The clearing and reporting requirements of Frankendodd have barely gone into effect, and the unintended consequences are already beginning to pile up. Who coulda seen that coming, eh?
Even I couldn’t have made up the bestest of them. Namely, as a result of the SEC’s bizarre portfolio margining rule, ICE has said that it will not clear single-name CDS. You know, the weapons of financial mass destruction that were supposed to be the reason for needing a clearing mandate in the first place. So ICE won’t clear the poster children for the clearing mandate. Like I say: you cannot make up this stuff.
Ice Clear Credit has shelved plans to clear single-name credit default swaps (CDSs) for clients of its member firms, as a result of a new Securities and Exchange Commission (SEC) policy on portfolio margining. Under the terms of that policy, circulated late on March 8 – the last working day before the start of mandatory clearing for CDX index trades in the US – clients would be able to benefit from risk offsets between cleared index and single-name contracts, but the vast majority would be charged twice the margin calculated by a central counterparty (CCP).
The move sparked a furious response from some buy-side firms and has now dissuaded Ice’s CDS clearing house from offering the service at all.
“Last Friday, the SEC issued a temporary approval requiring broker-dealer futures commission merchants (FCMs) to charge two times the initial margin requirement of the CCPs. This was unfortunate, so we made a decision, based upon that unexpected development – news of which we received very late in the day on Friday – and based upon input from many clients, that it would be better not to offer single-name clearing under those conditions than to make single names available,” Peter Barsoom, chief operating officer of Ice Clear Credit, told attendees at the Futures Industry Association (FIA) annual conference in Florida last week.
The SEC policy gives temporary approval for an FCM to allow cross-margining if it collects 150% of the margin required by a CCP, but only if the client has “virtually no credit risk”. For all other clients, 200% must be collected on positions held in the portfolio margin account, which participants say would apply to most buy-side firms.
Portfolio margining across asset classes is theoretically beneficial, but practically dicey due to the instability of correlations, which often result in positions being undermargined during conditions of market stress. And yes, individual name CDS and indices can diverge, again particularly during periods of financial stress. But a portfolio consisting of a position in an index and offsetting positions in single names (especially names in the index) is less risky than either leg on its own. This means that it is possible to improve capital efficiency while holding risk level constant by giving margining offsets for portfolio benefits. But noooooooooooo. In its infinite wisdom, SEC has decided to punitively margin these portfolios. This reduces substantially the benefits of clearing individual name CDS, so ICE says to hell with it.
Again, the irony is almost too much. The risks of single-name CDS were constantly invoked to justify the clearing mandate. Those arguments were largely bogus, but regardless, due to regulations adopted to implement the mandate, single-name CDS will not be cleared for the foreseeable future. Yay!
This is yet another example of the perverse effects of regulatory setting of margin levels. I’ve been saying this so much I’m blue in the face: you could call me the smurfwiseprofessor. For the zillionth time: regulatory margin setting is a form of price control, risk price control specifically. Price controls never work. Worse than that, price controls always lead to distortions. First with futurization and now with portfolio margining, we are seeing these distortions appearing, big time. And they’ll likely only get worse, when margins on non-cleared swaps are finalized.
Regulators have neither the information or incentives to set these prices right. They bewail regulatory arbitrage, but their attempts at price control are the destined to set off a regulatory arbitrage land rush.
But it gets better! Even the seemingly banal task of reporting swap trades is overwhelming the CFTC. According to Scott O’Malia, they cannot find a London Whale in a phone booth:
Dodd-Frank Act derivatives rules are failing to give regulators a full picture of the swaps market and wouldn’t help them detect a loss similar to JPMorgan Chase & Co. (JPM)’s London Whale trades, according to Commodity Futures Trading Commission member Scott O’Malia.
Swap-trade data the agency has been receiving since the end of last year from repositories including the Depository Trust and Clearing Corp. is inadequate to identify large positions and have overwhelmed government computer systems, O’Malia said in a speech prepared for a Securities Industry and Financial Markets Association conference in Phoenix.
The data “is not usable in its current form,” said O’Malia, 45, one of the agency’s five commissioners. “The problem is so bad that staff have indicated that they currently cannot find the London Whale in the current data files.”
. . . .
Different swap dealers and trading counter-parties are using their own reporting formats because the government failed to specify standards, O’Malia said.
“It means that for each category of swap identified by the 70-plus reporting swap dealers, those swaps will be reported in 70-plus different data formats because each swap dealer has its own proprietary data format it uses in its internal systems,” he said. “The permutations of data language are staggering. Doesn’t that sound like a reporting nightmare?”
The CFTC’s computer systems are failing to handle the incoming data. “None of our computer programs load this data without crashing,” O’Malia said.
This should be no surprise. The issues with CFTC computers particularly. The GAO issued reports in the ’80s ripping the agency for its IT dysfunctions.
Frankendodd has barely come to life, and it is already wreaking havoc. I am sure there are more good times to come!
And I am totally, totally sure that Obamacare will work just as well. No prospect for unintended consequences there!