On 25 July 2008, HM Treasury published a Consultation Paper entitled Modernising the insolvency protections for the operation of financial markets - proposals to reform Part 7 of the 1989 Companies Act (the Consultation Paper).
Part 7 of the Companies Act 1989 (Part 7) and accompanying secondary legislation and the Financial Services and Markets Act 2000 (Recognition Requirements for Investment Exchanges and Clearing Houses) Regulations 2001 amend general insolvency law to protect clearing houses and exchanges recognised by the FSA in the event that one of their members defaults on the obligations it has entered into in the course of buying or selling financial instruments.
In the Consultation Paper there were proposals to update Part 7. Proposed amendments covered:
- An expansion of the definition of market contracts.
- Specific provision for the operation of default funds and cross-margining arrangements.
- Minor technical issues regarding “client accounts”, to ensure that, where appropriate, “client monies” provisions of other jurisdictions are honoured and that exchanges or clearing houses are able to use excesses on members’ house accounts where there is a deficit on the members’ client account.
Definition of market contracts
The protections in Part 7 apply in relation to "market contracts". Part of the definition of "market contracts" is that they include contracts entered into for "...enabling...rights and liabilities...under transactions in investments to be settled". Regulation 7 of the Financial Services and Markets Act 2000 (Recognition Requirements for Investment Exchanges and Clearing Houses) Regulations 2001 makes clear that the activity of clearing houses and exchanges is not to be limited to transactions in investments.
However, due to its definition of market contracts, the protections in Part 7 only apply to transactions in investments. Investments are the list of financial instruments covered by the Financial Services and Markets Act 2000. The fact that transactions in non-investments are not covered by Part 7 discourages the provision of central counterparty clearing services for such products. By acting as central counterparty for such products without Part 7 protection, an exchange or clearing house could bring into question the robustness of its overall central counterparty clearing activities. HM Treasury is therefore proposing that Part 7 protections should be extended to the clearing of non-investment products.
HM Treasury also proposes to extend the definition of market contracts so that it applies to contracts between recognised clearing houses pursuant to a parallel clearing structure. This is because at present the Part 7 definition of a market contract refers only to contracts between a recognised clearing house and its members. This does not reflect recent initiatives designed to improve interoperability and increase competition in clearing services.
Operation of default funds
There is currently no explicit mention of default fund arrangements in Part 7. Part 7 only refers to "margin" and "cover for margin" as UK clearing houses did not have default funds in 1989 nor when the legislation was updated by the Financial Markets and Insolvency Regulations 1991. "Margin" and "cover for margin" may be interpreted as to include default fund arrangements. However, margin can only be used to offset the losses of the defaulting member providing the margin whereas default fund contributions may be used to offset the losses arising from the default of a member other than the one providing the contributions. Relying on such a broad construction leaves some uncertainty for central counterparties. It is intended that there will be explicit mention of default funds in Part 7 in order to remove any uncertainty.
The Financial Markets and Insolvency Regulations 1991 and the Financial Services and Markets Act 2000 (Recognition Requirements for Investment Exchanges and Clearing Houses) Regulations 2001 do not expressly recognise payments made by central counterparty clearing organisations under cross-margining agreements. In addition, the current wording of Part 7 only covers contracts that are directly cleared by the central counterparty. By definition cross-margining/margin offset arrangements involve contracts that are not directly cleared. HM Treasury belives that it is important that cross-margin agreements should be covered by the concept of a market contract since in the event of default of a common member subject to such an agreement the relevant exchange or clearing house would be under an obligation to pay margin covered by the agreement.
Comments on the Consultation Paper are due by 16 October 2008.