes into account, and 
generates margin levels commensurate with, the risks and particular 
attributes of each of the CDS and CDS Options at the product and 
portfolio levels, appropriate to the relevant market it serves, 
consistent with Rule 17Ad-22(e)(6)(i) and (v). In addition, LCH SA 
believes that the margin calculation under the revised CDSClear Margin 
Framework would sufficiently account for the 5-day liquidation period 
for house account portfolio and 7-day liquidation period for client 
portfolio and therefore, is reasonably designed to cover LCH SA's 
potential future exposure to participants in the interval between the 
last margin collection and the close out of positions following a 
participant default, consistent with Rule 17Ad-22(e)(6)(iii). LCH SA 
also believes that the new pricing methodology with respect to CDS 
Options, based on widely accepted and used Bloomberg Model with 
appropriate adjustments, as supplemented by methodology for 
circumstances in which pricing data are not readily available, would 
generate reliable data set to enable LCH SA to calculate spread margin, 
consistent with Rule 17Ad-22(e)(6)(iv).
    Further, Rule 17Ad-22(b)(3) requires a clearing agency acting as a 
central counterparty for security-based swaps to establish policies and 
procedures reasonably designed to maintain the cover two standard.\10\ 
Similarly, Rule 17Ad-22(e)(4)(ii) requires a covered clearing agency 
that provides central counterparty services for security-based swaps to 
maintain financial resources additional to margin to enable it to cover 
a wide range of foreseeable stress scenarios that include, but are not 
limited to, meeting the cover two standard.\11\ LCH SA believes that 
its Default Fund Methodology, with the modifications described herein, 
will appropriately incorporate the risk of clearing CDS Options, which, 
together with the proposed changes to the CDSClear Margin Framework, 
will be reasonably designed to ensure that LCH SA maintains sufficient 
financial resources to meet the cover two

[[Page 39629]]

standard, in accordance with Rule 17Ad-22(b)(3) and (e)(4)(ii).\12\
---------------------------------------------------------------------------

    \10\ 17 CFR 240.17Ad-22(b)(3).
    \11\ 17 CFR 240.17Ad-22(e)(4)(ii).
    \12\ 17 CFR 240.17Ad-22(b)(3) and (e)(4)(ii).
---------------------------------------------------------------------------

    LCH SA also believes that the proposed rule change is consistent 
with Rule 17Ad-22(e)(1), which requires each covered clearing agency's 
policies and procedures reasonably designed to provide for a well-
founded, clear, transparent, and enforceable legal basis for each 
aspect of its activities in all relevant jurisdictions. As described 
above, the proposed rule change would streamline the description of 
margin methodology and default fund sizing methodology in CDSClear 
Margin Framework and Default Fund Methodology. LCH SA believes that 
these change would improve the organization and clarity of these 
policies and provide for a clear and transparent legal basis for LCH 
SA's margin requirements and default fund contributions, consistent 
with Rule 17Ad-22(e)(1).
    For the reasons stated above, LCH SA believes that the proposed 
rule change with respect to CDSClear Margin Framework and Default Fund 
Methodology in connection with clearing of CDS Options are consistent 
with the requirements of prompt and accurate clearance and settlement 
of securities transactions and derivative agreements, contracts and 
transactions, and assuring the safeguarding of securities and funds in 
the custody or control of the clearing agency or for which it is 
responsible, in accordance with 17(A)(b)(3)(F) of the Act.\13\
---------------------------------------------------------------------------

    \13\ 15 U.S.C. 78q-1(b)(3)(F).
---------------------------------------------------------------------------

B. Clearing Agency's Statement on Burden on Competition

    Section 17A(b)(3)(I) of the Act requires that the rules of a 
clearing agency not impose any burden on competition not necessary or 
appropriate in furtherance of the purposes of the Act.\14\ LCH SA does 
not believe that the proposed rule change would impose burdens on 
competition that are not necessary or appropriate in furtherance of the 
purposes of the Act. Specifically, the proposed changes to CDSClear 
Margin Framework and Default Fund Methodology would apply equally to 
all Clearing Members whose portfolio includes CDS and/or CDS Options. 
Because the margin methodology and default fund sizing methodology are 
risk-based, consistent with the requirements in Rule 17Ad-22(b)(2) and 
(e)(6), depending on a Clearing Member's portfolio, each Clearing 
Member would be subject to a margin requirement and default fund 
contribution commensurate with the risk particular to its portfolio. 
Such margin requirement and default fund contribution impose burdens on 
a Clearing Member but such burdens would be necessary and appropriate 
to manage LCH SA's credit exposures to its CDSClear participants and to 
maintain sufficient financial resources to withstand a default of two 
participant families to which LCH SA has the largest exposures in 
extreme but plausible market conditions, consistent with the 
requirements under the Act as described above. Therefore, LCH SA does 
not believe that the proposed rule change would impose a burden on 
competition not necessary or appropriate in furtherance of the purposes 
of the Act.
---------------------------------------------------------------------------

    \14\ 15 U.S.C. 78q-1(b)(3)(I).
---------------------------------------------------------------------------

C. Clearing Agency's Statement on Comments on the Proposed Rule Change 
Received From Members, Participants or Others

    Written comments relating to the proposed rule change have not been 
solicited or received. LCH SA will notify the Commission of any written 
comments received by LCH SA.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 45 days of the date of publication of this notice in the 
Federal Register or within such longer period up to 90 days (i) as the 
Commission may designate if it finds such longer period to be 
appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    (A) By order approve or disapprove such proposed rule change, or
    (B) institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Comments may be submitted by any of 
the following methods:

Electronic Comments

    <bullet> Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
    <bullet> Send an email to <a href="/cdn-cgi/l/email-protection#bdcfc8d1d890ded2d0d0d8d3c9cefdced8de93dad2cb"><span class="__cf_email__" data-cfemail="daa8afb6bff7b9b5b7b7bfb4aea99aa9bfb9f4bdb5ac">[email protected]</span></a>. Please include 
File Number SR-LCH SA-2017-007 on the subject line.

Paper Comments

    <bullet> Send paper comments in triplicate to Secretary, Securities 
and Exchange Commission, 100 F Street NE., Washington, DC 20549-1090.

All submissions should refer to File Number SR-LCH SA-2017-007. This 
file number should be included on the subject line if email is used. To 
help the Commission process and review your comments more efficiently, 
please use only one method. The Commission will post all comments on 
the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). Copies of the submission, all subsequent amendments, all 
written statements with respect to the proposed rule change that are 
filed with the Commission, and all written communications relating to 
the proposed rule change between the Commission and any person, other 
than those that may be withheld from the public in accordance with the 
provisions of 5 U.S.C. 552, will be available for Web site viewing and 
printing in the Commission's Public Reference Room, 100 F Street NE., 
Washington, DC 20549 on official business days between the hours of 
10:00 a.m. and 3:00 p.m. Copies of the filing also will be available 
for inspection and copying at the principal office of LCH SA and on LCH 
SA's Web site at http://www.lch.com/asset-classes/cdsclear.
    All comments received will be posted without change; the Commission 
does not edit personal identifying information from submissions. You 
should submit only information that you wish to make available 
publicly. All submissions should refer to File Number SR-LCH SA-2017-
007 and should be submitted on or before September 11, 2017.

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\15\
---------------------------------------------------------------------------

    \15\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

Eduardo A. Aleman,
Assistant Secretary.
[FR Doc. 2017-17546 Filed 8-18-17; 8:45 am]
 BILLING CODE 8011-01-P


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