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Risk Management & Clearing FIA Asia Derivatives Conference: August 11, 2005 Nick Bolton, Director Asia-Pacfic
© Chicago Mercantile Exchange Inc. All rights reserved. 2 Agenda Clearing – Best Practices and the necessary framework to attract and protect Customers Power of Clearing Risk Management Essentials Legal Transparency Bankruptcy Law Customer Protections Membership Standards Applying Best Practices – CME example
© Chicago Mercantile Exchange Inc. All rights reserved. 3 The Power of Clearing Buyer Seller Buyer Seller Exchange matches buyers and sellers The Clearing House consummates transactions with both sides Clearing House performs novation/substitution, and becomes seller to buyer and buyer to seller Buyer and seller are guaranteed performance by the Clearing House Buyer and seller no longer have credit exposure to one another Price is the sole differentiator Parties can closeout transactions with whomever provides the best price since the Clearing House is the central counterparty Market Served by a Central Clearing House: CME Clearing House
© Chicago Mercantile Exchange Inc. All rights reserved. 4 Successful CCP Essentials Legal environment protecting sanctity of contracts and facilitating multi-lateral netting Bankruptcy environment that provides protections for the clearing house in the default of a participant Unfettered access to performance bond collateral with simultaneous possession and control Customer protection mechanisms (CFTC regulation requires customer segregation of positions from proprietary) Ability to establish membership standards and availability of transparent information formed about clearing house participants to facilitate ongoing surveillance Sufficient liquid capital resources to back the clearing house guarantee Default Procedures and Extraordinary Powers
© Chicago Mercantile Exchange Inc. All rights reserved. 5 Legal Transparency Laws & Regulations Rules are easily accessible to the public Clarity of rules, procedures, and contractual provisions for participants Detailed overview of default procedures Precedence of Clearing Rules Over Insolvency Laws Otherwise applicable bankruptcy automatic freeze of debtor collateral does not apply to a commodity broker (clearing organization) Cross-border Participation Rules support cross-border arrangements while maintaining adequate protections
© Chicago Mercantile Exchange Inc. All rights reserved. 6 Bankruptcy Law Protections U.S. Bankruptcy Code and CFTC regulations contain a number of provisions that provide preferential treatment to a clearing member’s public customers and to the Clearing House. For Example: A trustee may not void pre-bankruptcy payments of original performance bond or settlement variation made to the Clearing House The filing of a bankruptcy petition will not stay a setoff by the Clearing House of claims for original performance bond or settlement variation payments owed by a clearing member against cash, securities or other property of a clearing member that the Clearing House holds Neither a clearing member’s bankruptcy nor any order of a bankruptcy court can prevent the Clearing House from exercising any contractual right it has to liquidate a commodity contract
© Chicago Mercantile Exchange Inc. All rights reserved. 7 Customer Protection Futures market customers face credit risk in doing business through any particular clearing member. A default by a customer of a clearing firm may harm non-involved customers. Generally, CME’s role in the customer protection process is to require all customers to post adequate performance bonds, to administer financial surveillance programs designed to monitor the financial viability of clearing members and, when necessary, to impose specific remedies in an effort to avert the consequences of financial deterioration. CME, provides a second tier of protection in the form of the CME Trust, which contains $60.9 million in net assets as June 30, 2004.
© Chicago Mercantile Exchange Inc. All rights reserved. 8 Membership Standards Established requirements for participants’ financial resources and creditworthiness Size of firm Clearing for indirect participants Products cleared Operational Capability Arrangements to meet payment obligations Risk management policies Internal audit of risk controls and IT systems Ability of clearing house to monitor and enforce standards by reviewing validity of member financial disclosures and credibility
© Chicago Mercantile Exchange Inc. All rights reserved. 9 Applying best practices – CME example CME Clearing Business Profile Risk Management Structure Active Clearing Member Requirements Audits Functions Daily Risk Management- SPAN® Performance Bond Collateral Protections & Extraordinary Powers Default Procedures
© Chicago Mercantile Exchange Inc. All rights reserved. 10 CME Clearing Business Profile Matches and guarantees every matched trade as the buyer to the seller and the seller to the buyer (unlike cash or OTC transactions, where counterparties maintain counterparty risk with each another) The only direct counterparties to CME Clearing are its clearing members Manages over $40 billion in performance bond collateral and a security deposit of $1 billion Moves approximately $1.5 billion in variation settlements daily Average daily volume for July ’05 of 3.7 million contracts with open interest of over 30 million contracts Establishes minimum performance bond parameters Manages risk by monitoring exposure and collateral CME meets and exceeds IOSCO recommendations for central counterparties (www.iosco.org/library/pubdocs/pdf/IOSCOPD176.pdf)
© Chicago Mercantile Exchange Inc. All rights reserved. 11 CME Clearing Business Profile 1Q 03 2Q 03 3Q 03 4Q 03 1Q Q 04 3Q 04 NOTE: Based on futures and options on futures Excludes individual equity options 4Q 04 1Q 05 ADV (round turns, in millions) Eurex - CME - CBOT - E uronext. liffe 2Q 05
© Chicago Mercantile Exchange Inc. All rights reserved. 12 CME Risk Management Structure Membership standards Capital Requirements Security Deposit Equity Guarantees Risk Management Mark-to-Market Monitoring & Stress Testing Performance bond- CME SPAN ® Collateral Requirements Default Customer or Proprietary Account Default Line of Credit Unsatisfied Obligations Financial Resources Available to Cure a Default Protections & Extraordinary Powers Bankruptcy Law Protections Customer Protections
© Chicago Mercantile Exchange Inc. All rights reserved. 13 Active Clearing Member Firm Requirements Adjusted Net Capital of: Minimum capital requirement of $2.5 Million or 8% of customer and 4% of non-customer (excluding proprietary) risk maintenance performance bond requirements or CFTC or SEC minimum regulatory capital requirements Risk Committee routinely reviews capital requirement levels Additional Current Requirements Minimum security deposit of $500,000, determined by participant’s percentage of overall volume and open interest Parent Guarantee for any person or entity which Owns of 5% or more of a the clearing member Owners of 50% or more must guarantee 100% of house obligations
© Chicago Mercantile Exchange Inc. All rights reserved. 14 Audits Functions Division Operates a sophisticated financial surveillance program Performs direct audit surveillance for 31 active CME clearing member firms and performs financial surveillance on the remaining 57 non-actively clearing firms Assures compliance with all regulatory financial and capital requirements as well as clearing fee policies Submission and review of monthly and annual financial statements Annual financial/operational review If a clearing member fails to maintain financial requirements the Audits department can recommend suspension or termination
© Chicago Mercantile Exchange Inc. All rights reserved. 15 Audits Functions Risk Reviews Clearing House and Audit Staff performs periodic ‘Risk Audits’ on each clearing firm Ensures the firm’s risk policies, procedures, systems and capabilities are appropriate for their scope and scale of business Topics covered include credit review of accounts, risk monitoring of accounts, operational risk management, and liquidity risk management The review may result in recommended changes and improvements if any deficiencies are found Biennial reviews of risk management practices, more frequent if warranted Audits every nine to fifteen months, dependent on the results of a risk-based evaluation
© Chicago Mercantile Exchange Inc. All rights reserved. 16 Daily Risk Management Mark-to--Market twice daily Facilitates daily payments between buyers and sellers for changes in value of futures contracts Ensures that market losses do not accumulate to greater than one day’s market move Settlement Banks All clearing members must have accounts with an approved bank and with debit authority granted Shifts credit risk from clearing members to banks twice daily Performance Bonds Posted by market participants to ensure sufficient collateral to cover the maximum likely one day loss on a portfolio Recalculated and collected twice daily Proprietary method CME SPAN® is to calculate Performance Bond requirements
© Chicago Mercantile Exchange Inc. All rights reserved. 17 Daily Risk Management (Continued) Intra-day Monitoring Current position and price evaluations are conducted throughout the day to estimate profit and losses on clearing level positions Exception reports highlight changes in risk profile and exceptionally large variation payments The Clearing House Risk Management Department receives real-time positions and pricing Stress Testing All clearing level portfolios are subject to many stress-testing scenarios to evaluate cash flow implications on a daily basis Client reportable account level are also subject to stress tests on a basis Ad Hoc stress testing is performed as needed
© Chicago Mercantile Exchange Inc. All rights reserved. 18 Risk Management: Collateral Requirements Exposure & Collection of Collateral Ability to impose higher collateral requirements on high-risk participants CME monitors firm exposures hourly and collects collateral twice daily Daily revaluation of collateral assets Potential Price Movements Measured over one day time interval, the time period needed to close most positions in the event of default Additional “ concentration” margin applied for participants with high exposure levels relative to capital resources Coverage of collateral requirements is at least 95% of price changes over a one day period, determined by historical volatility and value at risk models
© Chicago Mercantile Exchange Inc. All rights reserved. 19 CME SPAN ® Standard Portfolio Analysis of Risk ® Developed in 1988 by Chicago Mercantile Exchange Inc. to effectively assess risk on an overall portfolio basis. CME SPAN is a market simulation based Value At Risk system which has been reviewed and approved by market regulators and participants world wide. CME SPAN is the official Performance Bond (Margin) mechanism of 50 exchanges and clearing organizations world-wide, making it the global standard for portfolio margining. CME SPAN’s Risk Based margin requirements allows for effective margin coverage while preserving efficient use of capital. CME SPAN assesses risk for a wide variety of financial instruments including: futures, options, physicals, equities, bonds or any combination there of.
© Chicago Mercantile Exchange Inc. All rights reserved. 20 CME SPAN ® SPAN answers the question: “With a given set of risk parameters, what is the maximum that a given portfolio is likely to lose?” For example, CME Clearing sets its parameters to cover at least a 95% confidence interval over a one day time horizon Used in conjunction with twice daily mark-to- market, gives CME Clearing and its clearing members strong tools to prevent clearing losses The margin-setting authority has total control over the margin parameters or degree of margin coverage.
© Chicago Mercantile Exchange Inc. All rights reserved. 21 EUROPE London International Financial Futures and Options Exchange (LIFFE) International Petroleum Exchange (IPE) London Metals Exchange (LME) London Clearing House (LCH) Euronext Paris – (Paris Bourse) (SBF); including SBF, MATIF and MONEP Markets Euronext Paris – Clearnet SA EUREX Clearing AG – EUREX KDPW (Polish Clearing Organization) Budapesti Arutozsde (Budapest Commodities Exchange) Budapesti Ertektoszde (Budapest Stock Exchange) KELLER (Hungarian Clearing Organization for Derivatives and Securities) Norsk Opsjonssentral As (NOS) Nordpool Clearing ASA OCEANIA Sydney Futures Exchange, Ltd. Sydney Futures Exchange Clearing House Pty. Limited New Zealand Futures and Options Exchange INDIA Bombay Stock Exchange and Bombay Stock Exchange Clearing House National Stock Exchange of India, Ltd. And National Securities Clearing Corporations, Ltd. Multi Commodity Exchange, India CME SPAN –GLOBAL STANDARD USA Chicago Mercantile Exchange, Inc. (CME) BrokerTec Chicago Board of Trade (CBOT) Mid-America Commodity Exchange (MIDAM) The Clearing Corporation (TCC) Kansas City Board of Trade (KCBOT) and Kansas City Board of Trade Clearing Corporation Minneapolis Grain Exchange (MGE) New York Board of Trade (NYBOT) and New York Clearing Corporation (NYCC) New York Mercantile Exchange (NYMEX) including the Commodity Exchange (COMEX) Division One Chicago Nasdaq-Liffe (NQLX) EUREX US (U.S. Futures Exchange) Chicago Board Options Exchange (CBOE) Chicago Climate Exchange CANADA Canadian Derivatives Clearing Corporation Winnipeg Commodity Exchange ASIA Shanghai Futures Ex change (SHFE) Hong Kong Futures Exchange and Hong Kong Futures Exchange (HKFE) Clearing Co. Osaka Securities Exchange (OSE) The Tokyo International Financial Futures Exchange (TIFFE) Tokyo Stock Exchange (TSE) TAIFEX Singapore Exchange (SGX, formerly SIMEX) SPAN Licensed Exchanges And Clearing Organizations
© Chicago Mercantile Exchange Inc. All rights reserved. 22 Protections & Extraordinary Powers Position Limits Additional Margin Additional Capital Calls Credit Control Policy Force liquidation or transfer of positions Right to assess clearing members for any unsatisfied obligations in the event of default
© Chicago Mercantile Exchange Inc. All rights reserved. 23 Default Procedures Attempt to transfer non-involved customer positions and monies to another clearing member (For a proprietary default, all customer positions and monies would be transferred) Take control of or liquidate involved customer positions and house positions (only house positions in the case of proprietary) Apply the clearing member’s security deposit and house performance bond deposits to the failed obligation Attach all other assets of the clearing member that are available to the Exchange (e.g., shares and membership interests) Invoke the parent guarantee (Proprietary) Note: Customer assets (positions and/or monies) on deposit with or in the control of the Clearing House may not be used or impaired by the Clearing House in the case of a clearing member default resulting from house account activity.
© Chicago Mercantile Exchange Inc. All rights reserved. 24 Available Financial Resources in the Case of Default Tier 1 Resources of the Defaulting Firm(s) Aggregate Performance Bond Deposits = $44.3 Billion Market Value of Pledged Shares = $870 Million Tier 2 Temporary Liquidity Facility = $750 Million Tier 3 CME Capital Contribution Surplus Funds = $60 Million Tier 4 Risk Capital Contribution Security Deposit = $1.07 Billion Tier 5 Contingent Risk Capital Assessment Powers $2.94 Billion Total Financial Safeguards Package = over $4 Billion
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