While this is a very sound argument, I think it is, first, off-base and second, dangerous.
Here’s why it’s off-base. We believe the idea that OTC clearing would be a multi-billion dollar opportunity is overstated. Given that the swaps market, like any other market, will be dominated by a select number of major players, which may or may not be the same large global banks of today, we can expect that these dealers and heavy users will have significant influence over where they trade and how their trades are going to be cleared.
The less expensive the clearing, the greater the incentive will be to migrate clearing to that cost-effective venue – clearing competition. Given that clearing has been traditionally paid for by market participants and will be volume-weighted with the largest participants paying the most to the clearinghouse, the largest participants will have a significant incentive to pressure clearing firms to reduce fees to an “affordable” rate.
While this may mean that total clearing revenues may be measured in the billions, we think that it will most likely be in the low billions, $1 or $2 at most. Given that the ICE made $655 million from clearing CDS in 2009 – and we estimate that this is greater than the revenues from interest rate swap clearing – we believe that the market is currently at most $1 billion.
We also believe that increased competition and a reduction in dealer profitability from an OTC migration to SEF/exchange-traded will not allow the profitability of swaps to be compromised by dramatically increasing the cost of clearing on a macro basis.
At TABB Group, we cannot see this amount increasing dramatically, even with a clearing mandate. Eventually, this cost needs to be paid by the largest users, who are not unsophisticated and will easily see their pockets being picked by a clearing firm, ready to rebel if they feel abused.
The other major problem is risk. Clearinghouses are set up to mutualize risk, which means if one player defaults and their margin and default fund contributions do not cover their loss, the loss must be shared with other clearinghouse members. The larger the participants, the greater positions, the more significant the risk, the greater the margin and the default fund contributions. This is why clearinghouses such as LCH Clearnet and ICE have Tier I capital mandates of $5 billion. That way, if the market tanks and a major dealer goes under, the clearinghouse margin and capital, backstopped by the other dealers, will have the financial wherewithal to withstand the crisis.
Reducing the amount of capital needed to become a member to $50 million from $5 billion means that there will be a larger number of smaller players. Although these players may be financially more stable than the larger banks, they will be by definition smaller. With a greater number of smaller players, there will be more dealers to supervise, regulate and financially monitor to ensure their safety. If these dealers are not adequately capitalized, the larger dealers will be financially guaranteeing the smaller ones, as larger dealers, given that the risk is not concentrated, can bail out smaller dealers. But it would be difficult, if not impossible, for smaller players to bail out the larger dealers.
In addition, now with a mandated Federal Reserve/Central Bank guarantee, clearinghouses will be able to tap central bank liquidity in case of an emergency. If a clearinghouse got into financial trouble, it could go to the central bank for a loan, leaving the government (and taxpayers) as the central guarantor of the clearinghouse.
Putting this all together, the migration from OTC to centrally cleared/SEF (exchange-traded) swaps will reduce the profitability of large dealers who will look to pressure clearing houses to reduce their fees.
Responding to cost pressures, the clearinghouses will open themselves up to a larger number of smaller participants, who may or may not be financially stable, and compete over the lowest fees, margin and default fund contributions.
This will make the clearinghouse less safe and more likely to get into financial trouble. When they do experience trouble, they will have fewer resources (lower margin and default fund contributions) available to bail themselves out. As the default funds are used to offset the loss, the losses must be taken as a financial loss, which could jeopardize the health of the smaller dealers. As these dealers default, it would increase the burden on the remaining dealers who agreed to mutually share the clearing risk.
This could spiral easily until the largest dealers would not need to bail out only the initial defaulters, but the entire market.
Who picks up the bill? The Federal Reserve/Central Bank (taxpayers), who now backstop this whole mess.
Unless we want clearinghouses to become a systematically important risk magnifier, we need to be careful who we let into the clearing club; make sure they are financially healthy; ensure they have the deep pockets to withstand not only a self-created crushing loss, but a systematic (multi-dealer) crushing loss; and make sure that the clearinghouses do not have a mandated Federal Reserve/Central Bank/taxpayer implicit or explicit guarantee.
Otherwise we are creating a race to the bottom that incentivizes firms to take risks, clearinghouses to magnify those risks and governments (taxpayers) to pick up the bill.
In other words, when you are dealing with OTC derivatives turnover measured in the thousands of trillions of dollars (quadrillions), any systemic problem will make the credit crisis look like a walk in the park.
OTC Derivatives Reform (
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26 Comments to "Cutting OTC Derivatives Clearing Capital Requirements: Making the Credit Crisis Look like a Walk in the Park":
gbollenbacher
27 December 2010
One of the functions of central counterparties ("CCPs") has always been to margin positionholders during the life of a commitment. This serves to keep overall risk under control, and to prevent the kind of implosion of the market that Larry talks about. Certainly, to run a derivatives CCP without strict margin requirements would be to invite financial disaster, but I didn't think that was the plan. Of course, margining derivatives positions might be a little more complicated than margining futures or options positions, but all those smart people in the derivatives market can come up with a way, I'm sure. If they can't, they shouldn't be trading such huge volumes, don't you think?
Comments (48)
prowady
28 December 2010
we are in the early innings of a very long game. major transformation of the OTC derivative biz will go on for several years. therefore, it is important in these formative stages to move carefully. High capital requirements are critical to this. However, I expect that as central clearing of OTCDs becomes more commonplace and better understood, there will be a much better argument for reducing capital requirements - perhaps not to $50m but maybe to $1b, as the next notch on the belt...
Comments (77)
jonjacobs
29 December 2010
I just checked the CFTC site and the proposed rule restricting clearing members' capital requirement has not yet been published in the Federal Register. I wonder why? It's been 13 days since they voted to publish it, and other rules discussed at the same Dec. 16 meeting (including one related to DCOs) have since been published. Three further observations: 1.ICE Trust U.S. has withdrawn its application for DCO status, apparently in response to this proposed rule (see http://www.cftc.gov/PressRoom/PressReleases/pr5959-10.html). 2.The Dec. 11 NY Times hatchet-job by Louise Story, which I think already sparked a response here on the Forum, loomed large in the CFTC's deliberations on DCO minimum capital rule. I know because I listened to the entire meeting. The following exchange between Chairman Gensler (who mentioned the article several times) and a staffer made me smile. Gensler: You read the New York Times piece too? Staffer: Of course. Gensler: It was not mandatory. 3.To be sure, the rule as discussed at the meeting (though I haven't seen the actual text, which apparently hasn't been published yet) would allow a DCO some leeway to control its membership. For instance, a CFTC staffer said a DCO could reject an applicant if it could demonstrate operational risk or deficiencies that would prevent the applicant from fulfilling the responsibilities of a clearing member. And Gensler said although a DCO could not "exclude" an applicant because their capital fell below some threshold greater than $50 million, the rule would permit a DCO to “scale” the members -- limit their positions based on their capital.
Comments (16)
kmcpartland
03 January 2011
Jon you raise very good points. We saw what seems to be a similar situation with the SEF rules - an early proposal was "leaked", the industry (us included) fired back, and the rules were ultimately adjusted to be more realistic. I assume we'll see the same thing here. We do not want regulators telling clearinghouses how to manage their risk. Regulators write and enforce rules, they are not risk managers.
Comments (80)
yiannis
03 January 2011
Larry, apologies, but I must be missing your point. Why can't clearinghouse participants be required to have capital proportional to the positions (i.e., the risk) that they introduce to the clearinghouse? While it makes sense for the 10 large dealers to clear a similar $5 billion threshold, if a regional broker-dealer were to trade 1/100th of the notional, why should they have to maintain more than 1/100th of the Tier 1 capital? This would be similar to normal margin requirements for all types of trading. Similarly, why should a bail-out of a failed institution be shared equally among the clearinghouse members and not proportionately to the risk they have introduced? As to the point about the bulge-bracket dealers pushing down the clearing cost themselves -- let alone the less obvious but very real issue of not allowing a competitor to actually clear through them at all, thus locking up the market, again -- this is probably not going to happen, as evidenced by the still wide bid/offer spreads on swaps trading which face a similar type of intra-dealer competition.
Comments (13)
ltabb
03 January 2011
Because I believe that the way the default funds work are virtually an unlimited blank check backing. So if the firm goes bust, they tap into the firm's margin, then the firm's default fund, then the firm's assets, then the collective default fund, then the collective firm's assets till there is nothing left. So if the guys with the deepest pockets take the most risk. So lets say I have 1m in margin, and 10m in the default fund, and 100m in tier I capital (just for round numbers sake). But the products have tremendous leverage, so I take a big position but still under my limits, but it goes south - really south quickly - like a Russian default or a May 6th but it doesn't come back. So my margin is toast, my clearing fund is busted, and not only because I bet big in clearing house "A" but I have exposures elsewhere my tier I capital is bust. So the positions will be sold off, and any losses will be socialized throughout the clearinghouse. But if it isn't just me, and there are more folks that go bust then the losses begin to mount and it puts pressure on the clearinghouse's clearing fund contributed by other firms and eventually the firms will need to write checks / wire in money to cover the loses. Now I guess that you could allocate the losses according to your exposure. But then the smart guy who is on the right side of the trade pays nothing, while the stupid guys foots the bill. Or you can do it by volume - but then high volume guys pay and the low volume guys don't. But then you could be punishing a broker with no exposure over folks with low volume and high exposures. Or someone with good risk management over someone with poor risk facilities. Or you can do it by capital - but then the larger guys always foot the bill. And if the larger guys always foot the bill then there is a very significant disadvantage for larger guys to even join, because they will always be putting their default funds in jeopardy of the smaller guys going bust. But there is one huge assumption here - that the large guys won't go bust more frequently than the smaller guys. The Credit Crisis can both nullify this argument and / or back it up. If you look at the credit crisis - the larger guys got into a lot more trouble than the smaller guys - yes but they were also bailed out and at the end of the day - the larger guys are still in business and if I recall over 300 medium and smaller banks went bust since the crisis and only one larger guy (lehman). So I guess the bottom line is that if there is an unlimited liability, the larger guys will cover a larger percentage of the losses - and if they don't have a say in the credit worthiness of the other players then they just won't play. And if that happens then there is no market. Or building a market becomes much harder.
Comments (303)
gbollenbacher
03 January 2011
What we are talking about here is the essential nature and business of clearing corps and CCPs. They are, or should be, in the business of managing margin and risk so that catastrophes are prevented. In order to do that, they price positions daily and require timely margin maintenance. Clearing corps work this way in the option and futures markets, two of the higher risk and volatility markets around, and they have for years. If the swaps clearing corps aren't going to price and margin daily, then they are a catastrophe waiting to happen. As I said in an earlier post, pricing an margining swaps is more difficult than futures or securities, but the requirement to do that is, or should be, the whole point of having a CCP in the first place.
Comments (48)
yiannis
03 January 2011
But I thought the purpose of the clearinghouse is twofold: one to minimize the bilateral transactions (and that alone would be open to all the problems you mention) and two to run daily risk and require adequate margin for that risk. In 2005 a reasonable margin for, e.g., a CDS swap was 5%. It could be done for much less if you had leverage (AIG I'm sure averaged much less than 1%...), but after having seen the risk of over-leveraging I would assume the margin would be around 10-20% today. Also, the role and the --mandated-- "equal treatment of its participants" of a clearinghouse requires posting sufficient margins in general, and higher margins for more risky instruments. That is, there should not be an incentive to trade with dealer A because they demand less margin than dealer B, as the margin would always be the same and demanded and adjusted daily by the clearinghouse. So regardless of the risk controls of an individual clearinghouse member, the margin the clearinghouse demands should cover it -- and if a margin call is not met, it should liquidate the trade immediately. To your example, the numbers would look like: $100 million margin, $10mm default fund, $100mm tier I capital, for, say, $10 billion in open positions. Can the open positions collectively lose more than 10% in one day? Possible, but highly unlikely. And if they do, the effect will be bigger for larger dealers who will have much more than $10 billion outstanding anyway. By volume fees is the norm in FDIC insurance and in most other forms of insurance. Sure, if a broker has high volume but they take very low risk they will be unduly penalized; that's what happens in crises. When LTCM went bust the dealers ponied up $100mm each (except for Bear Stearns and Lehman - oops; I am not surprised they were thrown out of the club when the opportunity came...); in the 2007 crash the bill was footed by the public. And so on. At least the broker who did not take risk will not be hurt by their own losses.
Comments (13)
ltabb
03 January 2011
Gbollenbacher and yinnis - yes I know. Clearing houses are not meant to fail. That is why they collect margin. That is why they have default funds. That is why derivatives CCPs do a daily mtm. On any normal day, everything should go swimmingly. But the big issues is catastrophic risk. What if (I know this is an equities example but...) on May 6th the market didn't bounce back and what if they even went down further? And given 10x leverage a 10% drop would wipe out 100% of equity. Who picks up the bill? CCPs are about failures and defaults. Now you can say will the the larger guys will go bust too and the government (taxpayer) will pick up the bill anyway so why worry. But that isn't the point. The taxpayer shouldn't be taking it in the shorts and the government shouldn't be bailing the industry out. As for FDIC vs a clearing house. I think clearinghouse members (for OTC products) have unlimited risk - but I could be wrong here. The other issue will be - risk / reward. If the large dealers feel the risk is to great for the profit they are making they will just shut down the desk and not play. I am also not saying that the number needs to be 5b. I don' t know what the number should be. And given that these will be more standardized and more easily netted - the risk should be less - a lot less. But I am not sure 100x less or from 5b to 50m.
Comments (303)
yiannis
03 January 2011
Well, credit is by nature safer than equity: it is higher on the capital structure and therefore less volatile by definition. A single position can move more than 10% in a day if the market is _very_ skittish (like the highs of the last crisis) or if there is fraud that is uncovered very quickly (Parmalat and Enron come to mind) or if there is another run on the bank, like Lehman going south. But a basket of multiple positions (say, 50 or more) is extremely unlikely to drop by 10% in one day. This has never happened, even at the peak of the bond crisis of 2007-2008. To put it in perspective, the investment grade index would have to go from 100 basis points to 1,100 in one day. At the peak of the last wreck that index went to 500 basis points or so, and it took several days, if not weeks, for that to happen. Even the high yield index did not go much higher than 1,100, from a normal level of 500, again within several days. Even the (as I said, by definition of the underlying instruments) more volatile stock market has not seen many (if any...) days of 10% losses for the indexes. Think of the LTCM crash: the banks ponied up $100mm each -- and there was no clearinghouse to collect proper margins from LTCM either. So $50mm with good margin practices would go a long way. Then think of the AIG crash: the banks (you think they would have learned their lesson from LTCM) would have to pony up several billions each... which they didn't have, hence the AIG government bailout. That's because they allowed huge leverage with no margin for AIG. Morale: with good margin practices you don't need a lot of (if any) extra capital for losses; with bad practices, the sky is the limit when it comes to potential losses...
Comments (13)
ltabb
03 January 2011
Good points. Well, it looks like we will find out how well these ideas play out because that is what the regulators seem to be looking for. I just hope that a) we don't have a 6 or 7 sigma event (or more) that stresses the system too badly b) the dealers decide that the risks are ok and decide to capitalize the clearing houses - cause if they don't, I am not sure there will be a market, and c) if everything does go nuts (or worse) that the clearing houses have enough margin/capital so they or the banks don't need to get bailed out at taxpayers expense. Even though the banks did payback the TARP (with interest) i am not sure the financial industry would survive another PR hit like that in the near future.
Comments (303)
yiannis
03 January 2011
a) We will :-) In time. The big events are 20+ standard deviation accidents, not 6. And they happen more regularly than people want to remember... A good margin system should take that into account. b) There is too much money at stake for anyone to leave. c) People forget quickly... but I hope too that they won't have to.
Comments (13)
ltabb
03 January 2011
If a 6 Sigma daily event is 1 in 2.5m days or 1 in 10,000 business years I would really hate to see 20 sigma event. and if we had one - I wouldn't be worried about the derivatives market - that is guns, ammo, and canned tuna time.
Comments (303)
yiannis
03 January 2011
Sorry, my mistake; I was thinking in terms of volatility of spread moves in basis points (even then, mostly of individual issues or structured products, not general market indexes). In terms of broad market indexes these moves would be around 5 stdev moves in one day (depending on how many days are used to calculate the historical stdev). These "one-time disasters" though happen quite frequently: 2000 internet crash, 2007 debt market crash, 2008 stock market crash... Not unlikely we'll see another one (or two) in this decade.
Comments (13)
Anonymous
04 January 2011
The CCP liability to a member firm is not unlimited. There has to be a limit - otherwise banks can't be members. Their capital adequacy requirements can't allow unlimited liabilities on their balance sheets. With respect to CCP capital adequacy, clearing houses have essentially 3 kinds of capital - fixed (member contributions/default funds), variable (margins) and contingent (insurance). Let's ignore insurance for the time being as there aren't any sufficiently highly credit rated insurers who would take the risk at the time being. With respect to fixed vs. variable capital, there is a trade off to ensure the capital adequacy of the CCP. If fixed is constrained, that variable (margins) would need to go up everything else equal. Also, and some clearing houses already do this, the CCP can charge a "super margin" for members whose positions place the balance sheet of the CCP at risk (in the event of a significant event). If they can't stump up the capital, well then, they either can't trade or get unwound. The problem is that this all works well for defined and liquid contracts. It is yet to be seen how much variabiity CCPs accept, and how they clear them. Swaps contracts can run for 10, 50 years. Yes they will be standard, but how liquid will they be. In the event of a default, what will the clearing house do? They will farm out positions to members. They can be reconstructed/synthesised by a series of shorter period swaps, but can smaller firms/members manage these? If you want to talk about clearing house capital adequacy and systemic risk, let's talk first about what capital and collateral they keep (government bonds? securities?) and where they keep their cash capital and margins (perhaps in a member bank?). This is a very simple game, it is about the banks who very well gate keep these markets. There are lots of levers here: Market structures (RFQ v CLOB) - RFQ where the banks keep their position by acting as market makers. Clearing house membershop - setting up membership such that only the big banks can join Trade processs - making it such that a trade must be bilateral before it is cleared (meaning that ISDAs still need to be in place ameliorating the ability of fund to trade directly with banks). There are plent of others.
ltabb
04 January 2011
Anon - thanks. So you believe that clearing houses with lower capital requirements can be as strong as the ones with larger cap requirements as long as the margin process can be kept sacrosanct. I guess meaning that the products stay liquid. And if the products go illiquid then they either need to beef up margin, their trading privileges are revoked, or their positions are sold off (or multiple of the above). So let me think about that. I have x amount of capital - I put on trades, the products go illiquid or a x sigma event happens which requires me to put up more margin, I tap out my margin and x amount of capital so I can't put up the margin, so the clearinghouse has to liquidate my collateral, at possibly a significant loss, (which can blow out my x amount of capital and put me out of business) but selling the positions will also put more downward pressure on the market, possibly putting others in jeopardy. So don't I as a clearinghouse want folks with deeper pockets rather than not? Now as i said before - how deep is deep? I don't have a clue - but if was my money at risk, I still think I vote for deeper pockets rather than thinner. I really wish I knew more about risk modeling and the impact of x sigma events on derivatives clearing. I do agree that the clearing houses have been set up as a big boys network, and I am sure that $5billion in capital seems a bit arbitrary and exclusionary but is 50m enough? I don't know. But you are right - proper margining and product liquidity are absolutely the right things to be thinking about.
Comments (303)
Anonymous
04 January 2011
Hi Larry. Thanks for the reply. Couple of observations. Firstly, and as you note, there is a big gap between $5b and $50m. And wearing my negotiation goggles, I would venture that $50m is the CFTC's first bid. As you would have likely read (as an illustration) in the 28 Dec Bloomberg article by Christine Harper that the banks are throwing huge lobbying resources at this area of regulatory reform. By the way, this is the same article that quotes industry executives as saying that "Successful companies shouldn’t be punished for the sins of those that failed". If they don't consider the government and FED interventions as failure prevention, I don't know what is failure. Yes, as a CCP you'd want members with deeper pockets, but assuming away the costs of many members, you would prefer lots of members with medium size pockets than few with deep - deconcentration of risk, and none too big to fail. Are people serious when they say that firms, like Newedge, don't have a big enough balance sheet or credit management capitability to be OTC CCP members? Newedge's customers are the hedge and money funds - the people the big banks don't want participating in the market. Re CCP, their risk modelling varies, but some of the things they model are their biggest member (or 2/3 members) defaulting and the market falling a significant amount - eg 25%. How much capitial would be required to withstand the shock? Recall also that CCP's (generally) only hold equity capital and not debt, and there is a difference between capital and cash. This all get's complex in an OTC environment when contracts can go long term and may not all be perfectly fungable. What is missing from this whole conversation is capability. Membership should be a function of capital AND capability. That is, in the event of an illiquid market, the capability of clearing house members to be allocated a portfolio of swaps positions from the defaulting member and to manage it out. $5b of capital won't answer that question.
Anonymous
04 January 2011
"so the clearinghouse has to liquidate my collateral, at possibly a significant loss, (which can blow out my x amount of capital and put me out of business)" -- How is that different from what happens today at every other exchange? Or, what happens today in the swaps markets in particular (but bilaterally) as dictated by the ISDAs? If your positions go down (which is what "illiquid" means: nobody buys them at the price you want to sell them or mark them to market; when things go up liquidity typically explodes; remember oil in 2009?) then you either post margin or your positions are liquidated. It's the law of the marketplace in order to prevent contamination of other innocent parties which would have to absorb the losses above your posted margin otherwise.
ltabb
04 January 2011
Very true.
Comments (303)
Anonymous
04 January 2011
Let us not forget that the requirement to own a trading desk in order to liquidate positions of a defaulting member is another artificial construct to limit clearinghouse membership. It is very easy to outsource that liquidation function: call 5 brokers and send them a bid wanted in competition (BWIC). Why do you have to run that function internally for the one time that will be needed? As for the capital requirement for clearinghouse members: how easy it will be to tap that capital in case of emergency? Are the regulations going to provide for a protocol to collect that "capital" (what "capital"? Cash? Treasuries? Auction rate municipals? Asset Back Securities? Real estate?...) and liquidate it? If not, then let us also treat the capital requirement for what it is: a way to limit clearinghouse membership.
Anonymous
04 January 2011
Agreed. But it's not my idea to put this stuff in a clearing house. If the regulatory policy objective is to mitigate systemic risk, there are other ways to do it. All CCPs do is bring risk into one place and try to manage the risk through margining and mutualization. If the clearing house model is the chosen path, then it needs to be done right. If it is not implemented properly, you are left with a situation worse and riskier than started.
ltabb
04 January 2011
this is absolutely true. If the clearinghouse is not properly margined or the risk management process is not right then all that will happen is that it will fall over and create a worse disaster than if there wasn't a clearing house as all.
Comments (303)
Anonymous
04 January 2011
Excuse my cynicism, but modern political goverance is no longer about the best overall outcome, but the best outcome for the constituents with the best lobbying/government influence capabilities. Let there be no doubt that the clearing house solution was pushed by an interested party. The current clearing houses that exist, and withstood the 2007/2008 market events without a single problem (recall how well the exchange positions of Lehman's were managed) emergered not from regulation or Government fiat, but by the market and market participants coming together to manage a market problem and market need. What we have here is, like Menken said, for every complex problem, there is a solution that is simple, neat, and wrong.
ltabb
05 January 2011
Folks, I just got this compliments of Duncan Wood of Risk Mag. This is a summary of the Dec. 16th CFTC hearing proposals on OTCD Clearing requirements. I assume most of you have seen many of these but in case you haven't. However, I do not believe that these have been published yet. The CFTC expounded 6 core principles of which one was DCO Participant and Product eligibility. The proposal requires that each DCO establish appropriate participant and product eligibility standards. With regards to membership criteria, members must have sufficient financial resources and the operational capacity to meet the requirements arising from participation. Proposal 39.12 – is designed to ensure that participation requirements do not unreasonably restrict any entity from becoming a clearing member, while at the same time limiting risk to the DCO and other clearing members. Proposal 39.12.A -- Requires that a DCO establish participation requirements that permit fair and open access. To achieve fair and open access the proposal would prohibit a DCO from adopting a particularly restrictive requirement if it could adopt a less restrictive requirement that would not materially increase risk to the DCO or its clearing members. --The proposal would prohibit participation requirements that have the effect of excluding or limiting membership of certain types of market participants, unless the DCO can demonstrate the restriction is necessary to address financial risk or deficiencies in a participant’s operational capabilities that might prevent them from fulfilling their obligations as clearing members. --It would prohibit a DCO require a clearing member maintain a swap portfolio of a particular size or that they meet any transaction volume threshold. --It would further require that clearing members have access to financial resources to meet obligations arising from participation in a DCO. --Require DCOs to establish capital requirements that are based on objective, transparent and commonly accepted standards that appropriately match capital to risk. --It will require that capital requirements are scaleable so that they would be proportionate to the risk posed by individual clearing members. Thus, if the clearing members risk exposure were to increase, the DCO could increase the clearing member’s corresponding capital requirements. --The proposal will specify that a DCO is not permitted to set a minimum capital requirement of more than $50 million. --With regards to operational requirements….clearing members must be able to participate in default management activities as required by the rules of the DCO.
Comments (303)
gbollenbacher
05 January 2011
There is one thing we need to keep in mind about clearing corps and DCOs. In all cases where clearing corps exist today, membership is generally made up of market makers and market insiders. Positions carried by the public are on the books of the clearing members, not on the books of the clearing corp. Thus the disciplining of public positionholders (daily mtm and variation margin, for example) is handled by the clearing members, not the clearing corp. (This same relationship is true of securities depositories, of course.) Is the same arrangement anticipated for derivatives DCOs? If so, will the same banks who are at the base of the swaps triangle be the clearing members of the DCO? I'm not sure that arrangement gives me much comfort as to systemic safety. Or will any public participant be allowed membership in the DCO? Will, for example, municipalities who enter into rate swaps against floating rate debt issues be expected to be members of the DCO?
Comments (48)
yiannis
05 January 2011
My understanding has been that one of the driving forces of this exercise is to police the margin requirements, which got out of hand and caused the domino effect, e.g., with AIG's positions. So chances are that the margin would be required by the clearing corporation. It could fall to the members to police the margin of their customers, but not to define it. Also, if the members are allowed to define the margin then they could use different standards, so the lax standards of one could cause a cascading effect again, burdening the other parties. And third but not least, if the margins are not centrally mandated then competition will force them lower, exactly as it did in the past, again causing serious problems in a market crash. As for corporations or individuals being DCO members I doubt it. The barrier of entry is not (well... should not) be the capitalization or the existing market position of a firm, but becoming a member involves technical integration and operational burdens, which are typically not undertaken by anyone not in the business of running an execution platform. On a personal note, I surely wish municipalities were so good at running businesses that they could compete in wall street! It would be good for all the citizens. Right now most of them can't even shore up their own finances...
Comments (13)