Streetwise Professor

February 15, 2013

With “Fixes” Like These

Frankendodd runs hundreds of pages.  The regulations written to bring it to life run to thousands more.  Every word on every page has the potential to wreak havoc: hell, apropos the position limit case, even the commas matter.

Case in point, the CFTC’s proposed rule on protection of customer funds, most particularly Section 1.22.  Some of the relevant language:

The Commission proposes to amend § 1.22 by clarifying that the prohibition on the FCM’s use of one futures customer’s funds to margin or secure the positions of another futures customer, or to extend credit to another person, applies at all times.

. . . .

Further, the Commission is proposing language providing a clear mechanism to ensure compliance with this prohibition, which is to require an FCM to maintain residual interest in segregated accounts in an amount which exceeds the sum of all margin deficits for futures customers.

This is very inside baseball, but has seismic implications.

The basic thing is that some customers are late in meeting margin calls.  This gives rise to margin deficits.  Under the traditional omnibus model used in futures markets for donkey years, futures commission merchants (brokers-”FCMs”) can cover customers’ margin deficits with the margins of other customers.  Effectively, customers lend one another money to address the timing issues that the rigorous mark-to-market and variation margin processes inevitably create.  Moreover, the FCM is ultimately on the hook to cover the losses of a defaulted customer.  The FCM’s customers can lose only if there is a default by a customer that the FCM can’t cover (resulting in an FCM default).

That is, customers effectively lend to one another, and thus there is “fellow customer risk”-a solvent customer can lose as a result of the default of another customer. The CFTC rule is intended to eliminate this risk.

Problem: the risk can’t really be eliminated, merely shifted around.  Related problem: the likely reaction to this attempt to shift risk.

The CFTC seems to want to shift the risk to the FCMs: the “residual interest” language means that the FCM has to have enough of its own money on hand to cover any margin deficits.  This will require the FCM to hold substantial precautionary balances, because (a) the magnitude of margin deficits is likely to be quite variable, and particularly will be large in the aftermath of a big price move (that can’t be predicted in advance), and (b) there are serious penalties to being undersegregated.  Alternatively, FCMs are likely to require customers to post margins far in excess of exchange margin levels, thereby reducing the likelihood that any customer’s account will have a margin deficit, and the amount of residual interest the FCM must hold to cover any such deficits.

Either way, there will be a substantial increase in the amount of cash tied up, and the needs for customers and FCMs to have access to contingent liquidity.  The omnibus model was an effective way for customers to supply liquidity to, and obtain liquidity from, other customers.  Yes, there are risks, but there are corresponding benefits: the near universality of the omnibus model in futures markets, and its survival for decades, provides compelling evidence that the benefits far exceed the costs.

But apparently that’s not good enough for GiGi and the Gang.

The clearing and collateral mandates-combined with Basel III and other regulatory measures-are already requiring substantial increases in the amount of collateral-liquid assets-that will be tied up to support derivatives trades.  This will just add to that.  And insofar as being a customer protection mechanism: uhm, customers will pay for it.  Don’t act as if your are doing them a big favor. (Raising the question if its so valued by customers, why hasn’t some FCM adopted voluntarily what the CFTC wants to impose by fiat?  If it’s so great, customers would flock to firms offering that model.)

It also comes at a terrible time for the FCM industry.  The economics of the business are terrible.  ZIRP has blown a hole in a major source of revenue, volume is down sharply, and competition is intense.  A recent Celent study details the carnage:

“The leading FCMs in the US are struggling with falling revenues and profits,” saysAnshuman Jaswal, PhD, Senior Analyst with Celent’s Securities & Investments Group and author of the report. “This puts them in an unenviable position, especially when we consider the overall impact and related costs of various regulatory implementations taking place in the next couple of years.”

Another data point: SocGen just wrote down its investment in big FCM Newedge.  This is not a thriving industry, and ladling more costs onto it won’t help it one bit.

The ostensible purpose of this new regulation is to prevent another MF Global or Peregrine situation.


MF Global broke every rule in the book about segregation and the treatment of customer money.  Peregrine’s owner ran a huge fraud for 20 years. So creating more rules for troubled or criminal FCMs to break will help?  If the CFTC or SROs couldn’t enforce the old rules and thereby prevent losses of customer funds, why should we expect they’ll do any better with the new ones?

It’s also hard to see how these rules, if they had been in place, would have prevented either the Peregrine or MFG situations.  Furthermore, there are other ways of attacking the exceptional-and MFG and Peregrine were exceptional-without imposing crushing burdens on the ordinary day-to-day operation of the markets, FCMs and their customers.  For instance, the Peregrine fraud could not have continued if Peregrines regulator (the NFA) had direct electronic access to the firm’s accounts, thereby preventing Wasendorf from altering the paper statements he sent on to regulators to cover up his fraud.  Hell, in the MFG case, having more excess margin in customer accounts would have just increased the money that Corzine could have tapped to cover the company’s losses and own margin calls: it is just that excess margin that disappeared somewhere, somehow.  I would further note that since an FCM is most likely to be tempted to get at customer funds when it is in financial jeopardy (which is what happened with MF), adding to its financial burdens could create more problems than it solves.

The cost-benefit analysis the CFTC advanced in support of the rule is just the kind of joke I’ve come to expect.  This is actually a problem that is amenable to calculation.  Collect data on the distribution of customer margin deficits under current rules.  Figure out the 99.9th percentile of this distribution.  (Importantly, condition this distribution on market conditions-find out what that percentile is during very volatile periods.)    Given the rigor of the rule, it is plausible to assume that additional funds equal to this 99.9th percentile will have to be held by customers, FCMs, or both will be held to ensure compliance.  Calculate the return on this sum lost because customers and FCMs are required to hold low-yielding assets in order to comply with the rule.  That’s one component of the cost.

Another cost is the additional operational cost required to ensure compliance.  This will not be trivial: indeed, one reason FCMs might require substantial increases in customer margins is to reduce the operational burdens required to maintain compliance.

One cost that is important is hard to quantify.  As I’ve written repeatedly, spikes in liquidity needs during periods of market stress can be systemically destabilizing.  This rule will: (a) restrict one vital source of liquidity, namely, intracustomer loans; (b) result in far more liquid assets being tied up in brokerage accounts; (c) lead to increases in liquidity demand during periods of high volatility, as FCMs will either have to hold more liquid assets, or will force customers to hold more excess margin, during high volatility periods in order to maintain compliance (i.e., the 99.9 percentile is much bigger during high volatility periods, requiring more margin to meet this threshold-the distribution of liquidity demand spikes caused by this could be calculated); and (d) result in position unwinds by those unwilling to incur the cost of the elevated margins.  All of these effects are pro-cyclical, and tend to exacerbate market instability/volatility.  Liquidity problems are what create or exacerbate crises.  Derivatives market “reforms” have already imposed substantial liquidity burdens: this will only add another.  That is systemically risky.

Benefits?  Uhm, hard to ascertain.  As noted above, the rule is ill-suited to address either a Peregrine or MFG problem, even though those are the examples the CFTC repeatedly invokes in their support.  Moreover, it must be noted that reducing the amount of loss arising from the default of fellow customers is not necessarily a benefit.  This is primarily a transfer of wealth from one party to another.  The relevant issue is whether one risk sharing rule is better than another.

This is another example of the pernicious effects of attempts to “fix” high profile problems such as MF Global and Peregrine.  In response to truly extraordinary episodes, we get “fixes” that (a) don’t really do anything to address the problems they are supposed to be fixing, and (b) impose substantial burdens on the ordinary operations of the markets, operations that have gone on swimmingly for decades under the old way of doing business, thank you very much.

As a rule of thumb, I think it wise to be very suspicious of rules designed to prevent recurrence of an extreme event or events.  That is especially true in this case.   Another example of all pain, no gain.

Is that the CFTC’s motto now?

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  1. Punishing the fraud at MF Global might be a way to discourage future episodes but of course we couldn’t do that to Mr. Fundraiser.

    Comment by ACS — February 15, 2013 @ 6:59 pm

  2. 1. I agree with your points on MF and Peregrine. If you want to prevent another MF Global, Jon Corzine should be wearing an orange jumpsuit. The more he walks around free. The more people are convinced that having political connections is a license to steal.

    2. You said, “Raising the question if it’s so valued by customers, why hasn’t some FCM adopted voluntarily what the CFTC wants to impose by fiat? If it’s so great, customers would flock to firms offering that model.” I think a better question is whether there are any large customers who negotiate agreements that do not allow for their funds to be used to cover other customer’s deficits. If not, I agree with you. If so, I would actually be concerned since smaller accounts would be disadvantaged versus larger accounts. (My concern would not be assuaged by the new rule for the reasons that you lay out.)

    Comment by Highgamma — February 15, 2013 @ 7:01 pm

  3. @ACS & @Highgamma. Corzine walking free rather than doing the perp walk is truly outrageous.

    @Highgamma. Yes . . . there could be externalities if some individual accounts were able to contract separately to protect their funds. What I was envisioning was a blanket arrangement applied to all accounts.

    The ProfessorComment by The Professor — February 15, 2013 @ 7:05 pm

  4. 1. Amazing how the reaction of government to past evils they could have prevented had they done their jobs is always to impose these externalities on the victims and on honest third parties, all in the name of “protecting” the public. Perhaps the regulators who didn’t do their jobs should also be wearing orange jumpsuits.
    2. This is yet another example of the substitution of government policy for fiscal policy, rendering the latter irrelevant and impotent. This has to reduce monetary velocity while our Dear Monetary Leader is desperately trying to conjure up animal spirits. We can argue whether dollars or widgets are worth more, but when government policy changes, the latter might just look more attractive.
    3. Professor, would appreciate a post on oil markets and the Rosneft hedge. Did the Chinese get the better end of the deal?

    Comment by dh — February 16, 2013 @ 7:58 am

  5. @dh. Re 1-2: Absolutely. The schizo nature of government policy (your #2) is especially pronounced. I think it reflects the silos in which these policies are made. To imagine Gensler et al are thinking of the monetary/fiscal policy implications of their decisions is kind of humorous, actually. They have this “more collateral is always better” mindset, and are hell-bent on reducing the credit implicit in derivatives, but have no clue as to how the system will reconfigure to undermine these efforts, and have even less of a clue as to how their stoking demand for liquid assets and contingent liquidity will feedback into monetary and fiscal policy (to the extent there’s a difference these days).

    Re 3-Was definitely thinking of doing a post on the Rosneft deal. It is fascinating on many levels. One is the fact that a company that has presumptions of being a supermajor can’t fund an acquisition through the capital markets, or through banks directly, but has to get a sleeve through Glencore and Vitol. The pricing of the Chinese deal is intriguing, but impossible to know with certainty. My surmise is that yes, the Chinese got a good deal. But this will just lead to pricing disputes later on, as occurred in the aftermath of the 2009 deal where the Chinese financed a Russian pipeline (providing $20 billion to Rosneft and Transneft) an bought oil on a long term basis. Here are a couple of articles that provide some information on the pricing disputes. Another interesting angle is the impact on market prices. There’s been some hyperventilating about this, but IMO this reflects ignorance of just what forward prices are.

    Look for something over the weekend. Thanks for the suggestion.

    The ProfessorComment by The Professor — February 16, 2013 @ 9:23 am

  6. They’d have been better off jailing Corzine and asking questions later. But he never made a never seen YouTube video on the Muslim Brotherhood.

    Comment by Jeff — February 17, 2013 @ 8:35 am

  7. [...] See full story on [...]

    Pingback by With “Fixes” Like These | Fifth Estate — February 17, 2013 @ 8:49 am

  8. [...] Craig Pirrong and Jon Lothian have excellent analysis on this issue.  Craig worked on the exchange floors, and [...]

    Pingback by The Price of Your Food and Fuel is Going Up - Points and Figures | Points and Figures — February 17, 2013 @ 9:19 am

  9. “This is another example of the pernicious effects of attempts to “fix” high profile problems such as MF Global and Peregrine.”

    Reminds me of the rule of thumb that laws that are named after specific people are almost always terrible ideas.

    Comment by srp — February 17, 2013 @ 8:02 pm

  10. @srp-yes, similar to that. Also an example of generals fighting the last war. Also an example of sorting on the outliers.

    The ProfessorComment by The Professor — February 17, 2013 @ 10:30 pm

  11. [...] rule has caused a wholesale freakout among FCMs and market participants, and for good reason, as I pointed out in that post.  The rule would not have prevented an MF Global or Peregrine situation-those involved fraud [...]

    Pingback by Streetwise Professor » If the law supposes that … the law is a[n] ass—a idiot — July 26, 2013 @ 9:53 am

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