RBA: Assessment of Chicago Mercantile Exchange Inc. against the Financial Stability Standards for Central Counterparties Standard 11: Exchange-of-value Settlements
If a central counterparty is involved in the settlement of transactions that comprise two linked obligations (for example, securities or foreign exchange transactions), it should eliminate principal risk by ensuring that the final settlement of one obligation is conditional upon the final settlement of the other.
11.1 A central counterparty should eliminate principal risk associated with the settlement of any obligations involving two linked obligations by ensuring that the payment system or securities settlement facility employed operates in such a way that the final settlement of one obligation occurs if and only if the final settlement of the linked obligation also occurs, regardless of whether the securities settlement facility settles on a gross or net basis and when finality occurs.
In those cases where settlement of derivatives contracts involves the transfer of linked obligations, CME has arrangements in place that seek to ensure the linked obligations settle simultaneously, with the final settlement of one obligation conditional on the final settlement of the linked obligation. CME's CS facility licence application includes futures on US Treasury securities, which are settled by the delivery of US Treasury securities.
Delivery of US Treasury securities takes place via book-entry transfer in Fedwire Securities between banks that are members of the Federal Reserve System. Settlement of the securities obligation occurs on a delivery-versus-payment basis, with the transfer of funds conditional on delivery of the securities. The settlement mechanism in Fedwire Securities is designed to achieve final and irrevocable settlement of the linked obligations on an item-by-item basis intraday. CME has no direct involvement in the settlement process; CME's only role is to match clearing participants with delivery obligations to clearing participants due to receive securities.
CME also settles physically delivered commodity contracts and foreign exchange contracts. Although CME's CS facility licence application does not extend to these contracts, the Bank has nonetheless considered these arrangements at a high level, similar to CCP Standard 10. CME ensures physically delivered assets are stored and delivered via approved commodity warehouses, stockyards and delivery agents. The participant with delivery obligations must be in possession of the relevant commodity and associated documentation on the day of tender, and provide a delivery notice to CME of its intent to deliver, which CME then passes to the matched participant due to receive delivery (see CCP Standard 10). Once the receiving participant has made a payment in same-day funds, the receiving participant is entitled to the documentation to convey title and possession. CME's systems are designed such that title does not pass until payment is confirmed by the relevant settlement bank.
CME facilitates settlement of deliverable foreign exchange contracts through Continuous Linked Settlement (CLS), which is a payment-versus-payment settlement service for foreign exchange transactions. CME is not directly involved in the settlement of CLS-eligible foreign exchange contracts, and instead matches clearing participants long the futures contract (due to receive foreign currency) to clearing participants that are short (due to receive the ‘paired’ currency).[1] As with physically delivered contracts, CME does not guarantee delivery of the foreign currency, only the replacement cost (see CCP Standard 10). For non-CLS-eligible currencies, CME designates a bank in the country of the relevant foreign currency and a bank in the ‘home’ jurisdiction for the paired currency.[2] Clearing participants must make funds available to the designated settlement banks the day prior to delivery (for details on CME's settlement banks, see CCP Standard 9.3). Once CME has received notification from the relevant settlement bank that the foreign currency has been received, CME will transfer the paired currency from the account of the clearing participant due to pay the paired currency (receive foreign currency) to the other clearing participant due to receive. These transfers occur in same-day funds.
11.2 A central counterparty should eliminate principal risk associated with the settlement of linked obligations by ensuring that it employs an appropriate delivery versus payment (DvP), delivery versus delivery (DvD) or payment versus payment (PvP) settlement mechanism.
Settlement of securities transactions arising from the expiry of US Treasury futures contracts cleared by CME occurs on a DvP Model 1 basis. This involves the simultaneous transfer of cash from the buyer to the seller through the Federal Reserve System and transfer of US Treasury securities from the seller to the buyer by book-entry between the clearing participants' banks, on an item-by-item basis.
CME utilises CLS for eligible currencies, which provides for PvP settlement. Currencies that are not eligible to be settled in CLS are settled using CME's settlement banks as escrow agents. Payments are only released once CME's agent bank receives the corresponding, contra-currency obligation from the clearing participant. As with other physically deliverable contracts, CME only guarantees replacement cost rather than delivery of these currency contracts.