Cleared Term DBV 23 July 2013

1. Cleared Term DBV 23 July 2013

2. Key dates • February 2014: • Market testing on an end-to-end LCH.Clearnet/CREST test platform • March 17 2014: • Euroclear UK & Ireland launch underpinning settlement changes to the CREST system. • April 2014: • LCH.Clearnet launch their new Term £GC service and start the transition from the current Sterling GC service.

3. AGENDA • Term DBV: a perspective from the Bank’s front office • Andrew Hauser: Head of Sterling Markets Division • The case for change • Toby Davies: Head of Market Services Division • Key features of the new Cleared Term DBV service • CREST system enhancements: David Nicholas, Euroclear UK & Ireland. • New Term £GC product: Nigel Bradley, LCH.Clearnet. • Sub-group update, and member actions required • Ian Fox: Chair, MMLG sub-group for Cleared Term DBV. • Q&A (Panel session) • Closing remarks • Ian Mair: Chair, London Money Market Association

4. Cleared Term DBV 23 July 2013

5. Term DBV: a perspective from the Bank’s front office Andrew Hauser Head, Sterling Markets Division Chair of Money Market Liaison Group Chair of Securities Lending and Repo Committee

6. From small acorns...

7. ...secured flows now dwarf unsecured Average daily turnover in sterling money market (Nov 2012)

8. Gradual shift to secured: a global trend Secured transactions as share of total turnover

9. Improving market resilience • Repo reduces (though not eliminates!) counterparty risk • But highly collateralised world increases macroprudential risks – some of which crystallised during the financial crisis • Global response overseen by Financial Stability Board: • Main focus on ‘procyclicality’ • But mitigating operational risk also important • UK challenges not on same scale as eg US triparty - but mismatch between daily DBV settlement unwind and term of underlying deals does pose operational and liquidity risks

10. Term DBV volumes: the only way is up!

11. The Bank’s front office interests • Broad interest in stability of the market: key transmission channel for monetary policy • DBV central to Bank’s own operations: • Peak daily value during crisis = £85bn • From July 2011, Bank counterparties have had option of using Term DBV in OMOs and OSFs... • ...and we made it clear that we were ‘minded to discontinue use of Rolling Overnight DBV’ • MMLG oversight

12. “The system may be safer, but what’s in it for me?” • Safer system benefits everyone, but also... • Settlement costs and exposures(Toby Davies will cover) • Margin costs (LCH.Clearnet will cover)

13. “The system may be safer, but what’s in it for me?” • Safer system benefits everyone, but also... • Settlement costs and exposures(Toby Davies will cover) • Margin costs (LCH.Clearnet will cover) • Front office engagement crucial to success of the exercise • Good practice guidelines (Toby/Ian will cover)

14. Cleared Term DBV 23 July 2013

15. The case for change Toby Davies Head of Market Services Division 23 July 2013

16. Current DBV mechanism • Current overnight DBV model is tried-and-tested • low cost easy way of delivering market-defined baskets of GC • no substitutions or mark-to-market needed because collateral is returned every morning • reliable • But it masks hidden issues • an inefficient and risky churn of daily return and reissue • dependency on provision of central bank liquidity through auto collateralised repo to fund intraday positions

18. Risks • In the event of a counterparty or system-wide outage intraday between morning unwind and afternoon re-input: • DBV counterparties would be left holding the ‘wrong’ asset • counterparties would be required to manage liquidity dislocation DBV counterparties and their CREST settlement banks would be left with credit exposures • the Bank would be left with intra-day liquidity extension to settlement banks that might need to be converted into overnight facilities • The values are substantial

19. 11 November 2011 • Severe SWIFT outage on 11 November 2011 meant many of the day’s DBVs (including LCH’s) could not be submitted until very late in the day • DBV value input after the outage was resolved was £159bn • Outstanding IDL (a large proportion of which is normally repaid automatically in afternoon DBVs) was at £82bn at the point of failure

20. The challenge • The Bank has been exercised by the risks for many years • Objective is to align the settlement arrangements with the underlying economic terms of the repo • not to change the fundamental form of the trade • The challenge is to reduce risks while retaining the benefits of the DBV basket collateral mechanism. • The introduction of Term DBV within CREST in 2011 provided an underlying mechanism • but could not gain sufficient traction without being cleared through LCH.C which accounts for ~40% of DBV value settled.

22. Benefits • From reduction in daily cash and collateral settlement flow • in aggregate, less credit needed for settlement • reduced position management ahead of DBV settlement window • reduced reliance on central bank liquidity provision • Tail risk • reduced risk from operational interruption • only overnight and new business exposed to intraday interruption • reduced potential dislocation of liquidity

23. Good market practice is essential • collateral giver • to maintain pool of eligible collateral to feed mark-to-market and substitutions • collateral taker • to ensure substitutions do not fail by keeping received collateral available for substitution and return • CREST is able to manage substitutions because it recognises a closed loop of collateral given/received in DBV. This breaks down if you deliver away received stock other than as DBV. • Two approaches: • Hold stock in segregated account • Careful position management

24. Summary • Focus today is LCH introduction of a cleared Term GC product. • The issue is to align the settlement process with the economic terms of the repo • without fundamentally changing the latter • The objective is to reduce potentially significant risk in the event of a counterparty or system-wide outage that prevents DBV settlement • The change will need to be carefully coordinated.

25. Cleared Term DBV 23 July 2013

26. Clearing Term DBVBank of England Seminar23 July 2013

27. Functional Overview • Input and selection • Uses existing DBV algorithm (basket based and size first) • Return date (1 day – 2 years) • Settling between 3:00pm and 4:10pm • Mark to Market • Overnight: identifies DBVs that are incorrectly collateralised (based on closing price) • Intraday: Generates transaction to rebalance collateral levels to cover cash value of transaction • Generated (in full or partial) if stock is available • Links across multiple transaction legs (even where position is flat)

28. Functional Overview • Substitutions (Eligibility & Giver Recall) • Automatic recall based on Corporate Action or settlement need • Delivery versus delivery • Runs throughout the day to support settlement fails • Recall/substitution possible over a wide chain/array of transactions • Adjustments • Ability to adjust the value of collateral sought, consideration or length of term during the term of the DBV • Interest Calculation • Interest accrued daily for length of term (TDI)

29. Recall Substitution • Simple Substitution (Bilateral model) • Day 1: delivers £100m DBV (UBG) 7 day term • Day 2: Party A delivers £25m gilt 1 to Party C DBV £100m UBG Party A Party B £50m Gilt 1 £50m Gilt 2 7 day term £100m Gilt 3 Party A Party B Sub (TDG) £25m Gilt 3 £75m Gilt 3 £25m Gilt 1 £50m Gilt 2 £25m Gilt 3 Sub (TDG) £25m Gilt 1 DEL £25m Gilt 1 Party C

30. Recall Substitution • Complex Substitution • CCP is less vulnerable to subs fails given the large number of counterparty holdings TDG £5m Gilt 2 Mbr F Mbr H DEL £30m Mbr X Mbr A TDG £5m Gilt 1 TDG £10m Gilt 2 Gilt 1 TDG £30m Gilt 2 TDG £10m Gilt 1 TDG £30m Gilt 1 Mbr B Mbr G TDG £20m Gilt 2 LCH Mbr C TDG £20m Gilt 1 Mbr H Mbr D Mbr I Mbr E

31. Cleared Term DBV Enhancements • Direct input of Term DBVs and Term DBV Adjustments from LCH.C • Support settlement of Giver Recall Substitutions, Term DBV Maturity Returns and Own Account Transfers alongside DBV settlement in order to satisfy settlement efficiency/minimise fails • Support early closing of a open term DBV via LCH • Substitutions triggered by Term DBV Amendment (during DBV settlement) • Removal of diary time slicing (full availability of substitutions) • Support of negative interest rates

32. Market Practice • Successful operation of substitution functionality – dependant on collateral being maintained within collateral arrangements (no onward Delivery of Collateral other than by Term DBV) • Substitution not possible where collateral moved outside collateral arrangements • No enforcement tools • No Settlement Discipline regime • Requires adherence to good market practice • Options to avoid unintentional delivery of collateral outside of collateral arrangements: • Account Segregation - Main Trading and Collateral Accounts • Single Account – inventory management challenge

33. Account Segregation • DBVs ‘Collateral Account’ separate from Main Trading Account • Advantages: • no possibility of unintentional delivery of collateral outside of collateral arrangements • Clear view of Available Balance (securities available to trade/deliver) • Disadvantages • Account rebalancing necessary (top up/draw downs) • Own Account Transfers in DBV settlement window • Movements in individual lines of securities

34. Single Account • Single account for all activity (DBVs and Main Trading Account) • Advantages: • Maximum flexibility • Disadvantages • Requires accurate management of positions • Clear view of what is held as collateral • What is available for delivery • To support a single account: • Addition of ‘non Collateral Balance’ to CREST GUI and FT DEX messages (derived) – visibility of unencumbered balance • Available Balance – Collateral Balances

35. DBV Reporting Tools • To support the market: • Report per participant • Highlighting any inadvertent breaches of good practice • Nil Return Report – confirming non-breaches • Monthly summary reports • No participant details • Persistent breaches – highlighted to participants individually

36. Testing Availability • Test Environment available for testing Term DBV functionality • Block Booking – Nov/Dec 2013 • No charge for testing during this period

38. Cleared Term DBV 23 July 2013

39. Term £GC Product Overview Bank of England 23 July 2013

40. Term £GC Overview Sterling GC Term £GC Trading Term £GC Product Definition Sterling GC Product Definition Features of cleared product Settlement mechanism GB00BC7H8L40 GB00B1347K44 • Term £GC Key Benefits • Reduced operational risk and settlement credit needs due to the elimination of the requirement for daily return of cash and collateral compared to the current Sterling GC product. • Introduction of margin offsets between trades relating to specific bonds e.g. the existing cleared Gilts market, and allocations resulting from Term £GC trades. TDBV Settlement DBV Settlement

41. Term £GC Overview • Sterling denominated repo trades based on the CREST Unstripped British Government (“UBG”) Delivery by Value (“DBV”) class. • Term £GC will be made available for trading via electronic trading platforms and anonymous trading will be available. • Bilateral and voice brokered trades will also be supported. • Overnight trades and term trades (up to 374 day term) accepted. • Settlement, using Euroclear UK & Ireland’s (“EUI”) Term DBV (“TDBV”) settlement platform, is • instructed by RepoClear and automatically matched via the Direct Input facility. • Collateral allocated as part of a Term £GC trade can be substituted in the same manner as any • other collateral utilised within the TDBV environment. • Participants’ positions will be maintained in CREST utilising standard Mark to Market functionality • augmented with LCH.Clearnet Risk management processes.

42. Term £GC – Trading, Clearing and Settlement

43. Trade Registration • Trade registration supported from 07.00 to 18.00 (all times are London time) • Cut off for registration of trades for same day settlement: 14.30 • Fixed term trades • Fixed repo rate (positive, negative or zero) • Cash fill basis (defined in GBP) • Based on EUI’s definition of Unstripped British Gilt (“UBG”) class • Consistent with Sterling GC • LCH.Clearnet retains ability to exclude specific ISINs • Overnight to 374 day terms will be supported • Forward start periods of up to 374 days

44. Risk Management Initial Margin • Term £GC trades will be margined both intra-day and at end of day. • For trades received on a same day settlement basis, IM will initially be calculated based on a synthetic allocation of bonds. • Once the settlement allocations are known, positions will be margined based on the actual allocations as part of all subsequent margining processes. • Initial margin offsets will be supported between Term £GC trades and trades executed against specific collateral cleared via the existing Gilts market. • Variation Margin • Variation Margin will be called to reflect the change in the net present value of the repo interest only. • Delivery Margin • Delivery Margin will not be applicable to Term £GC (as per Sterling GC).

45. Risk Management Intra-day Risk Management • Term £GC will utilise the standard CREST TDBV functionality which adjusts collateral levels on a daily basis to ensure that the value of collateral appropriately covers the cash value of the transaction. • This will be augmented with an additional level of market risk management by LCH.Clearnet

46. Settlement Netting The settlement netting process for Term £GC will be run as two independent steps: “Term Netting” and “End Date Netting” Term Date Netting • The Term Netting process will seek to offset trades for which settlement will • be instructed “Today” (Day1 in the graphic) where trades have the same start and end date. • As per the graphic, in the Day 1 Term Netting process, trades 1 and 2 are netted to produce a settlement instruction for +£30mn End Date Netting • This process examines the positions that have been instructed for settlement in CREST previously and • determines whether those existing positions can be increased or decreased in size, or potentially terminated in order to minimize the level of open positions within the TDBV settlement platform for the participant. • On Day 1 there are no positions that have been previously instructed for settlement, so no End Date netting takes place.

47. Settlement Netting TDBVSettlement Position in CREST following Day 1netting • As a result of the netting and settlement instruction which took place on Day 1, there is now a settlement position in place in CREST for +£30mn which has an end date of day 7. • On day 2, there is only a single trade for the counterparty so no Term Date netting can take place. • However the trade for -£20mn with an end leg settlement date of the day 7 must be considered for End Date netting. • Thus, the new trade and the existing position are End Date netted and the existing TDBV position in CREST is reduced from £30mn to £10mn. TDBVSettlement Position in CREST following Day 2 netting

48. Settlement Netting • Repo Interest • A separate netting process is utilised with respect to repo interest payments such that, on a daily basis, a single net repo interest payment in respect of all closing trades is instructed to CREST for settlement as a cash-only payment . • This mirrors the process that is used in the current Sterling GC product. • Settlement Instruction • LCH.Clearnet submits all settlement instructions using the CREST Direct Input facility so that participants do not need to instruct or match in CREST themselves as a “business as usual” activity. • This facility is used for all settlement instruction including the amendment of the size/early termination of settlement positions.

49. Substitution of Collateral • The use of collateral substitution within the Term £GC product is twofold: • In line with the bilateral market, substitution will be used by collateral givers where a specific bond is required in relation to a participant’s Delivery vs. Payment or Free of Payment transaction. • In relation to the Term £GC product specifically, substitution transactions will be automatically generated to support the return of the correct collateral to its original giver as part of the end leg settlement process. • The volume of substitution transactions which could be generated as a result of collateral return process may be significant: • On any given day there are likely to be multiple givers of collateral to LCH.Clearnet and multiple recipients of collateral from LCH.Clearnet. • Collateral delivered to LCH.Clearnet on an overnight basis may be allocated to a collateral taker on a term basis.   • It is essential that collateral which is allocated to participants as a result of the settlement of Term £GC trades is available for substitution using standard CREST Term DBV functionality. • Any costs incurred by LCH.Clearnet as a result of substitution failure in these circumstances will be charged to the member who fails to support the requested substitution.

50. Tariff Structure • Registration Fees • Registration fees for Term £GC trades will be charged on an ad-valorem basis as per the below table using a 360 day count convention: • The first 1-7 days @ 0.00275% • The next 8-90 days @ 0.00225% • The next 91+ days @ 0.00100% • In addition, a processing fee of £0.70 is levied per registered trade. • This fee structure is the same as that which is currently in place for Sterling GC. • Settlement Fees • Settlement related costs incurred by LCH.Clearnet in settling participants’ Term £GC positions in the EUI Term DBV settlement system will be recovered from participants.