RBA: Assessment of Chicago Mercantile Exchange Inc. against the Financial Stability Standards for Central Counterparties Standard 3: Framework for the Comprehensive Management of Risks

Identification of risk

To promote sound risk management practices in achieving its organisational objectives, CME Group has established an ERM program (see CCP Standard 2.6). As part of the ERM program, CME has established a Risk Management Framework which provides a high-level framework to identify and manage risks specific to CME's CCP operations. The Risk Management Framework identifies the key risks that CME faces and sets out broad principles, policies and responsibilities for mitigating these risks (see below).

Risk policies, procedures and controls

The Risk Management Framework is comprised of a number of specific policies and procedures that seek to address the risks CME faces as a CPP. The Risk Management Framework identifies the following areas of risk and sets out specific policies to address each risk:

• Credit and counterparty risk. CME has established a Credit Risk Policy, encompassing a number of risk management tools including: monitoring of participants through regular risk-based surveillance; establishing internal credit ratings for participants; and counterparty limits. See CCP Standard 4.
• Market risk. To protect itself from adverse market movements during a clearing participant default, CME collects initial margin and calculates variation margin on a daily basis via a mark-to-market process. See CCP Standard 6.
• Liquidity risk. CME identifies, monitors and manages liquidity risks in accordance with its Liquidity Risk Framework. See CCP Standard 7.
• Concentration risk. CME may call for additional initial margin from clearing participants, or their customers, who have highly concentrated or directional portfolios. See CCP Standard 4.2.
• Model risk. CME expects to undertake full external reviews of its key risk models (i.e. stress-testing, haircut and margin) during the second half of 2014. See CCP Standards 4.5, 5.3 and 6.7.
• Default risk. CME has set out rules and procedures to address the default of a clearing participant. See CCP Standard 12.
• Operational risk. CME has established a Clearing House Operational Risk Management Framework (ORMF) which seeks to identify, measure and mitigate the operational risks CME faces. See CCP Standard 16.

In addition, CME has established policies and procedures that address, for example: legal risks (see CCP Standard 1); risks arising from governance arrangements (see CCP Standard 2); risks around accepting certain forms of collateral (see CCP Standard 5); and custody and investment risk (see CCP Standard 15).

A number of committees and bodies are responsible for overseeing CME's risk management processes, including the: Board; Risk Management Department; Audit Committee; CHRC; and IRSRC. For more detail on the responsibilities of these bodies, see CCP Standard 2.

Key risk management and information systems

CME utilises a number of information and control systems to provide information in respect of its risk policies, procedures and controls. This includes receiving information on risk exposures to clearing participants and their customers, and the aggregation of risk exposures across the CCP.

Key risk management systems include:

• Margining. CME uses CME SPAN to calculate initial margin requirements for Base products, and a Historical Value at Risk (HVaR) model for IRS (see CCP Standard 6).
• Stress testing. CME carries out daily stress testing to determine the adequacy of CME's financial resources and to monitor the risks associated with clearing participants' positions (see CCP Standard 4).

CME conducts daily monitoring of clearing participant exposures – 24 hours a day, six days a week – including real-time positions and prices produced by its information management systems to identify changes in positions that may require investigation and/or action. These reports include, but are not limited to, large trader reports, which identify customers of clearing participants with large and highly concentrated holdings, and daily position reports (see CCP Standards 4 and 18.2, respectively).

CME's systems provide information to clearing participants about positions and margin requirements to assist participants' management of credit and liquidity risks. CME publishes detailed margining information on its website, including descriptions of margining methodologies, schedules of margin rates and daily CME SPAN margin parameter files. This information allows participants to calculate margin requirements for hypothetical or actual portfolios in futures Base products. CME also provides margin estimation software, called PC-SPAN, to participants to help with these calculations. For IRS and OTC FX Base products, CME has developed an online, interactive margin calculator, called CME CORE, which allows clearing participants and their customers to estimate initial margin requirements for hypothetical or actual portfolios.

Internal controls and review

The CRO is responsible for implementing the Risk Management Framework. Any significant changes to the Risk Management Framework, or to policies under the Framework, must be approved by the Clearing President. Material changes are also brought to the attention of the relevant Risk Committee and the Board. Minor changes to policies under the Risk Management Framework are overseen by senior management of CME.

The Global Assurance Group conducts risk-based audits of components of the Risk Management Framework on a periodic basis; each component that the Global Assurance Group is tasked to review is reviewed at least once every four years. Beginning in 2014, the Global Assurance Group expects to review the processes established by CME for performing model validation on an annual basis. The audits provide assurance that the Risk Management Framework is being implemented correctly. Where appropriate, CME complements the work of the Global Assurance Group by auditing components of the Risk Management Framework externally.

The CHRC and the Board review the Risk Management Framework on an annual basis. The CCO also reviews the Risk Management Framework as a part of its annual DCO compliance assessment against the DCO Core Principles, and conducts a self-assessment against the Principles.

For more detail on these internal controls and governance arrangements, see CCP Standard 2.

Clearing participants' financial obligations to CME include: initial margin against their positions (see CCP Standard 6); contributions to the Guaranty Funds (see CCP Standard 4); daily variation margin payments (see CCP Standard 6.4); and minimum capital requirements (see CCP Standard 17).

Initial margin is set to cover CME's risk exposure, with at least 99 per cent confidence. The methods used to calculate CME's exposure to its participants take into account the size, volatility and correlations of each participant's portfolio in each of the three separate product classes (Base products, IRS and CDS). This framework aims to ensure a participant's obligations for initial margin are proportional to the size, scope and magnitude of the participant's activities and risk profile. See CCP Standard 6 for details on how CME calculates initial margin.

For each of the Guaranty Funds, a participant's contribution is proportional to its relative size and activity. For the Base Guaranty Fund, participant contributions are computed as the greater of US$500,000, or the results of a weighted average of the participant's relative size and activity over the previous three months. Contributions to the IRS Guaranty Fund are calculated as the greater of US$50 million, or the results of a weighted average of the participant's risk and open interest over a 30-day period.

During a participant default, allocation of losses and any obligations to bid at auction for a defaulting participant's portfolio is proportional to the scale and nature of its activities. CME has established a separate default waterfall for each major asset class – Base products, IRS and CDS – and each waterfall is isolated from the others, ensuring that clearing participants are only liable for losses associated with a default within the asset classes in which they participate (see CCP Standard 4.3). Within a Guaranty Fund, losses would be allocated on a pro rata basis (see CCP Standard 12.1 for details on the respective default waterfalls).

CME imposes minimum capital requirements on clearing participants, which are determined by the classification of the participant (i.e. non-bank or bank) and the product categories the participant clears (see Standard 17.1). If CFTC or SEC capital requirements for a clearing participant exceed CME's requirements, CME hold the clearing participant to the higher requirement.

Clearing participants are required to have the operational capability to engage in clearing transactions (see CCP Standard 17). In addition to general requirements, participants clearing IRS are subject to specific risk and operational requirements. Participants that clear for customers must be able to track, and provide to CME, all of the clearing participant's customers' positions.

Because initial margin and Guaranty Fund requirements are designed to be proportional to the risks clearing participants pose to CME, participants have financial incentives to manage and contain the risks of their portfolios. CME's framework for managing concentration risk (i.e. concentration margin) provides additional incentives for clearing participants to contain such risks (see CCP Standard 6.3).

Loss-sharing arrangements have been established by CME to reflect participant risk profiles, by assigning losses proportionate to Guaranty Fund contributions (see CCP Standard 12).

Participants clearing on behalf of customers can set limits, monitored by CME, on their customers' positions. CME notifies clearing participants in real time if limits are exceeded, and allows clearing participants to block or cancel limit-exceeding trades.

The Risk Management Framework provides a high-level framework to manage risks resulting from interdependencies with other entities. These risks are measured, monitored and managed in accordance with the specific policies CME has established for each type of risk, including: payment and settlement intermediaries (see CCP Standard 9); custodians (see CCP Standard 15); utilities and essential service providers (see CCP Standard 16); and other Financial Market Infrastructures (FMIs; see CCP Standards 16.5 and 19).

CME provides clearing services to two other FMIs: Eris Exchange (Eris) and the Dubai Mercantile Exchange (DME). Both Eris and DME depend on CME to provide clearing operations in order to process trades. CME monitors, margins and manages clearing participants from each of these partner exchanges as if they originated from a CME Group-owned exchange. This ensures risk management techniques are consistent across all clearing participants. CME also conducts business continuity tests with its partner exchanges (see CCP Standard 12.4). The contractual agreements between CME and each exchange set minimum service levels and standards that CME must fulfil (see CCP Standards 16.5 and 19).

CME also provides certain technological and operational support to CME Clearing Europe including: Clearing Operations; Risk Management; and Disaster Recovery and Business Continuity (see CCP Standard 16.9).

CME has addressed crisis scenarios in which it may be prevented from providing critical operations in its Business Continuity Plan. This plan includes contingency arrangements and other mitigating steps that CME would take. See CCP Standard 16.

CME is currently in the process of developing a Recovery and Wind-down Plan (RWP) which will address CME's recovery and orderly wind-down procedures. CME has finalised its RWP but has been granted an extension from the CFTC until December 2014 in order to ensure its RWP complies h with CPSS-IOSCO guidelines on recovery plans; these CPSS-IOSCO guidelines are expected to be finalised by September or October 2014. The Bank will expect to conduct a review of these plans once this work has been completed.