RBA: Assessment of Chicago Mercantile Exchange Inc. against the Financial Stability Standards for Central Counterparties Standard 7: Liquidity Risk

Sources of liquidity risk

CME identifies two potential sources of liquidity risk:

• the management of participant defaults – termed a ‘direct’ liquidity risk by CME
• stresses related to the insolvency or operational failure of commercial banks that provide settlement, custodial or liquidity services to CME – termed an ‘indirect’ liquidity risk.

CME's participant default liquidity risks arise from the fulfilment of the variation margin obligations of the defaulting participant, cash flows relating to any hedging transactions executed for the defaulting participant's portfolio, and payments arising from the auction and close-out of the defaulting participant's cleared positions.

Daily operational liquidity flows primarily consist of the payment of settlement variation to participants (see CCP Standard 9) and the return of cash collateral collected as initial margin. CME also faces cash flows resulting from investment activities. CME's Liquidity Risk Framework does not explicitly cover daily operational liquidity flows or include daily operational liquidity targets. The Liquidity Risk Framework is based on stressed market conditions, which would also at a minimum cover daily requirements. To meet daily liquidity requirements CME retains the majority of its cash uninvested, rather than investing it to the full extent allowed under its Investment Policy (see CCP Standard 15); invested cash remains uninvested intraday and is invested overnight. CME monitors its holdings of intraday cash, to ensure its holdings do not exceed the credit limits it sets with its counterparties (see CCP Standard 15).

Managing liquidity risk

CME identifies, monitors and manages liquidity risks in accordance with its Liquidity Risk Framework, which is governed by the Credit Committee and implemented by the Credit Risk Department. The Liquidity Risk Framework came into effect during the December quarter of 2013, following approval by the Credit Committee. CME is continuing to enhance the framework as it does for all policies, and is increasing its internal resources in the Credit Risk Department, including those responsible for monitoring and managing liquidity risks. The Bank will continue to engage with CME as it develops its formal framework.

The Liquidity Risk Framework will be reviewed annually by both the Credit Committee and the CHRC; because liquidity risks are a general risk matter the IRSRC and CDSRC do not review and validate the Liquidity Risk Framework as a matter of course. However, if liquidity risks arose that were specific to one of these product sets, the relevant Risk Committee would be informed. The technical aspects, including the stress testing models (see CCP Standards 7.3 and 7.8), of the Liquidity Risk Framework will be audited by CME's Global Assurance Group on an annual basis; the first such review is planned for the September quarter of 2014. The framework is supported by additional rules relating to liquidity events (see CCP Standard 7.9). These rules are currently being reviewed by the CFTC and the Federal Reserve Board; both regulators are also reviewing the Liquidity Risk Framework as a part of this review.

Under this framework, direct liquidity risks are monitored through daily stress testing and compared against CME's available liquid assets (CCP Standard 7.3). Indirect liquidity risks are addressed through credit risk monitoring of settlement banks, custodian banks and liquidity providers, under the Credit Risk Policy and Settlement Bank Policy (see CCP Standards 4 and 9.3, respetively). CME also monitors key risk indicators in order to provide warning of market stress or market-wide liquidity pressures.

In addition to monitoring liquidity risks, CME seeks to minimise the size of its potential direct liquidity risk through daily and – for Base products – intraday settlement of variation margin. CME can conduct extra intraday settlement cycles for either, or both, product classes if market conditions warrant (see CCP Standard 6.4).

CME provides participants with pricing information for IRS products and SPAN margin parameter files for Base products, as well as software to estimate their margin obligations for actual and hypothetical portfolios. This allows participants to monitor and manage their liquidity needs and risks, which in turn mitigates the risk posed to CME. In addition, CME systems monitor the settlement activity of clearing participants and – if observed settlement activity differs from typical activity – CME will provide early notice of the higher-than-usual estimated variation margin to clearing participants to ensure data accuracy and to allow clearing participants to manage their liquidity risks.

CME uses commercial settlement and custodian banks, and liquidity providers. In order to mitigate the risk of a disruption at any one settlement bank, CME utilises a range of commercial settlement banks. CME monitors and evaluates the indirect liquidity risks arising from its exposure to settlement and custodian banks through counterparty credit risk monitoring under its Credit Risk Policy and Settlement Bank Policy (see CCP Standards 4 and 9.3, respectively). Where counterparty credit risk monitoring identifies credit weakness at a settlement or custodian bank, CME would seek to limit its exposure to that counterparty, in order to mitigate potential liquidity (and credit) risk (see CCP Standard 9.3). In addition to counterparty credit risk monitoring, CME monitors the ability of its liquidity providers and gauges their capacity.

CME has a committed liquidity facility, provided by a syndicate of banks, which allows it to convert assets held as collateral into cash (see CCP Standard 7.4). CME assesses the capacity of the banks in the syndicate through counterparty credit risk monitoring and by conducting test draws of the facility at least annually (see CCP Standard 7.6).

CME uses an internally developed system to monitor a variety of factors relevant to liquidity risk in real time, including: participants' positions and variation margin obligations; the value of participants' collateral balances; and the value and concentration of assets held at settlement and custodian banks. End-of-day reports provide a detailed account of all collateral on deposit with CME, including the type of collateral, the haircut and par value, and the US dollar-equivalent value of foreign currency-denominated collateral. The information is available by participant, account type (customer or house), currency and asset type. The reports list all settlement and custodian banks at which collateral or cash is held.

CME monitors the value of assets held at settlement and custodian banks at least daily (see CCP Standard 5.3).

CME monitors the liquidity risks posed by its liquidity providers by monitoring their creditworthiness in accordance with CME's Credit Risk Policy (see CCP Standard 4). CME conducts at least annual due-diligence reviews of settlement banks, custodian banks and liquidity providers against a number of eligibility criteria and reviews counterparties' internal policies, particularly those relating to liquidity, operational and credit risk management. Counterparties with lower internal credit ratings are reviewed more frequently.

To manage direct liquidity risks, CME performs daily stress testing to identify the participant (and affiliates) that would generate the largest payment obligations in the event of default in extreme but plausible market conditions (see CCP Standard 7.8). These stress tests are calculated separately for each Guaranty Fund and then aggregated across related entities in order to determine total liquidity requirements resulting from a default. CME terms these payment obligations the ‘Stressed Potential Payment Obligation’ (SPPO).

The SPPO is then compared with the ‘Stressed Qualifying Liquid Resources’ (SQLR) that CME would have available in order to meet those payments as a result of a default of that clearing participant. Only assets that are sufficiently liquid are included in the value of the SQLR (see CCP Standard 7.4).

CME also considers the payment obligations that would result from the two clearing participants (and affiliates) that would generate the largest payment obligations in the event of default, but this is not included in the calculation of the SPPO. This amount factors into the Credit Committee's decision on how much SQLR should be held above the SPPO.

In order to monitor the adequacy of the SQLR relative to the SPPO, CME prepares reports that summarise:

• the largest SPPO and corresponding SQLR for US dollars, as well as aggregated foreign exchange (FX) cash
• the SQLR by category and currency, and the SQLR utilised by the SPPO (see CCP Standard 7.4)
• any liquidity gaps (where the SQLR is not sufficient to meet the SPPO) or exceptions (where the SPPO exceeds the SQLR by a pre-defined internal threshold)
• the payment obligations that would result from the two clearing participants (and affiliates) that, if they defaulted, would generate the largest payment obligations.

These reports are reviewed by senior management from Credit Risk Department on a monthly basis, or more frequently during a stressed market environment. The Credit Committee reviews the adequacy and approves the level of available liquid resources on a quarterly basis.

If daily monitoring identifies a liquidity gap (that is, the SPPO exceeds the SQLR), Credit Risk department staff will notify senior management of Credit Risk Department. The Credit Committee will then hold an ad hoc meeting in order to determine appropriate action. In order to address a liquidity gap, the Credit Committee could: recommend reduction of the clearing participant's positions that are generating the SPPO; require a clearing participant to change its posted collateral in order to increase the SQLR; or seek to increase CME's committed liquidity facility or prearranged funding arrangements in order to increase the SQLR (see CCP Standard 7.4).

The SQLR is determined by valuing the resources available to meet the payment obligations of the clearing participant creating the largest payment exposure, in aggregate and per currency. Haircuts are applied to account for the costs of liquidating or drawing some of these resources, as appropriate. All assets that CME accepts as collateral meet the CFTC's requirements for qualifying liquidity resources. These assets either qualify directly (cash, interest earning cash deposits and letters of credit), are highly marketable collateral supported by prearranged and highly reliable funding sources, or are used to secure committed lines of credit. CME's Investment Policy requires it to invest in a subset of these assets (see CCP Standard 15); accordingly, the assets that CME invests in either can be used to secure the facility or are US Treasury securities that qualify as highly marketable collateral.

• Cash, interest-earning cash deposits and letters of credit. CME holds cash at commercial banks. Only cash in the currency of the payment obligation is included in calculating the resources available for that currency. Letters of credit are counted as qualifying for US dollars for Base products (see CCP Standard 5.1).
• Highly marketable collateral. CME holds US Treasury securities as collateral and it considers these assets to be highly marketable collateral which are eligible for inclusion as qualifying liquid resources. In order to qualify, these assets must have prearranged and highly reliable funding arrangements. CME maintains a number of prearranged uncommitted Master Repurchase Agreements to facilitate access to liquidity secured by US Treasury securities, which it considers are highly reliable. In addition, all clearing participants that are Primary Dealers (or which are affiliated with entities that are Primary Dealers)^[1] will be required to, under proposed Rule 901.Q, enter into a Master Repurchase Agreement with CME. This rule is designed to widen CME's group of counterparties and seeks to ensure CME has highly reliable funding arrangements to convert its US Treasury securities held as collateral to cash in times of market stress.

• Committed lines of credit. To ensure its assets are readily convertible into cash, CME has a committed liquidity facility with a syndicate of banks. This facility provides liquidity in most major currencies in which CME may face payment obligations, including Australian dollars.

  The facility can be drawn up to US$7 billion and, subject to per currency limits, can be drawn in a number of major currencies.^[2] The facility can be expanded to US$10 billion at CME's request, and without requiring the consent of the syndicate banks. CME can access the credit facility within an hour of notifying the facility's banking group.

  The Rulebook does not restrict the circumstances in which CME may use the facility; CME might, for example, draw this facility against participants' collateral in the event of a participant default or a liquidity constraint at a settlement or custodian bank.^[3] CME has reviewed the terms of the facility to ensure it would be available in extreme but plausible market conditions and performs test draws of the facility at least annually (see CCP Standard 7.6).

  The terms of the liquidity facility allow CME to pledge any asset that CME accepts as collateral from participants, aside from certain foreign currency cash (of which CME holds only small amounts and has small payments obligations in).^[4]

CME engages a liquidation agent to assist in the liquidation of its non-cash collateral. CME conducts regular tests with its liquidation agent to ensure it is able to meet CME's requirements. CME also has its liquidation agent review its internal assessments of its ability to liquidate non-cash collateral in extreme but plausible market conditions.

CME does not currently hold an account with a Federal Reserve Bank, does not have access to the Federal Reserve's Discount Window and does not assume access to such in assessing the adequacy of its liquid resources. However, as a SIDCO, CME may be granted access to the Federal Reserve's Discount Window under extreme or exigent circumstances, and is eligible to apply for an account at a Federal Reserve Bank under section 806 of the Dodd-Frank Act.

CME does not supplement its qualifying liquid resources with other forms of liquid resources to assist in the event of a default in covering the largest SPPO.

CME holds a variety of collateral which it would use to meet a liquidity shortfall, either by liquidating the collateral (directly or through its liquidation agent) or pledging collateral to its committed liquidity facility. CME also has contingent liquid resources, which permit the substitution of certain non-defaulting participants' collateral under certain conditions (see CCP Standard 7.9). CME's Liquidity Risk Framework sets out the order in which each source of liquidity would be used.

To ensure counterparties to Master Repurchase Agreements that are Primary Dealers are able to perform, CME assesses these counterparties' capacity and willingness to finance securities using data available from the Federal Reserve Bank of New York; the methodology for this assessment is outlined in the Liquidity Risk Framework.

CME tests access to its funding arrangements at least annually by performing collateral liquidity drills with liquidity providers and test draws from its committed liquidity facility. The results of these tests are reported to the Credit Committee for review. In addition to annual tests, CME seeks to ensure the ability of its liquidity providers to perform thorough regular credit assessments of its liquidity providers, settlement banks, custodian banks and other financial counterparties. Liquidity providers must maintain a minimum internal credit rating, determined as part of the credit assessment process; these ratings are reported to the Credit Committee on a quarterly basis.

Under Section 806 of the Dodd-Frank Act, CME is eligible to apply for an account at a Federal Reserve Bank and may be granted access to the Federal Reserve Discount Window in unusual or exigent circumstances as part of its designation as a SIDCO by the Financial Stability Oversight Council. However, CME does not currently have access to the Federal Reserve and does not rely on access to the Discount Window in assessing the adequacy of its liquid resources. CME will establish rules that allow it to – under certain circumstances – pay variation margin obligations in kind to participants that do have access to the Discount Window (see CCP Standard 7.9). These rules are currently being reviewed by the relevant regulators.

The Reserve Bank has not determined CME to be systemically important at this time.

CME uses stress tests to assess the sufficiency of its liquidity resources (see CCP Standard 7.3). The stress tests are used to identify the SPPO. Although the SPPO is based on losses over the close-out period, CME assumes the full liquidity requirement will be needed from the first day of the default as a conservative assumption. CME compares the stress-test-calculated SPPO with its SQLR and the results are reported to the Credit Committee monthly, or whenever the SPPO exceeds the SQLR (see CCP Standard 7.3).

Stress tests are run daily, using standard and predetermined parameters. The stress tests take into account a range of factors, including historical peak price volatilities, multiple defaults over various time horizons, simultaneous pressures in funding and asset markets, sudden increases in position or price volatility, changes in market liquidity and model risk. CME considers participants with multiple relationships (e.g. clearing participants that are also liquidity providers) as part of its credit risk monitoring; however, the stress tests do not currently include scenarios of simultaneous failure of participants who have multiple roles with CME (e.g. a participant that is also a liquidity provider).

In addition to daily stress testing, CME monitors a number of key risk indicators relating to liquidity and counterparty risk. If this monitoring identifies a material change in risk, senior management in the Credit Risk Department may recommend an intraday stress test.

The liquidity stress-testing model and methodology, including parameters and scenarios are determined by the Stress Testing Committee and are consistent with CME's stress-testing methodology for sizing its Guaranty Funds (see CCP Standard 4.5). The assumptions and parameters of the liquidity stress-testing model and methodology are reviewed on a quarterly basis by the Stress Testing Committee, and monthly by senior management within the Credit Risk Department. On an annual basis the liquidity stress-testing model and methodology will be reviewed and validated by an independent party who is not connected with the development of the stress-test model or methodology. CME plans to commission a full validation of its stress-testing models, parameters and assumptions, including liquidity stress testing, in the second half of 2014.

The Credit Committee plans to consider in 2014 whether it should incorporate reverse stress testing into the Liquidity Risk Framework, in order to identify the market stress scenarios that would exceed the SQLR.

CME maintains a number of emergency liquidity resources on which it could draw in the event CME declared a ‘Liquidity Event’. CME can declare a Liquidity Event if it cannot obtain sufficient liquidity to meet same-day settlement obligations through asset sales, uncommitted funding arrangements, committed lines of credit or committed repurchase agreements. CME has proposed rules that would enable it, in the event of a declared Liquidity Event, to substitute a defaulting clearing participant's US Treasury securities in exchange for cash contributed to the Guaranty Fund by defaulting and non-defaulting clearing participants; in addition, CME can satisfy variation margin obligations to Primary Dealer participants via ‘payment in kind’, by transferring US Treasury securities (valued and haircut at the previous day's close). The rules giving effect to these arrangements are currently being reviewed by the CFTC and the Federal Reserve Board.

In the event of counterparty deterioration or market stress, senior management of the Credit Risk Department or CME Clearing Division may determine that a ‘Contingency Liquidity Plan’ is appropriate. The decision to invoke the plan must be taken by the Credit Committee. This plan provides specific steps that CME would take in order to obtain additional liquidity. The Credit Committee determines whether the Contingency Liquidity Plan needs to be developed on an annual basis; the Credit Risk Department is responsible for developing this plan. CME plans to formalise its Contingency Liquidity Plan in 2014 following the completion of the review of the rules giving effect to that plan by the CFTC and the Federal Reserve Board.