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European Central Bank Establishment of CCP(s) for Credit Default Swaps
July 9, 2009
Extending Security to OTC Markets Through Open Clearing Solutions
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Open Clearing Solution for Credit Markets
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Definition/Criteria
Central Counterparty Clearing
• Global use of central counterparty processing and clearing to significantly reduce counterparty credit risk and outstanding net notional positions
Portfolio Compression • Continued elimination of economically redundant trades through trade compression
Electronic Processing • Electronic processing of eligible trades to enhance T+0 confirmation issuance and execution
Elimination of Material Confirmation Backlogs • Elimination of material confirmation backlogs
Life Cycle Event Processing
• Streamlined trade life cycle management to process events (e.g. Credit Events, Succession Events) between upstream trading and confirmation platforms and downstream settlement and clearing systems
Risk Mitigation Through Affirmation • Risk mitigation for paper trades
Central Cash Flow Settlement • Central settlement for eligible transactions to reduce manual payment processing and reconciliation
Operationally ready
Operationally ready
Operationally ready
Operationally ready
Operationally ready
Operationally ready
Operationally ready
OverviewCME Clearing and Participants Align to Industry Commitments by Delivering a Strategic Vision Forward
CME Clearing/CMDX
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European Regulatory/Industry Approval Status• FSA review of ROCH to clear CDS - pending • Seeking RCH status• Pending approval, CME RCH intends to initially clear CDS
Once clearing CDS, will seek permission to clear additional asset classes through CME RCH
US Regulatory/Industry Approval Status• Petitioned CFTC for an order permitting customer funds used to margin, secure or guarantee
CDS to be held in CEA Section 4d segregated customer accountsPending the 4d order, customer funds will be held in separate accounts in accordance with CFTC Reg 30.7
• Received special exemption from SEC to clear CDS through CME Clearing• Licensed Markit credit default swap indices and Markit RED identifiers• Licensed ISDA credit definitions, and will follow ISDA declaration/settlement processes• Will clear CDS using combined guaranty fund• Completed Fed, SEC and CFTC risk management reviews
Open Clearing CDS Solution Overview Collaboration with Regulatory Authorities and Industry Organizations
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OverviewCME’s Open Clearing Credit Default Swap (CDS) Solution
Streamlines processing, centralizes market information and reduces operational risk by:• Processing trades real-time, throughout the day, every day• Confirming trade events as close as possible to the point of trade execution• Daily compression of portfolios• Managing the full trade lifecycle• Using straight-through-processing and industry standard protocols
Approach to legal and regulatory treatment of CDS products follows a well-established construct, taking into account the interests of all market participants, and including a time tested customer segregation regime
Standardized contract terms that are consistent with ISDA OTC templates, adhere to the determinations made by ISDA, and ensure submission to the ISDA auction process
Daily migrations of legacy contracts whether held in the DTCC TIW or an existing paper trade
Transparent and replicable multi-factor portfolio margining model
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Day 1 Product OfferingCovering Up to 75% of the Volume in the Corporate CDS Market
CDX IG, HVOL, and HY Indices• 3, 5, 7 and 10 year tenors
• Current and Previous 3 off-the-run series
iTraxx Europe, HVOL and XO• 3, 5, 7 and 10 year tenors
• Current and Previous 3 off-the-run series
iTraxx Financial Senior and Financial Subordinate• 5 and 10 year tenors
• Current and Previous 3 off-the-run series
Single Name constituents of the CDX and iTraxx indices (over 500 reference entities)• Standardized fixed coupons of 100 bps and 500 bps so that the risk profiles of the cleared contract match
those of existing OTC contracts
• Quarterly maturities (IMM) up to 10 years
Forthcoming product offerings (e.g. sovereigns, tranches, additional indices, additional single names) will be based on recommendations of the Product Advisory Board
Most Comprehensive Day 1 Product Offering
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CDS: Day 1 Product OfferingOverview of Contract Comparison
Bilateral Contracts Today
Bilateral Contractsafter April 2009* CME Cleared Contracts
Credit event determination
• Either counterparty can submit credit event notice
• Notices handled on bilateral basis
• ISDA will hardwire credit event determinations
• Will adhere to ISDA determinations
Cash settlement for non-Restructuring credit events
• Settlement process is bilateral
• Market participants typically adhere to ISDA auction protocol and settle based on auction final price
• Cash settlement hardwired based on ISDA auction
• Will adhere to ISDA cash settlement processes
Physical settlement for non-restructuring credit events
• Settlement process is bilateral
• Market participants typically adhere to ISDA auction protocol and settle based on auction final price
• ISDA auction protocol hardwired into contracts
• Participants will have right to take part in the auction
• Physical settlement is an option through the ISDA auction
* Expected date for ISDA amendment incorporating the ISDA Credit Derivatives Determination Committee
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CDS: Day 1 Product Offering cont’dOverview of Contract Comparison
Bilateral Contracts Today
Bilateral Contractsafter April 2009* CME Cleared Contracts
Succession event determination
• Determined bilaterally; however counterparties generally adhere to advise of ISDA and market
• ISDA will hardwire Succession event determinations
• Will adhere to ISDA determinations
Calculation agent • Bilaterally agreed upon • Bilaterally agreed upon • CME Clearing
Restructuring • ISDA declaration stipulates whether restructuring has occurred
• When restructuring occurs and a protocol is decided, ISDA puts positions in tenor buckets and holds auctions
• Same as today • Will adhere to ISDA determinations
• In case of small bang in Europe, will adhere to auction settlement
• In case of small bang in N. America, will adhere to same settlement process as defined by ISDA
* Expected date for ISDA amendment incorporating the ISDA Credit Derivatives Determination Committee
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Temporary Liquidity Facility
CME Capital Contribution
• European CDS, pending approval, will have separate financial safeguards
• CME Group capital contribution• Customer capital contribution – fluctuating based
on number/portfolios of participants• Designed to anticipate potential market exposures,
ensure sufficient resources available to cover future obligations
• Multi-factor portfolio margining model designed to efficiently, transparently assess risk
• Thoroughly tested, even in volatile periods and with toxic portfolios
• Total margin: sum required to cover individual shocks to each of the 7 factors (and subject to a minimum total portfolio margin requirement)
• Macro-economic credit risks: • Systematic, curve, and spread
convergence/divergence risk• Sector-level risk• Idiosyncratic risk• Liquidity risk• Basis risk
Risk Management – Financial Safeguards
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Net Benefits of CCP
Bilateral
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Firm A Customer A
Same Trade with CME CCP
Firm A Customer ACME FCM
Principal Principal
• Principal to principal transaction• Non-zero risk weight based on
counterparty, collateral and maturity
• Principal to CCP transaction + Zero risk weight due to qualified CCP status - Fees incurred for the CCP service
• FCMs clear customer business as Agent- Additional capital requirements to
carry customer business+ Ability to charge fees to clear
customer business+ Potential to make spread on deposits
NET BENEFIT NET BENEFIT
Principal Principal Agent Principal
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We Offer an Open Clearing Model
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OTC Domain Clearing Domain
Clearing Member Firm
Clearing Member Firm
Clearing Member Firm
Clearing Member Firm
OTC CUSTOMER
OTC DEALER
OTC Confirmation ServiceElectronic or Manual
Matching : Affirmation : Confirmation
CMEClearing
CMEClearing
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• Independent of execution
• Security from significant mitigation of counterparty risk
• Certainty of independent, neutral settlement prices
• Efficiencies for capital and operations
• Complementary to existing OTC trade execution systems
• 100+ years of risk management experience and financial safeguards
CME: Expanding Across Asset Classes
Flexible clearing services open to all OTC market participants
Commodities(Energy & Ags)
Credit FX Interest Rates
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Risk Management OverviewDefault Management
For more information on Financial Safeguards, please visit http://www.cmegroup.com/clearing/files/financialsafeguards.pdf
CME Clearing will facilitate an orderly liquidation and protect its clearing members in the event of a clearing member default
CME Clearing
Clearing Member
Buy-side Firm
Pre-Default Position
• Provides transparent and consistent daily margining
• Daily Multi-lateral position netting• Provides financial safeguards• Improve market oversight and risk
management through required disclosure of position related information
• Provides access to CME Clearing• Collects margin and processes mark to market
from customers in accordance with CME Clearing’s policies & other applicable regulatory requirements
• Customer margin requirements held in segregated account
• Collateral protected through segregated accounts
• Positions protected under clearing member default
• Margins are calculated on a net portfolio basis
Defaulting members positions• Market access is restricted• Collateral is captured• Portfolios are smoothly liquidated, in part due to liquidity on
the trading facilityCustomer protection• Collateral is held in a segregated account • Positions are maintained and moved to a new clearing
member
Event of a Clearing Member Default
CME Clearing
New Clearing Member
Buy-side Firm
Defaulting Clearing Member
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If a clearing member were unable to meet its financial obligations to CME Clearing and a default occurred, CME Clearing may act immediately to:
In Over a Century, CME Clearing has Never Defaulted on Its Obligations, and No Party has Ever Defaulted to CME Clearing
For more information on Financial Safeguards, please visit http://www.cmegroup.com/clearing/files/financialsafeguards.pdf
Attempt to transfer all segregated customer positions and moniesto another clearing member
Take control of or liquidate the positions in the proprietary account of the clearing member
Apply the clearing member’s aggregate performance bond deposit to the failed obligation
Attach all other assets of the clearing member that are available to the Exchange (e.g., market value of pledged shares and memberships)
Invoke any applicable parent guarantee of the clearing member
Chicago Mercantile Exchange Inc., a wholly owned subsidiary of CME Group, would next apply its surplus funds (CME capital contribution) and the risk capital contribution security deposits of the clearing members
If the default continued to remain unsatisfied after CME’s capital contribution and aggregate risk capital contribution security deposits were applied, CME Clearing would then invoke its right to assess clearing members for any unsatisfied obligations
Attempt to transfer non-involved customer positions and monies to another clearing member
Take control of or liquidate positions of customer in default, and proprietary positions of clearing member if necessary
DEFAULT OF CLEARING MEMBER PROPRIETARY ACCOUNT DEFAULT OF CUSTOMER ACCOUNT
Should the defaulting clearing member’s obligation not be fully satisfied
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Clearing Firm Participation StandardsRequirements Vary By Type of Participant
CURRENT CLEARING MEMBER CLEARING CDS
NEW CLEARING MEMBER FOR CDS ONLY
NON-CLEARING MEMBER PARTICIPANTS
• Clearing Members with Adjusted Net Capital (ANC) of $300M face minimal additional requirements
• Verification of existing business, financial, and operational capabilities to support CDS market activity
• Additional security deposit may be required to reflect CDS book of business
• Minimum Tier One capital or ANC of $300M
• Minimum membership requirement deposit of $5M
• $7.5M minimum to clear one CDS contract
• Verification of existing business and operational capabilities to meet CDS clearing member requirements
• Non-Clearing Members required to transact through a CME Clearing Member
• Account administration and verification performed by chosen firm
• Existing Prime Broker may have futures affiliate that is a CME Clearing Member
• Financial health via submission of certified and/or regulatory financial filings • Disciplinary history including verification with other exchanges where the firm is a member • Credit reviews through a credit check • Ability to submit end of day CDS curves and participate in the event of a default
ADDITIONAL SCREENING MAY INCLUDE
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Executive Summary: Reporting Metrics
CME has been working with the CDS industry and the Regulators to design: (1) consistent reporting metrics as well as (2) an efficient and secure reporting process
CDS Reporting Metrics• Reporting metrics should incorporate “base concepts” of open interest, trade volume, and mark-to-
market flow• CME’s platform supports a wide range of reporting metrics, and CME can provide those metrics at the
detailed product level or in a variety of aggregated forms• CFTC identification of accounts; “Form 102”; identity of position holder and position
CDS Reporting Process• CME contemplates at least three potential processes for regulatory reporting
(1) Directly to Regulators(2) Through a 3rd-party data aggregator(3) Through DTCC’s TIW
• CME is willing and able to report through any combinations of these methods – our objective is to meet the needs of the market participants and the Regulators
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CDS Reporting MetricsCME is experienced at working with the industry to report the necessary metrics and summary statistics to Regulators
Open interest
Mark-to-market
Description
Potential reporting metrics
For CCPs: Net notional outstanding (one-sided) facing the clearing house on the reporting dateFor TIW: Gross and net notional amount of all contracts legally confirmed and outstanding on the reporting date
For CCPs: Gross pays and collects within clearing firms, net pay or collect to/from CCPNet mark-to-market transferred between CME and clearing members/customersData provided in detail for a variety of aggregated forms (see right)
Potential summary statistics
1) Counterparty type – Dealer/clearing member, buy-side firm/customer
2) Product or product type –Corporate single name, corporate index, sovereign
3) Product risk –Investment grade, high yield
4) Sector –Basic material, consumer goods, financials, etc.
5) Time to maturity –1 year, 3 year, 5 year, 7 year, 10 year
VolumeFor CCPs: New trades confirmed directly by a CCP, including volume that establishes new exposures and volume that offsets existing exposuresFor TIW: New OTC bilateral trades confirmed in TIW and either marked for clearing or not
CME can provide Regulators with detailed product-level data, OR data in aggregated form. For example, data could be aggregated by:
Key factor for successful reporting – Collaboration across all parties to ensure consistency in reporting metrics and level of data reported to Regulators by each CCP and the TIW
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Executive Summary: Interoperability
Interoperability Overview:• Basic models with one CCP a “member “ of the other or interoperate on equal basis:
Potential issues as to whether “member” CCP is fully collateralized for purposes of its users’regulators for their capital calculation requirementsCompetition concerns versus “member” CCP and regular membersQuestions of relevant jurisdictionLack of international standards for inter-CCP risk managementNeed for inter-CCP collateralization model versus regular member modelFees
• Alternative models with more flexibility: “sub-CCP” models in which one CCP is the “lead CCP” of a group of CCPs
• Jurisdiction: Determined by lead CCP or jurisdiction is negotiated amongst group• Risk Management: CCP sets rules or “sub-CCPs” retain some autonomy• Defaults Management: “sub-CCPs” governed by lead CCP provisions or each CCP governed
by independent provisions• Regulatory reporting: maintained by lead CCP or each CCP maintains independently with a net
inter-CCP balance• Trade flow: Direct to lead CCP, allocated to “sub-CCPs” or trades flow directly to each CCP
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Executive Summary: Interoperability
Interoperability Concerns• Product Approval Process• Fungibility : Feasibility of all CCPs being required to clear all products cleared by other CCPs• Competition: Disincentives for product design and new services• Risk Management Standards: membership requirements, bankruptcy jurisdiction, default pools,
margin methodology, collateral rules, CCP credit exposures to one another• Logistics of coordinating disparate clearing cycle timings and building clearing system interfaces• Intraday – Coordinating between CCPs that have and do not have intra-day settlement cycles
and handling super-intra day calls (ad-hoc ITDs)
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Kim ECBJuly 8, 2009
Extending Security to OTC Markets Through Open Clearing Solutions