RBA: Assessment of Chicago Mercantile Exchange Inc. against the Financial Stability Standards for Central Counterparties Standard 5: Collateral

CME's Collateral Policy sets out its principles for determining and reviewing the collateral it will accept from clearing participants to meet margin and Guaranty Fund requirements. The objective of the collateral eligibility criteria, as set out in the Policy, is to promote asset diversification, while minimising credit risk, liquidity risk and market risk. To mitigate remaining risks, CME conducts ongoing reviews and daily valuation of collateral received, and applies haircuts and concentration limits. In the event of a clearing participant default, CME's Collateral Policy establishes procedures for liquidation of collateral held.

Acceptable collateral

CME's collateral eligibility criteria emphasise the quality and market liquidity of collateral assets. At a high level, eligible collateral must: be liquid with minimal credit risk and market risk; have a liquid and transparent secondary market; and be subject to a legally robust framework. Further, if the collateral cannot readily be liquidated within an hour, additional liquidation arrangements must be established to support the use of the collateral to meet obligations arising in the event of a clearing participant default.

The Credit Risk Management team conducts an initial review of new collateral types for acceptability, focusing on the credit profile of the issuer, secondary market liquidity, price volatility, market development and operational arrangements for pledging collateral to CME.^[1] For collateral that does not have a natural same-day settlement time horizon, arrangements must be in place to facilitate access to cash in the currency of the defaulted obligation on a same-day basis.

CME accepts the following collateral:

• For initial margin contributions across Base, IRS and CDS products, CME accepts: US dollar cash, select foreign currencies,^[2] physical gold, US Treasuries and agencies, select foreign sovereign debt,^[3] letters of credit (Base only), US equities (Base only), and certain CME-managed Interest Earning Facility (IEF) programs.^[4] At the end of June 2014, cash, US Treasuries and CME-managed IEF funds accounted for around 90 per cent of total initial margin held.
• Variation margin obligations must be settled in cash. Obligations are denominated in the currency of the underlying position.
• Effective from April 2014, collateral for participant contributions to Guaranty Funds may be in the form of: cash or US Treasury bills; and US Treasury notes or bonds with remaining time to maturity of 10 years or less.

Letters of credit are accepted to cover initial margin related to Base futures products only. Effective from July 2014, letters of credit are classified as ‘Category 2’ collateral, capped at the lesser of 25 per cent of core collateral requirements or US$500 million per clearing participant (see CCP Standard 5.5 for more information on the different categories of collateral). Financial-affiliated clearing participants are not permitted to meet house initial margin requirements using letters of credit, except to meet intraday margin calls as a buffer (if approved by an Executive Director or above from CME's Risk Management Department). At the end of June 2014, letters of credit accounted for around 2 per cent of total initial margin held.

Letters of credit can only be supplied by approved banks; these ‘letter of credit banks’ are determined under CME's Credit Risk Management process (see CCP Standard 4). Letter of credit banks are rated as part of CME's internal credit risk scoring process on at least an annual basis, and must maintain a score as established in the Credit Policy. Letter of credit banks are monitored on a daily basis. If deterioration in the financial health of any of these banks is detected, CME can reassess its risk profile more frequently. In this situation, CME could reduce the limit of the letter of credit bank, stop accepting new letters of credit issued by that bank, or remove the bank from CME's list of acceptable issuers. A list of approved letter of credit banks and requirements for letters of credit is published on CME's website.

Letter of credit banks are assigned limits according to the risk assessment scoring process and CME's assessment of each bank's ability to fund the commitment. As noted above, letters of credit are capped at the lesser of 25 per cent of core collateral requirements or US$500 million per clearing participant. In addition, clearing participants may only post letters of credit from a single letter of credit bank up to 40 per cent of that bank's established limit. If this target were exceeded, CME may consider revising the limits assigned to letter of credit banks, or the 40 per cent cap. Credit Scoring and Credit Limits are approved by the Credit Committee.

The Bank will monitor the acceptance of letters of credit as collateral, including through the provision of data from CME.

Wrong-way risk

The Credit Risk Management team monitors and reviews each direct clearing participant's portfolios and collateral on an ongoing basis to identify and mitigate exposures that may give rise to wrong-way risk. This includes monitoring correlations between a clearing participant's credit rating and its posted collateral and cleared products, and between clearing participants and the sovereign issuer of collateral. CME's rules prohibit its participants from posting assets that have been issued by the participant, or an affiliate of the participant. CME also prohibits participants from accepting securities or letters of credit issued by a customer or its affiliates as margin payments for that customer, without permission from CME.

Governance

Collateral eligibility, haircuts and limits are reviewed by the Credit Risk Management team on at least a monthly basis, or more frequently as market conditions warrant. A report is presented to the Credit Committee each quarter detailing the concentrations of each type of collateral held throughout the previous quarter.

The Collateral Policy is governed by the Collateral Committee, consisting of senior management from the Risk Management and Financial departments. Recommendations for acceptance of new types of collateral or changes to current collateral guidelines are presented to the Collateral Committee and Credit Committee for approval. Under exceptional circumstances, the Collateral Committee can meet on an ad hoc basis to expedite changes to the Collateral Policy. The Collateral Policy is reviewed on an annual basis by the Credit Risk Management team.

To provide for flexibility in collateral eligibility, CME accepts a range of currencies, including Australian dollar cash, and sovereign securities as collateral for initial margin contributions (see CCP Standard 5.1). Variation margin obligations must be met in cash in the currency of the underlying position.

CME reviews requests from participants, customers and other stakeholders to accept additional forms of collateral. A Request Form is publicly available on CME's website. CME will consider such requests where the relevant asset meets certain quality and liquidity criteria for eligibility (see CCP Standard 5.1). CME provides advance notice to market participants regarding changes to collateral eligibility.

The Bank expects CME to consider accepting Australian government bonds as initial margin in the event that direct Australian-based participant in CME becomes material. CME has indicated that it will investigate the acceptance of Australian government bonds as initial margin during the second half of 2014. The Bank will review CME's progress by year end.

CME marks non-cash collateral to market on at least a daily basis. Given the high liquidity of eligible non-cash collateral – such as US Treasuries and agencies, and select foreign sovereign debt – price information is readily available.

Valuations are validated by CME using an alternative pricing verification service to test collateral pricing regularly. Exception reports are used to validate prices that exceed defined thresholds for intraday price moves. CME reviews these exception reports to validate current market prices with approved third-party data sources and can override prices as appropriate.

Audit reports are produced and reviewed by the Financial Department on a daily basis, highlighting any securities for which no prices are available. Any securities that are not being priced are investigated and excluded from the list of eligible collateral.

CME applies haircuts to all non-cash collateral posted and all cash collateral that is not in the same currency as the product being covered. Haircuts are calibrated to ensure, with a high degree of confidence, that in the event of liquidation at a time of market stress, cash received would be at least equal to the value of the collateral. Haircuts are calculated based on at least a one-day, 99 per cent confidence interval of price movements over the past 12 months. Longer liquidation periods are used for foreign currencies, physical gold, foreign sovereign debt and the IEF4 collateral program (Corporate Bonds). CME can also apply ad hoc haircuts if significant volatility is observed in the markets relevant to acceptable collateral.

CME's analysis of the appropriateness of haircuts also incorporates additional quantitative data on tail risks, utilising data over the prior four years, as well as qualitative market information that may not yet be reflected in the market data.

Collateral haircuts and limits are reviewed on at least a monthly basis, or more frequently as market conditions warrant, by the Credit Risk Management team (under the governance of the Collateral Committee) to ensure they accurately reflect market conditions. This monthly analysis involves assessing market data over a one-year and four-year time horizon, as well as qualitative inputs (e.g. to reflect recent changes to market characteristics). CME plans to complete an independent validation of its collateral haircut models in the second half of 2014.

CME's procedures and risk management standards are designed to establish stable and conservative collateral haircuts. To establish haircuts, CME's formal policy is to apply a 99 per cent confidence interval, with a one-year look-back period. In practice, however, CME considers a longer time horizon when setting haircuts. The aim is to have more static haircuts with reduced procyclicality.

For more information on how CME establishes haircuts, see CCP Standard 5.3.

CME accepts collateral that can be liquidated at short notice. CME classifies collateral as Category 1, 2, 3 or 4, imposing limits on each category commensurate with the liquidity or credit risk, or price volatility of the included assets. Effective from July 2014, the following types of collateral are accepted for Base products:

• Category 1 assets are cash in major currencies and US Treasuries Category 1 assets are considered by CME to be sufficiently liquid that the unlimited eligibility of these assets as collateral will not have any material impact on market liquidity or price.
• Category 2 assets are letters of credit (capped at the lesser of 25 per cent of core collateral requirements or US$500 million per clearing participant) and IEF5 (Interest Earning Deposits).
• Category 3 assets are select US Government agency debt and mortgage-backed securities, and special types of US Treasuries including STRIPS and TIPS. Category 3 assets are capped at 40 per cent of the participant's core collateral requirement per currency and capped in combination with Category 4 assets at US$7 billion per clearing participant.
• Category 4 assets are physical gold, equities, assets subject to the CME-managed collateral programs IEF2 (Money Market Mutual Funds) and IEF4 (Corporate Bonds), and foreign sovereign debt. Category 4 assets are capped at the lesser of 40 per cent of core collateral requirements per currency or US$5 billion per clearing participant. The IEF2 (Money Market Mutual Funds) program is not subject to the 40 per cent cap. As noted above, Category 3 and Category 4 assets are capped in combination at US$7 billion per clearing participant.

The acceptable collateral types, categories and limits described above also apply to IRS products, subject to the following exceptions: letters of credit and equities are not accepted as collateral for IRS.

CME's Credit Policy and Collateral Policy each define risk management standards and requirements for determining the acceptability of eligible collateral. Liquidity arrangements are scaled to cover the potential liquidation of the largest participant that holds the maximum allowable amount of Category 2 and Category 3 assets.

CME routinely conducts liquidity analysis to ensure potential liquidity needs could be met with the resources available. The calculation of the largest liquidity need for CME is driven by scenarios relating to the default of the largest potential clearing participant, using actual and hypothetical clearing participant collateral profiles.

Liquidity risks are measured and monitored through liquidity stress testing, performed on a daily and monthly basis. Stress testing analyses the liquidation of a collateral profile and the conversion of the collateral to cash through funding arrangements to meet liquidity needs. The stress-testing model assesses collateral profiles with reference to potential variation margin payment obligations by currency and available liquidity resources by currency. A number of parameters can be factored into these scenarios, including collateral price shocks, forecast liquidation costs, the potential roles of key entities (such as affiliates) and the timing of liquidity demands (e.g. from settlement cycles). Liquidity risks are highlighted to the Credit Committee, along with the overall stress-test results.

CME also conducts simulated collateral liquidation drills. These are performed internally and externally with contracted liquidation agents on at least an annual basis. For further information on liquidity risks and management, see CCP Standard 7.

Based on its analysis, the Collateral Committee determines eligible collateral types and sets limits on their acceptance (see CCP Standards 5.2 and 5.5). Cross-border collateral is reviewed and analysed by CME for all major risks, including liquidity risk, market risk, operational risk and legal risk, before being accepted to ensure that the collateral can be used in a timely manner.

CME considers the legal implications of all cross-border collateral as part of its initial review of eligibility and on an ongoing basis. As part of this review, CME identifies and seeks to address any material conflicts of law between jurisdictions, and demonstrates that its laws, rules, procedures and contracts are enforceable in relevant jurisdictions.

In addition, CME undertakes legal assessments when it seeks to provide offshore clearing services; for example, legal reviews were conducted prior to CME accepting certain sovereign debt as collateral, holding collateral offshore and using a foreign custodial bank. CME has indicated to the Bank that it is planning to implement a program under which these assessments will be reviewed regularly (see CCP Standard 5.7).

Operational risks are also considered, including time-zone frictions and custodial banks' operational timelines for moving collateral. If market transactions typically occur outside the US time zone of major operations, CME ensures cross-border collateral can be pledged to its committed secure credit facility, or other facilities as warranted (see CCP Standard 7).

Collateral management system

CME's collateral management system allows for the timely valuation and management of collateral holdings, according to various rules and limits. CME has the ability to modify settings of the system, including margin types and limits. CME ensures that there is appropriate staffing to support the collateral management system, taking into account peak periods.

CME has a clearly defined operational timeline for clearing collateral deposits and withdrawals, calculation of collateral value and collateral reporting. CME can also perform ad hoc collateral valuation cycles as needed. CME reconciles internal systems against its holdings at custodial banks and institutions daily.

CME maintains appropriate control of collateral, as each clearing participant grants to CME a first priority security interest and unencumbered lien on all collateral deposited with CME.^[5] The majority of collateral is transferred into an account in CME's name at a custodial bank, which guarantees simultaneous possession and control. CME accepts pledges of ‘control only’ collateral in instances where CME is satisfied that the mechanisms for taking possession in a default situation would be unchallengeable.

CME accepts physical gold held in approved custodial vaults located in London as collateral to meet proprietary margin requirements of participants. Prior to posting physical gold as collateral to CME, a clearing participant is required to execute a title transfer agreement, which covers all subsequent deposits of gold. The title transfer agreement ensures that CME has control over the collateral that is specified in CME rules, under English law, since the gold is physically located in London.

CME assesses the quality of its claim to pledged collateral via a legal examination of its collateral acceptance mechanisms. Legal assessments are sought when CME is considering the acceptance of new collateral types or in the event of changing bankruptcy laws. If, as a result of a legal examination, CME identifies material issues with its claim to collateral, the collateral will not be accepted. As noted in CCP Standard 5.6, CME has indicated to the Bank that it is planning to implement a program under which these legal assessments will be reviewed regularly.

Re-use of collateral

CME does not currently re-use non-cash collateral posted by participants. However, Rule 827 (Securities Lending Program) gives CME the right to re-hypothecate certain types of collateral deposited by clearing participants in satisfaction of Guaranty Fund or margin requirements. CME is reviewing Rule 827 in light of bankruptcy remoteness and Basel III standards, and the rule may be revised or eliminated (see CCP Standard 15).