RBA: Assessment of Chicago Mercantile Exchange Inc. against the Financial Stability Standards for Central Counterparties Standard 19: FMI Links

CME has three FMI links: a MOS with SGX; and two cross-margining programs, with the OCC and the FICC. The operation of these links is outlined in CCP Standard 19.4.

Identifying link-related risks

Before entering into an FMI link, all arrangements must be reviewed and approved by the appropriate Risk Committee(s). For the three current FMI links, only the CHRC is relevant because the links do not relate to CME's IRS or CDS products.

CME monitors the creditworthiness of its FMI-link counterparties on an ongoing basis in accordance with its Credit Risk Policy and Risk Management Framework (see CCP Standard 4). These general risk mitigants are in addition to the link-specific, credit-risk-related mitigants outlined in CCP Standard 19.5.

Managing operational risk

Operational issues related to cross-margining arrangements or the MOS are monitored and managed in accordance with CME's ORMF (see CCP Standard 16); CME does not have additional frameworks or policies for monitoring and managing operational risks associated with CCP links.

CME has operational support available 24/7 in the US and London to handle any issues, including those related to cross-margining arrangements of the MOS. In addition, with respect to the SGX MOS, under the MOS Agreement both CCPs are required to have operational staff available whenever the other CCP is open for trading. This requirement helps ensure inter-exchange transfers (see CCP Standard 19.4) occur promptly, regardless of time zone or business holidays and that staff are consistently available to handle operational incidents. FICC and OCC operate in the US, in the same time zone and on the same calendar as CME, but do not have the same operating hours.

Managing financial risk

CME manages the financial risks associated with its MOS arrangement by collecting initial and variation margin from SGX. For the two cross-margining arrangements, CME has methodologies in place to collect sufficient initial margin to cover its potential future exposures to cross-margining participants; for these two FMI-link arrangements, variation margin for cross-margined products is collected directly from participants and, therefore, does not need to be exchanged between CCPs (CCP Standard 19.4). For all three arrangements, CME has recourse to the default management waterfall associated with its Base Guaranty Fund should losses exceed the relevant defaulting participant's initial margin (or, in the case of the MOS, SGX's initial margin). In sizing its Base Guaranty Fund, CME takes into account the potential future exposures all three links may create (see CCP Standard 19.5). CME does not contribute to any of the other three CCPs' default funds, and none of the three CCPs contribute to CME's Base Guaranty Fund.

The Bank will engage with CME on aspects of its risk management of links, including the extent to which stressed market conditions are taken into account when calibrating collateral requirements for exposures to linked CCPs.

Two of CME's FMI-link counterparties – FICC and OCC – are based in the US and one – SGX – is based in Singapore.

The FICC and OCC agreements establish the rights of each participating CCP, including in the event of a cross-margining participant default. The jointly held collateral for the OCC cross-margining arrangement is held with two US custodians (see CCP Standard 19.4), both of which are currently custodians for CME's CCP services more broadly and are subject to CME's eligibility criteria for custodians (see CCP Standard 15). The agreements are governed by US law.

The SGX MOS Agreement is governed by US law and sets out CME's rights against SGX, including its recourse to collateral in the event SGX defaults. Collateral is held in the US, at a custodian acceptable to both CME and SGX. CME has confirmed that it has undertaken legal analysis of the enforceability of the agreements underpinning the MOS, including by obtaining external legal opinions, to ensure that Singaporean laws will not affect the operation of the link, or CME's rights under the MOS agreement. CME has informed the Bank that this analysis is updated as necessary, in the event of material regulatory changes that may impact the operation or enforceability of the MOS agreement.

Neither OCC nor FICC are licensed in Australia. CME's CS facility licence application also does not extend to products eligible for the OCC cross-margining arrangement, but does include cross-margining-eligible products under the FICC arrangement.

Australian clearing participants may be eligible to participate in the MOS to the extent they act as a carrying participant at CME for eurodollar contracts executed on their behalf by a clearing participant on SGX (see CCP Standard 19.4). No other MOS-eligible product is within CME's CS facility licence application scope.

If CME was to propose to enter into another FMI link that affected its Australian operations, the Bank would expect to closely engage with CME and the other FMI, paying particularly close attention to the risk management of the link, and the size and composition of associated collateral.

SGX MOS

The MOS is a peer-to-peer CCP link that permits clearing participants to execute on a trading venue cleared by one CCP, and have the position transferred to the other CCP to carry the position via a process known as ‘ inter-exchange transfer’. Contracts that can be executed using the MOS are: eurodollars, Euroyen, US dollar-denominated and Japanese yen-denominated Nikkei 225 futures and S&P CNX Nifty futures. Only the eurodollar contract is within the scope of CME's CS facility licence application.

Use of the MOS requires that agent–customer-like arrangements are established between participants of CME and SGX. Before being permitted to enter into MOS trades by either CME or SGX, therefore, these clearing participants must establish the necessary documentation. In order to limit the exposures CME has to SGX (and vice versa), both CCPs exchange initial and variation margin. Collateral that CME will accept from SGX to meet initial margin requirements includes cash, certain securities and letters of credit (see CCP Standard 19.5).

Regarding the acceptance of letters of credit to meet initial margin requirements, the Bank will monitor these arrangements with a view to revisiting this issue in a year or if there is a material increase in exposures across the link.

CME would handle an SGX default in the same manner as it would handle the default of other clearing participants (see CCP Standard 12.1). CME would have recourse to the default management waterfall associated with its Base Guaranty Fund in the event the initial margin collected from SGX was not sufficient (see CCP Standard 14.5). In sizing the Base Guaranty Fund, CME considers the MOS; CME does not collect contributions for its Base Guaranty Fund from SGX, nor does it contribute to SGX's default fund.

OCC cross-margining arrangement

The OCC cross-margining arrangement allows clearing participants, or their customers, to reduce their total initial margin requirements where they hold related, offsetting positions at OCC and CME.^[1] CME and OCC agree on the contracts that are eligible for initial margin offsets. Currently, CME allows offsets on a range of equity index futures and options. None of these products are within the scope of CME's CS facility licence application.

Collateral posted as initial margin for cross-margining accounts must be acceptable under both CCPs' rules (see CCP Standard 5 for CME's acceptable collateral). Initial margin is calculated using OCC's methodology. Further detail on the OCC cross-margining arrangement, including the collection of initial margin, and the assumption of risk, is discussed in CCP Standard 19.5.

In the event of a participant default, CME and OCC would coordinate a default management process to liquidate the positions. The positions held in these accounts are managed separately from any positions the defaulting participant has at CME and OCC. Collateral taken as initial margin against these cross-margined positions would be used to address any losses arising from the positions.^[2] In the event losses exceeded the available collateral, CME and OCC would be equally liable to meet the remaining loss.^[3] In accordance with its default management waterfall structure (see CCP Standard 12.1), CME would first use any collateral of the defaulting participant that CME holds and then apply the subsequent layers of the default management waterfall. In calculating the size of the Base Guaranty Fund, CME takes into account potential exposures resulting from cross-margined positions. CME and OCC last tested the default management arrangements for the cross-margining accounts in November 2013. OCC and CME routinely coordinate and discuss as appropriate their overall default management efforts.

In effect, the cross-margining account acts as a third quasi-CCP, to which both OCC and CME are equally exposed. This equal split in exposure is used regardless of the split of cross-margined positions between CME and OCC products. CME regularly reviews the split of positions to ensure equal ownership and exposure remains appropriate and, under the cross-margining agreement, both parties must annually review the split and determine in good faith whether it should be revised.

CME is exposed to OCC only insofar as OCC failed to assume its half of the losses. CME would address such a loss by using the default management waterfall associated with the Base Guaranty Fund.^[4] CME has no business-as-usual credit exposure to OCC.

FICC cross-margining arrangement

Under the FICC cross-margining arrangement, clearing participants do not establish a separate cross-margining account. Rather, all eligible positions held in a cross-margining participant's house accounts are eligible to be used for calculating margin offsets; participants do not need to designate certain positions for cross-margining. CME products that are eligible for cross-margining are limited to certain short- and long-term interest rate futures and options.

In calculating initial margin for cross-margining-eligible participants' house accounts, the two CCPs first calculate initial margin in isolation. The two CCPs then exchange position files and, independently, determine the offsets they will allow against the already-calculated initial margin. For CME, this methodology is similar to the way it permits offsets between related contracts under its SPAN methodology (see CCP Standard 6). These offsets then separately reduce the initial margin required from that participant by each CCP. In exchange, each CCP agrees to indemnify the other up to the amount its counterpart reduces initial margin for a clearing participant through offsets in the event that clearing participant defaults. CME uses the initial margin of the defaulting participant and then the default management waterfall associated with the Base Guaranty Fund to meet this indemnity (see CCP Standard 19.5).

CME handles the default of a cross-margining participant in the same way as other clearing participants (see CCP Standard 12.1). The only difference is that, to the extent the defaulting participant's collateral is insufficient to meet the losses on the portfolio, CME will seek indemnification from FICC.

For the 12 months to July 2014, the size of the positions held across the link with FICC were relatively small compared with CME's overall exposure.

In addition to the link-specific measures outlined below, CME monitors the creditworthiness of its FMI-link counterparties in accordance with its Credit Risk Policy and Risk Management Framework (see CCP Standard 4).

SGX MOS

CME faces current and potential future exposure to SGX in the event SGX defaulted, and margins its SGX exposure at levels consistent with the margin requirements for direct clearing participants.

To limit current exposures, CME exchanges variation margin daily with SGX in both US dollars and Japanese yen. The timeframes for determining settlement prices, and in which variation margin settlements must be made, are set out in the MOS Agreement. Variation margin settlements are settled across accounts established and controlled by SGX at a New York bank for US dollars and a Singaporean bank for Japanese yen. Both CME and SGX have until 8.00 am (in their respective time zones) to pay in variation margin to the account.

Funds are available to each CCP to be transferred out of the account at, or after, 8.00 am in their respective time zone. Because of the mismatch in time zones (which means the settlement account may have a positive or negative balance, reflecting whether CME has net paid in or been paid out, respectively), both CME and SGX issue and maintain a letter of credit to the other CCP – CME's to SGX in an amount equal to the negative balance on the account (if applicable) and SGX's to CME for the positive balance.^[5] These letters of credit are provided by separate banks, both of which are clearing participants of CME. CME only accepts letters of credit from approved banks, and these banks are subject to eligibility criteria, ongoing monitoring and concentration limits (see CCP Standard 5). As discussed in CCP Standard 19.4, the Bank will monitor the acceptance of letters of credit with a view to revisiting this issue in a year or if there is a material increase in exposures across the link.

CME collects initial margin from SGX to cover its potential future exposures to SGX and this collateral is held in a US bank separate from all other funds CME collects (and vice versa). Under the MOS agreement, cash, certain securities and letters of credit are acceptable collateral to meet initial margin requirements. Letter of credit banks are subject to the same requirements and limits as for participant-provided collateral (see CCP Standard 5).

For the 12 months to July 2014, the size of the positions held across the link with SGX was relatively small compared with CME's overall exposure.

The amount of initial margin that is collected is calculated by the ‘home’ CCP. CME is the home CCP for eurodollar futures and SGX is the home CCP for all other products. The other CCP in the link arrangement must collect at least as much margin from the clearing participant(s) carrying the position(s) as required by the home CCP. Both CME and SGX use CME SPAN and margin on at least a one-day, 99 per cent confidence basis in calculating the margin requirement for their respective home products (see CCP Standard 6).

As noted in CCP Standard 19.4, an SGX default would be handled consistent with CME default management standards applicable to direct clearing participants. In the event the initial margin collected from SGX was not sufficient, CME would have recourse to the default management waterfall associated with its Base Guaranty Fund. In sizing the Base Guaranty Fund, CME considers exposures that may result due to the default of SGX.

OCC cross-margining

As noted in CCP Standard 19.4, in the event of a participant default, CME and OCC are jointly and equally liable for the positions held in the cross-margining account. Accordingly, CME is exposed to OCC to the extent that OCC must assume half of the risk of those positions.

To limit current exposures to participants using the cross-margining program, CME collects variation margin for the futures products held in the cross-margining account; all of the OCC products eligible for the cross-margining arrangement are options, and therefore do not require daily variation margin settlement.^[6] Participants designate a bank account at a settlement bank acceptable to OCC and CME to be used for the settlement of variation margin for cross-margining accounts.

In order to protect both CCPs from potential future exposures relating to a participant's cross-margining account in the event of participant default, participants are required to post initial margin against the cross-margined positions. Collateral taken as initial margin to cover cross-margined positions is held in an account separate from the collateral held for their positions at either CME or OCC. The amount of initial margin collected against positions in cross-margining accounts is determined using OCC's methodology. Because the size of positions held in the cross-margining account is relatively small compared with CME's overall exposure and because this cross-margining program will not be available to Australian clearing participants under the current scope of CME's CS facility licence, the Bank has not assessed OCC's methodology against CCP Standard 6.

In the event initial margin was insufficient to cover the losses in a cross-margining account resulting from a default, CME would have recourse to the default management waterfall associated with its Base Guaranty Fund. Potential exposures resulting from cross-margining accounts are included in sizing CME's Base Guaranty Fund and, as noted in CCP Standard 4.4, the methodology used to size the Base Guaranty Fund is designed to cover, with a high a degree of confidence, the potential credit exposure resulting from the default of the two largest participants in extreme but plausible scenarios. Exposures to the cross-margining account of clearing participants that utilise the cross-margining arrangement are included in sizing the Base Guaranty Fund.

FICC cross-margining

The FICC program is structured to keep each CCP separately and wholly responsible for the positions clearing participants hold at that CCP. Accordingly, CME manages the current and potential future exposures these participants (and therefore, indirectly FICC) pose to CME through its normal framework – that is, by collecting initial and variation margin, and through the default management waterfall associated with the Base Guaranty Fund (see CCP Standards 4 and 6).

CME faces potential future exposure to FICC if a participant using the cross-margining arrangement defaulted. In the event of a default, each CCP would separately carry out its default management process. To the extent that either CCP had losses in excess of the collateral available to it, the other CCP agrees to indemnify it up to the amount of initial margin offsets permitted by the CCP incurring the loss (see CCP Standard 19.4).^[7], Therefore, CME may be exposed to FICC in two ways: as a creditor, where CME incurs a loss because it does not hold sufficient collateral; or as debtor, where it must indemnify FICC for (part of) the loss incurred by FICC. These exposures would be met in the same way as if they were due to a defaulting participant – that is: first, with the defaulting participant's available collateral collected as initial margin or Base Guaranty Fund contribution; and then, by applying the default management waterfall associated with the Base Guaranty Fund (see CCP Standard 12.1).

For both cross-margining arrangements, the relevant CCPs could, as a risk mitigant, suspend or remove a participant from participation in the arrangement, including where that participant's credit was deteriorating. In doing so, any risks between CCPs would be eliminated and the risks presented by the clearing participant would be brought back into each CCP's credit risk framework (i.e. its standard margin methodology and default arrangements).^[8]