Capital Structure

Regulatory requirements

According to the Norwegian Securities Trading Act a clearing house shall have risk capital appropriate for the risk exposure assumed by the clearing house. There are also strict regulations of the investment management of the clearing house capital.
In addition to the above mentioned regulation, NOS adheres to international standards and recommendations for clearing houses:

• The European Association of Central Counterparty Clearing Houses (EACH) has established standards of risk management for its members. These standards give guidelines regarding financial resources of clearing houses.
• Recommendations for Central Counterparties are given by Bank for International Settlements (BIS), International Organization of Securities Commissions (IOSCO), the European System of Central Banks (ESCB) and the Committee of Securities Regulators (CESR).
• Throughout 2010 and 2011, the regulators in EU and USA have intensified the work to support the G20 decision to move derivative markets into trading platform and clearing houses. The Dodd-Frank Wall Street Reform and Consumer Protection act (“Dodd-Frank”) in US, the European Market Infrastructure Regulations (“EMIR”) and MiFID 2 in the EU are expected to redefine and strengthen the regulation of market participants and the infrastructure supporting the derivatives markets.

Default Funds

In preparation for the implementation of regulatory reform in the EU pursuant to the European Market Infrastructure Regulation (“EMIR”) and the US Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), NOS has modified its default waterfall and introduce two mutual default funds with effect from 1^st November 2011. The new structure is in line with that of most other clearing houses and will have a positive risk impact on NOS’ clearing members.
 

NOS has introduced one default fund for the freight related markets (dry and wet freight, as well as bunker fuel-oil and iron-ore) (the "Freight Default Fund") and one default fund for the seafood market (the "Seafood Default Fund"). The clearing members will be required to make an equal contribution and will bear an equal risk within each of the two markets. Clearing members active in the freight related markets will each contribute USD 150 000 to the Freight Default Fund as mutual base collateral. Clearing members active in the seafood market will each contribute NOK 150 000 to the Seafood Default Fund as mutual base collateral. Each clearing member’s joint obligation will be limited to its contribution to the default fund(s), and this capital will only be at risk once the preceding default waterfall resources have been exhausted.

Assessing the Capital Adequacy

A clearing house assumes the counterparty risk in each position that is cleared. To cover this risk, the clearing house calculates and requires the clearing members to post collateral. The residual risk occurs if the collateral based on the margining methodology applied proves to be insufficient to cover the costs associated when the clearing house closes out the positions of a defaulting member.
To estimate the residual risk, and hence the need for risk capital, NOS conducts stress testing. When stress testing, NOS is simulating the effect of market movements beyond what is used in ordinary margin calculations.
The simulated market movements in the stress test shall reflect extreme, but plausible market conditions.
The present internal rule requires that the risk capital of NOS must be sufficient to cover the hypothetical default of the largest member exposure (the member whose positions generate the largest stress-test loss) and the next two members with the highest stress-test loss in the same market scenario as the largest member.

Risk Bearing Capital

The Norwegian Securities Trading Act provides a capital requirement, stating that a clearing house shall have sufficient risk capital according to the risk exposure with a minimum of NOK 50 million in liable capital. There are also strict regulations of the investment management of the clearing house capital. These regulations are very much similar to international recommendations regarding the financial resources for clearing houses. EMIR, the coming new regulation for clearing houses introduces some changes, and NOS has adapted to the prescribed and widely used principle of having a default fund included in the overall risk bearing capital of NOS. In case of a clearing member default, the risk bearing capital shall absorb the cost of closing the defaulting member’s position. The sequence in which the funds are used is called the ‘default waterfall’.

From 1^st November the risk bearing capital consists of NOS own capital and two default funds, one for the freight and freight related markets and one fund for the seafood market. The default funds consists of the Mutual Base collateral for each clearing member.

NOS default waterfall from 1^st November 2011:

1. The individual margins posted by the defaulting clearing member. The margins are scaled to be large enough to cover 99,8 of all market movements.
2. The individual base collateral posted by the defaulting member. The individual base collateral is kept on segregated accounts and is not subject to joint liability.
3. The defaulting member’s Mutual Base collateral which is the member’s contribution to the default fund.
4. NOS’s contribution to the default waterfall with10 million USD in front of the freight fund and 20 million NOK in front of the seafood fund.
5. The mutual default fund with the contributions from the non-defaulting members.The size of the default fund depends on the number of active clearing members.The clearing members are required to make an equal contribution and bear an equal risk in the markets they are active in.
6. If a default exhausts the layers up to and including the default fund, the remaining risk is backed by NOS own capital.

NOS Clearing ASA holds risk capital in the case of a default which, together with the margins held, is more than needed to satisfy the regulations, the current exposure and the expected growth.