Streetwise Professor

This afternoon I attended the Working Group on Financial Markets at the Chicago Fed.  The scintillating topic was segregation models.  Really!  It was scintillating!  For a certain kind of geek, of which I am one.

It was scary, actually.

Segregation of customer money has been a subject of discussion post-Frankendodd, and I have written several posts on the subject.  Segregation has received even more discussion post-MF Global (AKA Corzine-gate, but since he’s a made man I guess he will skate).  The model that has been implemented for cleared swaps, and which (according to clearing maven John McPartland of the Chicago Fed) is likely to be adopted for cleared futures is LSOC-legally segregated, operationally commingled.

Back in the summer of 2011, I wrote that segregation could make the markets more fragile, because it would tend to reduce credit (mainly intraday credit) used to finance variation margin.  This is important, because the markets depend on using credit to fund margin payments.  If this credit freezes up, the markets will freeze up.  Indeed, a cleared system works on such tight deadlines that an interruption of credit can be catastrophic.  If margin calls aren’t met in a timely fashion, absent credit, margin payments don’t flow to those on the winning side of trades.  When this happens, the clearing system breaks down.  And in a Frankendodd world dependent on clearing, a breakdown in clearing means a meltdown in the markets.

Indeed, even delays of hours or even minutes in making margin payouts, or doubts that CCPs will make margin payments in a timely fashion, can be catastrophic.  Almost exactly 25 years ago, on 19 October, 1987, the mere rumor that the CME would not pay out variation margin led to a run on FCMs and the CME clearinghouse that almost brought the market to a crashing halt.

One of the speakers at today’s event, Barclays’ Kevin Murphy, noted that under segregated models FCMs don’t have a lien on  the collateral in customer accounts.  Which means they won’t extend credit to customers because there is no collateral backing the loans.  Murphy said that broker intraday credit is likely to be a thing of the past under greater segregation.

Think of the consequences on a day when markets move a lot.  Those on the winning side are expecting to receive variation margin payments.  Those on the losing side will be scrambling for cash to meet their VM obligations.  Where will they get it?  Not from their FCMs.  From their banks?  Uncertain-even if the customers arrange credit lines, banks can often find reasons to delay providing the credit, or not providing it at all.

This all means that there is a risk that VM owes will not be paid in time.  With no credit being extended, or the amount of credit being sharply constrained, there is a serious risk that VM pays will not be made on time.   If that happens, particularly during a period of market stress, all bets are off.  Almost literally.  People will fear that CCPs are insolvent, and there will be runs on them-people will liquidate positions to recover their margin money.

That would be very ugly indeed.  Again, a cleared system is very tightly coupled, more tightly coupled than OTC markets.  Tightly coupled systems are more prone to going non-linear, and failing catastrophically.  Segregation increases the tightness of the coupling.   Connect the dots.

Of course, markets don’t stand still.  People will recognize the need for contingent liquidity, and make arrangements for it.  But will those arrangements be as robust as the system we have now?  There is serious room for doubt.  If more robust alternatives are available, why weren’t they chosen before?  I know this argument is not dispositive, given the coordination issues involved, but there are strong incentives to adopt better systems.   We should be very leery of changes that implicitly assume that market participants with large amounts of money and risk in the game systematically choose wrong.

The whole move to clearing has been intended to wring credit risk from the derivatives markets.  But every move to reduce credit risk-including moves to greater segregation-almost always involve creating greater liquidity risk.

If given a choice between credit and liquidity risk, I would choose credit risk every time .

In other words, you have to pick your poison: credit risk or liquidity risk.  Yeah, credit risk may be like arsenic.  But liquidity risk is more like cyanide.

I know which one I would choose.