Successful applicants to the DSS will  operate under a set of rules and regulations that have been modified to facilitate this.

The DSS is intended to last for five years, after which regulators will be better informed to design a permanent technology friendly regime for the securities market.

Firms that successfully apply to the DSS will be able to manage  the issuance, maintenance and the settlement of financial securities.

The central bank and UK regulator said it will also be possible to combine these activities with that of a trading venue, creating new business models.

The BoE and the FCA have three overarching aims, including: facilitating innovation to promote a safe, sustainable and efficient financial system; protecting financial stability; protecting market integrity and cleanliness.

Examples of financial instruments which could be issued and traded in the DSS include equities, corporate and government bonds, and money market instruments.

“The intention of the Bank and the FCA is that financial market participants, such as companies that use capital markets to raise finance, or participants in financial markets who trade securities, should be able to interact with the firms inside the DSS as normal while benefitting from the new technology,” the pair said in a statement.

“Similarly, unless otherwise specified by the regulators, all financial market participants will be able to use the securities issued in the DSS as they normally would any other security, including in securities financing transactions, or as collateral.”

Derivative contracts based on those securities can also be written, with those activities still being required to comply with the regulations that govern them.

The BoE stated that it will impose limits on the value of securities that can be issued in the DSS to protect financial stability.

The DSS will comprise of varied stages of permitted activity, with a series of gates for sandbox entrants to move through, with permitted activity increasing with each stage.

“The application of new technology such as distributed ledgers could materially improve the efficiency of ‘post-trade’ processes that take place after a trade is executed,” added the BofE and the FCA..

“By making these processes faster and cheaper, the adoption of these technologies could, if successfully implemented, lead to material savings across financial market participants, such as pension funds, investment firms and banks.”

In order to meet the aims of the DSS, while giving fair consideration to the impact of their policy on key stakeholders, the BoE and the FCA have released a consultation paper. The closing date for responses is 29 May 2024.

Following the review period, a formal communication will be issued with final guidance and rules. The DSS is expected to open applications in the summer of 2024.  

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The Bank of England and the US’s Federal Reserve Board, in conjunction with FINMA, have united to present a co-ordinated global resolution to the Archegos Capital Management failure – fining UBS Group a total $387 million.

The fines follow the acquisition of Credit Suisse Group by UBS last month with UBS having confirmed its intention to merge and operate as a consolidated banking group going forward.

The case is the first time an enforcement investigation by the Bank of England’s Prudential Regulation Authority’s (PRA)  has uncovered breaches of four Fundamental Rules.

The £87 million penalty issued by the PRA is a new record for the watchdog – despite it being reduced by 30% from £124.4 million following an agreement between it and Credit Suisse to resolve the matter.

The PRA specifically cited “significant failures in risk management and governance between 1 January 2020 and 31 March 2021, in connection with the Firms’ exposures to Archegos Capital Management”.

In the US, the Federal Reserve Board has announced a simultaneous fine of $268.5 million to UBS, specifying: “Misconduct involved Credit Suisse’s unsafe and unsound counterparty credit risk management practices with its former counterparty, Archegos Capital Management LP”.

Though not imposing a fine, FINMA also found that Credit Suisse “seriously and systematically violated financial market law in the context of its business relationship with the Archegos family office,” with the regulator issuing an order for corrective measures to UBS, following its recent acquisition of the banking group.

In addition to this, FINMA has also opened enforcement proceedings against a former Credit Suisse manager whose identity is so far undisclosed.

The default of Archegos Capital Management, a $10 billion family office founded by renowned New York investor Bill Hwang, occurred in March 2021. The collapse was ultimately sparked by a drop in the share price of US media group Viacom CBS and was one of the most dramatic downfalls in the finance world to date.

Read more: March Madness 2.0: The Archegos fallout

Archegos faced off with its prime brokers, demanding collateral to cover the fund’s exposure on swaps it had purchased on the technology stocks, however as the firm failed to meet the margin calls, a massive $20 billion fire stock sale was prompted as banks rushed to sell off the fund’s positions to make cash for Archegos to pay what was owed.

The severely under-margined swap positions represented a catastrophic risk to Credit Suisse, which following the fallout recorded around $5.5 billion in losses tied to Archegos.

At the same time, Nomura lost nearly $3 billion, and Morgan Stanley’s losses tallied just under $1 billion. Goldman Sachs, Deutsche Bank, Wells Fargo and UBS itself were also linked to the family office but losses were limited.

As well as the financial cost, Credit Suisse also suffered “reputational damages”, said the PRA. Throughout its relationship with the family office, prior to the default, it ignored repeated warnings related to the high risks posed, a report produced by Law firm Paul Weiss, Rifkind and Warton following the fallout concluded.

Read more: Scathing report highlights internal failures relating to Archegos at Credit Suisse

Speaking in an announcement, the PRA has stated that the failures around the event were “symptomatic of an unsound risk culture within the business line that failed to balance considerations of risk against commercial reward appropriately […] The Firms had failed to learn from past similar experiences and had insufficiently addressed concerns previously raised by the PRA.”

“Credit Suisse’s failures to manage risks effectively were extremely serious and created a major threat to the safety and soundness of the firm. The seriousness and widespread nature of those failures has led to today’s fine, which is the largest ever imposed by the PRA,” added Sam Woods, deputy governor for prudential regulation and chief executive of the PRA.

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The survey – which includes responses from senior executives at 61 sell-side firms – found that more than half of market participants are confident that higher interest rates will be sustained long enough to make medium to long-term decisions about business expansion.

According to Acuiti, survey responses indicate that even if rates do come down in the coming years, most FCMs are “secure in their revenue streams emanating from interest rates”.

Jerome Kemp, president at Baton Systems, told The TRADE that while interest rates will likely offer revenue generating opportunities, they also present operational challenges relating to the margining process.

“With the cost of funds no longer being close to zero, higher rates have shone a very bright light on the need for FCMS to optimise the mix of cash and non-cash they post to satisfy margin requirements across their CCP memberships,” he said.

“Manual processes, poor visibility of the data that ultimately drives economically intelligent decisions, and the inability to quickly mobilise and move both cash and securities carry an opportunity cost that FCMs should be addressing.”

Amid this expected growth, over a third of firms surveyed by Acuiti, including almost half of Tier 1 banks, said they would consider adjusting the spread they charge on client balances if interest rates rise.

Elsewhere, only 18% of FCMs responded that they were not passing on the increased cost of capital to clients. A majority of 82% confirmed that they were charging extra for the cost of capital in some way to some clients.

The report explained that it would take rates falling by more than 2% before FCM would see their interest income negatively affected, explaining: “The significance of the interest rate increases is that under current models for charging spreads on client funds, FCMs are well hedged if interest rates fall slightly from current highs as the economy weakens”.

Following turbulence in the market over several years, interest rates are on the rise. On Thursday, the Bank of England rose interest rates to their highest level in 15 years.

With this, comes increased scope and reach of FCM clearing as well as economic growth in the business, Acuiti’s report found.

Understandably, respondents reported that this flow is set to open the door to new FCM entrants, with more than 40% of those interviewed agreeing or strongly agreeing that increased competition would be of benefit to the overall market.

Additionally, FCM’s were demonstrated to be increasing their clearing memberships, with 60% expecting a slight expansion in the number of clearing memberships over the next three to five years and a further 3% anticipating a significant expansion.

Around 95% highlighted “client demand and/or increased volumes on specific exchanges” as the top motivator, followed by “organic growth of company” and “increased interest rates”.

For Kemp, aggregated data is essential for FCMs looking to extend the number of CCPs they work with.

“Without this an FCM will find itself exceptionally challenged to derive greater value from its treasury operations,” added Kemp. “At Baton we are proud and excited to be accompanying the growth of numerous FCMs by providing them with the tools and technology that allow them to optimise the opportunities presented by a sustained higher rate environment.”

On the other side, for the firms looking to decrease the number of memberships – which are in the minority – and for FCMs looking to enter the market, capital requirements were found to be a high barrier to entry as the cost of operating in this space is high.

The report explained: “Post the financial crisis reforms and new rules such as SA-CCR have, in many instances, increased the capital required to run clearing businesses and continues to put pressure on existing firms and create a hurdle for new entrants.”

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The launch follows the UK gilt crisis in September last year where in less than three days, 30-year UK gilt yields spiked following the announcement of the mini-budget by the former Chancellor of the Exchequer, Kwasi Kwarteng, ultimately forcing the Bank of England to step in and buy gilts to stabilise the price.

Today’s launch is intended to understand institutional behaviours in periods of stress to learn lessons for the future. As part of the new system-wide exploratory scenario (SWES) exercise, participants including major banks, hedge funds, asset managers and pension funds will be asked to evaluate the impact of “severe but plausible” stress including what actions they might individually take in that scenario, with a focus on the UK markets.

“Large institutional investment managers hold huge systemic importance to the global economic system, with some of the world’s biggest asset managers falling very much into the ‘too big to fail’ category,” Joseph Cordahi, product strategy director at NeoXam, told The TRADE.

“Hedge fund and pension fund managers should not wait for central banks to come knocking at their doors, they need to act now and begin voluntary stress testing measures. This will not only equip them for regulation down the line but will give them a competitive edge, which given the current climate, is crucial. To accurately stress test, asset managers need to have an accurate and timely view of portfolio transactions, trading positions, corporate actions, as well as pricing to support investment.”

The markets included in the exercise include gilt market, gilt repo market, sterling corporate bond market and associated derivative markets. The exercise is not designed to test the resilience of firms but rather to understand collective actions and responses from firms and how these could then also have an amplifying effect on the initial stress.

BofE, the UK’s Financial Conduct Authority (FCA) and the Pensions Regulator will work together to collate data from all corners of the market.

A final report will be published in 2024, BofE said, including any findings and assessments of risks of UK markets’ stability.

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Efforts are gathering pace to challenge the decision by the Swiss regulators to pay Credit Suisse equity-holders CHF3 billion whilst writing down the value of AT1 debt-holders to zero. 

The write-down, announced the evening of 19 March before markets opened on Monday morning, has decimated the $250 billion AT1 bond market in Europe, with a cataclysmic impact on both market pricing and market liquidity. But with these instruments being held not only by hedge funds and institutional investors, but also distributed to smaller and retail investors, both Swiss and overseas, many players are now calling for urgent redress. 

Over 600 people joined a webinar on Wednesday hosted by Quinn Emanuel, “the most feared law firm in the world” (and one with a history of litigation against Credit Suisse), to explore their options with regards to litigation claims against both the bank as an issuer, and Switzerland as the enactor, of the recent AT1 bond write-down. 

Changing lanes 

The crux of the challenge would appear to be the special ordinance passed by the Swiss government on 16 March, prior to the merger being made official and without any announcement to investors or the public, which gave FINMA the authority to ignore the established enforcement of loss hierarchy in the event of a write-down.  

The emergency decree created a new law to enable the terms of the merger transaction (including the waiving of shareholder approval and the decision to place equity obligations above the rights of junior creditors) because under the existing ‘too big to fail’ Swiss legislation, it appears the deal in its current form may not have been possible.  

Article 19 of the Swiss Capital Adequacy Ordinance states that: “Common Equity Tier 1 capital shall absorb losses before the Additional Tier 1 capital,” and that: “Additional Tier 1 capital shall absorb losses before Tier 2 capital.” It also clarifies that: “Should individual instruments of the same capital component (outside CET1) absorb losses differently, the bank must specify this in its articles of incorporation or at issue of the instrument.

The new ordinance allowing FINMA to sidestep the established loss hierarchy is believed to have been adopted partly on 16 March and partly on 19 March, but was only made public on 19 March – crucially, after the merger was announced, and after the bond write-down was confirmed, the timing of which could become a key element in any court case.  

In addition, in the AT1 documentation for the bonds themselves, the law firm suggested that the definition of a ‘write-down’ event could also be challenged: as the requirements would seem to indicate that the bank had to be in danger of insolvency in order to trigger a write-down to zero (along with other factors).  

The fact that other regulators, including the European Central Bank (ECB) and the Bank of England, immediately distanced themselves from the Swiss decision and reaffirmed their commitment to the standard hierarchy for bank funding also indicates, said Quin Emanuel, that there could be international support for a challenge to Swiss law. So what avenues are available to investors?  

What can be done? 

One possibility mooted in the Quinn Emanuel webinar could be a legal challenge brought in Switzerland against the issuer (Credit Suisse) for mis-selling. Based on the bank’s fixed income investor presentation of 14 March 2023 in which it stated that its capital adequacy situation was sound and that liquidity issues had been addressed. Given that the bank did not disclose any issues that could have warned the market about adverse conditions, there could, suggested the firm, be a case to argue that any bonds traded/purchased in the period between 14 March and 19 March were based on inaccurate statements by Credit Suisse. The key point here would be the issue of market expectations regarding the terms of the prospectus versus the risk of ad hoc legislation: did Credit Suisse know about the new ordinance on 16 March and if so, were they under an obligation to inform their investors/bondholders of the possibility?  

Another avenue could be a claim against Switzerland itself – either the government and/or the regulatory agencies, notably FINMA. Any challenge to FINMA’s decision would need to be addressed in court within 30 days of the FINMA order, with Quin Emanuel suggesting that a challenge could be made on the basis of a violation of property rights and arbitrary exercise of discretion. 

The constitutionality of the 16 March special ordinance could also be challenged – and here, it would seem that the wheels may already in motion. The Swiss Parliament is apparently (said Quinn Emanuel) convening an extraordinary assembly, beginning 12 April, after Swiss government representatives demanded to discuss the emergency decree.  

“Apparently the government can’t just introduce new laws,” said one lawyer. “There is uproar in Switzerland right now, with people asking why they had a superb ‘too big to fail’ regulation for 10 years that everyone planned against, which was thrown away overnight to be replaced by a new regulation that took away rights and breached standard hierarchy. There is a lot of potential here for litigation, but there is also the option for political redress.”  

Other options are to take action against Switzerland in other countries, potentially based on bilateral investment treaties (BITs) – of which Switzerland has many, designed to protect the rights of foreign investments in the host country. Non-Swiss AT1 bondholders could plausibly base action on these, although they would have to be based in jurisdictions with Swiss BITs: such as Singapore, Hong Kong, the UAE, Saudi Arabia and Qatar.  

Swiss treaties – including BITs – usually contain requirements that any expropriation, nationalisation or “measures tantamount to expropriation” cannot be effected without compensation. The devaluation of AT1 bonds could potentially be viewed as a government measure of expropriation, suggested Quinn Emanuel, thus triggering an obligation to compensate bondholders. BITs require “fair and equitable” treatment of foreign investors, and also usually include a requirement to provide procedural fairness and transparency, which could be argued to include the honouring of legitimate expectations about the state’s laws that an investor reasonably had when making the investment. The emergency law passed to legalise the write-down could potentially, the law firm noted, be seen as a breach of that fair and equitable treatment standard: a challenge that could stand independently or in conjunction with an expropriation claim.  

There is some potential to make a claim in the US under either Federal or state securities law (such as California’s popular ‘blue-sky’ law). However, this would be more difficult – first, the Credit Suisse AT1 bonds were predominantly sold to US investors using the 144A exemption, meaning that they are exempt from registration with the SEC. That doesn’t mean the seller is immune to liability – claims can be brought under Rule 10b-5 if the plaintiff can prove that the seller knowingly made a misrepresentation that cause economic loss – but Credit Suisse would almost certainly argue that they didn’t know at the time of sale and therefore could not be liable for fraud. So although it would potentially be possible to bring a challenge in the US, in Quinn Emanuel’s opinion “these claims would face very serious challenges”.  

Urgent action, swift recovery 

Either way, the clock is ticking and investors will have to make some quick decisions on which path they choose to take. “We essentially have a 30-day window,” concluded a Quinn Emanuel lawyer. “There is a strong argument to get arguments together and get letters out quickly.”  

With multiple law firms currently pitching for work in the litigation stakes, it’s therefore likely that we could see some rapid movement – and this hope of redress has already worked some magic in the trading stakes. 

 “After an initial selloff, the AT1 bond market has recovered somewhat from the shock of the Credit Suisse write-down,” said Paul Summer, head of structured notes and financials trading at fixed income investment bank KNG Securities. “The affected Credit Suisse AT1 bonds are now trading at around 5% of notional value, as some investors see hope of a legal challenge.” 

Notably the Credit Suisse Tier 2 bond 6.5% 08/08/23 (which was not written down even though it included bail-in language) dropped to 60% but is now trading above 90%. 

Read More – Lone CoCo bond escapes the Credit Suisse carnage 

 “Investors in other AT1 bonds were comforted by comments from the EU and UK authorities that they would expect common equity instruments to absorb losses before AT1 is written down,” added Summer.  

“However, in our view, this will permanently affect the AT1 market, with investors having to pay much more attention to the terms and conditions of future new issues, and consequently demanding a higher interest premium.” 

The ripple effect 

And at the risk of being pessimistic, it’s not just the bond write-down that could cause a legal headache in the coming months.  

“When deposits are volatile and market confidence is uncertain, focus increases on banks’ tightening liquidity.  When liquidity tightens, we can expect to see an uptick in claims between banks and their customers and counterparties,” warned Charlotte Henschen, a partner in the commercial and banking litigation team at international law firm RPC.  

After the global financial crisis, for example, banks faced a tidal wave of litigation for mistreating customers. When times get tough, banks tend to get tougher – which can, suggested Henschel, result in actions which amount to a breach of their agreements with their clients as they seek to protect their own interests.  

“Litigation could arise from disputed margin calls, where customers consider that a margin call was invalid or unjustified, the parties dispute the valuation of the collateral posted,” she noted.  

“Banks may also be taking a close look at their exposure to customers and the adequacy of the security which they have in place. This may result in litigation where the parties disagree as to the valuation of such security, with arguments as to whether such valuations were previously inflated artificially.” 

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Bank of England

The European Central Bank (ECB), Bank of England, Federal Reserve and others yesterday announced a coordinated action to enhance the provision of liquidity via standing US dollar liquidity swap line arrangements; in a bid to ease pressure on the funding market amid the current banking turmoil.  

Read More – LIVE updates from the UBS takeover of Credit Suisse and market implications 

The Bank of Canada, the Bank of Japan and the Swiss National Bank also joined in a bid to improve the swap lines’ effectiveness in providing US dollar funding by increasing the frequency of 7-day maturity operations from weekly to daily. 

Daily operations commence on Monday, 20 March 2023, and will continue at least until the end of April. 

“The network of swap lines among these central banks is a set of available standing facilities and serves as an important liquidity backstop to ease strains in global funding markets, thereby helping to mitigate the effects of such strains on the supply of credit to households and businesses,” said the ECB in a statement.  

The Bank of England’s first daily 7-day maturity repo operation ran at 08:15 on Monday 20 March, with bids closing at 08.45. Results of the day’s US dollar repo operations are due to be announced at 10:00 AM daily, or as soon as possible thereafter. The funds will be offered at the US overnight rate plus 25bps.  

The current standing arrangements were put in place in October 2013, following a conversion by the group of central banks of their temporary bilateral liquidity swap arrangements to a permanent agreement. Daily dollar auctions across time zones were last put in place as a liquidity measure during the Covid crisis in 2020.  

“The standing arrangements will continue to serve as a prudent liquidity backstop,” said the Federal Reserve.  

The increased access to US dollar liquidity comes in response to the current market turmoil as multiple bank crises hit the industry, including the collapse of Silicon Valley Bank and the fire-sale of Credit Suisse to UBS on 19 March. Funding markets are expected to experience severe stress this week, especially given the decision to write down the entirety of Credit Suisse’s AT1 debt – to the tune of around CHF16 billion ($17.2 billion).  

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The Bank of England’s annual supervision of financial market infrastructures (FMI) report this week laid out plans for the future supervision of systematically important FMIs.

“As a global financial centre, the smooth and safe operation of UK FMIs is vital for international markets,” said deputy governor for financial stability, Sir Jon Cunliffe. “The Bank’s supervision of FMIs is essential for financial stability by ensuring that their risk management and resilience frameworks enable them to carry out their vital functions in normal times and during periods of stress.” 

The bank regulates three broad categories of FMI: payment systems, central securities depositories (CSDs) and central counterparties (CCPs). Currently, it supervises one CSD (Euroclear UK & International) and three CCPs (ICE Clear Europe, London Clearing House (LCH) and the London Metals Exchange); along with payment platforms including Bacs, CHAPS, LINK, Visa Europe and Mastercad Europe, among others.  

The role of FMIs is to simplify complex networks of counterparty exposures, making financial transactions more efficient and secure. Their central role in the financial system means that maintaining their operational and financial resilience is of crucial importance to financial stability. 

However, FMIs can be exposed to multiple sources of disruption, including from other market participants and service providers, as well as their own operations, which can give rise to both financial and operational risks. “FMIs must be financially and operationally resilient in order to be able to absorb, rather than amplify, shocks,” stressed the Bank of England.  

Market volatility over the past year has demonstrated the importance of the resilience of FMIs for financial stability in the UK and abroad, and the latest report outlines how the central bank has stepped up its supervision of these entities in response to the challenging times.  

This includes a new agenda on CCP resilience and recovery, an updated policy on the recognition and supervision of overseas CCPs and CSDs that want to provide services in the UK, and targeted enhancements to supervisory frameworks – with new requirements on FMI operational resilience including consultations to reflect an increased reliance on outsourcing. Also this year, the Bank published its first public supervisory stress rest of UK CCPs, which (reassuringly) confirmed their resilience to market stress scenarios calibrated to be of equal or greater severity than the worst historical market stresses. 

“The BofE’s annual report reinforces the increasing importance of interconnection between FMIs across Europe.”

“The BofE’s annual report reinforces the increasing importance of interconnection between FMIs across Europe,” said Javier Hernani, head of securities services at SIX Group, speaking exclusively to The TRADE.  

“What market participants crave is a far greater array of choice when it comes to clearing services. For instance, if an international trading firm is opening a new euro clearing account, they need to have direct access to the domestic CSDs. Providing connectivity like this is paramount to ensuring the financial stability that the BofE has outlined.” 

Going forward, the UK’s Future Regulatory Framework (currently before Parliament) is likely to step up supervisory attention, as it grants the Bank of England sole rulemaking power over CCPs and CSDs operating in the UK.  

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The Level 3 Data provided by BMLL offers full transparency of the order book, derived from insert, modify, execute or delete order messages across venues. Clients – including BofE – can use it to examine order behaviour, fill probability, resting time and queue dynamics.

“We are very proud to work with the Bank of England by delivering the most granular order book data available, enabling their ongoing research and analysis,” said BMLL chief executive officer, Paul Humphrey.

The news follows an announcement from BMLL in October that it had raised $26 million in a in Series B investment from Nasdaq Ventures, FactSet, IQ Capital’s Growth Fund and ACF Investors, among others to finance its North American expansion.

“The race for speed is over and the race for data and analytics is on,” Humphrey told The TRADE in October.

“When we’re speaking to our customers in the US and UK, it is clear that there is an increasing demand from trading firms for analytics that help them understand how markets truly behave. At the same time there is a real lack of quant resources to carry out the data analytics necessary to make better trading decisions.” 

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Regulated financial services firms and financial market infrastructure firms (FMIs) are provided with services by CTPs that have the ability to affect financial stability and cause harm to consumers if they fail or are disrupted. The discussion paper, published collectively by the supervisory authorities, aims to reduce this risk.

The use of third parties for well managed outsourcing and other arrangements can provide firms and FMIs with benefits such as improvements in efficiency, lower costs, scalability, enhanced innovation and improved operational resilience. The Bank of England’s financial policy committee (FPC) noted however that financial stability could be affected by disruption at a small number of third-party service providers upon which firms and FMIs rely.

The Government responded to these concerns by including legislative proposals in the Financial Services and Markets Bill, which is currently before Parliament, to provide supervisory authorities with the ability to oversee the resilience of services that CTPs provide to the UK financial sector – particularly data and cloud services providers, along with some intermediaries.  

The discussion paper released by the supervisory authorities this week sets out potential measures for how they could use their proposed powers, including a framework for identifying potential CTPs; minimum resilience standards which would apply to the services that designated CTPs provide; and a framework for testing the resilience of material services that CTPs provide to firm and FMIs.

Firms and FMIs’ existing responsibilities to manage risks from contracts with third parties will not be replaced by these measures but will instead complement them. The supervisory authorities stated that they would only oversee the systemic risks arising from the services CTPs provide to firms and FMIs.

Comments on the discussion paper are open until 23 December this year and subject to the outcome of Parliamentary debates on the Financial Services and Market Bill, as well as responses to the discussion paper, the supervisory authorities intend to consult on their proposed requirements and expectations for CTPs next year.

“Financial market infrastructure firms are becoming increasingly dependent on third-party technology providers for services that could impact the financial stability of the UK if they were to fail or experience disruption,” said Jon Cunliffe, deputy governor for financial stability.

“The potential measures examined in this DP provide an initial, but important step for the Bank of England to manage these systemic risks (in coordination with the FCA). The DP also includes suggestions to improve coordination between the Bank/PRA and FCA, international financial regulators, and UK non-financial regulators, which is key given the cross-border and cross-sectoral nature of many CTPs and the services they provide.”

Nikhil Rathi, chief executive of the FCA added: “In an increasingly digital world, financial businesses are more dependent on a small number of third-party providers. That can bring significant benefits, but also comes with resilience risk. We want an open discussion about how we should use new powers Parliament is giving us to oversee the services these third parties provide to the financial sector and reduce the risk of major disruption, which could cause harm to consumers and markets.”

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The review comes in light on the upcoming UMR Phase 6 deadline on 1 September, impacting the largest amount of buy-side firms thus far.

“In our view, the existing governance process, in which firms rely primarily on the International Swaps and Derivatives Association (ISDA) for updating SIMM or negotiating add-ons for model underperformance, may result, for some counterparties, in margin levels not adequate to cover for risks at the 99% confidence level as required by regulations,” said the PRA in its review letter. 

Two areas of potential concern were highlighted by the PRA in its review. Firstly, several limitations related to 3+1 back-testing – a historical methodology introduced by ISDA as the main performance metric for SIMM – were identified. Namely, the usage of in-sample data as well as limitations related to not accounting for non-modelled risk factors in the testing process.

As a result of these limitations, PRA has suggested that 3+1 may not always adequately identify poorly-performing models, as required by the Regulatory Technical Standards (RTS). The regulator noted that in instances where the 3+1 performance measure is unsatisfactory, the resulting initial margin (IM) may not be sufficient to cover for risks at the 99% confidence level as required by the RTS for some counterparties.

The PRA also observed that firms’ primary reliance on the global ISDA governance process for updating SIMM or negotiating add-ons, may not be sufficient to ensure timely action is taken to remediate model underperformance – which is fundamentally firms’ own responsibility under the RTS.

“These findings are not related to the specifics of the model design, such as a calibration methodology which is relatively less sensitive to current market data. Our primary focus is to ensure that in-scope firms are adequately margined (in the sense specified by the RTS) on an individual portfolio basis and that they are meeting the requirement of the RTS,” added the PRA.

Impact on hedge funds portfolios

As the approaching UMR phase 6 deadline looms, more hedges funds than ever before will be brought into scope for the regulation. The PRA stated that “these funds may have portfolios with risk profiles significantly different from those to which SIMM has to date been applied. These portfolios may also be significantly exposed to risk factors not directly modelled in SIMM, due to overall materiality.”

The PRA observed that under existing practices by firms using SIMM, back-testing exceptions are considered for remediation – either by firms applying IM add-ons or by ISDA changing SIMM – only if the model shortfall exceeds a large absolute threshold. Another observation was the 3+1 back-testing is usually insensitive to non-modelled risk factors.

“This means that, without firms taking action, some portfolios will risk being systematically under-margined, for example where the overall shortfall is below the ISDA materiality threshold and/or the underlying risk factors are not modelled in SIMM,” noted PRA.

Concluding its review letter, the PRA said it expects to see evidence that the risk of under-margining is being addressed by individual firms through a self-assessment as well as by providing a corrective action plan for any gaps identified by the assessment.

In response to the letter, an ISDA spokesperson told The TRADE: “The ISDA SIMM performed robustly during the COVID crisis and the extreme volatility caused by Russia’s invasion of Ukraine, with no widespread and material instances of under-margining reported by its wide universe of users. We continually review the SIMM methodology and governance, and the methods we use to assess the performance of the ISDA SIMM meet requirements across regulatory jurisdictions. We look forward to further engaging with the UK PRA to address its concerns.”

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