LSE warns that new collateral rules will hit treasury income

Source: London Stock Exchange

London Stock Exchange Group plc ("LSEG") notes that the European Securities and Markets Authority ("ESMA") and European Banking Authority ("EBA") have both now published the advice that they have provided to the European Commission in connection with new technical standards for the regulatory requirements for European central counterparties ("CCPs") under the European Market and Infrastructure Regulation ("EMIR").

The announcements mark the end of the ESMA / EBA consultation process on the draft technical standards with their recommendations now put forward to the European Commission. The European Commission now has a period of three months to endorse these recommendations before finalising technical standards that will govern the regulatory capital requirements of European CCPs in the future. The new recommendations differ considerably from the initial proposals published in March 2012.

These proposed regulatory changes come at a time of rapid development within the financial services industry and, in particular, the capital markets infrastructure sector. On-going regulatory developments and an industry increasingly focused on transparency and risk management are driving new regulatory requirements for central clearing, including in OTC derivatives, alongside heightened customer demand for post-trade services. LSEG regards the introduction of measures designed to broaden the role of CCPs as a positive development and the ESMA / EBA publications to strengthen them should be viewed in this context.

Although the new ESMA / EBA recommendations are finalised, their precise application remains subject to discussion with the relevant regulators. If adopted in their current form, the recommendations will have some implications for LSEG's existing wholly owned subsidiary CCP, CC&G. In addition, LSEG, subject to satisfaction or waiver of certain conditions, has agreed to acquire a majority interest in LCH.Clearnet Group Limited ("LCH.Clearnet") and the recommendations will, if adopted in their current form, also have some implications for LCH.Clearnet.

The advice setting out the technical standards, if implemented, will in summary require, among other things:

· the capital of any European-based CCP to be at least equal to the sum of (i) its gross operational expenses for winding-down or restructuring over an appropriate time span, subject to a floor of six months and (ii)ni)nd (ii) the capital required to cover overall operational and legal risks, credit, counterparty credit and market risks stemming from certain activities and business risk;

· any European CCP to notify its regulator if it holds less than 110% of its capital requirement; and

· any European CCP to hold an additional amount of its own resources equal to 25% of its capital requirement, which it must use before using the default fund contribution of non-defaulting clearing members to cover losses arising from the default of a clearing member.

In addition, EMIR provides that a CCP's cash deposits placed with financial institutions shall be subject to collateralised arrangements. In the advice relating to this requirement, ESMA has proposed that 95% of such deposits must be collateralised with debt instruments meeting certain conditions regarding, among other things, liquidity and credit and market risk.

Initial guidance in relation to the implications of the advice is set out below in respect of CC&G and LCH.Clearnet. As the advice is subject to European Commission review, the position may be subject to change. Further refinements are likely as the detailed application of the proposed rules is developed.

CC&G

As of today, CC&G holds approximately €100 million of capital available for regulatory requirements. Assuming the European Commission endorses the regulatory technical standards in the form of the advice published LSEG's current expectation is that, although the new regulatory framework is likely to provide more stringent rules on regulatory capital, the requirements would be met from CC&G's existing capital resources and current year profit generation.

As previously indicated, LSEG expects that as market conditions improve and increasing stability returns to the inter-bank market this will result in a more normalised return, compared to recent elevated levels, from its treasury management activities. The recommendations as published by ESMA, if adopted in their current form, would further reduce net treasury income in the group's financial year ended 31 March 2014 as a consequence of the proposed requirements in relation to deposits of collateral1. However, although CC&G will gradually adapt its investment policy in advance of the mandatory enforcement, according to our initial estimates this potential decrease is not expected to have a material impact on current FY 2013 market estimates for net treasury income.

This reflects the recently occurring large difference existing in the Italian money market between the interest rate paid on cash deposits and that available in the repo market (or other "secured" investments).

LCH.Clearnet

LCH.Clearnet released an announcement today stating that, if the new recommendations are adopted in the form set out by ESMA / EBA, LCH.Clearnet Group currently estimates that it will increase its regulatory capital by approximately €300 million to €375 million which it intends to have in place during the first half of 2013 in order to comply with the new regulations in advance of applicable regulatory deadlines.

LCH.Clearnet has announced that it is already in compliance with the recommendation, described above, concerning cash deposits placed with financial institutions.

LCH.Clearnet has announced that it will work in close cooperation with its board and members to assess the impact of the recommendations with a view to ensuring that it can continue to deliver an acceptable return on its capital employed for the benefit of its current and future shareholders.

LCH.Clearnet has further announced that, in accordance with its ongoing business strategy, it continues to implement further product growth and geographic expansion, develop new trading venue relationships, and expand its client clearing and risk management services, while continually reviewing its pricing and expense base. Any future business plans and financial projections will take into consideration the finalised implications of the capital requirements referred to above. In addition, LCH.Clearnet expects to further strengthen the growth of its leading clearing businesses, following significant regulatory changes requiring additional OTC instruments to be cleared through a CCP.

LSEG continues to seek opportunities to accelerate its diversification and growth, particularly in the post-trade sector, as well as develop deeper relationships with customers and other trading venues. The combination with LCH.Clearnet continues to meet those strategic objectives whilst maintaining a user-governed, open access and non-discriminatory service provider model. Whilst LSEG is confident in its ability to make a capital contribution, it is in discussions with LCH.Clearnet regarding the potential financial implications of both ESMA's / EBA's recommendations and the measures LCH.Clearnet is exploring to ensure it can continue to deliver an acceptable return on its capital employed.

A further update will be provided in due course.

More generally in relation to the LCH.Clearnet transaction, filings have been made with all relevant regulatory authorities and it is targeted that all necessary outstanding clearances and approvals will be received during Q4 2012.

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