Assessment of Chicago Mercantile Exchange Inc Developments Relating to the Bank's Assessment

CME is a Chicago-based central counterparty (CCP) that provides clearing services for a number of products from its US operations. CME operates three clearing services: an over-the-counter (OTC) Interest Rate Swap (IRS) clearing service; a ‘Base’ clearing service; and an OTC Credit Default Swap (CDS) clearing service. The Base service accounts for the majority of CME's total clearing activity and covers exchange-traded interest rate futures and options on futures, foreign exchange (FX), equity, soft commodity, energy and metal futures, certain OTC FX forwards and options, and commodity swaps.^[1] CME maintains separate default resources (i.e. default waterfalls) for each clearing service. Further background on CME's risk management is set out in Appendix B.2.

In Australia, CME holds a CS facility licence, which permits it to offer clearing services to Australian-based institutions as direct clearing participants for OTC interest rate derivatives (IRD) and non-Australian dollar-denominated IRD traded on the CME market or the Chicago Board of Trade (CBOT) market, for which CME permits portfolio margining with OTC IRD.^[2]

Given the nature and scope of CME's current activities in Australia, the Bank has not considered it necessary at this stage to conduct a detailed assessment of CME against all of the CCP Standards. The Bank instead conducts and publishes a narrower assessment, focusing on CME's progress towards addressing key issues.

This document summarises developments during the assessment period in relation to the Bank's outstanding regulatory priorities for CME set out in the Assessment of Chicago Mercantile Exchange Inc. published in March 2017 (the March 2017 Assessment).^[3] This document also summarises the Bank's priorities and supervisory focus for the 2018 assessment period and highlights other relevant regulatory developments.

Progress against Regulatory Priorities

CME was granted a CS facility licence in September 2014. In assessing CME's licence application at that time, the Bank conducted an initial assessment of CME's observance of the CCP Standards.^[4] As part of that assessment, the Bank determined a set of initial regulatory priorities for CME reflecting expectations set out in the CCP Standards and by the Council of Financial Regulators (CFR) in July 2012 in its policy Ensuring Appropriate Influence for Australian Regulators over Cross-border Clearing and Settlement Facilities (CFR Regulatory Influence Policy).^[5]

The Bank set out a number of regulatory priorities for CME in its March 2016 Assessment, of which several had been fully addressed by CME at the time of the March 2017 Assessment.^[6] However, three regulatory priorities had not been fully addressed, and the Bank noted its supervisory focus for 2017 was to monitor the outcome of work planned or completed by CME to address these. The Bank did not set additional regulatory priorities for 2017.

The three outstanding regulatory priorities, and the Bank's assessment of the progress made by CME against these, are summarised in Table 1 and discussed in more detail below.

Recovery and wind-down plans

During the assessment period, CME continued to work on the implementation of recovery and wind-down plans for its Base and OTC IRS clearing services. As part of implementing these plans, the CME Board approved changes to the end of waterfall rules for its Base clearing service in late 2016; at the end of the assessment period, CME was working on conforming rule changes for the OTC IRS service and has indicated to the Bank these changes are expected to be implemented in 2018.

During the assessment period the Bank commenced its review of CME's recovery plan against the CCP Standards and updated CPMI-IOSCO report on Recovery of financial market infrastructures (Recovery Guidance).^[7] However, during the review CME informed the Bank it was updating both the recovery and wind-down plans. As a result, the Bank expects to complete its review in the next assessment period subject to the updated plans being received. The Bank will therefore carry over this regulatory priority to the next assessment period.

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 began depositing house funds in its account at the Federal Reserve Bank of Chicago in November 2016; CME's account for customer cash collateral at the Federal Reserve became operational in March 2017. As a result, the size of CME's unsecured investments of cash collateral with non-government obligors declined sharply over the assessment period. At end December 2017, CME had US$4.8 billion invested on an unsecured basis with commercial banks, down from US$15.2 billion at end December 2016.

The concentration of these unsecured investments also fell during the assessment period. At end December 2017, 56 per cent of CME's unsecured cash investments were held with three counterparties, down from 74 per cent at end December 2016. During the assessment period CME added additional counterparties to invest with on an unsecured basis, and expects to add more over time. CME continues to deposit a small amount of Canadian dollars with the Bank of Canada.

The Bank is satisfied that, by using accounts at central banks and expanding the number of investment counterparties, CME has materially reduced the size and concentration of its unsecured investments with non-government obligors. As a result, the Bank has concluded that CME has fully addressed this regulatory priority, although it will continue to collect data on unsecured investments with a view to revisiting the issue in case of any material developments.

Liquidity risk

As indicated in the March 2017 Assessment, the CME Global Assurance team conducted an independent review of the LRMF during 2016.^[8] In April 2017, CME provided the Bank with a copy of this review, which concluded that CME's credit and liquidity risk management processes and controls were ‘adequate’, the highest possible rating. The review focused on internal processes and controls, and was not intended to address the full extent of a validation under CME's Model Validation Framework.

CME commissioned an external validation of its LRMF and at the end of the assessment period indicated to the Bank the validation report was close to being completed. CME advised the Bank that the report would include (i) a review of the completeness, appropriateness and regulatory compliance of the LRMF; and (ii) a qualitative assessment of the liquidity tool and its implementation (i.e. liquidity stress testing, liquidity stress-test scenarios and the liquidity dashboard). In addition, the Global Assurance team continued its internal auditing of CME's credit and liquidity risk management practices during the assessment period.

The Bank expects CME to share these validation reports once they are finalised, and engage with the Bank on the results during the next assessment period. The Bank will therefore carry over this regulatory priority to the next assessment period.

2018 Priorities and Supervisory Focus

As noted above, the Bank will carry over the regulatory priorities related to recovery and wind-down plans and liquidity risk. The Bank is not setting any additional regulatory priorities for CME for 2018. During the next assessment period the Bank expects to:

• complete its review of CME's updated recovery and wind-down plans
• review the results of the external validation of CME's LRMF.

In addition, the Bank will have a supervisory focus on monitoring how CME's practices align with recent guidance from CPMI-IOSCO in relation to resilience (discussed further below); such guidance is applicable to all CCPs, and the Bank expects Australian-licensed CCPs, including CME, to align their arrangements and practices with this guidance. The Bank also continues to expect CME to consider any implications of the CPMI-IOSCO Guidance on cyber resilience for financial market infrastructures for its operations.

In the event that CME has material direct Australian participation, or should there be a significant increase in CME's provision of services in Australian-related products, consistent with the expectations set out in the CFR Regulatory Influence Policy, the Bank will expect that CME should:

• ensure that Australian representation in governance arrangements appropriately reflects the scale and nature of Australian participation
• ensure that local market practices are appropriately accommodated
• ensure that there is appropriate representation of Australian membership and regulators in default management
• provide adequate operational support arrangements to Australian participants, particularly during Australian market hours.

Other Regulatory Developments

CPMI-IOSCO implementation monitoring

In August 2016, 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.^[9] This review covered 10 CCPs internationally that provide clearing services for derivatives, including CME.

Over the assessment period the Bank participated in a CPMI and IOSCO follow-up review of CCPs' progress in addressing the most serious issues of concern identified in the August 2016 report. The Bank expects to discuss the findings of the follow-up review with CME in the next assessment period.

CCP resilience and recovery guidance

In light of the increasing systemic importance of CCPs, in 2015 a number of international standard-setting bodies developed a joint workplan to further enhance the effectiveness of CCP resilience, recovery and resolution. As part of this work plan, in July 2017, CPMI and IOSCO published Resilience of central counterparties (CCPs): Further guidance on the PFMI (Resilience Guidance) and updated guidance on Recovery of financial market infrastructures.^[10]

The Resilience Guidance provides further details on certain principles and key considerations in the PFMI, in order to improve the resilience of CCPs. The guidance focuses on five key aspects of a CCP's financial risk management framework: governance; stress testing for both credit and liquidity exposures; coverage of financial resources; margin; and a CCP's contribution to its pre-funded resources.

The revised Recovery Guidance provides additional clarifications in four areas of recovery planning: operationalisation of the recovery plan; replenishment; non-default-related losses; and transparency with respect to recovery tools and how they work.

During the assessment period, the Bank formally adopted both the Resilience Guidance and the revised Recovery Guidance in interpreting the relevant CCP Standards. The Bank therefore expects CME to consider the implications of this guidance for its financial risk management and recovery planning.

Footnotes

During the assessment period CME made several changes to its product and service offerings that were not directly related to the products it is licensed to clear in Australia. These changes included, among others, announcing the exit from its CDS clearing service in 2018, closing its European clearing house CME Clearing Europe Limited and launching bitcoin futures contracts in December 2017. [1]

A copy of the licence is available at <http://download.asic.gov.au/media/2018403/cme-cs-facility-licence-signed-30-september-2014.pdf>. [2]

See RBA (2017), ‘Assessment of Chicago Mercantile Exchange Inc.’, March. Available at <https://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/assessments/chicago-mercantile-exchange/2017/pdf/cme-assessment-2017-03.pdf>. [3]

See RBA (2014), ‘Initial Assessment of Chicago Mercantile Exchange Inc. against the Financial Stability Standards for Central Counterparties’, September. Available at <https://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/assessments/chicago-mercantile-exchange/2014/pdf/cme-assess-2014-09.pdf>. [4]

The CFR Regulatory Influence Policy sets out a graduated framework that imposes additional requirements on cross-border facilities proportional to the facility's activities in the Australian financial system. Available at <https://treasury.gov.au/publication/ensuring-appropriate-influence-for-australian-regulators-over-cs-facilities/>. [5]

See RBA (2016), ‘2014/15 Assessment of Chicago Mercantile Exchange Inc.’, March. 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>. [6]

See CPMI-IOSCO (2017), ‘Recovery of financial market infrastructures’, July. Available at <http://www.bis.org/cpmi/publ/d162.pdf>. [7]

The review covered processes and controls relating to credit and liquidity risk management. [8]

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>. [9]

See CPMI-IOSCO (2017), ‘Resilience of central counterparties (CCPs): Further guidance on the PFMI’, July. Available at <https://www.bis.org/cpmi/publ/d163.pdf>. [10]