By Matt Cameron, Duncan Wood
Plans to lower the bar for entry to the cleared derivatives space have sparked a fierce dispute between the large dealers and central counterparties (CCPs) that are already members of the club, and an array of other players that don’t have enough capital – or lack the trading and technology muscle – to meet existing requirements. Some CCPs currently require clearing members to have as much as $5 billion in capital – but the Commodity Futures Trading Commission (CFTC) proposed during a rule-making hearing on December 16 to cap such requirements at $50 million.
CCPs and dealers protest that allowing all-comers into the system will undermine its strength. “Some might look at the membership criteria and feel they’d like them to be easier, but clearing systems are only as strong as their weakest links. The challenge is finding a way to balance the objective of broader membership with default management integrity – otherwise we could see CCPs fail,” says Simon Grensted, managing director of business development at London-based clearing house LCH.Clearnet.
A spokesman for the CFTC says the agency has no choice in the matter – the bar has to be lowered because the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was signed into law in the US last July, calls for open access to CCPs.
As things stand, smaller firms argue they have been denied access to CCPs on two counts: hefty capital requirements, and the need for firms to participate in the so-called default management process, in which trades belonging to a collapsed clearing member are priced up and parcelled out in an auction process. Firms such as BNY Mellon, MF Global, Newedge and State Street have all failed to gain membership to clearing houses such as Ice Trust and CME Clearing because of these criteria.
The outsiders feel the bar is set too high. In a December 17 letter objecting to an application by Ice Trust – a US-based clearer of credit default swaps – to register as a derivatives clearing organisation (DCO), the Swaps and Derivatives Markets Association (SDMA) called Ice’s membership criteria unnecessarily limited, and said the clearer failed to validate the way its minimum capital level is set. The SDMA represents a group of 16 would-be clearing members.
“Capital required should be of the amount of risk you introduce into the system as a clearing firm,” says Mike Hisler, co-founder of the SDMA and managing director at Javelin Capital Markets in New York.
Eight days after the CFTC’s hearing, Ice Trust withdrew its DCO application, citing the significant changes proposed to the CFTC’s regulations in a letter submitted on the clearer’s behalf by law firm Winston & Strawn.
Even if the CFTC succeeds in capping entry requirements for capital – and some observers feel the proposal will run into strong opposition from bank regulators and financial stability experts – the default management criteria could still allow CCPs to cold-shoulder all but the biggest, most capable dealers. During the rule-making hearing, the agency also proposed that “clearing members must be able to participate in default management activities as required by the rules of the DCO”.
Typically, CCPs require that clearing members give end-of-day marks on their portfolios while also requiring them to participate in an auction process. If one member were to default, all remaining members must be able to bid on portfolios and have the operational ability to load those trades. In other words, every member must have a pretty sophisticated internal trading and execution desk.
This means firms that are unable to price and bid on potentially huge books of trades won’t be accepted as members – which the SDMA has a major problem with. “Certain clearing houses have artificially tied clearing to execution. This means that in order to be an over-the-counter derivatives dealer, you must self-clear. And in order to clear OTC derivatives, you must have a dealer desk internally. This clever construct prohibits independent dealers from participating in the cleared market-place, where they could naturally provide greater liquidity. Such a construct also prohibits well-capitalised independent clearing brokers from sharing the CCP risk in a proper and well-diversified manner,” says the SDMA’s Hisler.
All of this is beside the point, CCPs insist – existing requirements are not about running a closed shop. “Like it or not, the membership criteria are about ensuring the survival of the CCP and each member of that system has to consider the moral hazard of being a member and will therefore insist the CCP margins properly, and so on. Regulators want to see it, CCPs want to see it and shareholders want to see it – their worst nightmare would be a failed CCP,” says a source at one clearer.
And dealers are preparing for a scrap too. “This is really dangerous. CCPs also have minimum default fund contributions. If, for example, the minimum contribution is $25 million, and the entity only has $50 million in capital, then that capital base is halved instantly. What is more, clearing houses have the right to ask for extra contributions to the default fund at any time – sometimes more than double the minimum. How can a firm with $50 million capital meet this requirement? And what happens if there is a sequential default and the default fund is depleted? In theory, all members would contribute to top it up, but these smaller firms wouldn’t be able to pay. It goes against the whole concept of risk mutualisation,” says one clearing member of Ice Trust.