RBA: Assessment of Chicago Mercantile Exchange Inc. against the Financial Stability Standards for Central Counterparties Standard 12: Participant Default Rules and Procedures

Rules and procedures

The CME Rulebook, the Default Management Procedures and the IRS Default Management Guidelines address – for both Base and IRS products – a range of matters relevant to the management of a default. These include: the declaration of a default; the management of defaulting participants' portfolios; the allocation of losses; and CME's Assessment Powers to call for additional financial resources from non-defaulting clearing participants, and the obligations of clearing participants in the event all financial resources are exhausted.

The Rulebook and Procedures also address the default of a participating exchange – Eris and DME -cross-margining clearinghouse (FICC, OCC) or partner clearinghouse (SGX, through the MOS). Defaults by participating exchanges or partner clearinghouses would be managed in the same manner (covered under Rule 802.A.3) as defaults by clearing participants, that is CME would apply the same rules to discharge any outstanding obligations as in the case of a defaulting clearing participant.

The Rulebook gives CME the power to enter into any commercially reasonable transaction to eliminate or reduce the exposure created by a defaulting clearing participant. This includes hedging, liquidating or selling the defaulting participant's portfolio. All costs and expenses incurred by CME in implementing its default procedures are taken as obligations of the defaulting clearing participant to CME.

The Rulebook authorises CME to use all assets of the defaulting clearing participant available to CME to cover losses resulting from the default. Should the defaulting participant's assets be insufficient, the Rulebook authorises the mutualisation of losses via the default waterfall applicable to the defaulting clearing participant (see CCP Standard 4.4).

The Rulebook contains clauses designed to prevent defaulting clearing participants from impeding CME's actions. This includes preventing the defaulting clearing participant from filing any action in a court that seeks to stay the actions of CME with respect to the default. CCP Standard 1 discusses the enforceability of CME's rules.

CME's policies for handling a default are developed in consultation with, and reviewed at least annually by, the appropriate Risk Committee (i.e. the CHRC or IRSRC).

The policies cover:

• liquidation of margin and Guaranty Fund assets
• liquidation or auction of defaulting portfolios, including customer portfolios if defaults have occurred in the customer accounts
• CME's financial safeguards and liquidity facility
• announcements to the trading floor and public.

Management of any default event would be handled by Risk Management Department in conjunction with the relevant Risk Committees. The IRSRC would also be assisted by the DMC – see below – in the event of the default of an IRS clearing participant. The Clearing President has ultimate authority for decisions made in pursuing the Guidelines or Procedures, as appropriate.

Following a default, CME would notify the CFTC and relevant partner exchanges or clearinghouses of the default. The Clearing President would determine the timing of a public announcement of the default, taking into account the effect such an announcement might have on CME's efforts to reduce and mitigate its exposure.

Default management – IRS

In the event that a clearing participant was declared to be in default, CME would inform all members of the DMC, all non-defaulting IRS clearing participants, the CFTC and other regulators.

The IRSRC would second traders from non-defaulting IRS clearing participants to the Active DMC, which consists of a subset of the DMC. Membership of the Active DMC is determined by the IRSRC and is rotated among members of the DMC semiannually. While seconded to the Active DMC during a default, members of the committee are bound by confidentiality agreements and information firewalls are erected between seconded members and their firms.

In the event of a default, representatives on the Active DMC would be expected to be available for on-site default management planning within a prescribed timeline. There are no formal restrictions on non-US-based members participating on the Active DMC. However, given that representatives are required to be physically on-site during a default, practical considerations dictate against participation by representatives that cannot make themselves readily available in the event of a default.

The Active DMC would prepare the appropriate portfolio for auction by determining whether to split and hedge the defaulting clearing participant's portfolio and any defaulting customers' portfolios into smaller ‘Auction Portfolios’. Auction Portfolios do not commingle proprietary and customer positions, and are prepared according to the currency in which they are denominated.

If the defaulting clearing participant or any defaulting customers hold commingled interest rate futures in their IRS portfolios (i.e. cross-margined positions), these futures would be included in the Auction Portfolios as if they were swaps. Portfolios with cross-margined positions would be subject to the IRS default waterfall, and would be treated as IRS positions in respect of margining and default management procedures. To manage portfolios containing futures, every IRS-only clearing participant has either an affiliate or has arrangements with another participant able to clear futures products. IRS-only clearing participants are not eligible to participate in the portfolio cross-margining program (see below).

During the hedging and splitting stage, CME would attempt to port any non-defaulting customers' portfolios to another IRS clearing participant. If a customer's portfolio could not be ported to an alternative IRS clearing participant, it would be auctioned in the same manner as a defaulting clearing participant's portfolio. See CCP Standard 13.3 for details of CME's porting arrangements.

Once the hedging stage was complete, CME would begin auctioning the Auction Portfolios. All clearing participants would be required to submit a bid for each Auction Portfolio in the currency in which it clears. CME may allocate the Auction Portfolio to bidders in such a way as to minimise the cost to CME. CME has discretion to refuse bids if allocating the Auction Portfolio to the winning bidder(s) would jeopardise CME, cause financial instability or be contrary to law. CME incentivises competitive bidding by linking the application of non-defaulting participants' Guaranty Fund contributions to their bids (see below).

Use and sequencing of default resources – IRS

As outlined in CCP Standard 4, in the event that losses from a clearing participant's default exceeded that participant's margin and Guaranty Fund contributions, CME would access the next layer of the default waterfall – CME's Capital Contribution to the IRS default management waterfall. In the event that losses from a clearing participant's default exceed the participant's margin and Guaranty Fund contributions as well as the CME Capital Contribution, CME would then access the IRS Guaranty Fund contributions of non-defaulting clearing participants. Neither CME, nor non-defaulting clearing participants, have any recourse to the CDS or Base Guaranty Funds, unless assets held by CME in respect of the defaulting clearing participant for Base or CDS products are in excess of the losses that occurred in the liquidation of those portfolios (see below). Finally, if lossess exceeded all of the above layers, CME could issue assessments against non-defaulting clearing participants.

Available assets are the defaulting clearing participant's: initial margin; variation margin gains (if any); proceeds from the liquidation of the clearing participant's CME Group Exchange memberships or a deposit made in lieu of ownership of Exchange memberships; and the defaulting clearing participant's contribution to the IRS Guaranty Fund. If these assets are sufficient to meet the IRS losses, the clearing participant's excess assets can be used to meet any losses arising from the liquidation of other product categories on which the participant has also defaulted, if applicable (i.e. Base products and/or CDS products). Likewise, assets held by CME for Base or CDS products in excess of the losses incurred in the liquidation of those portfolios can be used to address any shortfall on IRS products.

A defaulting participant's customers' initial margin and variation margin gains (if any) cannot be used to offset losses arising from a clearing participant's proprietary account or from other, defaulting, customer accounts. See CCP Standard 13 for details of CME's customer account segregation arrangements for IRS products.

As at 31 July 2014, CME had contributed US$150 million of its own capital to meet IRS losses in excess of a defaulting clearing participant's available assets (see CCP Standard 4.4).

Any further IRS losses are then addressed using non-defaulting clearing participants' contributions to the IRS Guaranty Fund. The size of the IRS Guaranty Fund is determined according to the Rulebook, Chapter 8G07 (see CCP Standard 4.4). As of 31 July 2014, the IRS Guaranty Fund was approximately US$2.090 billion.

In order to incentivise competitive bidding in default management auctions, the IRS Guaranty Fund is split into three tranches: the subordinated tranche, the seniorised tranche and the remaining Guaranty Fund. IRS losses are allocated to the IRS Guaranty Fund: first, to the subordinated tranche, second, to the remaining Guaranty Fund, and finally, to the seniorised tranche. This structure gives clearing participants incentives to bid competitively on all Auction Portfolios to avoid having some or all of their IRS Guaranty Fund contributions used first as part of the subordinated tranche, and rewards winning bidders, by having the seniorised part of their IRS Guaranty Fund contributions used last.

• To determine the subordinated tranche, CME calculates two quantities for each Auction Portfolio and each IRS clearing participant: the clearing participant's Shortfall Percentage; and the Erosion Factor. The Shortfall Percentage, which is based on stress-test losses, is designed to capture the risk a clearing participant's portfolio presents to the IRS Guaranty Fund. The Erosion Factor reflects the competitiveness of a clearing participant's bid for an Auction Portfolio. Uncompetitive bidders have some of their Guaranty Fund contribution placed in the subordinated tranche.
• The seniorised tranche is calculated similarly for winning bidders, using their Shortfall Percentage, and the proportion of the total defaulting portfolio that the Auction portfolio represents.

In the situation where the Guaranty Fund was utilised, clearing participants would be required to fully restore their Guaranty Fund contributions to previous levels, before the close of business on the banking day after CME issues notice that replenishment is due; however, in the event of a default, replenishment would be subject to the participant's maximum obligations to contribute to the IRS Guaranty Fund, and to fund IRS Assessments (see below). This limit on replenishment only applies during the ‘IRS Cooling Off Period’. This period lasts for 25 business days following the default of a clearing participant. If another default occurred during the IRS Cooling Off Period, the 25-day period would begin again from the date of the later default. After the IRS Cooling Off Period, clearing participants must fully replenish their Guaranty Fund contributions.

The final resource in the default waterfall is the unfunded Assessments against each non-defaulting clearing participant (the CME Assessment); see CCP Standard 4.4. The maximum Assessment is sized to match the third and fourth largest stress-test losses. Once sized, the Assessment totals are allocated among all clearing participants. Each clearing participant's obligation is its share of the total assessment, calculated on the same basis as its IRS Guaranty Fund contribution.

Assessments are due to be paid to CME on the day they are called, unless the call is made within one hour of the close of Fedwire, in which case the assessment is due within one hour of when Fedwire next opens.

If a default occurred, CME may issue an advance Assessment demand to non-defaulting clearing participants. This would only occur in the situation where the collateral of the defaulting participant was less than 50 per cent of the margin requirements for its IRS contracts (e.g. due to extreme margin erosion). This would require non-defaulting clearing participants to contribute capital up to a maximum of the amount that would be necessary to bring the collateral of the defaulting clearing participant to 100 per cent of the relevant margin requirement. Any such Assessment would be allocated pro rata among participants, would be separate from any pre-funded Guaranty Fund contribution, and would be subject to any cap on Assessments established for participants (see below).

IRS Termination Event

If at any time following a default: CME was unable to cover a variation margin payment obligation and had no expectation of accessing funds to permit it to cover the obligation; CME determined that available collateral would be insufficient to satisfy auction bid results for the defaulting clearing participant's portfolio; CME otherwise determined that IRS losses were likely to exceed available collateral; or there was a bankruptcy event of the Exchange, an IRS Termination Event would be declared.

Should an IRS Termination Event occur, CME would conduct a final settlement cycle, netting offsetting variation margin gains and losses against the IRS clearing participant's assets held by CME. If non-defaulting participant variation margin gains exceeded variation margin losses, CME would haircut the gains pro rata. Likewise, if CME received more variation margin than it paid, these gains would be reimbursed to clearing participants in reverse order of the waterfall.

Interest rate futures held in a clearing participant's IRS account, or customer IRS account, under the commingled futures/swaps portfolio margining program would revert to being treated as futures, rather than swaps, should an IRS Termination Event occur.

Once this final settlement cycle was complete, all IRS contracts would be terminated.

Default management – Base products

With regards to default management in for Base products, the first step in closing out a defaulting clearing participant's portfolios (and defaulting customer omnibus) would be to liquidate the collateral held as initial margin against those positions. CME would then attempt to transfer all non-defaulting customers, along with their collateral, to another clearing participant. See CCP Standard 13.3 for details on CME's porting arrangements. CME has not established a DMC for Base products.

The Rulebook authorises CME to close out the defaulting clearing participant's portfolio, and any defaulting customer portfolios via:

• book-entry offset of open contracts in the defaulting portfolio
• open market liquidation on a CME Group Exchange
• private auction.

The decision to utilise a particular close-out mechanism would depend on a number of factors, including CME's assessment of the liquidity of the market and the complexity of the portfolio. CME has arranged for a number of default brokers to assist in the default management process, and has utilised these brokers in previous liquidation situations.

In closing out the portfolio, CME would determine which positions to liquidate and, for those positions that were to be auctioned, how the portfolio would be split.

Once Auction Portfolios were determined, CME would send details of the Auction Portfolios to clearing participants. CME has discretion over which firms it would offer Auction Portfolios. CME may determine the clearing participants that it would approach based on participation in previous drills and default management exercises, or based on products in which the clearing participants are typically active. Clearing participants may also contact CME to express an interest in bidding. Firms interested in participating would submit private bids for the Auction Portfolios. CME has discretion to select which bid to accept for the portfolio, taking all circumstances into account. Participation in auctions is optional.

During the management of a default, CME's exchanges and clearing operations, including variation margin settlement, would continue as normal.

Use and sequencing of financial resources – Base products

The costs of liquidating the defaulting clearing participant's portfolio are ‘losses’, including any costs incurred liquidating a defaulting customer omnibus portfolio above the initial margin held against that omnibus portfolio. Losses would first be met using the defaulting clearing participant's available assets for the Base portfolio. These assets are the defaulting participant's: initial margin; cross-margin assets (below); variation margin gains (if any); proceeds from the liquidation of the clearing participant's CME Group Exchange memberships; and Base Guaranty Fund contribution. As with IRS losses, if the available assets exceeded the losses, those excess assets could be used to meet losses arising from the liquidation of other product categories on which the participant had also defaulted (i.e. IRS and CDS products) and vice versa (see above).

The positions and initial margin in the cross-margin account of the defaulting clearing participant or in its (or its cross-margining affiliate's) account held at a cross-margining clearinghouse would be available to CME. The split of assets between CME and the cross-margining clearinghouse is determined by the Cross-Margining Agreement between CME and the cross-margining clearinghouse (see CCP Standard 19). Any shortfalls arising from the cross-margining program would be treated as losses.

If the participant's available assets were insufficient, losses would be met according to the default waterfall. Unlike in the case of the IRS Guaranty Fund (see above), a single non-tranched waterfall is used in practice for Base products; however, a rule exists (but is not operational) that splits the Base Guaranty Fund into a number of tranches.

As at 31 July 2014, the first US$100 million of any additional losses were met by CME's Capital Contribution. Losses would then be addressed using non-defaulting participant's contributions to the Base Guaranty Fund. As at 31 July 2014, the Guaranty Fund was approximately US$3.578 billion. See CCP Standard 4.4 for details on the method used to determine the size of the Base Guaranty Fund.

If CME had to use the Base Guaranty Fund, clearing participants would be required to restore their contribution to previously required levels, by the end of the next banking day; however, in the event of a default, replenishment would be subject to the participant's maximum obligations to contribute to the Base Guaranty Fund, and to fund Base Assessments. This limit on replenishment only applies during the ‘Cooling Off Period’. The Cooling Off Period lasts for five business days following the default of a clearing participant. If another default occurred during the Cooling Off Period, the five-day period would begin again from the date of the later default. After the Cooling Off Period, clearing participants must fully replenish their Guaranty Fund contributions.

Assessments of non-defaulting clearing participants would be made once CME had determined that a loss or deficit still remained after application of all available assets of the defaulting participant. The Risk Management Department would advise clearing participants of the existence and magnitude of an Assessment at the earliest possible opportunity. The maximum Assessment CME can call is 275 per cent of the clearing participant's Base Guaranty Fund contribution in the event of a single clearing participant's default, or 550 per cent in the event of multiple defaulting clearing participants within the same Cooling Off Period. Assessments are due to be paid to CME on the day they are called, unless the call is made within an hour of the close of Fedwire, in which case the Assessment is due within one hour of when Fedwire next opens.

Except as provided for in CME Rules 818.A and 818.B, CME does not have contractual provisions to close out, net and offset non-defaulting participants' open Base product contracts without CME declaring bankruptcy. Accordingly, if the waterfall was extinguished, CME would declare bankruptcy in accordance with Rule 818. In this event, all open positions across all product categories would be immediately closed through a final settlement cycle. Closed positions would then be netted and offset against all the participant's assets held at CME across all three product categories, in accordance with US bankruptcy law. The value of initial margin posted by non-defaulting clearing participants cannot be used to offset losses or the default of CME or another clearing participant.

1. require its participants to inform it immediately if they:
   1. become subject to, or aware of the likelihood of external administration, or have reasonable grounds for suspecting that they will become subject to external administration; or
   2. have breached, or are likely to breach, a risk control requirement of the central counterparty; and

The CME Rulebook sets out the notification requirements for clearing participants. Events that trigger a notification requirement include when the clearing participant: fails to meet CME's minimum capital requirements; suffers a reduction of net capital of 20 per cent or more; fails to meet any of CME's financial reporting requirements; or becomes subject to insolvency proceedings of any kind.

2. have the ability to close out, hedge or transfer, a participant's open contracts in order to appropriately control risk of a participant that:
   1. becomes subject to external administration; or
   2. breaches a risk control requirement of the central counterparty.

CME may implement any of the default management powers contained in the Rulebook as soon as a clearing participant default is declared. The Clearing President and the CRO have the power to declare that a participant is in default.

The CME Rulebook (Chapter 8G for IRS products) and the exchange rulebooks (Chapter 8 for Base products) define a ‘default event’ as when a clearing participant either: fails to promptly discharge obligations owed; or becomes subject to insolvency or equivalent proceeding. In the event that a clearing participant was declared to be in default, subsequent failures by that participant to meet obligations would be deemed to be part of the same default event. Defaults by multiple clearing participants, however, would be separate default events and would be managed separately.

The key aspects of CME's default rules are contained in the CME Rulebook (Chapter 8G for IRS Products) and in the exchange rulebooks (Chapter 8 for Base products). The rules are publicly available on CME's website. These rules outline when CME can take action against a clearing participant and the powers of CME in the event of a default, including the ability of CME to transfer customer positions to other clearing participants. The Rulebook explicitly sets out the treatment of house and customer positions for both Base and IRS products.

The procedures that CME would follow during a default are detailed in its Default Management Procedures. These Procedures are made available to clearing participants, but are not publicly available. Additional rules for IRS products detailing loss allocation and auction procedures are contained in the IRS Default Management Guidelines (see CCP Standard 12.1). These Guidelines are provided to IRS participants, but are not publicly available.

CME conducts semiannual default management drills for each product category. These tests involve clearing participants and certain customers of clearing participants, chosen by CME as appropriate. These drills allow participants to familiarise themselves with the default procedures and to test their capability to evaluate sizeable portfolios in extreme but plausible scenarios. Portfolios for the drills are structured to be consistent with participants' exposures and to incorporate large and complex portfolios. IRS and CDS clearing participants are required to participate in drills; participation in Base product default management drills is determined by CME.

In addition to clearing for the CME Group Exchanges, CME clears contracts listed by DME and Eris. Each DME participant is required to also hold a NYMEX membership. In light of their dual status as DME and NYMEX participants, DME participants are included in default management drills. Eris participants are not required to be clearing members of CME. Currently, CME does not require Eris participants to be included in the default management drills. CME is considering extending mandatory participation to cover Eris participants in the near future.

The relevant Risk Committees review and analyse the results of the default management drills. These results feed into the Risk Committee's annual review of the default management process. For IRS products, the DMC reviews drill results. The results of default drills are made available to the appropriate regulators.

CME is currently in the process of developing a RWP. CME expects the RWP to be finalised by the end of 2014 (see CCP Standards 3.5 and 4.8).

CME's DMC has at least two representatives from each IRS clearing participant. The DMC advises CME and the IRSRC during the default of a clearing participant, as well as on default management practices and procedures more generally.

CME's default management procedures aim to liquidate a portfolio with minimal market disruption.

• In managing an IRS default, the Active DMC pursues a hedging strategy, and splits the defaulting clearing participant's portfolio into smaller Auction Portfolios. These actions are designed to form relatively risk-neutral portfolios, to mitigate the risks to be assumed by successful bidders. Together with the incentives for competitive bidding, as detailed in CCP Standard 12.1, these processes are designed to facilitate timely auction completion and assist in reducing market disruption.
• In managing a Base product default, CME seeks to liquidate the portfolio either on-market or in private, invitation-only auctions. In addition, the Clearing President determines the timing of a public announcement of the default, taking into account the effect the announcement will have on CME's efforts to reduce and mitigate its exposure.

To provide for further stakeholder engagement, CME meets biweekly with industry participants (clearing participants, back-office vendors and middleware providers) through its OTC Clearing Firm Operations Forum to discuss developments and receive feedback (see CCP Standard 2.8). In addition, CME's Risk Committees include representatives from clearing participants (see above), as well as independent members.

The Bank expects CME to take appropriate account of Australian membership and regulators in default management. The Bank will engage with CME and the CFTC on how it is envisaged that the default of an Australian-based participant, or any participant with a large Australian dollar-denominated portfolio, would be managed. It is expected that such dialogue will clarify the roles of Australian-based participants in this process and the nature of cooperation with the Australian regulators.