Bank of England Weighs Letters of Credit for Initial Margin

The Bank of England is considering whether clearing houses should be allowed to accept unsecured letters of credit from commercial banks as collateral for non-financial firms' derivatives positions. The change could free cash for energy companies and other businesses that hedge prices. It would also make a clearing house depend on an issuing bank paying promptly if a clearing member defaults.

In a consultation published on 15 October, the Bank proposes to let non-financial firms use these bank promises for initial margin, including when they clear as clients through a member. The proposal does not extend to variation margin, which UK clearing houses typically collect in cash to settle current market moves. It is a consultation, not a rule change. Responses are due by 15 January 2027.

The practical test is whether the cash saved by hedgers outweighs the new credit and liquidity risk at central counterparties, or CCPs. The Bank proposes to halve the maximum exposure to a single letter-of-credit issuer from 10% to 5% of a CCP's total collateral, monitor issuers' creditworthiness and test failures in stress scenarios. Those controls are central to the proposal, not a detail to be settled after firms gain access.

Why a bank promise might free cash

A CCP sits between buyers and sellers in a cleared trade. It collects initial margin to cover possible losses between a member's default and the closing or hedging of its positions. If the member defaults, its collateral is the first resource used before losses can reach mutualised funds supported by other members. Collateral must therefore be available quickly at a dependable value.

Existing rules allow commercial bank guarantees only when they are fully backed by collateral and posted by non-financial firms that are themselves clearing members. A firm that has to set aside cash equal to the bank's entire commitment has little reason to pay for a guarantee instead of posting the cash directly. Most non-financial users enter clearing as clients, which also puts the current route out of reach. The Bank says no UK-based CCP currently accepts commercial bank guarantees as collateral.

The new proposal would remove the full-collateralisation requirement and permit letters of credit linked to eligible non-financial clients. A letter of credit gives a named beneficiary the right to demand up to a specified cash amount from the issuing bank. Under a possible pass-through arrangement, a client would obtain the letter from a bank, provide it to its clearing member and have it passed to the CCP. The Bank is describing such arrangements, not imposing a single contract model on firms.

The case for flexibility grew out of the 2022 energy shock. The Bank says the cumulative rise in initial margin requirements for ICE Clear Europe's futures and options service peaked at £30 billion between February and April that year. Some market participants told it they reduced hedging to limit immediate margin calls. The Bank argues that a usable letter of credit might let a firm keep hedging while meeting some or all of its initial margin without finding the equivalent cash upfront. If its margin rises beyond the letter's value, the firm would still need to cover the gap.

That would not solve every liquidity call. Variation margin remains payable in cash in normal UK CCP practice, and a letter of credit is not a substitute for a firm's own liquidity planning. The Bank also says firms may struggle to obtain a new letter during market stress. Its strongest case is for arrangements put in place before a shock.

The risk moves to the issuing bank

An unsecured letter is a claim on a bank, not cash already held by the CCP. If the bank cannot or does not pay promptly when called, the CCP may face a shortfall while it manages a default. The Bank says that risk is most acute when the CCP must redeem the letter after a clearing member default, or after both a client and its clearing member default. The structure also links banks and clearing houses more closely during stress.

The proposed safeguards would limit eligible issuers to authorised UK or overseas credit institutions. CCPs would assess their credit quality continuously, validate each letter with the issuing bank before accepting it and be able to demand replacement collateral as an issuer weakens. Accepted letters would have to be irrevocable, unconditional and payable on demand within the defaulter's portfolio liquidation period. A CCP would not have to prove a default to the issuing bank before drawing on a letter.

The proposed 5% single-bank cap is measured against all collateral held by the CCP, not just the pool of letters of credit. The Bank also wants to remove a current provision that can allow the concentration limit to rise to 25% when commercial bank guarantees account for more than half of total collateral. CCP stress tests would need to consider an issuer's failure, delayed payment and the simultaneous replacement of several letters. The Bank says CCPs should assess whether their prefunded resources still meet the requirement to withstand the default of the two clearing members to which they have the largest exposures under severe but plausible conditions.

Client arrangements add another complication. Some letters may name both the clearing member and CCP as beneficiaries. The Bank proposes that a member could draw on such a letter only with the CCP's prior consent, because a member's draw could leave less available if that member subsequently fails. The consultation also asks how letters would work in pooled client accounts and whether they could be transferred or replaced quickly enough when positions move to another member after a default. Those are open questions, not settled protections.

A proposal with a narrow route to adoption

The Bank estimates one-off compliance costs of about £605,000 to £620,000 for a CCP that chooses to accept letters, plus baseline annual costs of £3,500 to £5,000. It estimates £40,000 to £55,000 in one-off costs for a participating non-financial firm and £2,500 to £3,500 a year thereafter. Issuing-bank fees and costs would vary by creditworthiness and market conditions. The Bank has not quantified the overall cash saving or the number of firms likely to use the route, and says banks may be willing to issue letters mainly to creditworthy firms with established relationships.

Even if the Bank makes the rules, individual CCPs would decide whether to accept letters and would need supervisory permission. The Bank proposes final rules in the first half of 2027, with no separate implementation period, but they could not take effect before its wider UK CCP rulebook does. The immediate question for the consultation is whether the proposed checks make an unsecured bank promise reliable enough to serve as the first line of defence when a cleared trade fails.