Assessment of Chicago Mercantile Exchange Inc. – March 2017 2. Material Developments Relating to the Bank's Assessment

This section provides more details about CME's progress towards addressing the regulatory priorities outlined in section 1.1 and highlights other relevant regulatory developments.

2.1 General Regulatory Priorities

2.1.1 Recovery and wind-down plans

The March 2016 Assessment set a priority that CME should complete its work to implement its recovery and wind-down plans. During the assessment period, CME developed revised recovery and wind-down plans for its three clearing services, i.e. Base, OTC IRS and CDS, each with its own pre-funded resources, which remain separated when managing a default.^[6] CME implemented rule changes (required to give effect to these plans) for its Base clearing service at the end of the assessment period. In 2017, CME will, where applicable, make conforming changes to the end of waterfall rules for its OTC IRS and CDS services. During the process of developing its recovery and wind-down plans and associated rule changes, CME has engaged with the CFTC and taken into account the CPMI-IOSCO report on Recovery of Financial Market Infrastructures.^[7] CME has also consulted with clearing participants and other relevant stakeholders.

The Bank will review CME's recovery and wind-down plans in the next assessment period.

2.1.2 Unsecured investments

One of the Bank's 2016 regulatory priorities was that CME continue to reduce the size and concentration of its unsecured investments of cash collateral with non-government obligors. CME's governance arrangements include consideration of unsecured exposures. CME's Investment Policy outlines its key investment principles, in order of priority: safety and preservation of principal; liquidity; and return. The Investment Policy also sets out portfolio concentration limits for each asset type. These principles and limits guide CME's allocation of cash to different investments. In addition to this, CME has informal guidelines for investment targets that are used by staff for the day-to-day management of investments. CME's Investment Policy must be approved by the Credit Committee and the board-level Clearing House Oversight Committee, with reviews conducted at least annually by these two committees. In order to oversee investments, the board-level Clearing House Oversight Committee receives reports on a quarterly basis. These reports include information on investment exposures and the degree of concentration of unsecured investments at commercial banks. The board receives information on CME's investments via the Clearing House Oversight Committee.

Furthermore, CME's Credit Policy establishes minimum credit standards and an approach to assessing and managing credit risk to CME's investment counterparties. CME's management of credit risk involves conducting internal risk assessments and periodic reviews of counterparty risks, and states that single counterparty limits should be determined on a quarterly basis. The Credit Policy is reviewed and approved by the Clearing House Risk Committee at least once a year and is also subject to periodic internal audits.

During the assessment period, CME has worked towards expanding the number of investment counterparties it has, including opening accounts at central banks. In November, CME began depositing house funds in its account at the Federal Reserve Bank of Chicago. CME was also recently authorised to deposit client funds with the Federal Reserve. This was facilitated by the CFTC's announced exemptions that allow CME (and other systemically important CCPs) to place client funds in accounts with the Federal Reserve. CME also opened accounts at the Bank of Canada that became operational during the assessment period. CME deposits a small amount of Canadian dollars with the Bank of Canada. CME is also negotiating arrangements to invest on a secured basis, through reverse repos, with additional counterparties.

As a result, the proportion of cash collateral CME invests on an unsecured basis with non-government obligors has decreased modestly over the assessment period. This is despite an increase in the amount of cash collateral CME has received, which has meant that there has been little change in the size of CME's unsecured investments with commercial banks. At end December 2016, CME had US$15.2 billion invested on an unsecured basis with commercial banks.

The concentration of CME's unsecured investments fell during the assessment period, partly as a result of the addition of two counterparties that CME actively invests with on an unsecured basis. At end December 2016, 74 per cent of CME's unsecured investments were held with three counterparties, down from 79 per cent at end December 2015. CME is negotiating arrangements with several other commercial banks to invest on an unsecured basis.

The use of accounts at central banks and the expansion in the number of investment counterparties described above are expected to allow CME to reduce the size and further reduce the concentration of these investments. The Bank will monitor the outcome of these developments on a quarterly basis.

2.1.3 Model testing and validation

In the March 2016 Assessment, the Bank stated that it would monitor CME's application and the ongoing adequacy of the Model Validation Framework implemented during the previous assessment period, including the governance process. To support this, the Bank expected CME to share the reports from the validations that it finalised during the assessment period and engage with the Bank on the results. External validation reports for SPAN and the Collateral Haircut Model were completed in August 2016, and CME shared these reports with the Bank in early 2017.^[8]

CME updated its Model Validation Framework during the assessment period. The changes made reflect updated governance arrangements, which now require the board-level Clearing House Oversight Committee to approve the framework on an annual basis and all substantive changes. The revised framework also provided additional detail on the scope of model validations and the selection criteria for model validators.

The Model Validation Framework specifies that CME's Global Assurance team (i.e. internal audit) will periodically assess the model validation process to ensure that it is robust, complies with regulatory and CME requirements, and has appropriate management and controls. The most recent internal audit of the model validation process, which was completed in November 2015, concluded that the overall governance of the process was adequate, the highest possible rating.

CME's Model Validation Framework envisages that validations may be conducted either by external independent consultants or an independent internal model validation function. In either case, validators must be independent from both the developers and the users of the model. During the assessment period, CME utilised both external consultants and its internal audit team to conduct model validations.

2.1.4 Liquidity risk

In line with the Bank's 2016 priority on liquidity risk, CME has continued to engage with the Bank on its management and governance of liquidity risk, including how the board oversees the management of liquidity risk.

Over the assessment period, CME made improvements to the governance arrangements for liquidity risk. In addition to being approved by the Credit Committee and the Clearing House Risk Committee, the LRMF must now be reviewed by the board-level Clearing House Oversight Committee before a recommendation for approval is made to the board. This review and approval process is run at least annually. The LRMF is also subject to internal audits at the discretion of CME's Global Assurance team.

In addition to the internal audits, the Global Assurance team recently commenced an independent review of the LMRF.^[9] This review will meet the requirements of a validation under CME's Model Validation Framework. The review will include an assessment of the adequacy of the management reports on liquidity risk (its ‘liquidity dashboard’), to which CME recently implemented enhancements. The Bank expects CME to share the report from this review once it is finalised and engage with the Bank on the results.

CME also recently introduced liquidity-specific stress testing scenarios, consistent with the recommendation made in the recent review by CPMI-IOSCO (see section 2.3.2 for details).

2.1.5 Letters of credit

CME accepts letters of credit (LOC) as collateral to cover initial margin requirements related to Base products only. Clearing participants that are affiliated with a financial entity are not permitted to meet house initial margin requirements using LOC, except to meet intraday margin calls as a ‘buffer’, although they may provide LOC to meet non-financial clients' margin obligations.^[10] The value of LOC that CME will accept from any clearing participant, aggregated across house and client accounts, is capped at the lesser of 25 per cent of that participant's initial margin requirements or US$500 million. Limited exemptions to this cap, up to US$1 billion, may be granted to clearing participants that wish to post additional LOC on behalf of particular non-financial clients.

In the March 2016 Assessment, the Bank stated that it would monitor CME's acceptance of LOC as collateral, including the extent of exemptions granted. At end December 2016, CME's clearing participants had applied US$1.8 billion of LOC as collateral to meet margin requirements for Base products, equivalent to 1.7 per cent of total initial margin requirements for those products. Three clearing participants have been granted exemptions to date, allowing each to post additional LOC on behalf of a non-financial client. No additional clearing participants were granted exemptions during the assessment period.

As the use of LOC is limited and exemptions are expected to be granted on an exceptions basis, the Bank has concluded that CME has fully addressed this regulatory priority. However, going forward the Bank will continue to collect data on the acceptance of LOC as collateral on a quarterly basis, with a view to revisiting this issue if there is a material increase.

2.1.6 FMI links

CCP Standard 19 requires that a CCP that establishes a link with one or more FMIs should identify, monitor and manage link-related risks. The standard also sets specific requirements regarding links that CCPs maintain with other CCPs. CME maintains three links with other CCPs: a Mutual Offset System (MOS) arrangement with SGX and cross-margining agreements with the Fixed Income Clearing Corporation and Options Clearing Corporation.^[11]

During the assessment period, CME started regularly providing the Bank with data on the exposures across its links with other CCPs. The data indicate that CME's exposures to other CCPs in absolute terms remain relatively small compared to CME's overall exposure. CME continues to accept LOC to cover exposures across its link with SGX but has not accepted LOC for any other of its links. CME has not entered into any further links with other CCPs during the period.

The Bank has concluded that CME has fully addressed this regulatory priority. However, the Bank expects to be notified by CME if there is a material increase in exposures to linked FMIs. In such an event, the Bank will revisit this issue and seek to engage with other relevant regulators.

2.2 Australian Regulatory Priorities

CME does not currently have any direct Australian-based clearing participants, and its clearing of Australian dollar-denominated OTC IRD remains relatively low (See Appendix A for further details on activity in CME). The Bank does not therefore expect that CME should make substantial progress against regulatory priorities specifically related to the provision of services to the Australian market until such time that CME has material direct Australian participation or there is a significant increase in CME's provision of services of Australian-related products.

2.3 Other Regulatory Developments

2.3.1 CPMI-IOSCO implementation monitoring

In August, CPMI and IOSCO published a report on the results of a peer review examining consistency in the outcomes of CCPs' implementation of the Principles for Financial Market Infrastructures (PFMI) with respect to their financial risk management and recovery practices.^[12] This review covered 10 CCPs internationally that provide clearing services for derivatives, including CME.

CPMI and IOSCO recently launched a follow-up targeted review of CCPs' progress in addressing the most serious issues of concern identified in the August report. The Bank will be participating in this review, and through this will monitor how CME has responded, where relevant, to the issues identified.

2.3.2 Additional guidance

Cyber resilience guidance

In recent years, the growing threat of cyber attacks has posed an increasing risk to FMIs' operational resilience. Recognising this, CPMI and IOSCO have made the resilience of FMIs to cyber threats a strategic priority. As part of its work in this area, in June 2016, CPMI and IOSCO released guidance in the area of cyber resilience to support relevant requirements in the PFMI.^[13] The guidance is intended to help FMIs enhance their cyber resilience and provide a framework for supervisory dialogue.

The Bank has formally adopted the Cyber Resilience Guidance to support its assessments against relevant requirements in the CCP Standards. It therefore expects CME to consider any implications of this guidance for its operations.

CCP resilience and recovery guidance

In light of the increasing systemic importance of CCPs, a number of international standard-setting bodies have developed a joint workplan to further enhance the effectiveness of CCP resilience, recovery and resolution. As part of this work plan, CPMI and IOSCO are developing additional guidance that provides further clarity and granularity on several key aspects of the PFMI to further improve CCP resilience. In August, CPMI and IOSCO published for comment additional guidance on certain principles and key considerations in the PFMI.^[14] The proposed guidance provides more detailed descriptions of how CCPs are expected to implement the PFMI in order to improve their resilience and recovery planning. The guidance focuses on governance, credit and liquidity stress testing (including coverage of the resulting credit and liquidity resource requirements), margin and a CCP's contribution to its pre-funded resources. The report also proposes guidance that is intended to facilitate a CCP's development of its recovery plan by building on and reiterating certain aspects of the recovery report.

The Bank expects to adopt the CCP Resilience and Recovery Guidance after it is finalised, at which point it will expect CME to consider the implications of this guidance for its financial risk management.

Footnotes

As discussed in B.2.3, losses in one CME service cannot be applied to the mutualised resources of the default waterfall of another CME service, and in an extreme situation, a given CME service could also be closed, while the other services remained open. [6]

See CPMI-IOSCO (2014), Recovery of Financial Market Infrastructures, Bank for International Settlements, October. Available at <http://www.bis.org/cpmi/publ/d121.htm>. [7]

CME's model validation schedule for 2016 was revised during the assessment period, reflecting a number of factors including business priorities, regulatory requests and other operational factors. All revisions are reviewed and approved by the Model Risk Committee. [8]

During the assessment period CME determined that it was more appropriate for its Global Assurance team to conduct an independent ‘review’ of the LMRF, rather than have the model externally validated. [9]

The use of the buffer allows a clearing participant to temporarily use LOC to cover intraday liabilities arising from new trade registrations and intraday margin liabilities on existing positions. If this facility is used, the LOC must be replaced with another form of collateral by the next settlement cycle. CME has informed the Bank that no clearing participants have posted LOC as a buffer over the past few years. [10]

The MOS is a peer to peer CCP link that permits clearing participants to execute on a trading venue cleared by one CCP, and have the position transferred to the other CCP to carry. Cross margining arrangements allow clearing participants, or their customers, to reduce their total initial margin requirements where they hold related, offsetting positions at the two CCPs that participate in the arrangement. Due to the product scope of CME's Australian CS facility licence, the SGX link is the only link that is potentially of direct relevance to Australian clearing participants. [11]

See CPMI-IOSCO (2016), ‘Implementation monitoring of PFMI: Level 3 assessment – Report on the financial risk management and recovery practices of 10 derivatives CCPs’, August. Available at <http://www.bis.org/cpmi/publ/d148.pdf>. [12]

See CPMI-IOSCO (2016), ‘Guidance on cyber resilience for financial market infrastructures’, June. Available at <http://www.bis.org/cpmi/publ/d146.pdf>. [13]

See CPMI-IOSCO (2016), ‘Resilience and recovery of central counterparties (CCPs): Further guidance on the PFMI’, August. Available at <http://www.bis.org/cpmi/publ/d149.pdf>. [14]