Content warning!: this is a post about clearing minutia. But believe it or not, there are a select few who actually like that kind of thing–so this one’s for you!
I was thinking more about the segregation issue, and particularly the credit and systemic risk issue. I think I got the essence of the conclusion right, but was not completely happy with the supporting analysis, so I gave it some more thought and came up with something that I think is a more robust.
The issue is whether segregation or futures-style omnibus accounts lead to more market fragility during times of stress. My original intuition, and my newer analysis says that segregation is more fragile in times of stress; that is, a CCP is more likely to fail with segregation than with omnibus accounts. The basic reason is that segregation is more dependent on discretionary credit during times of stress; this dependence is a source of fragility.
The potential problem has its origins in the timing of cash flows in a CCP setup. CCPs make margin calls on brokers (FCMs) that the FCMs have to meet in a short time period, on both house and customer accounts. Often the FCM has to make payment on the customer account before the customers have made their variation margin payments; to meet the CCP deadline, therefore, credit has to be extended to these customers. The FCM’s bank may make the payment to the CCP even though there are insufficient funds in the FCM’s account at the bank to cover the payment. That is, banks for FCMs often extend credit to the FCMs to permit timely payment of margin calls to the CCP.
With omnibus accounts, the payment that the FCM owes on its customer account is the net payment owed to the CCP by all its customers on all their positions cleared through that CCP. This means that the maximum amount of credit that is needed to ensure that the bank makes the margin payment to the CCP on behalf of the FCM is this net payment owed.
With segregation, it won’t be possible to net customer payments against one another. This increases the amount of credit banks have to extend to ensure prompt payment of variation margin to CCPs. And that is where the vulnerability arises.
A very stylized example demonstrates the point. It is unrealistic in many ways but the elements of unrealism don’t overturn the basic result. Assume an FCM has zero capital. It has 10 customers, 5 who have to pay variation margin of 1000 apiece, and 5 who should receive 900 in variation margins apiece. Thus, the net amount owed on this FCM’s customer account is 500=5x(1000-900).
Assume that the margin payment is due immediately, but none of the customers who owe have posted the necessary cash. With some probability all will stump up the necessary cash in the future, but with some probability none will. In the latter event, there is a total loss of 5000 that is borne by others in the market: just who bears it depends on the type of account (0mnibus or segregated).
With omnibus accounts, the FCM owes the CCP 500. If the FCM’s bank lends the FCM the 500, it can meet the margin call and there is no default to the CCP. If all the customers who owe pay, the FCM can repay the bank, and the bank and the FCMs other customers get paid all they are owed. However, if the customers who owe don’t pay, the FCM defaults on its loan to the bank for 500, and also cannot pay its customers who are owed money the 5×900=4500 that is due them.
Note that in this example, the risk that the customers who owe variation margin payments will default is borne by the bank and the other FCM customers. That’s the “fellow-customer” risk in this setup.
Now consider the situation with segregation. Here, it is not possible to net customer pays and receives. Thus, it is necessary to provide 5×1000=5000 in credit to the FCM, or the FCM’s customers, to make it possible to meet the CCP deadline. If the customers end up paying what they owe, everything is the same as with co-mingling. If they don’t, however, the bank loses 5000–if it decides to extend the credit.
The total credit loss in the two alternatives is the same–5000–but the distribution is different. The bank is on the hook for 100 percent with segregation, but only 10 percent under omnibus accounts–again assuming that it extends credit in each case.
That is a crucial difference, because the bank has the discretion to extend credit: that is, it is not a given that the bank extends credit. It can say no. If it says no, the FCM goes into default on its obligation to the CCP, and the CCP is on the hook for the loss in the event the customers who owe default. This loss falls on the CCP’s capital, or on its default fund. This could conceivably threaten the CCP.
Clearly, the bank is more likely to say “no” to a request to borrow 5000 than a request to borrow 500. Note particularly this situation is likely to arise when the market is under stress. That’s when big price moves occur that can raise doubts about the ability of customers to meet their margin calls, and when excess margins held at the FCM are going to be blown through. It’s also when banks are likely to be more averse to taking on credit risk.
With omnibus accounts, there is credit extended, but much of it is not discretionary. In the example, the FCM’s in-the-money customers provide 4500 of credit. They have committed to do so by being customers of the FCM, and being on the winning side of their trades. In effect, customers provide irrevocable letters of credit to other customers–and in return, receive irrevocable LCs from those customers. These are not traditional LCs because their payoffs are conditional on market prices (and in a more realistic example, on the financial condition of the FCM). But in essence, if you are a customer of an FCM under an omnibus system, you commit to provide credit to other customers under some circumstances, and in return receive a commitment from other customers to grant credit to you under other circumstances.
That lack of discretion is crucial in preventing a market breakdown. “Freezing” of credit markets during times of market stress essentially means that lenders choose not to lend. The more that you rely on the discretion of lenders, the more vulnerable you are to a market freeze.
During the Crash of 1987, the reluctance of banks to lend to FCMs was what threatened the major CCPs. Consider that in the context of the example. In the example, under segregation, the bank is less likely to extend credit, making an FCM default more likely. Moreover, since there is no sharing of risk among customers, with segregation the CCP is on the hook for a bigger loss: 5000. With omnibus accounts, it loses only 500. CCP failure is obviously more likely when it has to bear a 5000 loss than one a tenth as large. Thus, with segregation, there is a larger probability that the CCP will absorb a loss, and conditional on a loss occurring, that loss is bigger. This means a greater likelihood of CCP failure–or the need for greater CCP capital.
In brief, the clearing system is more likely to break down during periods of market stress, the greater the reliance on discretionary credit to meet variation margin calls. This reliance is greater with segregation, than with futures-style omnibus accounts. The latter reduces reliance on discretionary credit by the use of (implicit) commitments among FCM customers to lend to each other. That makes the system more robust.
There is considerable symmetry in the commitments that FCM customers make, but that symmetry is not complete. Some customers are more creditworthy than others. They essentially subsidize the less creditworthy customers (unless, as I discuss below, commissions or other terms offset this effect). Moreover, tail risks that create default risks are not symmetric. Customers who are long stock index futures, for instance, are likely to experience big margin calls than those who are short because crashes are more likely than spikes. Customers who are short CDS are more likely to experience big margin calls than those who are long because of jump to default risk.
Even though the exchange of commitments is not necessarily of equal value (i.e., a given customer may provide a commitment that is more valuable than the commitment he receives from the other customers due to these sources of asymmetry), there is an exchange of value. Moreover, more creditworthy customers should be able to negotiate better commissions to reflect the benefits they are providing to other customers–which helps the FCM attract the business of these other traders. The ability to negotiate commissions and other terms of agreements between customers and FCMs (e.g., margins) reduces the scope for cross subsidies between customers. This limits the distributive consequences of omnibus accounts.
These credit issues are likely to arise only in rare circumstances, but those are exactly the circumstances in which a market breakdown and CCP failure would occur. A liquidity crunch occurs when due to heightened risk and asymmetric information, lenders choose not to lend. This is most likely to occur during periods of market stress–which is exactly when big margin calls increase the demand for liquidity/credit. That is, stressed conditions reduce the supply of credit and increase its demand. It is desirable to reduce reliance on discretionary credit in these circumstances. Omnibus accounts do just that. They are a liquidity pooling mechanism by which customers implicitly commit to extend credit to one another. This commitment reduces the need to rely on discretionary extensions of credit by banks in order to raise the cash necessary to make payments to CCPs. This, in turn, reduces the likelihood of a CCP collapse.
This analysis strongly suggests that the systemic risks of segregation are far greater than the CFTC acknowledges. Indeed, in its NOPR on OTC derivatives segregation, the agency argues that segregation reduces systemic risks. Its analysis fails completely, however, to consider the implications of segregation on the demand for credit during times of market stress. The foregoing analysis implies that segregation leads to higher demands for liquidity and credit precisely under the conditions in which liquidity and credit are likely to be in short supply. That, in turn, means that the possibility of market breakdown or CCP failure is greater with segregation.
Market participants will adjust on other margins, of course. CCPs will presumably require greater margins and greater default fund contributions with segregation: these are also essentially precommitments of resources that substitute for the precommited resources lost under segregation. They are also costly, and it is nigh on to impossible to know whether these costs are larger or smaller than the costs inherent in a system based on omnibus accounts.
But apropos my earlier post, CCPs, exchanges, FCMs, and their customers have strong incentives to adopt the system that minimizes these costs. They have skin in the game, and a bigger pie to split when the choose the lowest-cost mechanism. They also have better information to evaluate these costs than any regulator. No, their incentives aren’t perfect. Their information isn’t perfect either. But perfect isn’t an option, so those aren’t meaningful objections to relying on competition and contract to determine the choice of institutions, rather than regulatory fiat.