1
Impact of the new Principles on Financial
Market Infrastructures
Workshop on payments systems oversight
Kingston, Jamaica
5 December 2012
Klaus Löber
CPSS Secretariat
Bank for International Settlements
1 * Views expressed are those of the author and not necessarily those of the BIS
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Outline
The financial crisis and OTC derivatives markets reform
Principles and the role of CPSS-IOSCO
The new principles for Financial Market Infrastructures
(PFMIs)
Other related CPSS initiatives
– Assessment methodology and disclosure framework
– Recovery and resolution of FMIs
– OTC Derivatives
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Financial Market Infrastructures (FMIs)
Facilitate recording, clearing and settlement of monetary and other financial
transactions
Strengthen the markets they serve
Mitigate systemic risk
FMIs play a critical role in fostering financial stability
On the other hand, FMIs also concentrate risk – not the least through
interdependencies.
If this risk is not properly managed, FMIs can be sources of:
Credit losses
Liquidity and collateral dislocations
Financial shocks
FMIs could be major channels through which shocks are transmitted
across domestic and international financial markets
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Experience during the financial crisis
FMIs generally proved resilient to the crisis due to the efforts of last 20 years
– No materialisation of systemic risk in FMIs
– Global efforts towards intraday finality were essential: RTGS, DvP and PvP
– Abnormally high settlement volumes managed during volatility
– FMIs could cope with the default of a large counterparty
– Beneficial role of CLS and CCPs were widely acknowledged
However the recent financial crisis also highlighted i.a.:
– Significant counterparty credit risk in OTC derivatives markets
– Severe lack of transparency in the OTC derivatives market and absence of infrastructure to mitigate risk
– Insufficient (cross-border) information flow
– Shortcomings in default and liquidity risk management
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OTC Derivatives Market Reforms
G20 recommendations - Pittsburgh communiqué of September 2009
Trading and Clearing: All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties (CCPs) by end-2012 at the latest
Reporting: OTC derivative contracts should be reported to trade repositories (TRs)
Non-centrally cleared contracts should be subject to higher capital requirements
The FSB and its relevant members should assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse
Standard setting bodies should strengthen their risk
management standards
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Key international standards Financial Stability Board
Macroeconomic policy and data transparency
1 Monetary and financial policy transparency IMF
2 Fiscal policy transparency IMF
3 Data dissemination IMF
Financial regulation and supervision
4 Banking supervision BCBS
5 Securities regulation IOSCO
6 Insurance supervision IAIS
Institutional and market infrastructure
7 Crisis resolution and deposit insurance BCBS/IADI
8 Insolvency World Bank
9 Corporate governance OECD
10 Accounting and auditing IASB/IAASB
11 Payment, clearing and settlement CPSS/IOSCO
12 Market integrity (money laundering etc) FATF
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Role of CPSS and IOSCO
CPSS and CPSS-IOSCO standards are increasingly becoming
the foundation of FMI related oversight and regulatory activities
CPSS is recognised by the FSB as one of the relevant standard
setting bodies (SSBs). The PFMIs are among the key standards
for sound financial systems
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Old standards
CPSS Core principles for systemically important payment
systems (CPSIPS)(2001)
CPSS-IOSCO Recommendations for securities settlement
systems (RSSS) (2001)
CPSS-IOSCO Recommendations for central counterparties
(RCCP) (2004)
New standards
CPSS-IOSCO Principles for financial market infrastructures
(PFMI) (2011)
International standards for payment, clearing
and settlement systems
9 9
New Principles for the Financial Market Infrastructures:
The new principles are designed to be applied holistically because of their
significant interaction
Replace former three standards with one single, comprehensive set
of principles for all FMIs:
CPSIPS (2001), RSSS (2001), RCCP (2004)
Incorporate the lessons drawn from recent crisis experiences
– more demanding requirements in many areas
– new principles that were not or not fully addressed by the existing
standards
Ensure consistency among requirements to different FMIs while
reflecting the specific role of certain types of infrastructure (e.g.
CCPs, TRs)
Provide revised responsibilities of relevant authorities in regulating,
supervising and overseeing FMIs
Development of the PFMIs
A comprehensive review of the old standards was launched in February
2010 to
– support G-20 and FSB objectives to strengthen core financial
infrastructures and markets by strengthening existing standards and
broadening their coverage
– incorporate lessons learned from the recent financial crisis to adapt to
greater uncertainties and risks in financial markets
– promote consistent global enforcement across different FMI types,
different FMI designs, and different jurisdictions
CPSS and IOSCO issued a consultative draft of the PFMI in March 2011
and conducted extensive market consultation
A final version of the PFMI published in April 2012 incorporated the results
of the market consultation
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Status of the principles
CPSS and IOSCO members should strive to adopt the principles in the
PFMI by the end of 2012 and put them into effect as soon as possible;
FMIs are expected to observe the principles as soon as possible
“Binding” on members of relevant committees (CPSS, IOSCO, FSB) - not
directly legally binding but they enjoy the status of “soft law” because of:
– power of the arguments they contain
– membership of the committees
(increased legitimacy thanks to wider membership of CPSS)
Domestic regulation frequently based on them
(sometimes the basis of legislation too by way of incorporation)
Compliance of CCPs with the PFMIs is a condition for banks to benefit
from lower capital requirements (see Capitalisation of bank exposures to
central counterparties, BCBS, 2012)
Basis of assessments by IMF and World Bank for financial sector
assessment programmes (FSAPs)
Guiding philosophy in drafting
Express standards as broad principles in recognition that FMIs differ
significantly in organization, function, and design
Recognize that FMIs can achieve a particular result in different ways
Incorporate minimum requirements where appropriate to ensure a
common base level of risk management across FMIs
Adopt a functional approach to the applicability of the principles in the
PFMI to different types of FMIs
Adopt a holistic approach to the principles in the PFMI by having them
build upon and complement each other
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Interaction between the principles
The principles have significant interaction with each other and, as
previously noted, must be read holistically
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FMIs covered by the PFMIs
FMIs are sophisticated multilateral arrangements among participating financial institutions that handle significant transaction volumes and sizable monetary values
FMIs facilitate the recording, clearing and settling payments, securities, derivatives, or other financial transactions
These FMIs are regarded as systemically important because of the
critical roles in the markets they serve:
Systemically important (large value and retail) payment systems (SIPS)
Central counterparties (CCP)
Central securities depositories (CSD) and Securities settlement systems (SSS)
Trade repositories (TR) (newly included)
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General
organisation
Credit and liquidity risk
Settlement
CSDs and Exchange
Value Settlements
Default Management
General business and
operational risk management
Access
Efficiency
Transparency
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Responsibilities of Authorities
• Responsibility A: FMIs should be subject to appropriate and effective
regulation, supervision, and oversight by a relevant authority
• Responsibility B: Authorities should have the powers and resources to carry
out effectively their responsibilities in regulating, supervising, and overseeing
FMIs
• Responsibility C: Authorities should clearly define and disclose their
regulatory, supervisory, and oversight policies with respect to FMIs
• Responsibility D: Authorities should adopt and consistently apply the PFMI
• Responsibility E: Relevant authorities should cooperate, both domestically
and internationally, as appropriate, in promoting the safety and efficiency of
FMIs
Key differences between old and new standards
Unifies the set of standards for payment systems that are systemically
important, CSDs, SSSs, CCPs, and TRs (a new type of FMI)
Focuses requirements on its safety and efficiency to limit systemic risk and
foster transparency and financial stability
Introduces more-demanding requirements and provides greater guidance
when compared with previous standards
Addresses a number of important issues across several principles
– financial resources
– recovery or orderly wind down
– fair and open access
– tiered participation arrangements
– interdependencies, including interoperability
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New requirement Key discussion issues
Principle 4:
Credit risk
• Distinction between current exposures
and PFEs
• Full coverage of all exposures with high
degree of confidence
• Specific requirements for DNS with
and without settlement guarantee
• Greater emphasis on crisis scenarios
especially for CCPs
• Reference to exposure of all affiliated
entities of same group
• Contingency planning for uncovered
credit losses
• Does the FMI have enough
collateral?
• How to estimate potential
future losses?
• What stress scenarios?
• Normal versus extreme
condition: margins versus
other resources?
• Separate default funds?
Principle 7:
Liquidity risk
• Greater clarity on range of eligible
funding arrangements
• Greater emphasis on crisis scenarios
• Reference to different roles of
defaulter including as liquidity provider
• What funding arrangements
are eligible (only committed or
more)?
• Multiple roles of participants
• Role of central bank facilities?
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Current vs. potential future exposures
• Current exposure is the loss an FMI would face immediately if a participant
were to default
– Technically, the greater of zero or the market value of a transaction with a
counterparty that would be lost upon the default of the counterparty
• A PS or SSS faces current exposure when it extends intraday credit to a participant
• A CCP faces current exposure equal to the difference between the current market value of
open positions and the value of the positions when the CCP last marked them to market
• Potential future exposure is an estimate of credit exposure than an FMI
could face at a future point in time
– Technically, the maximum exposure expected to occur at a future point in time at a
high level of statistical confidence; arises from potential fluctuations in the market
value of positions and/or collateral
• A PS or SSS faces potential future exposure if the value of collateral securing an
extension of intraday credit could fall below the amount of credit extended, leaving a
residual exposure
• A CCP faces potential future exposure from potential fluctuations in the market value of
open positions with a defaulting customer between the last time they were marked to
market value and the time that they are liquidated or hedged
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PS and SSS requirements
Cover exposures to each participant fully with a high degree of
confidence
– This means that a PS or SSS must strive to collect collateral or maintain other resources with
values equal to or greater than the current and potential future exposures to each participant
– PS and SSS generally collect collateral to mitigate current exposure and apply haircuts to that
collateral to mitigate potential future exposure
– Note: “high degree of confidence” is not explicitly defined
– Exception to requirement: DNS PS and DNS SSS where there is no settlement guarantee
• A settlement guarantee may be provided either by the FMI itself or by the participants
For DNS systems where there is no settlement guarantee but where
participants face credit exposures arising from the FMI’s PCS processes, the
FMI should maintain resources to cover the exposures of the two participants
and their affiliates that would create the largest aggregate credit exposure in
the system
– A higher level of coverage should be considered for a PS or SSS that creates large exposures
or that could have a significant systemic impact if more than two participant families were to
default
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CCP requirements
• Cover exposures to each participant fully with a high degree of confidence
– This means that a CCP must collect margin or maintain other resources with values equal to or
greater than the current and potential future exposure to each participant
– CCPs generally collect variation margin (cash) to cover current exposure and initial margin
(cash and securities) to cover potential future exposure
– “High degree of confidence” is defined (in principle 6 on margin) as the 99% confidence level
(single-tailed) of the estimated distribution of future exposure
• In addition, collect additional resources to cover the default of one or two
participants and their affiliates in extreme but plausible market conditions
– Intended to cover a subset of “tail risk” (or beyond the 99 confidence level)
– CCPs generally collect additional collateral as margin or as contributions to a mutualized pool
of resources
• Document supporting rationale for and have appropriate governance
arrangements relating to the amount of total financial resources held
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Cover 1 or cover 2 for “extreme but plausible”
• Whether a CCP maintains sufficient resources to cover one or cover two
depends on the risk profile of its activities and its systemic importance
– Activities with a more-complex risk profile include clearing financial instruments that
are characterized by discrete jump-to-default price changes or that are highly
correlated with potential participant defaults
– Determinants of systemic importance in specific jurisdictions include consideration
of
• location of the participants
• aggregate volume/volume of transactions that originate in each jurisdiction
• proportion of its total volume/value of transactions that originate in each
jurisdiction
• range of currencies in which the instruments it clears are cleared or settled
• any links it has with FMIs located in other jurisdictions
• extent to which it clears instruments that are subject to mandatory clearing
obligations in multiple jurisdictions
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Key highlights in liquidity risk
Requirements are similar to those for credit risk, with a few key differences
– The likelihood that an FMI would have to cover two for liquidity is lower than for
credit
– PSs and SSSs in addition to CCPs are required to perform stress testing of liquid
resources
Strengthened as compared to previous standards
– Requires maintenance of sufficient liquid resources to effect settlement of payment
obligations same-day (for PS and SSS) or on time (for CCPs) with a high degree of
confidence
– Requires maintenance of sufficient liquid resources to withstand at least the default
of the participant and its affiliates that would generate the largest aggregate
liquidity obligation for the FMI in extreme but plausible market conditions
However, the PFMI expands the types of qualifying liquid resources as
compared to previous standards
New requirement Key discussion issues
Principle 6:
Margin
• Initial margin to cover not only
“normal” market conditions
• From quarterly to monthly
sensitivity analysis, daily back-
testing, annual methodology
testing
• Does the FMI have the „right‟
margining methodology?
• What and how frequent back
testing, stress testing, model
testing?
• Initial margin also to cover
extreme losses?
Principle 5:
Collateral
• Avoid concentration risk
• Avoid procyclicality
• Avoid wrong-way risks
• Higher quality
• What type of collateral, e.g.
government debt?
• How to reconcile trade off as
regards procyclicality?
• Does the FMI have the „right‟
collateral?
• How much can/should wrong-way
risk be avoided?
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Initial margin requirements
Initial margin is collateral collected to cover potential changes in the value of
each participant’s position (that is, potential future exposure) over the
appropriate close-out period in the event the participant defaults
– Meet an established single-tailed confidence level of at least 99% with respect to
the estimated distribution of future exposure (at the portfolio, sub-portfolio, or
product level)
– Have an initial margining system that takes into account the product characteristics
such as complexity, close-out period length, price volatility and correlation, jump-to-
default risk, and hedging strategies
– Use an appropriate close-out period that considers anticipated close-out times in
stressed market conditions and an appropriate historical period for each product
type
– Identify and mitigate any credit exposure that may give rise to specific wrong-way
risk
– Address procyclicality by adopting a forward looking and relatively stable and
conservative margin requirements
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Variation margin requirements
Variation margin is funds that are collected or paid out to reflect current
exposures resulting from actual changes in market prices
– Collect variation margin daily (and intraday where appropriate) to mitigate current
exposure
– Have the authority and operational capacity to make scheduled and unscheduled
intraday variation margin calls and payments
– Have highly reliable price information for marking positions to market; sources of
price information include
• market
• third-party pricing services
• CCP valuation models
• participants
Testing margin coverage
• Backtesting is an ex-post comparison of actual outcomes with outcomes
derived from the margin model
– Performed daily
– The CCP should have clear procedures to deal with instances where the model did
not perform as expected and determine whether a recalibration is warranted
– Backtesting does not evaluate effectiveness against forward-looking risks
• Sensitivity analysis tests how the margin coverage might be affected by a
wide set of scenarios designed to reflect potential market conditions
– Performed at least monthly
– Scenarios should include both historical and hypothetical situations
• Validation of the margin methodology should be conducted at least annually
by qualified and “independent” individuals
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Key highlights in collateral
An FMI should establish prudent valuation practices to have adequate
assurance of its collateral’s value in the event of its liquidation
– Mark-to-market collateral daily
– Ensure haircuts reflect potential values and liquidity to decline over the interval
between their last revaluation and the time by which an FMI can reasonably
assume that the assets can be liquidated
– Incorporate assumptions about collateral value during stressed market conditions
(including extreme price moves and changes in market liquidity)
An FMI should disclose its policies on the reuse of collateral (that is, the use
of collateral that has been provided by participants in the normal course of
business)
– Do not rely on the reuse of collateral to increase or maintain profitability
– May, however, invest any cash collateral received from participants on their behalf
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Principle Purpose Key discussion points
Principle 14:
Segregation and
portability
• Protect indirect participants;
• Increased importance
following mandatory clearing
• What model of segregation, at the
level of CCP or participant? Other
equivalent models?
• What form of portability (relevant
for capital requirements)?
Principle 15:
Business risk
• Recognise the fact that FMIs
may fail and create systemic
disruptions not only as a
result of member default, but
also as a result of non-default
related risks
• What types of non-default related
business risks?
• What ongoing quantitative
requirement (at least 6 months)?
• What liquid composition?
Principle 19:
Tiered
participation
• Identify and address any risks
that that the FMI may face
from indirect participants
• How far down the chain of tiering?
• FMIs as quasi-regulators?
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Key highlights in segregation and portability Segregation and portability arrangements must have a strong legal basis and
have a high degree of legal certainty under applicable law
A CCP should protect customer assets through the use of individual or
omnibus customer accounts
– Individual account structures and the collection of margin on a gross basis
provide flexibility in how a customer’s portfolio may be ported to another
participant, but are operationally and resource intensive
– Omnibus account structures are less operationally intensive and can be
more efficient when porting positions and collateral for a group of
customers, but may expose customers to fellow-customer risk and under-
margined positions with net margining
In certain jurisdictions, a cash market CCP may have alternative approaches
to protecting customers
– For example, laws that subject participants to explicit and comprehensive
financial responsibility or customer protection requirements
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Key highlights in general business risk
An FMI should maintain liquid net assets funded by equity equal to at least six
months of current operating expenses
– Actual amount held should be determined by the FMI’s general risk profile and the
length of time required to achieve a recovery or orderly wind-down of its critical
operations and services (and projected in its recovery or orderly wind-down plan)
– Actual amount held should be reviewed periodically using a variety of scenarios
– Calculation of operating expenses for these purposes may exclude depreciation
and amortization expenses
Liquid net assets held for these purposes cannot be used for any other
purpose
– However, equity held under international risk-based capital standards should be
included where relevant and appropriate to avoid duplicate capital requirements
An FMI’s capital plan should specify how it would raise new capital if its equity
capital were to fall close to or below the amount needed
– The capital plan should consider such factors as ownership structure and any
insured business risks 31
Risks from tiered participation
• Operational dependencies between direct and indirect participants could
affect the smooth functioning of the FMI, such as in the case of
– An FMI with a few direct participants and many indirect participants
– A large indirect participant operating though a small direct participant
• Credit and liquidity risks between direct and indirect participants may affect
the FMI
– The failure of an indirect participant may affect the credit and liquidity needs of
the direct participant
– A CCP may face exposures to indirect participants upon the failure of a direct
participant (at least until such time that customer positions are ported or closed
out)
• Default scenarios can create uncertainty about whether indirect
participants’ transactions have been settled or will be settled and whether
settled transactions can be unwound
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Principle Purpose
Principle 3:
Comprehensive risk
management
• Need for a holistic risk management view
• FMIs should address risks to and from other FMIs
Principle 18:
Access and participation
requirements
• Facilitate expanded direct access without
compromising the safety of the FMI (CGFS report)
Principle 20:
FMI links
• More specific and demanding requirements on different
types of links
Responsibility E:
Cooperation between
authorities
• Strengthening the need for cross-border cooperation
between authorities
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Elements of a risk-management framework
Types of risks that should be addressed
• Legal
• Credit
• Liquidity
• Settlement
• General business
• Custody and investment
• Operational
• Reputational
• Tiered participation
• Other
Potential sources of risks
• Participants and their customers
• Other FMIs
• Settlement and custodian banks
• Liquidity providers
• Service providers
Components of a risk-management framework to address these risks
• FMI design
• Policies (including participant incentives)
• Procedures
• Information and control systems
• Internal controls
• Recovery and orderly wind-down plans
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• A sound risk-management framework should identify the range of risks that an FMI faces and should appropriately address these risks
Key requirements by FMI type
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CSD-CSD Links
• Cover fully all extensions of
credit between CSDs with high-
quality collateral
• Place limits on extensions of
credit between CSDs
• Prohibit provisional transfers of
securities between linked CSDs,
or prohibit retransfer of
provisionally transferred
securities prior to the transfer
becoming final
• Ensure the link arrangement
provides protection for the rights
of participants
• Robust reconciliation procedures
are needed to ensure accurate
records
• Manage risks associated with the
use of an intermediary to access
another CSD
• Identify and manage potential
spillover effects from linked CCPs
• Cover current and potential future
exposures to the linked CCP and its
participants fully with a high degree
of confidence
• Financial resources used to cover
inter-CCP current exposures should
be prefunded with highly liquid
assets that exhibit low credit risk
• Financial resources provided by
one linked CCP to another should
be ring fenced from other resources
and should be at the bottom of the
waterfall
• Losses in a particular financial
product should be contained to
those participants clearing the
products
• Linked CCPs should consider
harmonizing their risk-management
frameworks
• Carefully assess additional
operational risks related to
links to ensure scalability and
reliability of IT and related
resources
• Ensure that changes in a
linked FMI will not inhibit the
smooth functioning of the link,
risk-management
arrangements, and non-
discriminatory access to the
link
CCP-CCP Links TR Links
Note: Links to payment systems are not addressed by this principle, but rather by principle 9 on money settlements.
Assessment Methodology
• Provides guidance for assessing observance of the 24 principles and 5
responsibilities defined in the PFMI
– Provides guidance for determining the scope of an assessment,
gathering facts, developing conclusions, and assigning a rating of
observance for each principle
• Intended primarily for external assessors at the international level, such
as the World Bank and the International Monetary Fund
• May also be used by national authorities, either as written or as an input
to their own methodologies
• Intended to promote objectivity and comparability across the
assessments of observance in different jurisdictions
• Consultative period on the Assessment Methodology ended June 2012
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Disclosure Framework Outlines basic information that an FMI should disclose to increase
transparency of its governance, risk-management, and operations in
order to provide participants, authorities, and the public with a
comprehensive understanding of the FMI and to facilitate comparisons
across FMIs
– The FMI’s organization, markets served, and key metrics
– Any recent changes to the FMI’s design and services
– The FMI’s approach to or method for observing each of the
applicable principles in the PFMI
Principle 23 of the PFMI requires FMIs to complete the Disclosure
Framework on a regular basis and disclose their answers publicly
Prepared in connection with the Assessment Methodology to ensure a
consistent framework for disclosure and assessment
Consultative period on the Disclosure Framework ended June 2012 37
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PFMI related follow-up
December 2012 Publication of final Assessment
methodology and disclosure framework
End 2012/early 2013 Starting of monitoring of implementation
by CPSS-IOSCO:
Reviews are considered to be carried out in three levels, assessing
(i) whether a jurisdiction has completed the process of adopting the
required legislation and other policies;
(ii) whether the content of new legislation and policies is complete
and consistent; and
(iii) whether there is consistency in the outcomes of implementation
39
PFMI related follow-up work
Recovery and resolution of FMIs
- Following the work undertaken by the FSB in respect of
resolution and recovery regimes for financial institutions
- Outlines the issues to be taken into account for different types
of FMIs when putting in place effective recovery plans and
resolution regimes consistent with the FSB Principles and Key
Attributes
- CPSS-IOSCO consultative report published in July 2012
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OTCD related follow-up work
OTCD Data reporting and aggregation requirements
– Laying out minimum data reporting requirements and standardised
formats, and the methodology and mechanism for data aggregation on
a global basis
– CPSS-IOSCO paper outlining considerations for data requirements for
Trade Repositories published in January 2012
Legal Entity Identifier
– Establishing a scheme for the issuance of unique legal entity identifiers
– FSB report published in June 2012
Access by authorities to trade repository data
– Guidance on the level of access by authorities having different
mandates (supervision, oversight, financial stability, etc.) to data stored
in TRs
– CPSS-IOSCO task force to prepare further guidance
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OTCD related follow-up work
Capital requirements for bank exposures to central counterparties
– Introducing the interim framework for determining capital
requirements for bank exposures to CCPs via additions and
amendments to “Basel II” (indicating that a PFMIs compliant CCPs
will receive a preferential capital treatment)
– BCBS document published in July 2012
Margining requirements for non-centrally-cleared derivatives
– Laying out a set of high-level principles on margining practices and
treatment of collateral, and proposing margin requirements for non-
centrally-cleared derivatives with the objectives of reducing systemic
risk and promoting central clearing
– BCBS-IOSCO consultative paper published in June 2012
Coordination of OTCD related regulatory activities
– Aiming to address gaps and overlaps of standard setting bodies
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What is next?
Globalisation and regional integration
Consolidation
Innovation
Interdependencies
…
Continued and enhanced global cooperation among authorities
is essential in promoting global financial stability