RBA: Assessment of Chicago Mercantile Exchange Inc. against the Financial Stability Standards for Central Counterparties Standard 4: Credit Risk

CME maintains a framework for managing credit exposures to its clearing participants, including a stress-testing regime (see CCP Standards 4.5 to 4.7), the use of variation margin to mark positions to market (see CCP Standard 6) and the maintenance of financial resources. These financial resources comprise initial margin and fully paid-up pooled financial contributions sufficient to cover obligations arising in the event of the default of the two largest participants in stressed market conditions (see CCP Standard 4.4).

CME's framework for managing credit exposures is set out in its Credit Risk Policy and Risk Management Framework (see CCP Standard 3).

• The Credit Risk Policy outlines CME's approach to measuring, monitoring and managing credit risk exposure to its clearing participants and counterparties (see CCP Standard 4.2). The Credit Risk Policy is reviewed on an annual basis by the Credit Risk Management team, with any recommendations arising made to the Managing Director (Risk Management). Outside of this annual review, policy reviews and updates can be brought to the Credit Committee ^[1] – which is responsible for overseeing credit policy – on either an ad hoc basis or at scheduled quarterly meetings.
• The Risk Management Framework outlines CME's approach to managing risks, including counterparty credit risk. The Framework covers CME's policies in determining and managing this risk, using a number of quantitative and qualitative measures, and also the execution of risk management tasks. The Risk Management Framework is reviewed annually by the CHRC and the Board, or more frequently to reflect significant changes in policy.

4.2 A central counterparty should identify sources of credit risk, routinely measure and monitor credit exposures, and use appropriate risk management tools to control these risks. To assist in this process, a central counterparty should ensure it has the capacity to calculate exposures to participants on a timely basis as required, and to receive and review timely and accurate information on participants' credit standing.

Sources of credit risk

CME's Credit Risk Policy outlines its methodology for measuring, monitoring and managing its credit risk exposure. In particular, the Credit Risk Policy addresses the credit risk exposure that CME faces from its counterparties, that is clearing participants (through the potential non-performance in satisfying clearing obligations), and from custodial and settlement banks (through potential non-performance in providing depository arrangements).

The following paragraphs (of CCP Standard 4.2) describe how CME monitors and measures the credit risk exposures it faces from its counterparties generally – that is, clearing participants, and custodial and settlement banks. The remainder of CCP Standard 4 will then focus on how CME manages credit risk exposures specifically arising from clearing participants. Additional measures CME takes to address credit risk exposure posed by settlement banks and custodians is addressed under CCP Standard 9 and CCP Standard 15, respectively.

Measurement and management of credit exposures

The Credit Risk Policy reflects CME's assessment of the credit profile of its clearing participants and other counterparties. The Credit Committee is responsible for overseeing credit policy, as well as the assessment of the credit profile of CME's clearing participants and counterparties. A primary function of the Credit Committee is to review and affirm CME's internal risk ratings (IRRs; see below) of its counterparties. Ratings are affirmed upon release of updated financial information concerning the counterparty, but can be reviewed more frequently as necessary. Ratings are approved by the Credit Committee.

The day-to-day implementation of the Credit Risk Policy, including monitoring of the credit ratings of clearing participants and counterparties, is delegated to the Risk Management Department. Within Risk Management Department, the Credit Risk Management team monitors any ongoing significant changes in the financial condition and market metrics of CME's counterparties, and is responsible for maintenance of the Watch List and Weak List (see below). The Credit Risk Management team also performs a credit review of each counterparty on at least an annual basis; the results are reported to the Credit Committee. The Market Risk team monitors participants' trading activity, and settlement of variation and initial margin calls/releases on a daily basis.

The Financial and Regulatory Surveillance Department monitors participants' compliance with financial participation requirements. This includes daily monitoring of customer segregated balances and account balance confirmations (see CCP Standard 17.3).

Risk management tools – Internal Risk Ratings

CME assigns an IRR to each counterparty based on a review of quantitative and qualitative data covering a range of areas, including but not limited to financial performance. Material used for the reviews include public and non-public financial reports, regulatory returns and results of on-site risk management due diligence visits. Counterparties are assigned an IRR from 1 to 10, with 1 indicating a strong financial profile and insignificant level of risk, and 10 indicating a counterparty in default or liquidation.

The IRR of each counterparty is reviewed at least annually and affirmed as necessary to reflect current market information. Counterparties are also monitored daily to identify any issues that may require a change in the IRR; CME has set triggers to alert senior Risk Management staff of notable movements in a range of indicators of a counterparty's creditworthiness. Credit review schedules are more frequent for counterparties with lower ratings.

CME maintains a Watch List and a Weak List to track the creditworthiness of counterparties that are deemed to pose a heightened risk to the CCP. The Credit Risk Management team is responsible for identifying counterparties for inclusion on the Watch List and Weak List; these lists are reviewed and formally approved by the Credit Committee on at least a quarterly basis. CME may place counterparties on the Watch List for a range of reasons, such as a decline in earnings that could impact the counterparty's ability to meet its financial obligations or public regulatory actions. Counterparties with an IRR indicating a weak financial profile are automatically placed on the Weak List.

Quarterly meetings are held with key representatives from each team in CME Clearing Division to ensure all groups are aware of counterparties on the Watch List and Weak List. Counterparties on the Watch List and/or Weak List are subject to increased monitoring by Risk Management Department, and may be required to post additional financial resources (e.g. margin or Guaranty Fund resources), raise additional capital, or reduce exposures to reduce the credit risk posed to CME (see CCP Standard 4.3).

Risk management tools – margin

CME performs routine margin calculations twice per day for futures products (intraday and end-of-day) and end-of-day only for IRS products. For futures clearing, routine intraday margin calculations include variation margin and initial margin on start-of-day positions and new positions submitted by 11.00 am Chicago time (see CCP Standard 6). When conditions require, CME may conduct additional intraday settlement cycles for futures products, and may also conduct intraday margining for IRS products (see CCP Standard 6.4).^[2]

To ensure that existing margin levels are not eroded before margin in relation to a new position is called, CME requires clearing participants to place credit control limits on all accounts. For IRS clearing participants, clearing limits are established so that large transactions are approved prior to acceptance. In part, these measures are designed to ensure that clearing participants are cognisant of customers putting on new positions prior to the collection of margin.

CME conducts daily concentration stress testing to monitor the effects of ‘extreme but plausible’ scenarios on participants' portfolios (see CCP Standards 4.5 and 4.6). Where stress-test results exceed predefined limits, additional margin will be called. This ‘concentration margin’ accounts for potential market exposures due to large positions relative to the counterparty's financial resources available to support those positions, taking into account the differences between the markets and typical position sizes in each major asset class.

For futures products, concentration margins are additional requirements imposed on clearing participants based on positions held, the clearing participant's excess adjusted net capital and payment history. This may result in a 10 to 50 per cent increase in margin requirements for the impacted product category, depending on the size of the stress-test loss relative to the participant's excess adjusted net capital or a predefined threshold.

For IRS products, concentration margins are assessed separately for specific currencies and applied based on the initial margin requirement. The level at which the concentration margins are set take into account the potential cost of liquidating positions that are sufficiently large to trigger a liquidity charge. The multipliers and margin ranges are designed to be progressive in nature. There is also a maximum margin amount, beyond which, the liquidity multiplier will remain flat.

Apart from the thresholds outlined above, Risk Management Department does not define any mandatory action in response to stress-test results, such as calling for additional margin. However, CME may take various actions (see CCP Standard 4.7).

CME uses a Watch List and Weak List to track participants whose credit standing may be in doubt (see CCP Standard 4.2). As specified in its Rulebook,^[3] CME may require that participants on these lists post additional financial resources (e.g. margin or Guaranty Fund resources), raise additional capital, or reduce exposures to lower the credit risk posed to CME. As noted in CCP Standard 4.2, the Credit Risk Policy establishes CME's risk tolerance, criteria for the triggering of exceptions (e.g. significant changes in financial conditions and market metrics that reflect changes in a participant's creditworthiness), and the roles of the Watch and Weak Lists.

The Clearing President has the power to declare an Emergency Financial Situation if a clearing participant breaches a risk control or participation requirement, or if the Clearing President determines that the financial or operational condition of a clearing participant jeopardises CME or financial markets. Depending on whether the participant is an IRS- or Base-product clearing participant (or both), this declaration convenes either: the Emergency Financial Committee, the IRS Emergency Financial Committee, or both. Each committee comprises the Clearing President, the CEO, the Executive Chairman, and the Chairman of the IRSRC or CHRC, as appropriate. The Emergency Financial Committee and IRS Emergency Financial Committee have the power to order: position limitation; suspension; a call for additional initial margin; liquidation of the clearing participant's portfolio; and any other action the Committee determines is necessary.

CME's risk controls include a range of financial resources to cover its credit exposures and to protect against losses in the event of a clearing participant default. These controls are often referred to as a ‘default waterfall’. CME has established a separate waterfall for each major asset class – Base products, IRS and CDS.^[4] 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.

Each waterfall consists of initial margin provided by participants in respect of their outstanding positions; a segregated, pooled default fund (Guaranty Fund) of paid-up contributions from clearing participants; and a number of additional safeguards (both paid-up and promissory).^[5] These resources would be used in the following order to cover losses due to a participant default: the defaulting participant's margin (see CCP Standard 6) and Guaranty Fund contributions; CME's Capital Contribution; contributions from non-defaulting participants to the Guaranty Fund; and promissory resources obtained through CME exercising its Assessment Powers. All of these are explained further below, except CME's Assessment Powers, which are discussed in CCP Standard 4.8.

Guaranty Funds

In the event that the losses from a participant's default exceed that participant's margin and Guaranty Fund contributions, CME will access the next layer of the waterfall – the respective mutualised Guaranty Fund contributions of non-defaulting participants. The size of the Guaranty Fund is based on stress-testing results and comprises contributions from clearing participants. The adequacy of the Fund is assessed on a daily basis, with participant contributions adjusted on at least a quarterly basis for Base products and at least a monthly basis for IRS, or more frequently if there are large changes in required participant contributions.

As at 31 July 2014, the size of the Guaranty Funds were: Base Products (US$3.578 billion); IRS (US$2.090 billion); and CDS (US$0.750 billion).

1. Base Guaranty Fund

The Base Guaranty Fund, which covers futures products, is sized to cover the default of the two participants and their affiliates^[6] that would potentially cause the largest credit exposure to CME under a wide range of stress-test scenarios (see CCP Standards 4.5 to 4.7). The Guaranty Fund is sized to cover the greater of either: the ‘cover 2’ stress exposure on the last day of the calculation period; or the average of the cover 2 stress exposures during the entire calculation period. CME communicates Guaranty Fund requirements to participants as a proportion of average daily aggregate initial margin across all clearing participants. At 31 July 2014, the size of the Guaranty Fund was around 4 per cent of average daily aggregated initial margin.

Stress-test outcomes are compared against the Guaranty Fund size on a daily basis. Any breaches beyond 10 per cent are immediately escalated to the Stress Testing Committee for further investigation and action, including increased margin, possible changes to the size of the Guaranty Fund, or participant-targeted increased Guaranty Fund requirements.

Participant contributions to the Fund are computed as the greater of US$500,000, or the results of a weighted average of each participant's relative size and activity over the previous three months; that is, a participant's contribution to aggregate initial margin and contribution to risk-weighted activity, weighted at 95 per cent and 5 per cent, respectively.

Participant contributions are routinely adjusted at the start of each quarter, based on average activity over the prior three months.

2. IRS Guaranty Fund

The IRS Guaranty Fund is sized to cover the default of the two participants and their affiliates that would potentially cause the largest aggregate credit exposure to CME under a wide range of stress-test scenarios (see CCP Standards 4.5 to 4.7). The Guaranty Fund is sized to cover the greater of either: the cover 2 stress exposure on the last day of the calculation period; or the average of the cover 2 stress exposures during the entire calculation period. CME calculates these credit exposures by measuring the shortfall between the stress-test result and collateral on deposit for each clearing participant. For clearing participants that clear for customers, the shortfalls are computed as the worse of: the shortfall of the house accounts; or the shortfall of the house accounts plus the largest customer accounts (currently two but monitored on an ongoing basis).^[7] Positions of affiliates are generally cleared through the direct clearing participant's house account and therefore captured in stress testing of that account. However, where a clearing participant's affiliates positions are not captured in the house account (e.g. if an affiliate of a direct clearing participant is also a direct clearing participant of CME), CME calculates the aggregate of the shortfall across all relevant affiliates.

Clearing participant contributions to the Guaranty Fund are calculated as the greater of US$50 million,^[8] or the results of a weighted average of each participant's risk and open interest over a 30-day period; that is, a participant's share of potential portfolio loss under stress testing and their gross notional, weighted at 90 per cent and 10 per cent, respectively.

Contributions are adjusted monthly, based on an average of daily data for the previous 30 days. CME may adjust contributions to the Guaranty Fund more frequently if the risk profile of the top two largest net debtors changes by more than 10 per cent from the calculation for the prior period. CME may request an additional deposit to the Fund from a participant if changes to the business of the participant require an increase in its contribution of 10 per cent or greater.

CME Capital Contribution

The CME Capital Contribution is an amount pledged by CME to absorb losses beyond the contributions of the defaulting clearing participant. The specific amounts depend on the asset class, but are generally set at least at the average size of clearing participants' calculated contributions. As at 31 July 2014, the CME Contributions were: Base Products (US$100 million); IRS (US$150 million); and CDS (US$50 million).

The adequacy of the CME Capital Contribution is reviewed in conjunction with the daily analysis of the overall financial safeguards package and the monthly Senior Management review.

CME conducts daily stress testing to monitor risk exposures to individual participants and to test the adequacy of its financial resources. Stress tests are performed on all clearing participants and available client portfolios. Daily stress tests are evaluated against each clearing participants': current contributions to the Guaranty Fund; individual maximum assessment powers (see below); margin held; adjusted net capital; CME IRR; other capital; and other items. The Market Risk team also assesses the stress-testing values in comparison to historical trends based on: stresses across all asset classes; Guaranty Fund size and characteristics; and across different time periods.

CME employs a number of separate stress-testing models to assess potential clearing participant exposures across markets.

Stress-testing models

CME uses ‘Largest Net Debtor’ (LND) stress testing as the basis for assessing the adequacy of the size of its Guaranty Funds in each asset class. This testing is conducted daily, incorporating a combination of hypothetical scenarios and the largest historical moves in each market.

For exchange-traded products, including futures, each market and account class based on origin is stressed up and down individually using extreme but plausible market fluctuations based on historical data for individual products as well as hypothetical stresses. The largest stressed loss in each market/origin is added together to arrive at the largest hypothetical loss for each clearing participant account.

For OTC IRS products, the LND is calculated using extreme but plausible stress-test scenarios for each participant's house account, and for the combined house and customer accounts. The larger of these two potential shortfalls is used as the basis for the sizing of the Guaranty Fund.

Hypothetical gains in the house account or collateral in excess of hypothetical losses in the house account are used to offset losses in the customer account. However, hypothetical gains in the customer account cannot be used to offset losses in the house account.

In addition, CME conducts account level stress testing of large trader accounts, clearing participant level stress testing, and concentration margin stress testing. Ad hoc stress testing can be conducted by Risk Management Department staff whenever this is warranted. The analysis can include both quantitative and qualitative techniques to support and complement the models used by CME on a daily basis.

Governance and validation

The stress-testing framework and policy that CME has in place is reviewed by the Board as part of the Risk Management Framework. For both futures and IRS, stress-testing results and recommended changes to the stress-testing program are formally reviewed every month by the Stress Testing Committee (comprised of representatives from Market Risk and Credit Risk Management, Risk Research and Risk Policy). In addition, representatives from Market Risk, Risk Research and Senior Management meet on at least on a quarterly basis to review stress-test parameters, underlying assumptions, and any proposed changes to policy. Risk Management Department staff may present stress-test results on a more frequent basis if these results diverge significantly, or if warranted by market conditions.

Also, any parameters that display new, more extreme moves will be reviewed and updated by the Risk Management Department. The new parameters are subject to approval by Senior Management.

CME plans to commission a full external validation of its stress-testing models, parameters and assumptions in the second half of 2014. The Bank expects to engage with CME on the results of its model validation and testing.

Base products

For futures, CME employs a number of stress-testing scenarios to capture the market shocks experienced during previous periods of economic distress and reflect a set of extreme but plausible market events, using both historical and hypothetical scenarios. Historical scenarios include historical dates with extreme changes. Hypothetical scenarios include a number of events based on previous financial shocks; these include, for example, an Oil Supply Crisis and Inflationary Expectations.

An expected shortfall approach of 99.9 per cent is used for each product set, with data going back to the 1980s, or whenever available. The hypothetical scenarios assume that the different expected shortfall amounts for each product occur on the same date.

CME reviews its stress-testing scenario parameters monthly and may adjust them as necessary to ensure that the risks it faces are adequately captured (see CCP Standard 4.5).

IRS

For IRS products, stress-test scenarios employ a combination of historical and hypothetical moves. Historical scenarios are established using a variety of measurements across different historical time periods and include, for example, tenor specific, tilt and curvature Scenarios. Hypothetical scenarios have been defined by CME for stress testing and include principal components analysis and additional event-based scenarios.

CME targets coverage of 99.9 per cent for almost all portfolios. Both historical and hypothetical parameters and scenarios are reviewed on a monthly basis, and adjusted as necessary (see CCP Standard 4.5).

All stress tests defined in the CME Stress Testing Policy and Procedures, unless otherwise noted, are generated and reviewed daily. Results from the stress tests are reviewed by the Market Risk team. The team identifies any changes in clearing participant potential exposures across all products, historical trends, and adequacy of resources to determine whether additional investigation or action is warranted. Changes in a clearing participant's behaviour or risk profile that are identified by the Market Risk team as warranting additional investigation are reported to Senior Risk Management for further consideration.

CME Risk Management Department does not define any mandatory action in response to stress-test results, but does maintain the right to request additional customer or clearing participant information, increase margin requirements, increase capital requirements, or to require that a clearing participant reduce or transfer its positions. Any proposed actions would be approved by CME Senior Management. The appropriate Risk Committee would be informed of any actions undertaken at its next meeting.

CME's prefunded pooled financial resources are sized according to stress-test results, with the relevant Fund size being adjusted on at least a quarterly basis, or more frequently if conditions warrant (see CCP Standard 4.4).

As discussed in CCP Standard 3.5, CME is currently in the process of developing a RWP, which will address how CME intends to fully cover any credit losses and replenishment plans. CME expects the RWP to be finalised by the end of 2014.

More broadly, CME has established rules around the default of clearing participants for each major asset class.^[9] As outlined in CCP Standard 4.4, which covers pre-funded resources, a default waterfall has been established for each major asset class that consists of margin provided by participants in respect of their outstanding positions; a segregated, pooled Guaranty Fund of paid-up contributions; and a number of additional safeguards, which include the CME Capital Contribution and CME Assessment powers.

In the event that the Guaranty Fund is drawn on to pay towards losses caused by a clearing participant default, each non-defaulting clearing participant is required to replenish its Guaranty Fund contributions by close of business, the business day following the payment.^[10]

CME Assessment Powers

In the event that the margin and Guaranty Fund contributions of the defaulting participant, the contributions of non-defaulting participants to the Guaranty Fund, and the CME Capital Contribution have been exhausted, CME can call for further funding from non-defaulting participants by utilising its Assessment Powers. These Assessment Powers can be utilised to allocate losses among non-defaulting participants, and to replenish the respective Guaranty Fund. Assessment totals for each clearing participant are calculated by CME and reported to individual participants with the same schedule and frequency as the Guaranty Fund requirements. Assessments are calculated individually for Base and OTC (IRS and CDS) products.

1. Base products

In the event that a single participant defaults, the total Assessment amount for participants in the Base products waterfall structure is sized at 275 per cent of the Base Guaranty Fund for exchange-traded products. This total is allocated between the surviving participants in the same manner as the Guaranty Fund; as a proportion of the participant's margin and volume. Should multiple participants default within a five-day period, the size of the Assessment would be raised to 550 per cent; this is the maximum amount that participants would be called.

The size of the Assessment amounts outlined above are set to cover the amount necessary to replenish the Guaranty Fund once exhausted and potential additional clearing participant defaults beyond the two largest.

2. IRS

For IRS products, Assessment Powers are sized to cover potential losses arising in the event of the default of the third and fourth largest theoretical net debtors (determined using the stress-test methodology described under CCP Standards 4.5 and 4.6). Once sized, the Assessment totals are allocated among all clearing participants. The total Assessment size assumes the simultaneous default of all participants used to size the Assessment, plus any additional participants as determined by CME Risk Management Department. The total Assessment is allocated among the remaining participants.

Each clearing participant's allocation of the IRS Assessment is based on its ‘Individual Maximum Assessment Power’ (IMAP). The IMAP is calculated based on CME's LND stress testing results across several scenarios, in which a number of LNDs default.

CME calculates the aggregate required IRS Assessment on at least a monthly basis, as well as each IRS clearing participant's maximum IRS Assessment. CME may calculate such requirements more frequently if the risk profile of the top two largest net debtors change by more than 10 per cent from the calculation for the preceding period. Following any recalculation, CME provides a report to each IRS clearing participant detailing its maximum IRS Assessment.

Other provisions

CME has outlined further provisions in its rules and procedures for uncovered credit losses.

1. Base products

In the situation where credit losses exceed financial safeguards, CME would follow the close-out netting procedures as described in its Rulebook.^[11]

2. IRS

If a default leads to losses that are larger than applicable financial resources, CME would follow the procedures outlined in its Rulebook.^[12] Rule 8G802 incorporates limited recourse standards and states that CME will fulfil variation margin payments to the extent that resources attributable to the major asset class are available, but variation margin will be haircut for participants with variation gains to offset the losses. These haircuts will be made on a pro rata basis, based on resources available.