RBA: Assessment of Chicago Mercantile Exchange Inc. against the Financial Stability Standards for Central Counterparties Standard 1: Legal Basis

CME is a wholly owned subsidiary of CME Group Inc. (CME Group), and is organised under the laws of Delaware in the United States of America (US). CME Group is a publicly traded company listed on the NASDAQ Global Select Market.

CME has numerous operating divisions which are part of the same legal entity, including the CME Clearing Division, which provides central counterparty (CCP) services. CME also provides exchange and exchange-related services (for futures and options on futures) in its role as a Designated Contract Market (DCM), and operates a Swap Data Repository (SDR) (trade repository, registered with the Commodity and Futures Trading Commission (CFTC)) and a Swap Execution Facility (SEF) (a trading platform for over-the-counter (OTC) products provisionally registered with the CFTC).

In its role as a CCP, CME clears a number of exchange-traded derivatives and OTC derivatives. CME provides clearing services to each of the four CME Group derivatives exchanges, and two external exchanges.^[1] In OTC markets, CME offers CCP services for interest rate swaps (IRS) and credit default swaps (CDS), as well as certain commodity and foreign exchange products.

CME has adopted policies and procedures to address conflicts of interest arising between its functional areas (see CCP Standard 2.9). Additionally, CME has separated its CME Clearing Division – and established Risk Committees to oversee the Clearing Division (see CCP Standard 2.2) – to ensure that CME's DCM activities do not compromise its CCP activities. CME is subject to CFTC regulatory requirements to separately maintain sufficient financial resources for each of its Derivatives Clearing Organization (DCO), DCM, SEF and SDR operations. The minimum financial resource requirements are additive in that each of CME's DCO, DCM, SEF and SDR operations are independently required to maintain sufficient operating capital to address its operating costs for a rolling one-year period (see CCP Standard 14.1).

CME Group also offers CCP services through CME Clearing Europe, a wholly owned subsidiary of CME Group. CME and CME Clearing Europe are legally separate entities; each CCP is separately capitalised and operates its own Guaranty Funds.

A wholly owned and separately capitalised subsidiary of CME, GFX Corporation, provides 24-hour market-making services in a number of currency futures contracts, as well as certain interest rate and equity index products as needed.

Legal basis

CME novates contracts accepted for clearing and nets obligations across each participant's open contracts. These activities require a high degree of legal certainty to ensure they will be effective, even in a default scenario. Key components of the legal basis under which CME operates are:

• CCP authorisation, regulation and supervision. CME is regulated by the CFTC as a: DCM; SEF; SDR; and DCO in its role as a CCP. These designations arise from the Commodity Exchange Act 1936 (CEA). CME has also been designated a Systemically Important Derivatives Clearing Organization (SIDCO) by the Financial Stability Oversight Council, under Title VIII of the Dodd Frank Wall Street Reform and Consumer Protection Act 2010 (Dodd-Frank Act); this designation gives the Board of Governors of the Federal Reserve System a role in CME's oversight. CME is also deemed registered with the Securities and Exchange Commission (SEC), in relation to its plans to clear security-based swaps.

  The CEA has established the DCO Core Principles. These are high-level, stability-related principles that a DCO must adhere to. The DCO Core Principles are implemented at a more detailed level through CFTC regulations.^[2] Title VIII of the Dodd-Frank Act also enables the CFTC to write additional regulations for SIDCOs. The CFTC has set out these additional requirements in the CFTC regulations (part 39, subpart C), which became effective on 31 December 2013.

• CME Rulebook. The CME Group Exchanges' operations are governed by three rulebooks, comprising the rules of each exchange, including their clearing arrangements. The rulebooks are: the CME Rulebook; the Chicago Board of Trade (CBOT) Rulebook; and the New York Mercantile Exchange (NYMEX) Rulebook. Rules for Commodity Exchange (COMEX) contracts are included in the NYMEX Rulebook. Futures contracts are governed by the rulebook of the exchange on which they are listed, reflecting the historical structure of the CME Group Exchanges. OTC contracts are governed by the CME Rulebook. CME has sought to harmonise the exchange rulebooks, including section numbers, aside from contract-specific terms. Remaining differences are listed on the CME website. CME has stated that its clearing rules are materially identical across the exchange rulebooks, aside from clearing fees.

  All direct clearing participants must enter into an ‘Attestation, Authorization and Agreement for Membership’ with CME. The agreement is a contract between CME and direct clearing participants that requires the clearing participants to comply with all rules (as defined in the CME Rulebook), which includes CME's Certificate of Incorporation, CME's bylaws, the three exchange rulebooks, all interpretations, orders, resolutions, advisories, notices, manuals and similar directives, and all subsequent amendments. This agreement contains provisions stating that it, and the CME Rulebook, is governed under the laws of Illinois. CME has provided the Bank with legal opinions regarding the enforceability of the CME Rulebook in the US. Before admitting foreign clearing participants, CME has confirmed that it seeks legal opinions to confirm the enforceability of the CME Rulebook and the effectiveness of the choice of law provisions in the foreign jurisdiction (see CCP Standard 1.6).

  CME relies upon contractual arrangements with settlement banks and custodians that are – as with clearing participants – governed by US law. All of CME's settlement banks and all but three of CME's custodian banks are located in the US. CME's practice is to obtain opinion from local counsel prior to using non-US custodian banks (see CCP Standard 1.6).

• Novation and netting arrangements. CME's novation and netting arrangements are established under the CME Rulebook and are protected by a number of ‘safe harbours’ contained within US bankruptcy law (see CCP Standard 1.5). In addition, should the Minister approve CME as a ‘netting market’ under the Payment Systems and Netting Act 1998 (PSNA), areas of CME's rules relating to novation and netting (among other areas) would gain the protection provided under Part 5 as ‘market netting contracts’. The PSNA covers several areas relevant to CCPs, including the CCP's rights to access a defaulting participant's collateral as well as terminate and net off the CCP's obligations with respect to an insolvent participant. CME has applied to the Minister to be a netting market for the purposes of the PSNA in conjunction with its application for a CS facility licence.

The Clearing House Risk Committee (CHRC), or other Risk Committee as appropriate (see CCP Standard 2.6), reviews substantial matters related to legal risk, including the admission of clearing participants, settlement banks and custodian banks. Components of CME's analysis may also be reviewed by the CFTC.

CME's Chief Compliance Officer (CCO) annually assesses the extent to which it complies with DCO Core Principle R – Legal Risk; this assessment is lodged with the CFTC.

Rights and interests

The rights and interests of CME, its direct participants and its direct participants' customers in clearing positions and associated collateral are defined in the CME Rulebook and governed by US law.

CME takes collateral by way of a first priority security interest, in accordance with the relevant provisions in the CME Rulebook. In order to do so, participants transfer collateral – both cash and securities – into accounts owned and controlled by CME at permitted depositories, as set forth in CFTC regulations, that are US-based or have a branch in the US (see CCP Standard 15). Participants retain the title to these assets and grant CME a first priority security interest in the collateral, in accordance with the CME Rulebook. Under the CME Rulebook, participants must ensure that assets provided as collateral are unencumbered. CME has stated that assets are transferred to accounts under CME's control in order to perfect the security interest by control, in accordance with the Illinois Uniform Commercial Code or the New York Uniform Commercial Code, as applicable. CME has provided the Bank with legal opinions regarding the efficacy and priority of the security interest granted by participants to CME with respect to their collateral comprising cash or securities.

CME also takes physical gold as collateral by title transfer at its three UK-based custodians (these custodians are not used for any other type of collateral). CME has stated that it takes only a small amount of collateral in this manner and participants are subject to limits on how much physical gold they can use as collateral (see CCP Standard 5). CME has stated that, prior to setting up these arrangements, it engaged external counsel to ensure the enforceability and efficacy of these arrangements. CME also accepts letters of credit in limited circumstances (see CCP Standard 5).

CME has stated that under US bankruptcy law, a DCO can immediately realise the collateral it holds to guarantee performance of a defaulting clearing participant's obligations. The rules governing CME's actions and rights in the event of clearing participant default are set out in the CME Rulebook (see CCP Standard 12).

The CME Rulebook governs the rights and responsibilities of CME and its participants. The CME Rulebook is available on the CME Group website. In addition, CME privately provides clearing participants with procedures that detail relevant features of CME's operations.

To ensure that its rules are consistent with relevant laws and regulations and that CME would not be prevented from exercising its rights under its Rulebook, CME has confirmed that it obtains legal opinions regarding its legal regime, including enforceability opinions. It does this for all relevant jurisdictions (see CCP Standard 1.6).

As a SIDCO, CME must lodge for review with the CFTC any rules that may materially affect the nature or level of risks that CME takes on; these rule changes are concurrently lodged with the Board of Governors of the Federal Reserve System. Other rule changes may be lodged voluntarily for CFTC approval or must be lodged with a self-certification that they comply with the CEA. The CFTC publishes all proposed rule changes on its website. CME also lodges rule changes with the SEC, including where the rule changes relate to the clearing of security-based swaps. CME publishes all CFTC and SEC rule filings on its website, as well as advisory notices to participants.

To ensure the basis for CME's activities is known and understandable, CME publishes the CME Rulebook on its website. Proposed changes to the CME Rulebook are lodged with, and published by, the CFTC (see CCP Standard 1.3), and also placed on the CME Group website. CME circulates advisories regarding certain rule changes and operational procedures to subscribers, and publishes them on the CME Group website.

CME publishes key information about its regulatory status and legal basis as part of its response to the Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO) Disclosure Framework for Financial Market Infrastructures, and describes its approach to meeting the legal basis requirements of the CPSS-IOSCO Principles for Financial Market Infrastructures (the Principles). In addition, CME assesses its compliance with DCO Core Principle R – Legal Risk annually as part of its CCO Annual Report, which is lodged with the CFTC.

As part of its CS facility licence application, CME has provided the Bank with certain legal opinions and memoranda regarding CME's legal basis.

As discussed in CCP Standard 1.2, all CME direct clearing participants enter into an Attestation, Authorization and Agreement for Membership under which the clearing participant agrees to be bound by the CME Rulebook, and agrees to the exclusive jurisdiction of Illinois courts for actions relating to the enforcement of the CME Rulebook. CME has stated that it analyses the jurisdiction of all non-US-based clearing participants to assess the legal risk presented by these participants and to ensure the enforceability of CME's rules against such participants, including by obtaining legal opinions (see CCP Standard 1.6). CME has provided the Bank with legal opinions regarding the effectiveness of the Attestation, Authorization and Agreement for Membership and the enforceability of the CME Rulebook against Australian participants.

Measures that contribute to ensuring a high degree of certainty for CME's activities are:

• Settlement finality. CME's agreements with its settlement banks set out the conditions under which settlement executed by a settlement bank on behalf of a participant with respect to obligations arising from contracts cleared by CME are final and irrevocable (see CCP Standard 8). CME has no exposure to its settlement banks in the course of settlement because its participants remain liable for the payment until it is received by CME (see CCP Standard 9). Separately, US bankruptcy law contains certain provisions designed to provide ‘safe harbours’ for DCOs to prevent margin payments from being clawed back by the administrator of an insolvent clearing participant; CME has provided the Bank with legal memoranda regarding the application of these safe harbour provisions to CME and its participants.
• Assumption of risk. Under the CME Rulebook, CME takes on counterparty credit risk via novation of the contract, such that CME becomes the buyer to every seller and the seller to every buyer. The CME Rulebook states that, for exchange-traded contracts, trades are novated immediately following the successful matching of trade data submitted by the two clearing participants on the long and short sides of a trade. For block trades, ‘Exchange for Related Position’ (EFRP) trades and the transfer of trades or customer accounts in exchange-traded products, novation does not occur until payment of the first margin obligation. For OTC products, trades are novated once the trade data are matched from both clearing participants, provided the trade meets necessary conditions and rules for clearing (e.g. the contract terms comply with those that CME will clear). Under CFTC rules, trades must be accepted or rejected for clearing as quickly after submission as would be technologically practicable if fully automated systems were used; CME explicitly imports this provision of the CFTC rules into the CME Rulebook. Swap trades executed on, or subject to the rules of, SEFs or DCMs are novated once the trades are accepted for clearing. Accpetance for clearing must occur within a time limit prescribed by the CFTC.^[3] Backloaded OTC trades are novated once the first margin obligation is discharged.

• Default of participants. The rights and obligations of CME and its participants in the event of a clearing participant default are set out in the CME Rulebook (see CCP Standard 12). CME has shared with the Bank legal advice that states that the provisions of the CME Rulebook are protected from the application of certain parts of US insolvency law by ‘safe harbour’ provisions contained in US insolvency law. These provisions seek to ensure certain netting arrangements and financial counterparties' interests in collateral (including CCPs) are not restricted by insolvency proceedings.

  These safe harbours apply to counterparties that, among other things, qualify as either ‘commodity brokers’ or ‘financial participants’ under ‘commodities contracts’ or ‘master netting agreements’. The definition of a commodity broker is set out in US bankruptcy law and includes DCOs and Futures Commission Merchants (FCMs) (with customers).^[4] CME has provided the Bank with a legal memorandum stating that it automatically qualifies for the safe harbours because of its status as a registered DCO, and is therefore able to rely on these safe harbours to avoid stays associated with insolvency proceedings in managing a participant default. A financial participant is generally defined as any counterparty with in excess of US$1 billion in notional principal outstanding of swaps, commodities contracts, securities contracts and repurchase agreements (across all counterparties) ^[5] or US$100 million in market value on the same basis.

  Commodity contracts, as defined by US bankruptcy law, include futures, options and cleared swaps, any collection of such contracts, or any contracts that are similar to such, and includes any security arrangement or credit enhancement associated with that contract or collection of contracts. A master netting agreement, as defined by US bankruptcy law, is any agreement providing for the exercise of certain rights – including netting, set-off, liquidation and termination – in connection with one or more commodity contracts and other similar financial contracts. CME has stated that the CME Rulebook, the contracts cleared under it, and the Attestation, Authorization and Agreement for Membership fall within these definitions. CME has relied on these safe harbours during past clearing participant defaults.

  CME has provided the Bank with legal memoranda regarding the application of these safe harbour provisions to contracts between CME and US- and Australian-based clearing participants.

  In addition, should the Minister approve CME as a netting market under the PSNA, areas of CME's rules would be protected as market netting contracts under Part 5 of that Act. These provisions seek to protect a CCP's rules from claims that might otherwise be upheld in insolvency proceedings. The PSNA covers several areas relevant to CCPs, including the CCP's right to access a defaulting participant's collateral as well as terminate and net off the CCP's obligations with respect to an insolvent participant. CME has applied to the Minister to be a netting market for the purposes of the PSNA in conjunction with its application for a CS facility licence and has provided the Bank with legal opinion regarding the application of the PSNA to CME.

• Winding up. The CME Rulebook provides close-out netting arrangements in the event of CME's insolvency, to provide participants with a clear and certain termination sum. For OTC IRS products, additional rules governing service termination in the event the IRS default waterfall is exhausted provide an avenue for orderly wind-down of the IRS clearing service without forcing CME into insolvency (see CCP Standard 12.1). Equivalent rules do not currently exist for Base products.^[6]

  As noted above, the CME Rulebook is governed by US law and CME and its participants benefit from certain safe harbour protections in US bankruptcy law which are designed to ensure the effectiveness of these winding up provisions in the CME Rulebook.

To manage the legal risk from non-US-based clearing participants, the Attestation, Authorization and Agreement for Membership states that it, and the CME Rulebook, is governed by US law. As at the beginning of August 2014, 59 of CME's 72 direct clearing participants were headquartered in the US.

Similarly, the contracts between CME and its settlement and custodian banks state that they are governed by US law. CME has no non-US-based settlement banks; however, CME uses some foreign branches of US-based settlement banks for certain currencies. CME has informed the Bank that it has been advised by local counsel in the relevant jurisdictions that the local law is not central to the settlement banking arrangement. CME has three UK-based custodian banks that are used to accept physical gold as collateral. CME has confirmed that, before entering into custodial arrangements with these institutions, CME engaged UK counsel and evaluated the UK legal and regulatory regime.

CME states that it evaluates the legal risks presented by non-US-based clearing participants, settlement banks and custodian banks prior to entering into a contractual arrangement, including by obtaining legal opinions on the enforceability of CME's legal and contractual rights and obligations. CME has stated that where it forms the view that the laws of a foreign jurisdiction may present a material legal risk (e.g. by restricting CME's ability to enforce its rules, or limiting access to a clearing participant's collateral in the event of a default) an institution from that jurisdiction would not be admitted as a direct clearing participant. CME has confirmed that it updates these opinions as necessary when there are material changes to either US or foreign laws that may impact CME's legal basis.

In the case of Australian-based participants, CME has provided the Bank with legal opinions on the effectiveness of the choice of law provisions in CME's Attestation, Authorization and Agreement for Membership and the enforceability of the CME Rulebook, including in the event of default.