Tuesday, September 27, 2016

CME clearinghouse - changing the rules

The clearinghouse is the truly special feature of any futures exchange because it allows buyers and sellers to comfortably come together to trade with only limited credit risk. Traders know that they do not have to worry about the specific risk of their trade counter-party because their risk is with the clearinghouse. We know that the actual structures in place are more complex than this simple story. The mechanics make all the difference so changes should be looked at closely.

There are member of the exchange who trade, but their special value has been diminished with closing of the floor. There are also futures commission merchants (FCM's) that are the members of the clearinghouse. In the case of a failure, the first defense is the FCM and the firms associated with that FCM. The risk of the client/user is with the capital of the FCM and the other clients of the FCM. The poor credit of the FCM’s clients place more risk on the FCM first and then the clearinghouse. The defenses of the FCM have to be eroded before the clearinghouse funds and those funds of the other clearinghouse members will be employed. These layers of protection make for a better system. What is key for the whole system is that any trader does not have to directly worry about the credit on the other side of any trade. The credit risk is worked through the margin system and the linking of FCM’s with clients and then other FCM’s and the clearinghouse.

There will be a new wrinkle for this clearing structure starting this month. Firms can now clear directly with the clearinghouse and by-pass the FCM’s. For the large well-capitalized firm, there is less credit risk because you don't have to worry about FCM risk or the risk of the other traders of their FCM. The FCM's can have some large clients taken-off their books and effectively reduce their capital charge. This can be a simple win for clients and FCM’s

Actually, it is a little more complex. The new direct members of the clearinghouse will be called Direct Funding Participants (DFP's), but they will still need a guarantee from an FCM called the DFP guarantor who will indemnify the clearinghouse against loss. The FCM who is a guarantor gets relieve from the full regulatory leverage capital requirements. The DFP posts more margin, approximately an extra 4+% and the DFP posts 4+% so the capital put up for the trades will be the same as if the user was still doing business with the FCM. The capital for using the exchange clearinghouse is the same but the cost is split differently.

What are the gains for the system? Settlements will be streamlined and less concentrated, which will be good in a crisis. Large clients will reduce their credit risk at a cost of higher margin, albeit these firms, likely money managers, will have excess cash. FCM’s get capital requirement relieve that is making their businesses less profitable. Everyone wins. 

The scenario of a win for everyone seems the most likely outcome, but there should be some nervousness with changes to the plumbing of financial markets. These changes are partially responses to the Basel III regulation of banks. These are advancements, but a conservative streak tells me there are usually some unintended consequences that we have yet to explore. For most times, this will be a non-issue, but with all plumbing, if it works well, it will never be a concern until it is too late.

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