Streetwise Professor

April 27, 2011

One Size Fits Few

Filed under: Clearing,Commodities,Derivatives,Exchanges,Politics,Regulation — The Professor @ 4:34 pm

The CFTC and SEC have released their swap definitions. Among other things, the CFTC rule excludes commodity forward contracts from the swap definition.

The CFTC proposed rule is 300 pages long.  Do you believe that such a massive attempt at definition will not have ambiguities and uncertainties that will require clarification?  Do you believe that market participants will not try to write contracts to take advantage of exclusions and exemptions, and that these attempts will not result in litigation?  Do you believe that a rulemaking that is far broader in its application than pre-CFMA laws and regulations  will not result in the growth of a thicket of decisions, interpretive letters, no action letters, etc., that will be more confusing and more contradictory than that which developed prior to 2000 (before the passage of the CFMA) to clarify the distinction between “futures” that had to be traded on exchanges and commodity forward contracts that didn’t?

If so, have a nice dream.  Reality will be waiting for you when you wake up.

The Commission also voted out a proposal for a hybrid margin segregation mechanism, where customer funds would be segregated operationally (i.e., held in a single account), but would not be at risk to a the default of another customer.

This is a victory for BlackRock and other big money managers who lobbied hard for it.  And yes, they are winners.  But make no mistake, the main effect of this rule is redistributive, meaning that there are losers.  And to the extent that it affects efficiency, the effect is negative because mandatory segregation encourages moral hazard: clearing member customers now have zero incentive to monitor their clearing members.

The distributive effect arises from the fact that removing customers from default risk mutualization means that default losses are just shifted elsewhere, e.g., CCP equity or the CCP’s default fund.  Alternatively, CCPs may choose to up margins to reduce default fund exposure to customer defaults.

The costs of default don’t go away.  They are mainly shifted around.  Low default risk firms (e.g., BlackRock, pension funds) will no longer be at risk and will benefit.  But somebody else will pay.

A much preferable approach would be to establish omnibus segregation as a default standard, but permit clearing members and their clients contract for individually segregated accounts .  This would permit those who value segregation more highly than it costs clearing members to segregate to negotiate mutually beneficial arrangements with clearing firms.  Such contracts would reflect information available only to the contracting parties, but which regulators could not know when setting a one-size-fits-all standard.

This would internalize (i.e., price) many of the costs of segregation which  under the CFTC proposal would be shifted to default fund participants (i.e., other clearing members) and from some customers (the BlackRocks of the world) to others.

For instance, if a large money manager and a clearing member negotiate a segregation arrangement, this would shift risk to the member’s other customers, and to the CCP default fund. The shift in risk to other customers would tend to reduce their demand for the member’s services, leading this firm to internalize some, and perhaps all, of the effects of this risk transfer.

However, the risk transferred to the default fund would not necessarily be priced.  This problem could be addressed by allowing the CCP to set default fund contributions based on segregation, with members with larger sums in segregated accounts being required to make a larger default fund contribution.

I don’t understand the mania for one-size-fits-all rules when private contracting can result in efficient outcomes that take into account individual differences.  Derivatives market participants are by and large quite sophisticated, and capable of trading off the costs and benefits of alternative arrangements, including alternative segregation arrangements.  Permitting individualized negotiation which prices these costs and benefits–which differ among market participants–is the most efficient and effective way of ensuring they optimize that trade off, and do so in ways that reflect differences among them.  Let CCP members who participate in the default fund come up with methods that internalize the potential spillover between segregation and the default fund.

One size fits all rules create a tremendous incentive for affected parties to influence the rulemaking process for their benefit.  BlackRock, Pimco, some big pension funds, etc., seem to have done that in this instance.  They’ve secured a rule that protects them from some risks–by shifting those risks to others, not by reducing them (in fact the overall risk likely has increased due to moral hazard).  The outcome is affected by the costs and benefits of exercising influence, not by the economic costs and benefits of alternative segregation mechanisms.

This is another example–as if we needed more–of a prescriptive regulation dictating an allocation of resources that is perfectly amenable to private contracting.  And one where there are no obvious barriers to private contracting, and where as a result such contracting would lead to an allocation that balances efficiently costs and benefits.

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  1. The choice of LSOC [Legally Separated, Operationally Co-mingled] is probably the most practical solution when trying to balance customer protection with operational efficiency, given the alternatives, and we pioneered this model at SwapClear.

    Those arguing for “full segregation” / individual segregated accounts with full traceability of individual assets overlooked the actual timing of collateral flows and related admin ie clearing members settle calls within an hour, whilst clients tend to settle later. As such, asking a clearing member to
    1. Fund each client’s account with individual transfer
    2. Substitute these amounts with the actual collateral provided by a client when it is actually received
    would have been very onerous and costly.

    Clearly the drawback is that assets lodged to cover margin requirement will have to liquidated to cash in the event of the default of a clearing member given that assets are not traceable to any one specific client. Hence, a client lodging a 20yr Treasury will receive cash instead [either directly or ported to an incoming clearing member] following a default. This gives them some collateral value exposure.

    However, the aspect you allude to is that end-users no longer face counterparty risk, which they formally did bilaterally, whilst any losses arising from the default of a clearing member that exceed the contributions of that member [initial margin + variation margin + own default fund contributions] have to be borne by the default fund contributions of the other members. Clients DO NOT contribute to the default fund. Hence, as you correctly state, we have merely transferred any losses onto a smaller number of firms [typically banks] rather than having them distributed as was the case before.

    A more reasonable outcome is mutualisation of losses across the entire market, reflect the utility nature of CCPs. Whilst end-users will argue that they should not incur losses for the default of others, especially those with whom they had no dealings, the default fund would be better viewed as an insurance fund to which every market participant contributes if they wish to enjoy the benefits of a CCP.

    Comment by John — April 28, 2011 @ 3:24 am

  2. Isn’t that what we had pre-dumutalization? Wasn’t clearing good to the last drop? It’s pretty clear that the CFTC just wants centralized clearing so that they can wash their hands of any culpability from the next financial melt down.

    Comment by Jeffrey Carter — April 29, 2011 @ 8:54 am

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