RBA: Assessment of Chicago Mercantile Exchange Inc. against the Financial Stability Standards for Central Counterparties Standard 15: Custody and Investment Risks

A central counterparty should safeguard its own and its participants' assets and minimise the risk of loss on and delay in access to these assets. A central counterparty's investments should be in instruments with minimal credit, market and liquidity risks.

15.1 A central counterparty should hold its own and its participants' assets at supervised and regulated entities that have robust accounting practices, safekeeping procedures and internal controls that fully protect these assets.

Under CME's Investment Policy, CME's cash – including cash posted to it by participants – can be held at central and commercial banks, invested in bilateral and tri-party reverse repurchase agreements, or used to purchase high-quality securities. These activities are conducted in accordance with CME's Investment Policy (see CCP Standard 15.4) and are consistent across Base, IRS and CDS products.

Non-cash collateral is held at regulated commercial custodian banks in the US and UK. These banks are prudentially regulated and supervised in their respective jurisdictions. CME has informed the Bank that it is confident that these banks apply appropriate accounting standards.

CME selects its custodian banks in accordance with its Settlement Bank Policy, Collateral Policy and Credit Risk Policy. These policies specify criteria against which custodian banks are assessed for suitability, including minimum internal credit ratings, liquidity and operational risk management, each bank's internal processes for monitoring and managing accounts, and operational processes and timeframes for moving collateral and money. CME Group publishes a list of approved custodian banks on its website. Custodian banks are approved and reviewed on an ongoing basis by CME in the same manner as settlement banks (see CCP Standard 9.3).

Under CME's Settlement Bank Policy, all custodian banks are reviewed at least annually to ensure they meet all relevant criteria. In addition, key representatives from each department in CME Clearing Division meet quarterly to discuss any issues that have arisen.

15.2 A central counterparty should have prompt access to its assets and the assets provided by participants, when required.

CME has custody agreements in place with each of its custodian banks, which specify that the assets of CME and its participants held by the custodian bank are maintained exclusively for the benefit of CME and do not constitute general assets of the custodian bank. In addition, the Rulebook requires that collateral from participants is unencumbered. Participants' collateral and Guaranty Fund contributions are held by CME in accounts at custodian banks in the name of CME and subject to CME's exclusive control, subject to certain name conventions and regulatory requirements for accounts holding assets of indirect participants (see CCP Standard 5). Because the accounts are in the name of CME and CME has control over the collateral, CME submits instructions directly to its custodian banks. These agreements and rules aim to ensure that CME has prompt and legally certain access to collateral, including in the event of a participant default (see CCP Standard 1.1).

In order to manage risks arising from foreign jurisdictions, CME ensures it has choice of law provisions in its custodian and settlement arrangements so that the laws of a foreign jurisdiction will not negatively impact CME's ability to perform any function or exercise any of its rights, including in a default or insolvency situation (see Standard 1.6). Before entering into a custody agreement with a non-US bank, CME obtains legal advice to assess any legal risks and to provide comfort regarding the enforceability of CME's rights.

CME currently utilises three UK branches of overseas banks as custodians in order to accept small amounts of gold as collateral (see CCP Standard 5). CME has operational and support staff available 24/7 and is able to issue instructions to custodian banks regardless of time zone. During a default, CME would be able to access the gold collateral held at these UK custodians on a same-day basis in the US during UK business hours or, at worst, on the following US business day. CME has performed specific test draws with these custodians to ensure it is able to access the assets.

Rule 817 permits CME to pledge assets to a credit facility in order to obtain timely liquidity in the event of a member default.

15.3 A central counterparty should evaluate and understand its exposures to its custodians, taking into account the full scope of its relationships with each.

CME reviews its custodians at least annually – and more frequently for certain counterparties, or if deemed appropriate – to determine the creditworthiness, liquidity resources and overall counterparty strength of its custodian banks. These reviews are conducted as part of CME's counterparty credit review process, overseen by the Credit Committee (see CCP Standard 4). These counterparty credit reviews take into account the entire relationship between CME and the counterparty across all its business relationships and consider, among other things, the safekeeping practices and internal controls of the counterparty. In addition, the Risk Department monitors indicative market data and external credit ratings on a daily basis, consistent with CME's Credit Risk Policy (see CCP Standard 4.2). If monitoring identified deteriorating creditworthiness of a custodian bank, the situation would be escalated to senior management, along with a summary of the exposure amounts and a recommended course of action. Recommendation actions may include discussion with the institution, restrictions on the relationship, or, in extreme cases, considering terminating the relationship. The recommended actions would also be presented to the Collateral Committee and Credit Committee for approval.

15.4 A central counterparty's investment strategy should be consistent with its overall risk management strategy and fully disclosed to its participants, and investments should be secured by, or be claims on, high-quality obligors. These investments should allow for quick liquidation with little, if any, adverse price effect.

CME invests cash in accordance with its Investment Policy, which details the principles and criteria for investing the cash balances held on behalf of participants. The primary objective of the Policy is to ensure the safety and preservation of capital, and the minimisation of liquidity risk. Consistent with these priorities, the Investment Policy defines counterparty eligibility criteria and defines the scope of permitted investments. In particular, investment counterparties must have minimum internal credit ratings, as referenced in the Investment Policy. Permitted investments are restricted to: central bank deposits; commercial bank deposits, subject to CME's Credit Risk Policy; reverse repurchase agreements of US Treasuries or US Government Agency securities with counterparties meeting internal credit requirements, subject to defined haircuts; or outright purchases of US Treasuries or US Government Agency securities, subject to limits on maximum maturity. CME does not invest non-US dollar cash it receives as initial margin; this cash is held uninvested at CME's settlement banks (see CCP Standard 9.3).

Single counterparty limits are set for each investment counterparty and take into account CME's internal rating of the counterparty, whether the investment is secured or unsecured, and the counterparty's capital. The limits are approved under the governance of the Collateral Committee and are reported to the Credit Committee on a quarterly basis. Limits are also placed on the concentrations of US Government Agency securities. To mitigate liquidity risk, reverse repurchase agreements are limited to overnight terms, or to open repurchase agreements that can be terminated with one business day's notice.

CME currently invests the bulk of its cash collateral on an unsecured basis with a relatively small number of commercial bank counterparties. However, CME has informed the Bank that it is working to establish relationships with a wider range of repo counterparties. Once these arrangements have been established, CME intends to invest the bulk of its cash portfolio on a secured basis. The Bank will continue to monitor CME's planned diversification program, with the expectation that CME should continue to manage counterparty concentration risk in the investment of its treasury investment portfolio.

Customers' funds must be invested in the categories set out in CFTC Regulation 1.25. CME's Investment Policy also adheres to these categories for all other, non-customer funds.

CME does not invest in its own securities or the securities of its participants.

Interest on securities – including the IEF programs (see CCP Standard 5) – held by CME on behalf of participants accrues to participants or their customers, as appropriate. CME does not guarantee returns to participants on the IEF programs and participants do not earn interest on cash collateral posted to CME outside of IEF programs.

CME does not provide its Investment Policy to clearing participants as a matter of course, but will communicate details about the Policy on an ad hoc basis in response to requests from clearing participants.

CME has, in the past, operated a securities lending program that reused non-cash collateral provided by clearing participants. However, this program is currently inactive while CME reviews the program in light of bankruptcy remoteness and Basel III standards. Under this program, CME – through agent banks acting as fiduciaries – is able to lend out securities posted by clearing participants and reinvest the cash received in a manner consistent with the Investment Policy. Only securities posted as collateral for house positions and the Guaranty Fund could be used for the program.

The Collateral Committee is responsible for determining eligible investments. This committee comprises senior personnel from across relevant areas of CME Clearing Division, including the CRO. These eligible investments are approved by the Credit Committee (see Standard 4 for more detail on the Credit Committee).

Day-to-day management of investments and liquidity is carried out by the Banking and Collateral Services Group, which monitors the performance of the investment portfolio in relation to the policy objectives. Any exceptions to the Investment Policy require approval of a Senior Director of CME Clearing Division or above and an Executive Director of Risk Management or above.

Daily monitoring and reporting is conducted on exposures against agreed limits, weighted average maturity of the portfolio, and the investment performance of each investment and the entire portfolio. To aid in monitoring adherence to the Investment Policy, the Clearing Banking and Collateral Services Group prepares quarterly and annual investment reports, which are approved by the Collateral Committee and provided to the Credit Committee. These reports include a management summary of the investments and transactions over the prior quarter.

The Investment Policy is reviewed annually by the Collateral Committee; any recommended changes must be approved by the Credit Committee.