The ESMA OTC Derivatives End User Exclusion

ESMA has released a Consultation Paper on the draft technical standards for trade repositories, OTC clearing and CCPs.

Discussion of non-financial counterparty exclusions begins on page 14.

OTC contracts that protect non-financial counterparties against risks "directly related to their commercial activities and treasury financing activities" are entirely excluded from a CCP clearing obligation.  OTC derivatives that do not protect against "directly related" risks but do not exceed clearing thresholds are also exempt from the clearing obligation.

To be "directly related" and therefore excluded from theshold computation, OTC derivatives contracts of a non-financial counterparty must be "objectively measurable as reducing risks directly related to its commercial activity or treasury financing activity or that of its group." There are two alternative tests for exclusion.  The first test is whether the OTC derivatives contract of the non-financial counterparty "individually, or in combination with other derivatives contracts", reduces "the potential change in the value of assets, services, inputs, products, commodities, liabilities that it owns, produces, manufactures, processes, provides, purchases, merchandises, leases, sells or incurs in the ordinary course of its business, or the potential change in the value of assets, services, inputs, products, commodities or liabilities referred to above, resulting from fluctuation of interest rates, inflation or foreign exchang rates."  The second test is whether the OTC derivatives contract qualifies for accounting treatment of a hedging contract under IFRS principles endorsed by the European Commission.  The rules are clear that whether the contracts consitute hedging under local GAAP rules is the standard, although ESMA expects most local GAAP treatment to meet the proposed definition.

If OTC derivatives contracts are not excluded, they count toward thresholds for clearing.  Clearing thresholds are set by notional amount and by asset class, with 5 asset classes defined: credit, equity, interest rates, foreign exchange, and commodity & others.  Breaching the threhold for any one asset class subjects the non-financial counterparty to a clearing obligation for all derivatives for all asset classes thereafter.  The notional amount thresholds will be phased-in, and periodically reviewed.

Non-financial counterparties will have to confirm OTC derivatives contracts by the end of the second business day following the trade day.

Portfolio reconciliation must be daily if counterparties have more than 500 contracts between them, weekly if between 300 and 500 contracts, and monthly for less than 300 contracts.

Portfolio compression is mandated for all counterparties with more than 500 non-centrally cleared contracts to be done at least twice a year.

Capital treatment will be addressed in a separate set of regulations on Basel III and CVAs.  There is still a significant likelihood that exclusion from clearing will result in a requirement of higher bilateral margin and contract re-pricing to include the CVA.

Much more in there, but this hits the high points.

Hurtling Towards Harmonisation

I spent most of yesterday reading the Financial Stability Board's OTC Derivatives Markets Reforms Third Progress Report on Implementation.  Thrilling stuff if you were desperately awaiting your next installment of regulatory waffle on harmonisation of global regulation and infrastructure for derivatives.

What struck me most powerfully about this report was the weakness of the policy agenda ("improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse" and motherhood and applie pie) and the absoluteness of the policy prescriptions ("[A]ll jurisdictions and markets need to agressively push ahead to achieve full implementation of market changes by end-2012 to meet the G20 commitments in as many reform areas as possible.").  After all, the global financial crisis was not caused by derivatives.  The financial crisis was caused by abusive securitisation of debt (mostly RMBS) which was impelled by preferential capital treatment under the Basel Capital Accords.

Why all?
Why agressively?
Why full implementation?
Why the deadline of end-2012?

I have been troubled by harmonisation of global regulations as an absolute objective for my entire career.  The Basel Capital Accords always struck me as dangerously simplistic in ignoring the national differences in banking systems.  Perhaps I am alone in thinking that different countries that have made different choices about legal principles and economic interest and market structure could reasonably hold different views about regulatory policy, priorities and practices.

A country like Britain whose banks are mostly giant global behemoths of nearly unmanageable size and complexity has a very different risk profile to countries like Russia or Saudi Arabia where most wealth is generated from resource extraction and the priority is protecting investments and ensuring market access.  Derivatives in London are used mostly for speculative trading and market making by intermediaries.  Derivatives in a resource economy will be mostly used for hedging and trade management.  And yet both are being subjected to absolute rules and absolute infrastructure requirements without regard to native interest or the different risk characteristics presented by empircal market practice and experience.

The report recognises that some countries are asserting native interests in requiring local clearing arrangements (e.g. Japan), but does not explore the policy rationale or recognise legitimate methods for protecting native interests.  Instead any variation from the desired consistency with the orthodox interpretation of requirements is treated as threatening the fabric of international markets (unless the US or central banks are doing it).

There is no recognition in the report of the risks of unintended consequences from implementing these reforms, even though much is being aired in the industry as the deadlines near.  Operational complexity will be massively increased for all market participants by parallel implementation of Legal Entity Identifiers and mandatory trading and clearing reforms.  Liquidity risks are growing daily as the shortage of quality collateral tightens amid downgrades and immobilisations.  Clearing houses are competing on lower margin requirements and taking lower quality assets, increasing the risks of a clearing house failure with massive systemic disruption and/or public bailouts.  Markets are suffering from declining liquidity, high volatility and impaired price discovery as end-users and institutional investors decide to sit on the sidelines to see what sort of markets emerge from the reforms.  Lawyers are struggling with renegotiating and redocumenting literally millions of bilateral agreements with varying terms and constraints into the new standardised construct.  And all of this is happening at a time when banks are undercapitalised, more encumbered than ever, stressed and struggling with both markets and regulators.

Why is "one size fits all" regulatory diktat a bad guiding principle for Communism but an excellent guiding principle for global capitalism?  Wouldn't we be more likely to discover what good public policy looks like if we allowed countries to take different views on market regulation and then compared empirical experience?  Both Denmark and Greece apply all Basle Capital Accord and EU directives, but they have very different financial markets with very different risk profiles.  They certainly have had very different experiences.  Shouldn't we ask what Denmark is doing right that Greece is doing wrong and learn from that, even if it is contrary to prevailing orthodoxy?

More generally, is a global financial system that insists on adherence to orthodoxy a strong system or a weak system?  If the policies are conceived and implemented in error - as the Basel Capital Accords may yet prove to be, no matter how many regulatory careers are built on them - then the adherence to orthodoxy weakens the entire construct and exposes everyone to severe systemic risk.

Given the massive cock ups revealed in the past five years, I'd rather have a period where different countries were free to experiment in legislating and regulating their financial systems than a rush to orthodoxy dictated by the same geniuses who caused the massive cock ups in the first place.  But I guess that's why I'm not a regulator anymore.

Derivatives as a Financial Crisis Accelerator

Following links a few days ago led me to a fascinating journal article by Professor Mark Roe of Harvard Law School.  He suggests that the preferential treatment of OTC derivatives and repo collateral transfers in advance of bankruptcy skews incentives to make the financial system much more leveraged and more risky than it would be otherwise.  The top dealers - who have the best overall view of asset portfolios, trading positions and debt structures - can secure cash and assets to themselves through collateralisation, and even fraudulent over-collateralisation, without any risk of challenge in the ensuing bankruptcy.  As a result, they finance much higher levels of systemic leverage and write many more OTC derivatives than they would if they had to actually worry about counterparty failure.  And the failed companies themselves are left with much less of value to satisfy other claimants (employees, pensioners, trade creditors and the government) or to attract investors that might resuccitate the failed firm.  Because repos and OTC derivatives are bilateral and not reported, it is impossible for other creditors of a firm to monitor the exposure of the firm or the pre-insovlency transfers of assets through margin calls to the preferred secured creditors.  The result is that the market economy becomes progressively less transparent, less resilient and less equitable.

Professor Roe's observation is worth seriously evaluating as it accords very nearly with what we have observed in the five years of financial crisis.  It also helps explain why the crisis stubbornly persists in the face of extraordinary fiscal and monetary policies.  Assets are transferred pre-insolvency to preferred repo and OTC derivatives creditors.  (In the case of Lehman Brothers International, the global market liquidations started in March 2008 as available assets - including customer assets - were liquidated globally to make progressively more demanding margin calls to a handful of preferred creditors.)  Losses are socialised to investors, trade creditors, pensioners and taxpayers, while the dominant global banks continue to record healthy profits.  Investors shy from taking on failed firms as they have in previous downturns, because too little is left worth salvaging.

It may be the situation is still getting worse, rather than better.  In the recent failures of Bear Stearns, AIG, Lehman and MF Global, the failures actually reinforced the dominance of the top incumbents and further concentrate dealing, custody and collateral to these same firms.  They have more market power today than ever, and better vantage should they choose to game the system.

Besides indicting the preferences of the Bankruptcy Code reforms, Professor Roe also suggests that the move toward central counterparty clearing will not improve the situation as hoped.  His objections include:

• Poor incentives in exchanges and clearing houses to manage risk as they are competitive and owned by the dominant incumbents;
• Clearing house margining of many OTC derivatives will not fully address credit risk as past experience indicates that many transactions look just fine right up until default is recognised - "jump to default" risk;
• The risks netted in a clearing house are only netted among direct clearing members, resulting in reallocation of the risks to those outside the circle of direct clearing members while concentrating assets in the hands of fewer and fewer dominant players;
• Clearing houses "up the ante" on Too Big To Fail by themselves being too big to fail, and concentrating liquidity and assets in the hands of clearing members and settlement banks.

I'd like to believe the work we are undertaking as an industry to implement CCPs will prove risk reducing, making the financial system stronger and more resilient.  But I also believed the same thing when I helped repeal Glass-Steagall and promoted OTC derivatives in my early career as a regulator.  I believed the same thing when I was involved in driving forward the harmonisation of laws on securities ownership, transfer and pledging globally.  I sincerely believed that deregulation and harmonisation would make the world a safer place for capitalism. Legal certainty of transaction enforceability grows markets, and our success in gaining legal recognition of repo, derivatives and their collateral arrangements underpinned the massive global growth in repo and OTC derivatives dealing that defines today's markets.

But capitalism requires risk if capital is to be allocated efficiently.  If the dominant players in the game never lose, because they can always allocate losses to others at the table, then that isn't really capitalism anymore.  The result will be consistent misallocation of capital and inequitable returns to firms that do not contribute to the overall social welfare and economic prosperity.  In a nutshell, this is what the Occupation movement objects to about the current system.

At its core, an economy requires wages be paid for there to be sustainable wealth creation.  As wages grow, so does broader prosperity.  Industries that create jobs and pay more and higher wages to more people contribute more to the greater social good.  Industries that are insensitive to the destruction of jobs, stagnation of wages and deflation of private wealth are bad for society.

Professor Roe suggests that reforms to bankruptcy laws that removed the risk of loss for repo and OTC derivatives counterparties went too far.  The small cohort of repo creditors and OTC derivatives counterparties that dominate global markets became insensitive to the business rationale or commercial prospects of their counterparties so long as they gained possession of enough quality assets as collateral to comfortably cover any credit risk.  Something is clearly wrong in a system where the dominant incumbents never lose while most of us become progressively more exposed to unemployment, pension devaluation, higher taxes and economic insecurity.

Bankruptcy law usually tells the end of a story.  If Professor Roe is right, we might consider whether the bankruptcy preferences created by a generation of visionary capital markets lawyers are somewhere near the beginning of the story of today's global financial crisis.

Initial Margin: Theory and Practice

The news that the CME CCP will be accepting corporate bonds and that LCH-Clearnet will accept RMBS for initial margin has me thinking about the dangers of demutualisation of clearing houses.  Managements of shareholder owned clearing houses are keen to compete for market share and volume to increase revenues, bonuses and profits (not necessarily in that order).  The interests of their members (and of central banks and taxpayers who may be asked for bailouts) may require more prudence than managements might prefer.

No where is the tension more obvious than in the scope of assets accepted for initial margin.  It is worth remembering that clearing houses only take very short term risk.  One day risk is normal for exchange traded derivatives.  A default will be determined, positions liquidated and final settlement of initial and variation margin made on the same day.  Several days to several weeks risk might be more sensible for OTC derivatives which are less liquid and more difficult to price quickly among a small cadre of dealing firms.

The initial margin the clearing house takes from each member is intended to cover the liquidation costs to the clearing house of disposing of the member's open positions at the time of a default.  As markets come under stress when members default, and members default when markets come under stress, it is quite likely that the clearing house will be closing out positions and liquidating initial margin assets into stressed markets.  The assets taken as initial margin should be of a quality that they are cash equivalent - traded in liquid markets where they can be disposed of for cash as and when the clearing house needs it.

For that reason it has been best practice for clearing houses to only take cash and very liquid government securities as initial margin.  Cash and government securities tend to be counter-cyclical assets in stressed markets, gaining value from their superior credit quality, liquidity and price transparency.  Corporate bonds and RMBS may be valuable assets, but we have seen that prices collapse and market liquidity evaporates under stress conditions.  They are pro-cyclical assets, and the very act of CCP liquidation will further stress already stressed markets against the CCP realising the value it might have projected before the default.

I'm sure that the risk committees at the CCPs are aware of all this, and that there are prudential limits and generous haircuts on the use of either corporate bonds or RMBS as initial margin in their rules.  It still makes me nervous that pro-cyclical assets will be eligible as initial margin.  Rules will tend to be relaxed and exceptions become more normative as markets become complacent and competition intensifies.

The IMF is projecting a huge shortfall in quality, liquid assets driven by record balance sheet encumbrance of banks forced to secured lending markets, immobilisation of collateral assets in margin and CCPs, and downgrading of assets which were once thought quality but now are looking worse and worse.  If clearing houses begin to compete on the scope of accepted initial margin, that will increase the risks already concentrated in the CCPs.

Members who must backstop the capital and default guarantee fund of each clearing house should be paying attention.  So should the central banks that will have to backstop liquidity for a CCP.  And so should treasuries - and behind them taxpayers - who may end up having to recapitalise or bailout a troubled CCP.

There was a reason that market infrastructure was run on mutual principles of membership for most of the last three hundred years.  It concentrated minds on risk management for the longer term - over the business cycle rather than the bonus cycle.

Are CCPs Increasing Risks? Part IV - With Slides!

The Post Trade Forum debate on Are CCPs Increasing Risk? was held at the London Stock Exchange yesterday.  Cheers, Gary, for letting me take part in such a fun event!

My slides are available to download here:  Are CCPs Increasing Risk?

Short story is that I see rising risks from mandatory margin of OTC derivatives with CCP fragmentation, and this will intensify during the transition.  We are not in normal times, and this sort of reform would have been challenging under the best conditions. 

CREDIT RISK: I concede that mandatory CCP clearing and CSA margin will generally reduce credit risk.  BUT . . . (a) Netting fragmentation means counterparties to multiple trades lose the big credit risk reduction of 100 per cent netting coverage; (b) Multiple variation margin flows on fragmented portfolios mean it is impossible to tell whether payments are reducing or increasing overall risk without consolidating all variation flows with the residual exposures for a close out value; (c) Tiered clearing and custody arrangements introduce other credit risks and dependencies; (d) It is a bit bizarre as a matter of public policy to ban banks from extending credit in connection with OTC derivatives while beating them about the ears in the media for not lending more.

VALUATION RISK:  CCPs normally rely on exchange price discovery for valuation of assets and exposures.  As OTC markets are not subject to exchange rules and price discovery, CCPs will not have access to reliable pricing or liquidity to the same extent.  Valuations for variation margin movements will be the CCPs' best estimate of the value of a series of future obligations, with the CCP having discretion over methodology.  Unlike bilateral pricing, there won't be any scope for objection or negotiation.  The risk of mispricing is significant, particularly given sensitivity of OTC markets to liquidity conditions, falling liquidity in many instruments and markets, and a likely further decline in participation as higher lifetime costs of holding OTC derivatives drive business away.  The high concentration of OTC derivatives trading - with 90 per cent among just 5 dealers - makes these markets particularly at risk to price distortions, intentional and unintentional.

LIQUIDITY RISK: The numbers are staggering.  The IMF Global Financial Stability Report is projecting a big shortfall in safe assets at a time when demand is rising due to Basel III Liquidity Coverage Ratio, mandatory CCP clearing and bilateral margin, and increasing reliance on secured lending facilities for liquidity. There just aren't enough "safe" assets in the world to margin all the CCPs and all the bilateral exposures by 2012 without a massive liquidity dislocation.  Whether the number is $200 billion (the Heller and Vause BIS estimate for just the G14 dealer banks) or $2 trillion (the Singh IMF estimate for all uncollateralised exposures), a huge margin call is looming.  Mandatory margin will be especially burdensome for 2nd tier and end user hedgers who may lack native liquidity in the assets demanded by CCPs or under stricter and more limited new ISDA CSAs.  Add to that the need to pre-position or reserve cash and assets against variation margin calls or increases in initial margin under volatility, and there is a real risk that CCPs will exacerbate pro-cyclical liquidity risks across the system.  Any default to a CCP will have wider destabilising effects on credit and asset liqudity.

OPERATIONAL RISKS:  The regulations aren't even final yet!  One thing I know from building clearing systems is that systems built from incomplete specifications and requirements are likely to prove unsatisfactory, if not be abandoned.  It's unlikely all the CCPs being built right now (over 20 in total!) are going to get their systems right.  For the industry, ISDA is just finalising the new documents that will be required to implement CCP clearing and new CSA structures.  Blackrock alone has over 1000 CSAs to renegotiate toward standardised margin practices.  And not everyone will be cooperative or responsive to the drive to standarise on the new document formats.  On the technology front, the complexity of more than 20 CCPs with their own processing requirements, timelines and data formats presents a major integration challenge.  Add to that the need for treasuries to shift to multi-currency variation margin payments and reconciliations, along with pre-positioning initial assets, tracking asset usage and monitoring mandates at custodians, and it's going to be a busy year for operations and IT staff.

CASH, CUSTODY AND CLEARING RISKS:  The big risk issues here:

• Different segregation models among CCPs and Clearing Agents (pooled, LSOC and fully client account segregation);
• Portability of client accounts and positions will be mandatory under the new CPSS-IOSCO principles for CCPs, despite it being a challenge under some resolution regimes;
• CCP and margin will force much greater concentration risks among the top clearing bank/custodians, reinforcing their already mammoth moral hazard in the system and giving them huge liquidity subsidy from deposits of margin cash by CCPs to their tender care as Settlement Banks behind the CCPs;
• CCPs will have differing default waterfalls, tiering claims on client margin, member margin, capital, Default Guarantee Funds, and contingent claims on members.
• Local resolution regimes are ill-adapted to quick resolution of claims and create risks around CCPs, which are by their nature systemic risks for the wider financial system. 

SYSTEMIC RISKS:

• Falling liquidity and rising shortfalls of safe assets for capital and margin make the whole system more fragile;
• There is a high risk of severe volatility returning as credit markets normalise to positive interest rates - or of deflation if investors give up on ever seeing a positive return again under financial repression;
•  Markets are not normal, with very high asset class correlation and increasing concentration risks.

Summarising some points from the discussion:

• Dodd-Frank and EMIR seem to be politically motivated to reduce derivatives trading without objectively banning it by making it more costly and burdensome;
• Getting all the regulatory compliance in place within the deadlines will be a huge challenge all around;
• Some CCPs have access to central bank liquidity facilities, but not all do.  Interesting to reflect on what kind of risk the UK taxpayer is taking on with so many CCPs concentrating in London, and potentially all making similar risk management mistakes under the same regulatory regime.
• Consolitation of CCPs would be desirable for efficiency and netting gains, but is difficult because of the prestige and protectionism of certain countries.  Even where governance has been consolidated by mergers in the past, often systems remained fragmented with different processing cycles and formats.
• The EMIR passport for pan-EU CCP operations might promote some consolidation on the merits.
• Clients are going to be hit hard by higher costs, lower returns, more complexity, and poor liquidity.
• Default funds should be broken out by asset class to prevent cross-subsidy and mutualisation of risk.

Only one person in the room believed that the overall impact of the forced migration to margin would be net risk reducing (she works for a CCP), and many are worried about the transition proving very stressful.

Finally, congratulations to Gary and Cathy Wright on their 30th wedding anniversary!

Are CCPs Increasing Risks? Part III

I've let the ball drop on blogging for the past few weeks, but have been thinking a lot about the issues.  The Post Trade Forum debate on Are Clearing Houses Increasing Risk? will take place on Tuesday morning at the London Stock Exchange. 

I've just finished my key note presentation for the debate, and I'm afraid I come down on the side of increasing risks.  I've been studying derivatives clearing infrastructure for more than 25 years, going back to the market crash of 1987 when I was at the New York Fed.  I just can't see how imposing structured clearing and margin which fragments efficient bilateral netting arrangments and stresses global liquidity can improve the current system.  I'm particularly worried about the liquidity implications for cash management, safe assets as initial margin and default guarantee fund assets, and systemic encumbrance.  At a time when credit to the real economy is already dampened, and banks are shrinking their balance sheets to fit the new Basel III capital requirements, the transition to CCP clearing could contract credit and liquidity, and prove highly deflationary.

My concerns about CCP clearing increased dramatically after talking to some Buy Side end users at last month's Risk Annual Summit.  My fellow panelists from corporations and asset managers were quite refreshing in admitting that they lack the expertise, systems, legal resource and operations capability to make the transition to daily, multi-currency CCP margining with multiple CCPs fragementing the market by product and region.  The same may be true of many banks, but they are much more reluctant to admit it openly as any admission of weakness would draw an expensive supervisor-mandated audit of systems and processes.

The Buy Side also worried that the residual bilateral portfolios with their bank counterparties would be hit with much higher Credit Valuation Adjustments (CVAs) under the new Basel III rules that become effective January 2013.  Even if they gain their objective of an opt out of CCP clearing, they will be penalised with even higher initial margin requirements under IOSCO proposals that bilateral clearing should be punitive. 

At a time when most governments are trying to jolly their banks into lending more to the real economy, Manmohan Singh of the IMF projected that the move to mandatory OTC clearing could be equivalent to a $2 trillion dollar margin call on 2nd tier banks, corporations and asset managers.   That would have a huge deflationary effect on credit and liquidity, and stall any recovery or deepen any recession.

So that's what I'm worrying about, but I'll provide much more detail on Tuesday morning.  I'll post the slides after the event.

Are CCPs Increasing Risks? Part II

Yesterday's post looked at the big risks in the CCP landscape from simultaneous requirements for mandatory margin, novated contract terms, complex portfolio and collateral valuations, reference data reforms, and default funds.  Today we'll look at the competitive differentiators that potential CCP members, sencond tier swaps dealers, and even end users should evaluate when deciding where to clear their OTC derivative transactions.  Note that each of these three categories will end up with a very different risk profile on these factors because of the influence of intermediation and waterfall effects.

Swaps Clearing Eligibility:  Each CCP will have a different range of eligible derivative transactions that they can clear and margin.  Since the real benefit of clearing derives from netting efficiency, it is important to choose a CCP that matches the scope of the member/end user portfolio as nearly as possible.  In a bilateral netting, the netting efficiency will be 100 per cent between the parties (excluding any independent amounts).  As CCPs will only accept "standardised" swaps for clearing, the netting benefit will be less - perhaps much less if there are more exotics in the portfolio.  Some of the key implications are:

•  The demand for initial margin will be much greater, especially from end users.  The CCP will require initial margin on the swaps being cleared at the CCP, and the swap dealer will also require initial margin for swaps which remain bilateral.  This will squeeze end users who are not natural holders of margin-eligible asset classes.  Indeed, corporates don't tend to hold large, deep pools of securities at all.  Those end users who do hold deep pools of high quality securities (that's you pension funds and insurance companies) may find themselves targets of clearing members trying to gain mandates over their assets for their own proprietary liquidity and collateral transformation purposes (e.g., see Lehman Brothers International and MF Global litigation).
  
  
• You could end up posting variation margin to the CCP and/or to the swaps dealer even when you are in the money, increasing your exposure to default and other risks.  Valuation of a bialteral swaps portfolio always produces one net number, positive or negative.  Split that portfolio into two - a CCP cleared portfolio and a residual bilateral cleared portfolio - and you are going to produce two net numbers - one for each subsidiary portfolio.  As you can be in the money on one, and out of the money on another, you can end up paying variation margin that increases your net default credit exposure.

Collateral Eligibility and Haircuts:   Swaps dealers and end users will hold assets which are attractive to them given their individual geography, investment objectives, liquidity needs and business models.  Hedge funds, pensions and insurance companies may have a pool of high quality, liquid securities that will be eligible for initial margin collateral.  Corporates may have just what they need for treasury management.  In the nature of things, end users will hold a lot of less liquid, more difficult to value, equities, corporate debt, municipal debt, money market instruments, etc.  This means there is going to be arbitrage in collateral transformation, with a lot of scope for things to go wrong - badly wrong.  Collateral transformation will also cost fees, require operations for monitoring, etc.  And the top tier firms don't just want your margin assets, they want all your assets to be subject to a pooling and margin arrangement, subject to a mandate allowing them to lend, repo and margin those assets at their discretion, profoundly changing custody expectations and protections.  As a result, members and end users will generally want a CCP that will take the assets they have as margin, minimising transformation costs and risks.

From Betting the Business: Once the dealer gets the securities it has the incentive to re-use them in many different ways to boost its returns beyond the commissions paid by the corporation for the collateral transformation services. As the bottom section of the figure shows, upon receiving the securities from the corporation, the dealer can exchange them into higher yield assets through swaps, sell them outright and invest on a cheaper synthetic through derivatives and get additional leverage. In all these transactions the dealer is taking higher risks, as well as counterparty risk. And remember that when the corporation decides to close the derivatives trade in the CCP, it returns the cash to the dealer, which in turn is obligated to give the securities back to the corporation. Because the investments made by the dealer do not match the securities that have to be returned to the corporation, the dealer is exposing itself to additional risks and can face big problems.

Valuation Models:  Each CCP will use a proprietary methodology for marking cleared swaps to market for purposes of calculating variation margin payments.  As these may be different than the valuation methodology used by swaps dealers as counterparties, and different still from the methodology used by end user hedge funds, institutional investors and corporates (who have different business model objectives than traders), there can be a risk that variation margin payments arise when unexpected.  This will naturally pose liquidity stress and risk as variation margin payments must be met daily, and intial margin demands may be higher than expected.  Swaps dealers and end users will want to evaluate CCP valuation models to ensure that they broadly agree with the principles and methods being applied, and that they can handle the projected volatility and variation that may arise under stress scenarios.  It is worth remembering that CCPs will not exercise the discretion and tolerance that are common in the OTC market when a disputed valuation arises.  The CCP will insist on payment of variation margin when due, and delivery of initial margin when demanded.  This makes the system overall much more fragile and difficult to predict.

Segregation Models:  There are three different segregation models emerging, and even these three are not entirely clear as to how they will work to protect CCP members and end users as the law keeps shifting.  The three models are (a) Net Omnibus Segregation (prevalent UK model with shared client risk); (b) Gross Omnibus Segregation or "Legally Segregated Operationally Comingled" (incoming US model); and (c) Individual Client Account segregation (only being offered from Q2 2012 by Eurex).  I'll go into the details of segregation options in a further post to follow, as it is important to address segregation risks arising in the clearing member as well as in the CCP.

Generalising here, pooling and netting are in the interests of dealers (minimising initial margin at the CCP and so optimising asset liquidity and re-use opportunities) and account level segregation is in the interest of end users (better protection and portability in a default).  Each potential clearing member, second tier swaps dealer and client is going to have make choices between cost, convenience and protection.  MF Global's collapse has left a lot of end users more wary and looking for better protection, so we are likely to see some differentiation as intermediaries self-sort with some offering more old-fashioned fiduciary protections.

Default Guaranty Fund Exposures:  Clearing members will have to contribute to the Default Guaranty Fund of a CCP.  Because losses that deplete the Fund should be uncommon if the CCP does its risk management and margining job right, the risk of a loss that hits members should be seen as a tail risk.  In that case, capitalising that risk will be very expensive and lock up quality capital, depleting market liquidity.  Supervisors are looking at other options which incorporate mutualising the contingent risk among the clearing members in ways that would only hit the members for contributions if losses occur.  How the Default Guarantee Fund is structured, funded, capitalised and administered therefore has serious implications for clearing members' credit, reserve, liquidity and liability management.  It's worth remembering that - just like deposit insurance - the time when a Deposit Guarantee Fund needs top-up from the members is likely to be a time of high stress and low systemic liquidity, complicating any draw on members.  Supervisors are likely to take different views on what is best for the CCP, best for the clearing members, and best for systemic financial stability.

That's enough for today.  Some of the points require much more complex analysis, such as segregation and default guarantee funds, and I'll address this in later posts.  More to follow!

Are CCPs Increasing Risks? Part I

The title of this post is the title of a debate being hosted Post-Trade Forum next month:

Post Trade operational risk: Are Clearing Houses increasing risks?

Gary Wright of B.I.S.S. Research has kindly asked me to give the key note.  I'm also on a panel next week at the RISK Annual Summit on Collateral Trends for Corporates which will cover some of the same ground.

In reflecting on the topic I realised that I have been studying the risk mitigation implications of swaps clearing for nearly 25 years, since the very first swap clearing house was proposed by the Board of Trade Clearing Corporation in the late 1980s while I was on the Settlement Systems Studies Group at the Federal Reserve Bank of New York.  I was co-inventor of the first global, real-time, ISDA-CSA compliant OTC derivatives margin system for Clearstream in the late 1990s.  I've written and thought about the clearing and margining of OTC derivatives for longer than almost any of my contemporaries.

So here's Part 1 of what I'm going to say about the risks of CCPs being rolled out globally later this year:

1. As someone who has supervised and built clearing and settlement systems for a long, long time, let me first observe that the single surest sign of system failure is pre-mature specification before the requirements and regulations are complete.  This always leads to cost overruns, delays and often complete abandonment of a half-completed system.  Since complete regulations have yet to issue in US, UK, EU and Asia, and since all these regulations will be inconsistent to some degree, the risks of project problems for CCPs are very high.  (Disclosure: Granularity has a great track record of problem project remediation so I consider this potentially good for business.)
   
2. CCP clearing will become mandatory for all "standardised" OTC derivatives.  One of the things that isn't yet defined is what "standardised" means in OTC derivatives.  In the broad array of financial instruments where two parties exchange cash flows based on fluctuations in reference indicators, the contract terms which must be common or configurable to be standard has never been completely described.  While standardisation has progressed quite a bit in the last decade with ISDA standard agreements and FpML, especially for products that are designed to clear through Swapclear and other facilities, there is a long way to go in establishing certainty as to which products must and can't be CCP cleared.  A side note to make here is that the regulators will try to force more standardisation by requiring bilateral exchange of intial margin for all swaps dealers and unilateral initial margin for end users for all instruments not cleared through a CCP.  The pressures both ways should create some interesting chaos as the industry grapples with a changed cost base, collateral demands, CSA amendments, tri-party collateral facilities, and CCP integration.  It should be noted that an end user will have increased exposure to his bank/counterparty for any initial margin provided in the event of the bank/counterparty's default, unless a tri-party agent is used for custody.
   
3. CCPs will have to provide daily valuations of cleared derivative instruments and portfolios in calculating variation margin.  This is not as straightforward as it sounds as there is a diversity across the industry in the modelling of valuations for OTC derivatives.  There is scope for some serious game playing in seeking advantage in steering the portfolio valuation methodology toward more accommodative models, especially as liquidity tightens or volatility increases.  Given that there has been tremendous concentration in the ownership of demutualised clearing houses in the past decade, there is a serious risk that owners/incumbents that dominate OTC dealing and clearing house risk committees could rig the system to their benefit.  Perhaps I'm being cynical in thinking this would ever occur to them, but let's face it, fiduciaries are harder to find than predators in the current market climate.
   
   On the operational side, daily valuations of OTC derivatives portfolios are standard for all financial institutions regulated under Basel Capital Accord principles, and for many investment banks who need to tightly manage their treasury operations.  Daily valuations are not standard for a very broad swathe of hedge fund, institutional and corporate counterparties, some of whom have very modest means and very few OTC derivatives.  Many businesses were forced by their banks to take interest rate swaps as part of a commercial loan origination.  These end-users are not going to benefit from CCP clearing as there will be little scope for netting gains and/or little improvement in their risk profile from CCP credit interposition relative to their bank. 
   
4. Besides the portfolio, the CCPs will have to provide daily valuation of collateral.  One of the challenges in building the Global Credit Support Service in the late 1990s was providing the valuation methodology for 54 currencies and over 180,000 securities in a manner which would allow the users to have real-time transparency of margin positions.  While systems have come a long way since then, collateral valuation remains a non-trivial challenge, not least because few models accurately capture the volatility and liquidity conditions which follow a default.  Because valuation is difficult, particularly for less liquid securities and currencies, the CCPs will tend to require high quality assets as initial margin.  Even there, we have seen huge volatility for sovereign debt in the past few years, and there is little sign that this will diminish going forward.  If a CCP is too restrictive on initial margin assets, it will be difficult to attract users, so there will be pressure to take lower quality assets at more generous valuations. 
   
5. Variation margin must be paid in the currency of the underlying swap obligation.  This sounds straightforward, but will prove an operational nightmare.  The practical implication is many times more payment confirmations to be reconciled in many more currencies.  Instead of one net payment in one currency, counterparties will have to track, confirm and reconcile payments in a range of currencies.  The costs and complexity will probably drive renegotiation of many existing derivatives to reduce the operations costs and burden.
   
6. The CCP drive comes in parallel with an initiative to standardise reference data, and in particular Legal Entity Identifiers (LEIs).  The standard has yet to issue though expected in June, so the CFTC is now proposing that US-based CCPs use a CFTC Interim Counterparty Identifier (CICI).  This may sound a small thing, but believe me the standardisation of reference data is a major headache. If it were an easy thing to do, it would have been done decades ago.  While I'm generally in favour of LEIs, the tight time frame for implementing such a radical reform which must then be integrated into multiple existing and new systems to accurately ensure mapping across internal and external reference data is a major technology and operations challenge. 
   
7. Finally (for this installment), CCPs will be subject to supervisor stress testing and scrutiny of Default Guarantee Fund arrangements.  It is expected that owners/members of the CCP will have to absorb some contingent liability for CCP losses as an alternative to the massive capitalisation that would otherwise be required to cover difficult to measure losses on OTC derivative portfolio defaults under stress conditions.  Again this is an area where regulators have yet to provide a detailed picture of what they want or what they will expect or what they will accept as sufficient.  The capital and liability-sharing arrangements will have implications for members as well as CCPs, so could become an element in CCP evaluation and competition. 

More to follow!

Complements to Basel

Goodhart's Law states that any statistical regularity or economic measure that becomes a target for the purpose of policy will lose the information content that qualifies it to play that role.  I've been thinking about that a lot lately in preparation for tomorrow's Complements to Basel conference at the Bank of England, a joint production of the LSE Financial Markets Group and the Centre for Central Banking Studies.  The conference will be chaired by Charles Goodhart himself.

It seems to me that bank capital has become a victim of capital adequacy regulation, in a further proof of Goodhart's Law.

For twenty-five years the Basel Capital Accords have made capital the focus of prudential supervision policy.  Capital during this period has become so distorted and debased by bank managements' determination to game the regulations - and enrich themselves - that it is almost meaningless as a measure of the adequacy of a bank's financial reserves or the competence of bank management.  It is worth noting in this context that profits which are not required as capital reserves go into the bonus pool, giving management a direct pecuniary interest in minimising liquid capital held as reserves.  Most of the banks that have failed in this financial crisis had surplus regulatory capital right up to the day of their collapse - at least according to their internal calculations.

Capital is meant to be held as highly liquid, marketable assets, that can be sold to raise funds in a hurry to support the confidence of depositors and other creditors.  It must be in assets that the financial world would recognise as having established value even under stress conditions if confidence is to be preserved that a bank will withstand the crisis.  Yield hungry managements, determined to hold as little capital as possible, and that in higher yielding, less liquid assets, have made a mockery of the whole concept of capital as a financial reserve.  When it becomes transparently clear that the assets they hold have minimal value and less liquidity, it is governments and central banks that are expected to pick up the slack at taxpayers and savers' expense.

Was RMBS liquid and marketable under stress?  Nope. (50 per cent risk-weight under Basel.)  Was interbank debt liquid and marketable under stress?  Nope.  (20 per cent risk-weight under Basel.)  How about those Greek or Portugese government bonds?  Nope.  (Zero risk-weight under Basel.)  Don't even get me started on credit default swaps, which only have value months later, and then only if an ISDA committee determines a default and the debt auction determining the pay out isn't rigged.


In consequence of banks being undercapitalised and illiquid under stress, governments have had to spend billions in bailouts, eroding their own credit standing and the very bonds their banks hold as capital at the same time, and central banks have "quantitatively eased" their currencies toward debasement.

No one looking at bank capital today recognises a liquid reserve of marketable assets.  Instead we see models which depict a show of compliance with 4,000 pages of standardised complexity.  Where the purpose of capital was once to shore up the confidence of depositors; its purpose now is to minimally satisfy supervisors.

Whatever bank capital once was, and whatever its purpose once was, has been massively eroded by capital becoming the focus of globalised, standardised prudential supervision.

Goodhart's Law confirms the irony that Basel Capital Accords have left banks woefully undercapitalised.  We are all poorer for the lesson.

Extra-Territorial Implications of Dodd-Frank - Part 2

Another excellent podcast on the extra-territoriality of Dodd-Frank as it applies jurisdiction and scope, provided by Julie Schieffer of DerivSource, with Donna Parisi of Shearman & Sterling and David Lucking of Allen & Overy.

The discussion of cross-border perfection of interests in securities has a particular resonance for me.  I was on the International Bar Association Ad Hoc Working Group on Modernising Ownership, Transfer and Pledging Laws which developed the modern legal standards for transfer and perfection of interests in securities.  After almost 20 years, it still isn't clear that US regulators and US judges would recognise international principles.

• Section 772 provides territorial scope of Dodd-Frank jurisdiction for CFTC and SEC, and they are different.  CFTC jurisdiction will not apply unless there is a “direct and significant connection” or attempted evasion of US law.  SEC jurisdiction shall not apply to business outside the USA unless there is evasion.  Both have evasion, but CFTC has “direct and significant connection” test.  Little guidance has been provided from either on how they will interpret these provisions, although CFTC has indicated it will address jurisdiction in Spring 2012.
•  “US Person” definition has not been provided for Title VII of Dodd-Frank.  Scope focuses on types of activities and where they take place and the connection with the US, rather than limiting scope by the nationality of entities entering into transactions.  There is no definition of “US Person” in the Commodities Exchange Act although CFTC rule says a “non-US person” is one organised under the laws of a foreign jurisdiction or that has a principal place of business in a foreign jurisdiction.  For the SEC, Regulation S has a whole body of law as to who is a US person for Regulation S.  Dodd-Frank seems to focus on impact of a transaction on the US for a connection to the US.
• If two persons are clearly outside the US, but the underlying basis of a transaction is in the US, then the status is unclear.
•  There are now final rules on registration provisions and registration can be found on the National Futures Association website.  Market participants are still confused on whether their activities and products bring them within the registration provisions.  Some will have to make a judgement call to start the registration process without being certain which entities or activities may be subject to registration on extra-territorial activity.
•  Likely there will be some structuring and activity which increases the cost of doing business as a consequence of uncertainty as to the application of registration requirements.  This may be particularly a constraint on a large international bank which is uncertain of whether the whole entity must register or just a US branch of the bank.  Requirements for registration include the principles of the organisation and the fingerprints of senior executives.  This will be difficult for some entities where management is likely to resent such intrusive US demands.
•   Both CFTC and SEC have made initial proposals on the definition of a “Swap Execution Facility”.  This is a new concept, though derives from exchanges or contract markets.  The regulators need to explain how SEFs will work.  The SEC and CFTC proposals are very different from each other – so equity derivatives and credit derivatives may be treated differently.  Similar products will have divergent regulation and execution requirements.  This may encourage some geographic migration as platforms are set up near underlying markets.
• Platforms in Europe may be considered to be SEFs by SEC or CFTC, but the authorisation principles and coordination on mutual recognition and supervision are unclear. 
• There was no international consensus that SEFs are “a good idea”.  The G20 did not embrace this idea, although Europe may be moving toward the concept.
• There is broad global consensus that mandatory, central clearing of some derivatives should be required.  The issue for market participants will work in practice.  Section 725(h) provides for exemption of a clearing entity if the CFTC determines it is subject to comparable regulation elsewhere.  The CFTC has not devoted resources to comparability analysis for foreign clearing organisations, so as a practical matter you have different CCPs in different geographies complying with different legal  regimes.
• The US Uniform Commercial Code creates a “security interest” in margin and collateral, but in Europe there are security interests using title transfer.  The two different legal models may create a conflict for anyone taking margin or collateral from a US entity because of the different implications for customer protection in a default.
• Some clearing houses might have gone for mutual recognition – choosing not to register in the US as a Designated Clearing Organisation (DCO).  If this is so, any US customer would have to use a US Futures Commission Merchant.  LCH-Clearnet and ICE, which are already registered as DCOs, have changed their rules to allow FCMs access to clearing members on behalf of their customers to meet US requirements.
• The CFTC has finalised rules on reporting (1) reporting of information to swap data repositiories, (2) public dissemination of information for post-trade price transparency.  Reporting is also a feature under EMIR.  There needs to be further clarity on mutual recognition of reporting or dual reporting requirements.  Confidentiality of information also raises issues in some jurisdictions and with some counterparties, which will have to be reflected in documentation so that reporting can comply with regulatory requirements.  It still isn’t clear that the US will recognise the sufficiency of overseas data repositories, or whether some form of global data repository would be preferable.
• The US political context will be influenced by US political priorities in an election year, including unemployment.  US extra-territoriality may be extended more strictly in order to preserve business in the US, and prevent firms from moving jobs, operations or transactions to overseas markets.  While it would be optimal to address these issues globally through Financial Stability Board or G20, the reality is that this remains impractical given competing domestic priorities.
• Dodd-Frank was enacted in 2010 but implementation is still lagging.  Actual requirements are now rolling out, and 2012 will be a big year to monitor developments and ensure businesses are compliant as rules become effective.  The rules will be evolving over several years as international understandings and clarifications address gaps and inconsistencies, so the compliance challenge will be ongoing.

Extra-Territorial Implications of Dodd-Frank - Part 1

Excellent podcast on the extra-territoriality of Dodd-Frank as it applies to trading, reporting and clearing of OTC derivatives, provided by Julie Schieffer of DerivSource, with Donna Parisi of Shearman & Sterling and John Williams of Allen & Overy.  Below is a summary of the key points, many of which are relevant to choices that clearing houses and CCPs must make in designing their operations, rules and compliance strategies.

Many of the issues for non-US clearing houses and CCPs are similar to those I addressed back in 1996 when I secured for Clearstream, then Cedel, the first exemption from US clearing agency registration which allowed it to clear and settle US Treasuries in Luxembourg.  At a little over two years, it was the fastest SEC determination on a CA-1 Clearing Agency application or exemption application in SEC history. Gaining an exemption from US clearing agency registration is no trivial undertaking, especially when the principles and conditions for such exemptions remain undefined.

• The task of ensuring compliance with US regulations is daunting as many rules remain undefined, and harmonisation of US requirements with those which may apply in Europe and Asia may be problematic for both compliance and commercial reasons.
• The market infrastructure has not yet been built and the interpretation of laws remain uncertain, yet businesses must make decisions on how and where they will contract their derivatives business.
• Title VII of Dodd-Frank defines CFTC and SEC jurisdiction in Section 722, but provides a safe harbour for business without a “direct” US connection or in evasion of US regulation, but there is little guidance on how these provisions would be interpreted in practice.
• Section 725 gives CFTC authority to exempt a clearing house from registration as a Derivatives Clearing Organisation if it can demonstrate that it is subject to an analogous foreign regime, and 752 encourages international harmonisation, but there has been no exemption and the CFTC has not provided guidance on how it might be applied. 
•  Legal extra-territoriality and operational extra-territoriality need to be addressed separately.  Each clearing house operates under a legal regime.  Both ICE Clear and LCH-Clearnet registrations with the CFTC have elected to register as DCOs with the CFTC going forward, so do not provide precedent for the scope or conditions of any exemption.
• Whether brokers need to register as Futures Commission Merchants is also an issue.  CFTC has required DCOs outside the US to change rules to require that clearing members outside the US that handle US clients must register as FCMs with the CFTC.  If a clearing house is not a DCO the CFTC may grant an exemption from clearing member registration as FCMs, but the issue remains unclear.  Exemption authority is not well defined, and may depend on how terms are defined within the regulations.  Needs to be a solution to allow US customers to deal with a foreign clearing member where that clearing member is mandated by foreign law to be domiciled and registered elsewhere.
• Inconsistent and sometimes contrary regulations will require some lead time as well as guidance to resolve.
•  No matter where you are doing business in the world, if you are doing business with a US customer then your business will be subject to Dodd-Frank requirements.  A non-US affiliate of a US person will probably not be subject to the requirements (e.g., a London affiliate of a US bank or corporate).  Branches may raise a more difficult question as branches are typically not treated as separate entities of a bank, so a non-US branch of a US bank may be treated as a US person.  SEC and CFTC interpretations on US persons remain inconsistent.
•  What level of US investor participation in an off-shore fund will trigger treating the off-shore fund as a US person?  Similarly, it may make a difference if there is a US-based investment advisor managing the off-shore fund.
•  The nature of the underlying contract may also have an impact, if the underlying is a US corporate or a US-exchange-traded contract.  The CFTC may be reluctant to carve these out from US jurisdiction.  “contacts and effects” test in 722 of Dodd-Frank may be inconsistent with the US Supreme Court pre-Dodd-Frank decision in the Morrison case which limited extra-territorial scope.
• In addition to CFTC and SEC, Dodd-Frank recognises prudential regulators for the purpose of determining adequate margin and capital.  Institutions subject to Federal Reserve oversight may benefit from a regulator which is more comfortable recognising home country rules on prudential supervision, but this then raises competitive issues for non-banks subject to more restrictive SEC or CFTC regimes.
• It takes quite a long time to sort out the answers to cross-border regulation, and the gaps are often filled by market practice rather than new rules.  Transactional certainty may remain elusive for a long time, which will chill international activity and makes for poor public policy.  Law firms and swap dealers will have to coordinate to fill in the gaps while the agencies deliberate the final rules.
• In the Lehman insolvency, we found great reluctance to cede local interests in times of extreme stress.  There will be various pools of client margin in different pools in different countries leading to lower efficiency and more risk. 
•  Systems and infrastructure should focus in the medium term on cross-margining and netting to reduce margin inefficiencies and provide greater certainty on close-out positions in resolutions.