RBA: Assessment of Chicago Mercantile Exchange Inc. against the Financial Stability Standards for Central Counterparties Standard 6: Margin

For all cleared products, CME collects ‘performance bonds’ (i.e. margin) from clearing participants. Performance bonds comprise ‘maintenance performance’ margin (which corresponds to initial margin as defined in the CCP Standards) and ‘settlement variation’ margin (which corresponds to variation margin as defined in the CCP Standards).^[1]

CME calculates initial margin twice per day for Base products and once a day for IRS products, to cover possible losses on the close out of a participant's position in the event of that participant's default. Variation margin is calculated twice daily for Base products and once daily for IRS products via a mark-to-market process to cover gains or losses on positions arising from price movements.

CME may also collect additional intraday margin throughout a trading session in the event of significant market movements (see CCP Standard 6.4).

The margining methodologies employed by CME are calibrated to take into account a range of risks, including the potential for concentration risk and liquidity risk. CME uses different methodologies to calculate initial margin, depending on the product type (see below).

Base products

CME calculates initial margin on its futures products using the CME SPAN methodology. Initial margin is calibrated to cover 99 per cent of forecasted price moves for a position over a minimum close-out period of one trading day (see CCP Standard 6.3).

Participants are required to deposit gross initial margin for customer segregated and customer sequestered positions. CME allows net initial margin deposits for non-segregated or proprietary positions.

CME SPAN model parameters for futures products are reviewed by CME Risk Management Department at least monthly, or more frequently during volatile market conditions (see CCP Standards 6.6 and 6.7).

IRS

The IRS margin methodology employs a HVaR model. The model aims to cover at least 99 per cent of losses over a five-day close-out period for a ‘large universe of portfolios’. The model coverage is backtested on a suite of over 20 000 portfolios including, but not limited to, outrights, spreads, butterflies, client portfolios, synthetic portfolios and random portfolios that have sensitivity to different tenors of the curve.

Since the model has been backtested against a very long history of different rate and volatility regimes, the parameters in the HVaR model employed by CME are static, and may only require adjustment where there are concerns about model coverage. The model uses an Exponentially Weighted Moving Average (EWMA) volatility forecast, which allows the model to adapt to changes in rate and volatility regimes. This enables the model to self-adjust on a daily basis without changing parameters (see CCP Standard 6.3). In addition, the model employs volatility floors to reduce the potential for procyclical effects.

Cross-margining of IRS and futures

CME offers IRS clearing participants, who also hold a CBOT Exchange Clearing Membership (for US Treasuries) and/or a CME Exchange Clearing Membership (for eurodollars), the ability to cross-margin eligible interest rate futures by allocating these positions to the participant's OTC derivatives portfolio. If participants choose to do this, the allocated interest rate futures will be HVaR margined, as for IRS products (rather than margined using the CME SPAN methodology), and are subject to a five-day close-out period. In a default situation, these commingled positions would continue to be treated as swaps, rather than futures (see CCP Standard 12.1).

CME only permits the commingling of futures and swaps where it results in a reduction of risk. CME performs daily calculations to determine whether commingling futures and IRS positions would decrease margin for the overall portfolio, which would indicate a reduction in risk. If the inclusion of a futures position would not reduce the risk of a commingled portfolio, it would remain in, or be transferred back to, the participant's futures account, as applicable.

If granted a licence, CME would offer futures and IRS products independently to Australian clearing participants; however, participants holding the requisite clearing memberships would have the option to cross-margin these positions.

CME has access to timely price data for its exchange-traded products. CME's primary sources of data are ‘direct’ sources, including trade quotes, and other market information gathered from product market transaction activity. To value the OTC derivatives products it clears, CME may consider a combination of relevant market data, including, but not limited to, trading activity, pricing data obtained from IRS market participants, the settlement prices of related products and any other pricing data from sources deemed reliable by CME. CME sources price data on reference interest rates from Reuters and Bloomberg.

Depending on the product, CME may use a range of methods for determining the settlement price, including: midpoint of the high and low quotes in the closing range; volume-weighted average price of the closing range; midpoint of bid-ask spread at closing time; and option price settlement, using price data for the underlying commodity and option pricing models.

IRS

To determine the settlement price for IRS products, data are first obtained from multiple recognised sources. Any material differences in prices from these sources are validated. The threshold of difference varies depending on the liquidity profile of the instrument. After the quote has been validated, a proprietary blending algorithm is applied to produce quotes for end-of-day curve construction.

If a settlement price derived by the normal methodology for a product is inconsistent with observed prices or other relevant market information, or if there is no relevant market activity, CME may establish a settlement price that best reflects its reasonable judgment of the true market valuation at closing time.

CME has established internal processes to review IRS settlement prices upon request from clients. In addition, CME runs automated comparisons of differences in settlement prices by obtaining data from multiple sources. The system will identify differences that exceed pre-established thresholds for staff to investigate. A final review will be conducted before the end-of-day settlement cycle, with all curve inputs being rechecked.

Base products

Settlement price information for futures products may be validated at the exchange level. CME can receive pricing data from up to approximately 30 vendors. To validate these data, CME may cross-check information with third-party vendors (e.g. Reuters and Bloomberg) or request information from price reporting agencies (e.g. Platts, Argus, OPIS), as necessary.

Participants are given all information necessary to create the end-of-day yield curve and independently calculate the net present value of any contract.

Base products

CME calculates initial margin requirements using the CME SPAN methodology. This methodology calculates initial margin that reflects the total risk of each portfolio. Initial margin is calibrated to cover 99 per cent of forecast price moves for a position over a minimum close-out period of one trading day. Forecast price movements are based on a variety of data, including: historical volatility over various time periods; price changes within a market session; forward-looking measures of potential volatility derived from analysis of the options market; and seasonal volatility.

CME calculates margin on some products or portfolios over a longer close-out period (e.g. 1.5–2 days) depending on factors such as liquidity profiles, and the complexity and concentration of a portfolio. CME Risk Management Department is responsible for determining and assessing the close-out period for products and portfolios. Regular default simulation drills are conducted to validate this process. Margin on new products is typically set based on at least a two-day close-out period. In addition, CME may use volatility floors, liquidity add-ons and other additional margin requirements (e.g. concentration margin; see below) to further increase the close-out period. Interest rate futures cross-margined with IRS positions are HVaR margined and so are subject to a five-day close-out period.

The key parameters in the CME SPAN methodology are the ‘price scanning range’ and ‘volatility scanning range’. These scanning ranges are calibrated to the distribution of price and volatility movements for a set of related contracts under normal market conditions. The scanning ranges are used to construct a set of 16 hypothetical risk scenarios used to measure the loss from a portfolio caused by a range of changes in price and volatility.

CME sets the scanning ranges to cover at least the 99th percentile of historical daily price moves over short-, medium- and long-term time periods. The selection of the time period depends on the specific product being evaluated, varying between 1 month and 10 years. For most products, historical volatilities covering 1, 3, 6, and 12 months are applied.

CME applies a series of adjustments within CME SPAN to account for correlations and specific risks within a given contract type. An upward adjustment can be made to the margin requirement for a given set of related contracts to account for less-than-perfect correlation between contracts with different expiries (known as the ‘intra-commodity spread charge’).

CME also applies offsets designed to account for reliable and economically robust correlations across different contract types (see CCP Standard 6.5). These ‘inter-commodity spread concessions’ reflect that, while the scanning risk for each ‘combined commodity’ (sets of contracts related to the same underlying commodity) is set based on the worst-case risk scenario for that combined commodity, it may be highly unlikely that the set of worst-case scenarios will occur simultaneously. This is particularly the case if a participant holds net long and net short positions in different combined commodities that have a robust positive correlation.

CME's Risk Management Department can approve adjustments – both increases and reductions – to margin rates (for futures and IRS products) if the standard statistical analysis would result in an economically inappropriate outcome. This may be required if the backward-looking statistical analysis does not take appropriate account of expected future price movements. Other reasons for using management discretion include insufficient historical data (e.g. where a product is new), seasonality in some products and isolated spikes in price movements that result in a distortion of statistical recommendations. CME policy also allows the approval of exceptions to the normal margin rate setting process based on a broader risk assessment. Any such changes must be approved by an Executive Director (or above) from Risk Management Department.

In conjunction with the application of margin, CME maintains a concentration margin program for each major asset class. Concentration margin can be applied to portfolios that may require a longer liquidation period. Each major product type maintains a unique trigger for its concentration charge. For exchange-traded products, participants' portfolios are subject to concentration margin if the results of stress tests exceed financial resources. A participant may be required to post additional collateral should stress-test outcomes reveal that the potential loss arising from its positions, as at the close of the previous day, exceeds their net adjusted capital (see CCP Standards 4.3 and 4.7). Directors in CME Risk Management Department also have the authority to further increase a participant's margin based on expert opinion and participant-specific risks.

IRS

CME uses HVaR to calculate initial margin requirements for IRS, with EWMA volatility rescaling to determine the margins for a given IRS portfolio. In this methodology, past events are used to generate possible scenarios in the future, with recent events weighted more heavily than events further in the past. Initial margin rates are set based on a 99.7 percentile confidence level, assuming a close-out period of five days, to target an ex post coverage of 99 per cent for almost all portfolios. A rolling look-back period of five years, in addition to including the global financial crisis period of 2008–09, is used to provide a set of historical scenarios. In addition, a volatility floor is established to protect against procyclicality.

The model also incorporates volatility scaling and considers risks associated with products and collateral that span multiple currencies.

As part of CME's concentration margin program, liquidity charge multipliers can be applied to IRS products. The liquidity charge multiplier is applied to the margin calculated for each currency to account for the potential cost of liquidating large positions. The multipliers and margin ranges are designed to be progressive in nature.

Wrong-way risk

CME addresses wrong-way risk in its Collateral Policy and Risk Management Framework. CME's policies and rules prevent its participants from clearing derivative instruments that may give rise to wrong-way risk or to post collateral that would have similar risk (see CCP Standard 5).

Procyclicality

As discussed above, the CME margin model for IRS products adopts a HVaR-based approach where historical returns are scaled using EWMA volatility. CME uses volatility floors to reduce the potential for procyclical effects, which prevent margins from falling below certain levels in times of reduced volatility and hence provide a buffer against sudden large market corrections. Volatility floors are set based on analysis of historical volatility and liquidity data at a product level. For example, for IRS the volatility floor is calibrated to be within the 40th to 50th percentiles of historical absolute EWMA volatility.

CME will introduce a stressed-VaR component to its margin model to further reduce the potential for procyclicality; pending regulatory approval, CME expects to implement this in the second half of 2014.

Margin requirements for both futures and IRS are calculated overnight, with variation margins based on closing prices each day, and notified to participants the next morning.

CME has the authority and operational capacity to make intraday margin calls and payments, as outlined in its Rulebook and Clearing House Manual of Operations. CME may make intraday calls where there is significant erosion in the margin cover provided by individual participants. Intraday margin calls reflect changes in participants' positions and price movements. For futures products, mark-to-market calculations are carried out routinely at mid-day and end-day, and on an ad hoc basis in situations CME deem necessary. For IRS products, variation margin is calculated at the end of the day. Although there is no routine intraday margining of IRS products, CME may carry out intraday margining in situations deemed appropriate (see CCP Standard 4.2).

CME maintains procedures requiring explicit approval of funds due by a certain time for each settlement cycle and trading day. Settlement banks give their irrevocable commitment to pay margin amounts at the established settlement time. Any shortage of payment by a participant may be treated as a failure to perform, which is defined as a default event (see CCP Standard 12). Further, CME has debit authority over all clearing participant accounts and can automatically debit the accounts for margin and variation payments (see CCP Standard 9).

Inter-commodity offsets

In applying the CME SPAN methodology to futures transactions, CME allows offsets in the form of inter-commodity spread concessions (see CCP Standard 6.3). These offsets reduce margin requirements to account for reliable and economically robust correlations observed across combined commodities.

The magnitude of inter-commodity spread concessions are gauged by evaluating 99 per cent volatility levels over multiple look-back periods. To be eligible for an offset, the relationship between the products must be stable and demonstrate a significant correlation. Further, offsets are only approved after a review by CME Risk Management Department staff so that a ‘common sense’ rationale is taken.

CME may adjust the inter-commodity spread concessions identified by CME SPAN to ensure that they appropriately reflect underlying economic relationships, including through periods of market stress. All recommendations for inter-commodity spread concessions, and reviews of existing offset levels, are evaluated and agreed by senior staff of CME Risk Management Department during weekly meetings.

Cross-margining

As noted in CCP Standard 6.1, IRS clearing participants also holding CBOT and/or CME Exchange Clearing Memberships can choose to cross-margin specific interest rate futures by allocating these positions to the participant's OTC derivatives portfolio. If participants choose to do so, the allocated interest rate futures will be HVaR margined, as for IRS products, with extensions to take into account the characteristics of the interest rate products being cross-margined and their correlations with the IRS products. As with IRS products alone, a five-year historical dataset is used. The methodology also addresses risks specific to each interest rate product, such as requirements around physical delivery for Treasury futures.

Interest rate futures in the pool under the HVaR methodology are subject to a five-day, rather than a one-day close-out assumption. CME states that, although HVaR margining can result in less conservative estimates of correlations, this longer close-out period means that cross-margined interest rate futures will typically be subject to higher margin requirements under the HVaR methodology, compared with the existing CME SPAN methodology.

Cross-margining between IRS and futures clearing streams recognises the economic relationship between these products and, to the extent that positions are indeed offsetting, would be expected to result in a reduction in the amount of initial margin required relative to the case in which positions were margined independently. The potential for changes in the relationship between IRS and interest rate futures, such as during times of stress, is captured through the VaR margining process.

Prior to implementation and on an ongoing basis thereafter, CME performs analysis to ensure the adequacy of margin levels for portfolios of IRS and interest rate futures. This includes verifying that the margin algorithm produces adequate and reasonable results for the amount of risk in these accounts. CME also monitors, on a daily basis, the variation and market risk of portfolio-margined accounts to ensure the additional future positions reduce risk to the swaps portfolio. If the futures positions are not risk reducing, CME will take several actions that include a detailed analysis of the risk and margin impact of transfer to the full portfolio. If needed, the Market Risk team will contact the participant to reduce the exposure, which could involve transferring futures positions back from the swaps portfolio margin account to the futures portfolio account.

Cross-margining between CCPs

CME also offers a range of programs between it and other CCPs, including the cross-margining programs with Options Clearing Corporation (OCC) and the Fixed Income Clearing Corporation (FICC), and its Mutual Offset System (MOS) with Singapore Exchange Limited (SGX). These are considered in detail in CCP Standard 19. Under the proposed scope of the CS facility licence, 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)

For futures products, margin levels are reviewed on at least a monthly basis by the Risk Management Department. Products that have large open interest or display significant volatility/liquidity factors are reviewed more frequently. CME Risk Management Department monitors market volatilities, and reassesses margins for any products that have experienced a perceived shift in risk profile. Daily price exception reports are distributed to CME Risk Management Department to highlight price changes that exceed margin levels for the preceding trading day.

Weekly meetings are held with senior management of Risk Management Department to discuss proposed margin changes and address product groupings that may have experienced increased volatilities. Each product offered by CME is covered at least on a monthly basis during these weekly meetings. Any changes to margin model parameters must have senior Risk Management Department staff approval, before being implemented.

Backtesting

Prior to implementation, every significant proposed change to a margin model is backtested against a sample of portfolios, representative of the full scope of the cleared products. Backtesting is used to confirm that the margin model performs at the required coverage level with the addition of the change.

CME conducts daily backtesting for each major asset class (Base products, IRS and CDS) at both the portfolio and contract level, monitoring margin held against the following day's (or five-day) market moves to ensure adequate coverage. The Risk Management team analyses the backtesting results to ensure that the margin model, and its parameters, is performing as expected, and that the participant's portfolios are meeting 99 per cent coverage levels. In the year to 31 July 2014, backtesting results for futures and IRS products showed coverage at 99.99 per cent and 100 per cent, respectively.

In addition to daily backtesting, CME performs monthly backtesting of each portfolio over a look-back period starting in 2008. CME also conducts periodic backtesting on a larger set of hypothetical portfolios, covering a range of risk profiles, around two to three times a year.

If backtesting results show that a participant has been holding insufficient margin to cover recently observed market moves, or the model is performing below the required coverage level, the model parameters will be reviewed to ensure they are tuned to prevailing market conditions. In addition, any backtesting failures will be escalated to senior Risk Management Department staff, who will determine the necessary steps to address the failure. These could include the participant being assessed for additional margin. Backtesting is also carried out when CME is testing the application of the margin model on proposed new products.

CME performs sensitivity analysis for margin models and monitors model parameters to ensure that they meet the required coverage standards.

Sensitivity analysis

CME conducts sensitivity analysis of margin levels, model parameters and coverage statistics upon release of additional IRS products and features (such as additional currencies and portfolio margining). Outside this process, sensitivity analysis for IRS model coverage is conducted ‘periodically’. CME is in the process of revising its procedures for conducting sensitivity analysis, with the expectation that the results of IRS sensitivity analysis will be brought before the Stress Testing Committee each month.

For futures products, sensitivity analysis is undertaken by reviewing and varying the CME SPAN model parameters; this includes varying price scan ranges. Sensitivity analysis is performed on a monthly basis and reviewed by the Stress Testing Committee at its monthly meeting.

CME Risk Management Department is responsible for developing margin models. Prior to implementation, all models designed by CME Risk Management Department or any significant changes to existing models, are backtested, presented to the relevant Risk Committees for approval, and vetted by independent experts (see CCP Standard 6.6).

Model validation

CME expects to have its margin models and methodologies reviewed and validated on an annual basis by a qualified and independent party. CME will also conduct additional validations that cover other items, such as liquidity issues.

As a general rule, CME selects the independent party on the basis of their knowledge of the specific product and margin model. For ongoing model validation, CME performs regular reviews, at least annually, using qualified internal staff. These staff are unconnected to the model development and approval process, and not involved in the daily margin process; see CCP Standard 19 for discussion of CME's validation of cross-CCP margining arrangements.

CME last reviewed its IRS margin model in 2013 and there have been no significant changes to the model since then.

Governance

Results from margin model backtesting, other documentation and analysis conducted by Risk Management Department, and independent reviews are presented to the appropriate Risk Committees for their approval.

For Base products, the CHRC is presented with margin model validations for review. For IRS products, IRSRC members receive monthly backtesting reports for relatively large-sized portfolios. CME staff will present to the Risk Committees on any crucial model/parameter changes including information on backtesting results, sensitivity analysis and impact analysis.

CME's timetables for margin calculation and collection are typically consistent with the operating hours of the relevant payment and settlement systems in which it operates. Where operating hours do not align across systems, alternative arrangements may be put in place.

CME currently operates 24 hours per day, 6 days a week. Accordingly, CME does not anticipate that it would need to change its hours of operation, if it were granted a CS facility licence, for Australian participants. For further detail on money settlements, see CCP Standard 9.

The Bank will engage with CME to understand the potential impact of the timing of routine margin calls for non-USD currencies (which currently fall outside Australian business hours) on Australian participants and on CME's exposures, and whether any changes are necessary.