Assessment of Chicago Mercantile Exchange Inc Appendix B: CME Regulatory Environment and Risk Management
B.1 Regulatory Framework
CME is incorporated in the United States and is primarily regulated by the CFTC under US legislation. As a designated SIDCO, CME is also subject to oversight by the Federal Reserve Board of Governors.
In Australia, CME is licensed under section 824B(2) of the Corporations Act 2001, which provides an alternative licensing route for an overseas-based CS facility subject to requirements and supervision in its home country that are considered to be sufficiently equivalent to those in Australia. The regulatory regime in the United States, as administered by the CFTC, is considered to be sufficiently equivalent to that in Australia.[14] The Bank and the Australian Securities and Investments Commission (ASIC) have established a joint Memorandum of Understanding (MoU) with the CFTC regarding supervision of CCPs that operate in both the United States and Australia.[15] The MoU provides a framework for cooperation among the authorities, including information sharing and investigative assistance.
CME is recognised as a third-country CCP by the European Securities and Markets Authority (ESMA) under Regulation (EU) No 648/2012 of the European Parliament and of the council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (commonly known as the European Market Infrastructure Regulation (EMIR)). CME is also authorised in Japan, Singapore, Hong Kong and Mexico. The Dubai Financial Services Authority (DFSA) has authorised CME as a Recognised Body. CME provides clearing services to Dubai Mercantile Exchange Limited (DME).
CME is exempt from the requirement to register as a clearing agency in Alberta, Ontario and Québec.
During the assessment period, a CME crisis management group led by the CFTC and the Federal Deposit Insurance Corporation (FDIC) was established, consistent with a recommendation by the Financial Stability Board (FSB) in its report: Key Attributes of Effective Resolution Regimes for Financial Institutions.[16] The purpose of this group is to coordinate with respect to resolution planning. The Bank is not a member of this group.
B.2 Risk Management in CME
A CCP acts as the buyer to every seller and the seller to every buyer in a market. This is commonly achieved by the CCP interposing itself as the legal counterparty to all purchases and sales via a process known as novation. These arrangements provide substantial benefits to participants in terms of counterparty credit risk management, as well as greater opportunities for netting of obligations. At the same time, however, they result in a significant concentration of risk in the CCP. This risk can crystallise if a clearing participant defaults on its obligations to the CCP, since the CCP must continue to meet its obligations to all of the non-defaulting participants.
CME manages this risk in a number of ways, including through participation requirements, margin collection, the maintenance of pooled resources and loss allocation arrangements.
B.2.1 Clearing participation requirements
To manage its exposure to its participants, CME only allows institutions to become clearing participants (referred to as ‘clearing members’ in the CME Rulebook) if they meet certain financial and operational requirements. Prospective clearing participants are required to meet minimum capital requirements. These requirements are set at: US$50 million for OTC IRS clearing participants; and US$5 billion or US$5 million for Base clearing participants that clear exchange-traded products only, depending on whether the participant is a bank or non-bank.[17] Prospective participants must also satisfy a number of other requirements, including regarding their operational and technological capabilities, and disaster recovery and business continuity arrangements. Once accepted, clearing participants must meet minimum guaranty fund contributions, set at a minimum of US$0.5 million for Base clearing participants (US$2.5 million for those clearing OTC-traded Base products) and US$15 million for OTC IRS clearing participants. CME also maintains the right to impose additional requirements on clearing participants specific to the type of entity or products they propose to clear.
B.2.2 Margin collection
To cover its credit exposures, CME collects several types of margin from its clearing participants.
- Variation margin. CME collects and pays out ‘settlement variation’ margin (which corresponds to variation margin as defined in the CCP Standards) for all cleared products. Variation margin is calculated to cover gains or losses on positions arising from observed price movements. This practice ensures that losses on CME participants' positions do not accrue over time. Variation margin is called twice a day for Base products and once a day for OTC IRS.
- Initial margin. In the event of a clearing participant default, CME would be exposed to risk arising from potential changes in the market value of the defaulting participant's open position between the last settlement of variation margin and the close-out of these positions. To mitigate this risk, CME collects ‘performance bonds’ (which corresponds to initial margin as defined in the CCP Standards) for all cleared products. Initial margin is called twice a day for Base products and once a day for OTC IRS. Consistent with CFTC Regulations, CME requires clearing participants to deposit gross initial margin for customer accounts, but allows net initial margin deposits for house positions. Clearing participants are required by CME and applicable CFTC Regulations to collect at least as much initial margin from each customer as CME collects from the clearing participants and to lodge this minimum amount with CME. CME requires clearing participants with speculative customer accounts to collect a higher level of margin from these accounts.[18]
- Intraday margin. CME may also collect intraday margin in addition to routine margin calls throughout a trading session in situations it deems appropriate, such as in the event of significant market movements. CME made no ad hoc intraday margin calls over the assessment period. The last ad hoc intraday margin call for the OTC IRS service was made in response to market movements on the day after the UK referendum on EU membership on 24 June 2016.
- Additional margin. CME may also collect additional margin from clearing participants in the form of ‘concentration margin’. Concentration margin is intended to cover potential market exposures due to a clearing participant holding positions that take longer or are more costly to liquidate, and provides an additional incentive for clearing participants to manage and contain the risk of their portfolios. For Base products, concentration margin can be applied if the results of stress tests exceed both a participant's variation margin pays threshold (an average of the three highest variation margin pays over the past 12 months) and capital threshold (or a pre-defined absolute threshold).[19] For OTC IRS, CME may apply a concentration margin in the form of a liquidity charge multiplier. CME routinely calls concentration margin from clearing participants.
CME calculates initial margin requirements for OTC IRS products using an Historical Value at Risk (HVaR) methodology, with historical returns scaled using exponentially-weighted moving-average volatility. To provide a set of historical scenarios CME uses a rolling look-back period of five years, in addition to including stressed periods such as the global financial crisis period of 2008–09. CME targets an ex post coverage of 99 per cent assuming a close-out period of five days. CME also has a volatility floor to protect against procyclicality.
Initial margin requirements for Base products are calculated using the CME SPAN methodology. This methodology calculates initial margin that reflects the total risk of each portfolio based on, but not limited to, historical price changes and volatility. CME calibrates initial margin requirements for Base products to cover 99 per cent of forecast price moves for a position over a minimum close-out period of one trading day. Base products that are portfolio-margined with OTC IRS positions are HVaR margined and so are subject to a five-day close-out period.
CME assesses the adequacy of its margin models through daily and monthly back-testing. CME also conducts sensitivity analysis on a monthly basis to assess the adequacy of its margin models.
B.2.3 Pooled financial resources
CME has separate default waterfalls (which CME calls ‘financial safeguards packages’) for its OTC IRS clearing service and its Base clearing service (as well as for its CDS clearing service), which determine the order in which financial resources would be used to cover default losses within each of the services. As noted above, this Assessment does not cover CDS products, as CME is not licensed to clear CDS in Australia.
Each waterfall is segregated from the others, ensuring that clearing participants are only liable for losses associated with a default within the services in which they participate. In the event of a clearing participant default, any losses arising would first be covered by the assets of the defaulted clearing participant, including its margin, contribution to guaranty fund(s) and any other of its assets that are available to CME. If the assets of the defaulted clearing participant are exhausted, CME may draw on other resources in the relevant default waterfall to meet remaining obligations.
Pre-funded resources
In the event that all of the defaulted clearing participant's margin, contribution to guaranty fund(s) and any other assets available to CME are exhausted, CME would seek to cover remaining losses arising from the default with a pool of pre-funded mutualised resources, which comprise CME's capital contributions and the guaranty fund contributions of non-defaulting clearing participants for the relevant service. CME would use its capital contributions (US$100 million for Base and US$150 million for OTC IRS, as at end December 2017) before allocating losses to the guaranty fund contributions of non-defaulting clearing participants. All clearing participants are required to contribute to the guaranty fund of each service in which they participate.
The Base and OTC IRS clearing service guaranty funds are each sized to cover the default of the two clearing participants and their affiliates that would give rise to the largest credit exposure to CME under a wide range of extreme but plausible scenarios, as determined by stress testing (the ‘Cover 2’ requirement). As at end December 2017, the sizes of the Base and OTC IRS guaranty funds were US$4.64 billion and US$2.57 billion, respectively. The value of each fund is set equal to the greater of: the Cover 2 stress exposure on the last day of the calculation period; or the average of the Cover 2 stress exposures during the entire calculation period. CME also adds a buffer to the guaranty funds, to account for potential increases in the exposures of participants between scheduled resizing dates. The scheduled calculation period is one month for both the Base and OTC IRS guaranty funds. When sizing the Base guaranty fund, CME considers the sum of the two highest stressed exposures from the same stress scenario. When sizing the OTC IRS guaranty fund, CME considers the sum of the two highest stressed exposures, irrespective of stress scenario.
The adequacy of the guaranty funds is assessed by CME on a daily basis through stress testing. As part of its daily stress testing process, CME calculates ‘portfolio residual losses’, which are stress test losses in excess of total collateral posted by the clearing participant.[20] In the event that CME is concerned that the value of the guaranty fund is insufficient, it has the ability under its rules to resize the guaranty fund and call additional guaranty fund contributions from all clearing participants outside the scheduled recalculation dates. A review of the guaranty fund would be prompted if the Cover 2 requirement was greater than 80 per cent of the guaranty fund size. The decision to resize the guaranty fund is discretionary and would be made by the Stress Testing Committee within 24 hours, taking into account how close the next scheduled resizing date is and how close the Cover 2 requirement has come to CME's pre-funded resources. In situations where one clearing participant is driving the increase in the Cover 2 requirement, CME may choose to call additional margin from that clearing participant. During the assessment period, CME performed off-cycle resizings of the OTC IRS guaranty fund on 12 January, 21 February, 25 August and 5 September. CME also performed off-cycle resizings of its Base guaranty fund, on 26 January, 12 July, 27 July, 7 September and 25 September.
Unfunded resources and loss allocation rules
In very extreme circumstances it is possible that CME's pool of pre-funded mutualised resources for the relevant clearing service could be used or even exhausted. In these circumstances, CME is able to call for additional resources from non-defaulting clearing participants using its ‘assessment powers’ to replenish the relevant guaranty fund or to allocate losses beyond the available pre-funded resources.
Calls for additional resources to allocate losses are due to be paid to CME on the day they are called.[21] In the event that the guaranty fund was drawn on to meet losses arising from a clearing participant default, each non-defaulting clearing participant would be required to replenish its guaranty fund contributions by close of business on the business day following the assessment call.
These payments are subject to participants' maximum obligations during the relevant ‘cooling off period’.[22] For the Base guaranty fund, the maximum amount CME can call varies depending on how many clearing participants have defaulted. If only one clearing participant defaults, the maximum amount is 2.75 times each clearing participant's Base guaranty fund contribution. If multiple clearing participants default within a five-day period (the Base cooling off period), the maximum amount CME can call is 5.5 times each clearing participant's Base guaranty fund contribution. Subject to these limits, CME would call for the required amount of additional resources from each non-defaulting clearing participant in proportion to that participant's contribution to the Base guaranty fund. For the OTC IRS guaranty fund, the maximum amount is sized to cover potential losses arising in the event of the default of the clearing participants with the third and fourth largest stress test losses. Subject to this limit, CME would call for additional resources from each non-defaulting clearing participant based on the relative size of that participant's stress testing result. After the cooling off period, clearing participants must fully replenish their guaranty fund contributions.
CME would implement its recovery plan when it utilises financial resources resulting from assessments. CME's recovery and wind-down plans have been developed in accordance with CFTC Regulations. The recovery plan outlines the tools available to address uncovered credit losses, liquidity shortfalls, or other business risks that could threaten CME's viability as a going concern. In late 2016, CME implemented rule changes to add voluntary contributions, voluntary tear-ups, and mandatory portfolio gains haircuts and partial tear-ups and full tear-ups as recovery tools for the Base service in the event that a clearing participant default(s) exceeds CME's pre-funded resources and assessment powers. For its OTC IRS service, CME would implement variation margin gains haircutting in conjunction with a full tear-up of contracts.[23] CME has indicated to the Bank that end of waterfall rule changes for its OTC IRS service are expected to be implemented in 2018.
Footnotes
More detail on the supervisory approach of the CFTC is available in the Bank's March 2016 Assessment. Available at <https://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/assessments/chicago-mercantile-exchange/2016/pdf/cme-assessment-2016-03.pdf>. [14]
The MoU is available at <https://www.rba.gov.au/payments-and-infrastructure/payments-system-regulation/pdf/memorandum-20140606.pdf>. [15]
See Financial Stability Board (2014), ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’, October. Available at <http://www.fsb.org/wp-content/uploads/r_141015.pdf>. [16]
Participants in the Base service that clear OTC-traded Base products, regardless of the type of entity, must have at least US$50 million in capital (US$5 million if only clearing agricultural OTC products). Banks that clear OTC-traded Base products as well as exchange-traded derivatives must meet the higher capital requirement of US$5 billion. [17]
In addition to maintenance performance margin, CME also sets ‘minimum initial margin’, which is applied only to speculative customer accounts that are cleared through a clearing participant. Customers who are charged minimum initial margin are required to deposit this amount with their clearing participant. The clearing participant is, in turn, responsible for depositing the maintenance performance margin portion with CME. The level of these minimum initial requirements is based on the risk characteristics of each product and is set at least 10 per cent higher than the maintenance performance margin level. If the customer's total margin holdings fall below the maintenance performance level, they will be re-margined at the higher minimum initial margin level. [18]
For non-bank clearing participants, capital is defined as adjusted net capital and calculated in accordance with CFTC Regulations. For bank clearing participants, capital is defined as Tier 1 Capital, which is defined in accordance with regulations applicable to the bank clearing participant. [19]
Total collateral posted by the clearing participant includes collateral posted to meet initial margin requirements, additional margin requirements and any excess collateral posted by the clearing participant. [20]
However, if the call for additional resources is made within an hour of the close of Fedwire, then these are due to be paid to CME within one hour of when Fedwire next opens. [21]
The cooling off period limits a clearing participant's maximum obligation to contribute to the guaranty fund and to fund losses, and lasts for a predetermined number of days following the default of a clearing participant. The cooling off period for the Base guaranty fund is five days and for the OTC IRS guaranty fund is 25 business days. It is due to the longer cooling off period for OTC IRS, during which multiple stress scenarios may be experienced, that CME uses a more conservative approach when sizing the OTC IRS guaranty fund. [22]
CME's Rule 8G802.B permits it to use variation margin gains haircutting in an OTC IRS ‘termination event’ (i.e. in the event of bankruptcy of CME Inc.), at which time all OTC IRS contacts shall be closed. The CME Rulebook is available at: <http://www.cmegroup.com/rulebook/CME/>. [23]