RBA: Assessment of Chicago Mercantile Exchange Inc. against the Financial Stability Standards for Central Counterparties Standard 10: Physical Deliveries
A central counterparty should clearly state its obligations with respect to the delivery of physical instruments or commodities and should identify, monitor and manage the risks associated with such physical deliveries.
CME's CS facility licence application does not include any physically settled contracts. However, because the service offered to the Australian market is an extension of CME's global offering, the Bank has nonetheless assessed CME against CCP Standard 10 at a high level.
10.1 A central counterparty's rules should clearly state its obligations with respect to the delivery of physical instruments or commodities.
In some cases, the settlement of derivatives contracts cleared by CME involves the transfer of physical assets and commodities. Examples of contracts that require delivery are certain agricultural, metal and energy contracts. Around 2 to 5 per cent of the peak open interest in physically deliverable contracts actually goes through physical delivery.
Chapter 7 of the Rulebook sets out the obligations of clearing participants and CME in regard to physical deliveries. Requirements relating to delivery (e.g. delivery locations and arrangements) are set out in the relevant contract-specific chapter of the Rulebook. CME also has rules to allow the transfer of in-delivery contracts erroneously taken into delivery by clearing participants that are unable to make or take physical delivery to clearing participants that can make or take physical delivery.
CME sets out in its rules that it only financially guarantees the commercially reasonable replacement cost for all physically delivered contracts and does not guarantee physical delivery. These costs are accounted for in the initial margin collected on these contracts. Further, CME is not directly involved in the delivery process (see CCP Standard 10.2). CME has recently amended the Rulebook in order to clarify and make more explicit its obligations for delivery failures. CME's settlement systems for physically delivered contracts are designed so that title for physically delivered assets and commodities does not pass until payment is confirmed by the relevant settlement bank (see CCP Standard 11).
10.2 A central counterparty should identify, monitor and manage the risks and costs associated with the storage and delivery of physical instruments or commodities.
CME mitigates the risks associated with physical delivery by minimising its involvement in the storage and delivery process. CME is not directly involved in the delivery process. Rather, following expiration of physically delivered contracts, CME matches participants that have delivery obligations with those that are due to receive. Long contracts (participants due to receive delivery) are matched by the date at which the long contract was established – that is, participants due to receive, which established their contracts earliest, are matched first. Short contracts (participants due to deliver) are matched in the order the participant due to deliver declared its intention to deliver.
CME is not involved in handling physically delivered products at any time during the delivery process. However, CME maintains an electronic delivery system that inventories electronic warehouse certificates and warrants for products. CME publishes daily reports on physical delivery metrics on its website. CME is also involved in monitoring and enforcing participants' compliance with their delivery obligations, including through fines, orders for restitution, and, in extreme cases, suspension or termination.
To mitigate the risk of delivery failures, CME communicates with clearing participants that are holding open interest and entering into delivery to ensure clearing participants are aware of their obligations, and the timelines and procedures for deliveries.
The Rulebook outlines that any storage facilities and transport entities involved in physical delivery must be approved by CME, that the underlying product is subject to grading and that appropriate delivery documentation processes must be followed. Grades and delivery locations for physically deliverable contracts are set out in the contract-specific chapter of the relevant Rulebook. CME approves and reviews delivery facilities, which are required to meet certain standards and requirements, depending on the particular product. These requirements are set out in Chapter 7 of the relevant Rulebook.
CME inspects approved delivery facilities at least biennially to ensure the facilities are in good condition and have the operational capabilities to process deliveries. These inspections may also be conducted on an ad hoc basis.