RBA: Assessment of Chicago Mercantile Exchange Inc. against the Financial Stability Standards for Central Counterparties Standard 9: Money Settlements

CME does not conduct money settlements in central bank money. The Bank considers that CME will not be systemically important in Australia in the near term and therefore CME will not be required to open an Exchange Settlement Account at the outset of its operations.

CME predominantly uses commercial bank money to effect money settlements (i.e. payments of initial margin and variation margin). CME normally calculates initial margin in USD, while variation margin is calculated in the currency of the underlying product. CME also uses internal settlement (called ‘Combined Cash Flow’) for settlements of non-USD variation margin. Both methods apply as described below to AUD money settlements.

CME's ‘normal’ settlement method

CME requires clearing participants to maintain demand deposit cash accounts at one or more approved settlement banks to facilitate settlement (see CCP Standard 9.3). Clearing participants must hold separate accounts for house funds, customer segregated funds and customer OTC segregated funds. CME issues distinct payment instructions for each account. Clearing participants that participate in non-USD denominated clearing must maintain additional demand deposit cash accounts for each applicable foreign currency. A clearing participant must inform CME of the name of each settlement bank it uses and the relevant account numbers. A participant must sign an agreement with each of its settlement banks to allow that bank to debit or credit its accounts automatically on instruction from CME to meet daily settlement requirements. Failure of a clearing participant to meet a payment is a failure of an obligation to CME and may result in CME declaring an event of default (see CCP Standard 12). A clearing participant's obligation is extinguished at the time at which CME receives payment (see CCP Standard 9.3).

CME runs two settlement cycles for USD each day (an end-of-day cycle and an intraday cycle), although it has authority to run additional cycles, for example if market conditions warrant it. CME calculates, through its asset management and banking system ‘Clearing 21’, clearing participant initial margin amounts in USD cash and variation margin amounts in the currency of the underlying product. CME allows clearing participants to meet USD variation margin requirements using investment in money market mutual funds under the CME-managed IEF2 collateral program (see CCP Standard 5), which is netted against the final banking instruction; similarly variation margin paid to a participant can be converted into IEF2 balances. Foreign currency obligations may be settled using the Combined Cash Flow method discussed below. CME then issues variation margin pay/collect and initial margin call/release instructions to the settlement bank.

CME applies thresholds for variation margin; amounts below the threshold are not sent to the settlement bank for processing. For example, a threshold of US$500 000 applies for USD variation margin requirements during the intraday settlement cycle; in addition no foreign currency variation margin pays or collects are made during the intraday settlement cycle.

CME holds accounts at each of its settlement banks. USD funds are paid into accounts at CME's settlement banks and are then concentrated at a single bank. All currencies except for JPY are concentrated at a bank designated for that currency. CME's concentration banks are: JP Morgan Chase (London) for AUD, NOK, CHF, GBP, NZD, SEK, TRY, SGD, HKD and ZAR; Citibank (London) for EUR, CNH, DKK, PLN, CZK and HUF; Citibank (Canada) for CAD; and BMO Harris Bank for MXN and USD. Concentration instructions are issued to settlement banks at the same time that CME issues settlement instructions, that is concentration occurs as part of the settlement cycle.

CME issues money settlement instructions via the SWIFT network. Interbank payments are effected through the Federal Reserve's Fedwire Funds Service.

CME's ‘Combined Cash Flow’ settlement method

As noted above, CME uses an internal settlement method called Combined Cash Flow for non-USD money settlements arising from futures products (CME does not use this method for IRS obligations). The objective of this method is to minimise the banking transactions that would otherwise result if the normal settlement method were used, that is it internalises foreign currency variation margin activity to the fullest extent possible. Under this method, CME does not automatically pay out to a clearing participant variation margin owed in a foreign currency; instead, this amount is credited to the clearing participant's ‘combined currency flow account’ held with CME (which holds the participant's foreign currency cash initial margin balances). Foreign currency variation margin owed from a clearing participant to CME is charged to the participant's combined currency flow account. Accordingly, a foreign currency collect instruction is only issued to the clearing participant's settlement bank if the required amount is greater than the cash balance in that currency in the account.

Balances remaining in the combined currency flow account can be used to satisfy initial margin requirements. If a clearing participant has excess cash in a particular currency over requirements, that excess cash can be used to meet initial margin requirements in other currencies (with a haircut; see CCP Standard 5.3). If the overall amount is not sufficient, CME issues a call for additional USD cash to meet initial margin requirements.

Clearing participants may opt not to use the combined cash flow settlement method, in which case the normal settlement method is applied for all obligations. A participant's legal obligations are not affected by the type of settlement method used.

CME publishes a list of approved settlement banks, and the products (Base, IRS, CDS) and currencies in which they support settlement, on its website.

CME maintains a Settlement Bank Policy which sets out its policies for measuring, monitoring and managing credit and liquidity risks arising from its commercial settlement banks. It is the responsibility of the Credit Committee to oversee the Policy and assess the credit profile of the settlement banks (see CCP Standard 4). The Policy is reviewed on an annual basis by the Credit Risk team, with recommended changes escalated to the Managing Director (Risk Management). Concentration banks are selected and monitored in line with the Settlement Bank Policy.

All settlement banks must be approved by CME and sign a ‘settlement bank agreement’. Prior to approval an initial credit review is conducted. CME conducts an on-site visit of potential settlement banks, covering a range of factors including the bank's financial capacity and and operational risk management processes. The bank must also demonstrate sufficient understanding of the responsibilities relating to the provision of settlement services.

The review also considers the regulation to which the prospective settlement bank is subject. Each prospective settlement bank is assigned an internal credit rating under the Credit Risk Policy (see CCP Standard 4). To be approved, a settlement bank must receive an internal rating of at least 6. Initial (and ongoing) reviews of settlement banks must be submitted for approval to a Credit Risk Manager, the CRO and the Credit Risk Committee. Finally, CME receives CFTC sign-off prior to accepting a foreign bank as a settlement bank. Criteria for settlement banks are discussed at a high level in CME's Principles for Financial Market Infrastructures Disclosure document.

For approved settlement banks, a credit review, including an on-site visit, is conducted on at least an annual basis. Any issues highlighted during the annual review are reported to the Managing Director (Risk Management) and discussed with the settlement bank. The review will also take into account the whole of the relationship that CME has with the bank (e.g. if it acts as both a clearing participant and a settlement bank). The Credit Risk Management team also monitors the financial condition and market metrics of settlement banks on a more frequent basis; issues with settlement banks are discussed by the Credit Risk Management team and can be raised to the Managing Director (Risk Management).

One of the principles of CME's Settlement Bank Policy is to provide for diversity in settlement banks, in order to reduce concentration of risk. CME monitors concentration risks across its settlement banks (e.g. the amount of pays the settlement bank owed to CME on a monthly average basis, and the largest 10 payments owed over the last year) and this is reported to the Credit Committee. If the Committee determines that a settlement bank poses too much risk to CME or the bank's creditworthiness has declined, limits may be implemented.

Rule 901.I obliges clearing participants to perform on payment obligations to the CCP; a clearing participant's obligation is extinguished at the time at which CME receives payment. This rule would continue to apply in the event of a settlement bank default. In such an event, CME would work with affected clearing participants to find an alternative method of processing payments, for example redirecting settlement activity to an alternative settlement bank or accepting settlement payments directly from the affected clearing participants. The Credit Committee conducts settlement bank default impact assessments, monitoring clearing participant exposures and distribution among settlement banks to consider potential alternative settlement banks to which clearing participant activity might be transferred. If a clearing participant were unable to pay, it may be declared to be in default.

In addition, CME maintains a fully secured committed line of credit with a consortium of international and domestic banks (see CCP Standard 7). CME may access this in the event that there is a temporary problem with the domestic payments system that would delay payments of variation margin between CME and its clearing participants; that is, this would allow CME to pay variation margin to all clearing participants even if financial obligations to CME had not been met. In such a case, to protect itself from the risks associated with the imbalance that would arise from making pay-outs before pay-ins were received, CME would contact the settlement banks experiencing the operational issue to ensure pay-in amounts were secured at those settlement banks.

CME also has the flexibility to calculate variation margin in only some currencies, change the settlement method employed for a settlement currency and redefine thresholds. There are no prescriptive circumstances under which this might occur and to date this has never been exercised. The decision to change the settlement method or currency would be made by the CRO and clearing participants would usually be given advanced notice via CME's standard notification protocols (i.e. a Clearing House Advisory Notice).

As discussed in CCP Standard 9.2, CME uses a form of internal settlement for foreign currency settlements, under which the required amounts are set off against foreign currency initial margin balances already held at CME. This reduces the number of foreign currency settlements required. Additional requirements are settled through the normal settlement bank process.

CME maintains contractual agreements with its settlement banks; these are governed under US law. CME's settlement bank agreements define the time at which settlement is final and payments are irrevocable, that is at the time when the settlement bank issues confirmation to CME (see CCP Standard 8). Similarly, payments made to the concentration bank are final and irrevocable at the time when the settlement bank issues confirmation to CME. The agreements include a timeline setting out settlement procedures for each settlement cycle, including non-routine cycles. For the end-of-day cycle, settlement banks make an irrevocable payment at 7.30 am Chicago time; for the intraday cycle this occurs at 2.00 pm Chicago time. For non-routine cycles, settlement banks have one hour from notification by CME of the non-routine cycle to accept the payment instructions. The settlement cycle is also outlined in the Clearing House Manual of Operations and is made available on CME Group's website. CME is in the process of amending its settlement bank agreements to incorporate automation into the confirmation process by replacing phone and fax confirmation with SWIFT messaging. CME is targeting the end of 2014 for completion of this initiative.

If a settlement bank does not confirm its acceptance of a payment instruction by the deadline, this would be escalated to CME senior management. As noted in CCP Standard 9.3, clearing participants continue to be obliged to perform on their obligations in the event of a settlement bank default.