The Bank of England (BoE) released a consultation paper on updated rules that would permit central counterparties (CCPs) to accept uncollateralized letters of credit (LOCs) as collateral as well as the risk mitigants that CCPs would be required to implement if they chose to accept this type of collateral.

The paper focuses on initial margin collateral and does not consider the use of LOCs in relation to variation margin. Central bank guarantees are permitted as initial margin collateral under the existing framework but are not typically used by market participants in central clearing.

Although the term ‘bank guarantees’ is generally understood to mean an irrevocable right for the named beneficiary to receive a cash payment from the issuing bank for a pre-specified amount. In the context of central clearing, bank guarantees require the issuing bank to cover – up to a specified limit – the outstanding amount of a defaulter’s margin requirement owed to the CCP.

The Bank of England noted that it remains for CCPs to decide what they can accept as collateral within their own rulebooks. Additionally, non-financial market participants making use of this policy would remain responsible for managing their liquidity needs and would be expected to maintain robust risk management standards to ensure they can meet margin requirements under a range of market conditions, including in stress.

Still, permitting LOCs could reduce liquidity pressures on firms by covering some or all of their initial margin requirements. In normal times, this can mean firms need less cash to meet initial margin requirements. These benefits may extend into periods of stress where firms can continue to utilise their LOC.