RBA: Assessment of Chicago Mercantile Exchange Inc. against the Financial Stability Standards for Central Counterparties Standard 13: Segregation and Portability

Under US law, FCMs and DCOs are required to offer certain types of account structures; in all cases, house and customer collateral and positions are legally segregated from one another. CME maintains omnibus segregated customer accounts for most Base products and Legally Segregated Operationally Commingled (LSOC) accounts for certain OTC-traded Base products and all IRS products (see CCP Standard 13.2). CME obtains an acknowledgement letter from each depository institution and custodian holding customer monies, which acknowledges that such funds are customer funds and that holding arrangements comply with relevant US laws. Further information on these settlement banks and custodians is outlined in CCP Standards 9 and 15.

As outlined in the CME Rulebook,^[1] in a default situation, CME would attempt to transfer (i.e. port) participants' customer positions and associated collateral, with respect to any customer account in which there is no default, to alternative clearing participants (see CCP Standard 13.3).

Under US law, participants clearing on behalf of customers are required to be registered as FCMs. For non-US-domiciled clearing participants, CME obtains legal opinions regarding the enforceability and efficacy of CME's rules and procedures (see CCP Standard 1). These opinions assess any legal risks that may arise from the clearing participant's jurisdiction, including to CME's segregation and portability arrangements.

US law seeks to prevent a defaulting clearing participant's insolvency administrator from reversing the transfer of customer positions. It is intended that these provisions would apply provided the porting arrangements were entered into before a clearing participant went into administration, or within seven days after, and provided the transfer were approved by the CFTC.

Under US law, DCOs are required to use LSOC accounts for all cleared swap customer positions and collateral.^[2] Of the products cleared by CME, currently IRS and certain Base product OTC FX forwards and OTC metals forwards fall into this category. For all other products, customer positions and collateral are required to be held in futures-style omnibus accounts.^[3]

OTC Base products and IRS

CME uses an LSOC model for customer positions and collateral in certain OTC-traded Base products and all IRS. Customer positions and collateral are segregated from those of the house account and therefore customer collateral cannot be used to offset losses arising on a clearing participant's proprietary account. In addition, under LSOC arrangements the initial margin and variation margin gains (if any) of defaulting participants' customers cannot be used to offset losses arising from other, defaulting, customer positions or collateral. Any losses incurred by CME in liquidating a defaulting customer's portfolio that exceeded the customer's initial margin would be treated as losses of the defaulting clearing participant (see CCP Standard 12.1).

Clearing participants are required to submit daily reports on the identity of customers and the amount of their initial margin. These reports are required under US law for cleared swaps customers. Customer positions are tracked by CME as they are cleared.

Initial margin for customer positions is calculated on a gross basis, per customer account; offsetting customer accounts at the same clearing participant do not net to reduce initial margin. CME requires clearing participants to call at least as much initial margin from each customer as CME calls from the clearing participant for that customer's account, and lodge this minimum amount with CME. In addition, under CME's ‘LSOC with excess’ program, clearing participants are able to deposit excess funds with CME on behalf of their customers, providing a buffer for those customer accounts.

Base products

CME offers omnibus customer accounts for Base products for which LSOC arrangements are not required. As a result, initial margin from non-defaulting customers could be used to meet losses arising from defaulting customers in the omnibus account. However, customers' initial margin and variation margin gains (if any) cannot be used to offset losses arising on a clearing participant's proprietary account. As with IRS, the clearing participant would be obliged to meet any losses arising from its customers in excess of the collateral held against the omnibus.

As required under US law, initial margin for customer positions is calculated on a gross basis. Clearing participants are required by CME to collect at least as much initial margin from each customer as CME collects from the clearing participants and lodge this minimum amount with CME. These participants also have the option to lodge excess customer collateral with CME. These two measures are designed to ensure that customer positions are unlikely to be under-margined.

Clearing participants report gross open-interest customer data for Base products twice daily. In the event of a default, CME would rely on its own records, received via the daily reporting process, to identify individual customers' positions and initial margin.

OTC Base products and IRS

In the event of a default, CME would work with non-defaulting clearing participants to port customer positions from a defaulting participant. In the meantime, CME would establish arrangements directly with non-defaulting customers of a defaulting clearing participant for their initial and variation margin payments, until they can be ported to a non-defaulting clearing participant. Customer collateral is legally segregated and identifiable to CME. If non-defaulting customer positions and collateral could not be ported, the customer positions would be liquidated in the same manner as those of a defaulting customer.

Customers of a defaulting clearing participant would be notified by the defaulting clearing participant of CME's intention to port them to a non-defaulting clearing participant. This would generally be done by negative consent letters. This means customers would be given the opportunity to remain at the defaulting clearing participant (and have their portfolio liquidated by CME), but a customer's non-response would be taken as consent to the porting arrangement. Following the management of the default, customers that were ported would be free to transfer their positions and collateral to a different clearing participant under business-as-usual porting arrangements.

Base products

In the event of a clearing participant default that also involved a customer default in a Base product omnibus account, CME would use its own records to determine which customer accounts had defaulted. CME would attempt to port non-defaulting positions and initial margin, net of losses incurred by the defaulting customer(s). Customer consent for porting would be obtained in the same way as for IRS.

CME seeks to improve the likelihood of successful porting through gross margining of customer positions, as this means customer accounts are less likely to be under-margined.

Other arrangements

To further improve the probability of successful porting of customer positions, CME would examine the customer portfolios of a clearing participant that appeared to be in distress. In this situation, CME would aim to identify non-defaulting clearing participants with similar or complementary customer profiles that could be well placed to take on non-defaulting customers if the distressed clearing participant defaulted.

CME's arrangements for segregation and portability are set out in the CME Rulebook, which is publicly available on CME's website. CME has also published: a summary of its financial safeguards, which outline the implications of the different account structures and the segregation protections these structures provide customers; and a separate disclosure on LSOC account structures, including the risks of using such arrangements.^[4]

In the event of a clearing participant default, under US law, CME cannot compel the porting of customer positions after a participant has filed for insolvency protection, absent a court order. Under US law, once insolvency protection has been filed, porting becomes the responsibility of the defaulting participant's trustee.

In regards to segregation arrangements, CME is required under US law to offer certain types of account structures; as discussed above, these account structures determine how losses are shared in the event of a clearing participant default (see CCP Standard 13.2). However, in the situation where a defaulting FCM is found not to be holding enough customer funds due to being in breach of its regulatory requirements, the effect of US law is such that customers of the defaulting FCM are required to share any losses on a pro rata basis. CME has indicated that there are no operational constraints preventing it from segregating customer positions and collateral.