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OTC Derivatives: Is the DTCC Too Big To Fail?

rc whalen's picture




 

"In order to streamline securities settlement, Congress ordered that shares traded on exchanges be immobilized, which obviates both physical delivery of certificates and registration of transfer because the shares usually remain registered in the name of a depository or its nominee. This process creates a discrepancy between ownership of the share (economic or beneficial ownership) and the legal status as shareholder (registered stockholder). The more of a market's securities that are registered in the name of a central depository, the greater the number of transactions that can be carried out on its books. The ultimate goal in this model is for all issuers to cede control over all shareholder data to a single entity, which would then conduct all of the market's transactions on its books, just as if all securities in circulation on the market had been dematerialized. Today, in fact, it is likely that a listed company will have only one registered shareholder, appropriately named "Cede & Company", the nominee of the Depository Trust Company (DTC), which is a subsidiary of the Depository Trust and Clearing Company (DTCC), the entity whose group clears and settles almost all securities transactions entered into on organized markets in the United States. The rules of DTC require that Cede be registered as holder for all deposited securities."

"The Rise and Effects of the Indirect Holding System: How Corporate America Ceded its Shareholders to Intermediaries"

Theodor Baums
Andreas Cahn
Working Paper No.68
Institute for Law and Finance
Frankfurt, Germany
09/2007

At our firm we frequently receive calls from clients and readers asking about the likelihood of the passage by the Congress in Washington of reform legislation regarding over-the-counter (OTC) derivatives, financial regulation and/or mortgage securitization. Our answer is small to none given the political trends and the state of the lobbies in Washington, most specifically the large bank lobby that protects the Sell Side monopoly in OTC derivatives and securities. The fact that Senator Richard Shelby (R-AL) is still apparently not comfortable with the entirely watered down House proposal to reform OTC derivatives, for example, tells you all you need to know. Stick a fork in it.

Regarding OTC derivatives, for example, the proposed reforms already are so feeble and ineffectual that whether they pass the Congress or not hardly matters. Financial services reform, you see, is less important that innovation in today's global marketplace, innovations such as centralized clearing for OTC derivatives and quantitative easing for fixing the related problem of widespread global insolvency. And the pace of innovation in the world of OTC markets is accelerating with or without the consent of the Congress thanks to the hard work of the economists who populate the Federal Reserve Board's division of supervision and regulation.

The latest signs of "innovation" on Wall Street can be seen in the announcement last week by the Fed Board of Governors approving the application by something called The Warehouse Trust Company LLC to become a Fed member bank. Warehouse Trust proposes to operate a central trade registry for credit default swap (CDS) contracts and to offer related services, including the processing of lifecycle events for the contracts and facilitation of payments settlement. The membership status becomes effective when Warehouse Trust purchases shares in the Federal Reserve Bank of New York.

Warehouse Trust is a wholly owned subsidiary of DTCC Deriv/SERV LLC (Deriv/SERV), which in turn is a wholly owned subsidiary of The Depository Trust & Clearing Corporation (DTCC). When it opens for business, Deriv/SERV's Trade Information Warehouse (TIW), which currently matches 95% of all CDS trades, will be transferred to Warehouse Trust.

DTCC, in case you are not familiar, clears most of the cash securities volume in the free world. DTC is a limited-purpose trust company organized under the New York banking law, and is a member of the Federal Reserve System. It is owned by the banks that it serves. DTC, and Fixed Income Clearing Corporation and National Securities Clearing Corporation are registered as clearing agencies with the Securities and Exchange Commission. Got it?

The creation of Warehouse Trust as a Fed member bank marks the latest attempt by the large dealer banks and the DTCC to cover the retrograde OTC derivatives market in the clothes of modern respectability. The solution to all things bad in the world of OTC derivatives, you see, is centralized clearing. DTCC has lent its considerable credibility to the large bank cause because, after all, its clients are large banks. Indeed, if you listen to the folks at the Fed, the DTCC and the large OTC dealer banks, the advent of centralized clearing is just barely less momentous than the second coming of the Messiah.

One of the benefits of spending a lot of time talking and writing about centralized clearing as the solution to all known troubles and woes in the world of OTC derivatives and especially in CDS contracts is that it keeps the attention of the Big Media, the Congress and the regulators away from the front office and the process of creating and selling complex structured securities and derivatives. It is in the front office where the true problems reside, but notice that none of the OTC reform proposals nor the Volcker Rule go anywhere near the sales and trading desks at the large banks.

Based on our study of the Volcker Rule, which proposes to strip all of the largest banks of their proprietary trading arms, we know that solving the problem is not the real object of financial reform in Washington. Just as the Volcker Rule does no violence to the sales and syndicate function of the largest Sell Side banks, the proposed OTC derivatives reform legislation leaves the dealer monopoly in OTC intact and just barely improves the degree of regulatory oversight of these closed, private markets.

In technology terms, fixing the back office issues of OTC derivatives or securitizations with innovations like Warehouse Trust is akin to announcing a new venture to build cars with internal combustion engines. The evolution of DTCC into the de facto back office of an equally de facto market known as OTC is nothing more than recreating the wheel of multilateral exchanges and joint and several liability of clearing members, albeit one inch at a time.

The advantage of slow motion innovation is that the large dealer banks get to extend the date of true reform of OTC markets by years and pretend to be dealing with the systemic issues created by these unregulated, deliberately opaque OTC instruments, all the while harvesting supra-normal returns from these high-risk, high margin activities. Consider that all of the activities now conducted by TIW and that will be assumed by Warehouse Trust are considered routine at any of the multilateral exchanges, but at the Fed and among the large dealer banks, this is called innovation.

The sad fact is that a great deal of the "reforms" imposed on the OTC markets over the past several years have done nothing to improve price transparency or lessen the monopoly market power of the OTC dealers. To the contrary, under Tim Geithner, first at the Fed of New York and now the Treasury, the thrust of US policy has been to protect and enhance the monopoly position of the OTC dealers, all the while limiting "novation" or assignment of contracts (and thus secondary market trading) and price discovery.

None of the technical issues that drove the Geithner OTC reforms are even issues on a multilateral exchange. Indeed, since the Fed of New York began to focus attention on the back office issues surrounding OTC markets, the dealer grip on the OTC markets has arguably gotten tighter. When a customer faces a dealer instead of an open outcry market, the situation is unfair by definition and goes against basic American practice and experience, and the law, when it comes to the organization of financial markets.

To us, the whole object of the strategy pursued by the OTC dealers and abetted by the DTCC is to adopt enough of the operational attributes of a multilateral exchange to blunt criticisms of the OTC markets with respect to systemic risk issues, but leave in place the dealer monopoly and odious front office sales practices, the rape and pillage mentality that thrives today among Sell Side firms operating in the CDS markets. Just read the Sunday New York Times article by Louise Story and Gretchen Morgenson, "Testy Conflict With Goldman Helped Push A.I.G. to Edge," to understand the relationship between American International Group (AIG) and its OTC dealer bank counterparties.

The aspects of the OTC markets which remain off the reform table includes the bilateral relationship between the client and dealer regarding credit and collateral, the lack of complete market price transparency and the lack of any significant secondary market trading, all to maintain the monopoly rents that the large OTC dealers earn from this activity. Today's OTC markets have all of the attributes of a 1920s bucket shop and now the hub of this closed monopoly market is the DTCC, especially as the clearing house evolves inevitably into a central counterparty for all OTC trades.

And now the DTCC, through OTC derivatives market evolutions such as the creation of Warehouse Trust, is become the single point of failure in the world's financial system by virtue of its role in the OTC derivatives market. Both DTCC and Warehouse Trust are Fed member banks, but the former is not considered a bank holding company because neither entity takes deposits and are thus not FDIC members.

However, in the approval order by the Fed, DTCC commits to submit to Warehouse Trust to Fed prudential supervision as though it were an FDIC insured bank. What a shame that the Fed did not instead require DTCC and Warehouse Trust to be FDIC members and thus subject them to the discipline of the joint and several liability of being federally insured depositories. That would put the entire banking industry on notice that they are on the hook for the OTC shell game rising atop the infrastructure of the DTCC. Duh!

The Fed does, after all, does have a legal responsibility to ensure the sound operation of member banks regardless of their status as deposit takers. The order states that "Warehouse Trust will be well capitalized at the time it commences operations, and it will maintain capital that is sufficient to allow for an orderly wind-down if confronted with the need to cease operations." This is what economists call a "living will" by the way. The only trouble with the Fed's thinking is that if Warehouse Trust ever had to be unwound, then the DTCC itself probably would be in trouble as well.

Since the Fed has allowed the Warehouse Trust application to be approved without imposing the de facto cross-guarantee of FDIC membership on DTCC and all of its affiliates, it seems reasonable to ask just how the Fed would unwind this new member bank without destroying the entire western financial system. More important, why has the Fed put the entity that clears every cash equity and bond trade in the civilized world at risk to also be the central nexus and perhaps eventually even the counterparty for all OTC derivatives?

As the DTCC evolves from a record-keeper today and into a central counterparty for OTC derivatives and particularly CDS in the future, the question seems to be begged: Is the Warehouse Trust and DTCC now "too big to fail?" In the DTCC and Warehouse Trust, have we arrived at the functional equivalent of a multilateral exchange, via unauthorized public bailouts and the monetization of debt by our independent central bank, but in a decidedly sloppy and haphazard fashion?

Or as one former Treasury official told The IRA: "You can't reiterate enough the point that DTCC is owned by the dealer firms and thus the NY Fed is actively and purposefully aiding and abetting the continued OTC monopoly at the expense of real reform."

We'll be talking about this further and look forward to your comments.

Questions? Comments? info@institutionalriskanalytics.com

 

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Wed, 02/10/2010 - 00:44 | 224527 Anonymous
Anonymous's picture

I think you're tilting at the wrong windmill here. The "warehouse" is going to record the transaction details in a central repository, clearance and payment take place outside the facility. DTCC offers gateways to SWIFT or other e-payment routes. CME, amongst others, are offering the new clearing facilities. Before the trades get to the warehouse they are electronically compared for accuracy by submitting counterparties via online platforms such as MarkitServ (formerly DerivServ.)

You should step back for a second and take a harder look at the facts.

OTC's do not settle like listed products which are almost invariably RVP-DVP with one party delivering cash or securities and the other receiving. In the Equities markets there is something called CNS, Continuous Net Settlement, which simply matches up and nets out a participant's cash and positions.

OTC's are all about cashflow matching. Premiums and other lifecycle events, dividends, coupons etc...are agreed upfront per the contract terms and the cash moves but that's it.

I understand your points about "transparency". In the '80's the Eurobond dealers went apeshit over the introduction of something called TRAX which was launched by the then AIBD (Association of International Bond Dealers).

Trading continued OTC...but transaction reports including prices were recorded thru this system and made available to regulators. The market survived, the industry adjusted. It was later in the 90's when the first bond dealing platforms launched. Different, spreads certainly narrowed and price transparency became more than just an ideal as TRACE and other reporting mechanisms captured these prints. Still, OTC is OTC...electronic or not.

Could CDS be traded "on-exchange?" Maybe but right now even central clearing isn't exactly lighting the markets up. You are right to talk about slow progress but the real fact is that it's far more difficult to retool and streamline these processes than you let on, way more difficult. It's more than a step up from basic plumbing.

As for collateral management practices there are absolutely efforts to address dispute resolution and the buy side is participating in these discussions with the Fed riding shotgun to move things along.

DTCC was formed when the industry was choking on paper in the 60's. Actually, C.C.S., the Central Certificate Service came first, that enabled DTC to come online.

CEDE & Co. - Central Depository. CUSIP = Committee for Uniform Security Identification Procedure

There is no secret plot and DTCC is not "abetting" anything it's just stepping up to support long needed change in how OTC's are processed and risk-managed.

In 2005, almost 60% of these CDS trades were unmatched over 90 days. That's real risk, precisely the kind of meltdown in process that gave birth to DTCC in the first place.

The OTC markets are diverse as well, CDS are largely traded amongst the dealers, maybe 80% of the volume. OTC Equity Derivs are only about 30% dealer to dealer. The product mix is way different as well.

You're finding a boogeyman where none exists. The dysfunctional investment banks all build their applications to serve the product streams so it's common for FICC, Equities and OTC's to all be running off many different front to back systems with middleware and vendor packages embedded along the process chain.

It's obvious that lack of explicit transparency suits and OTC dealer centric market. This has been known for years and predates CDS trading by decades.

DTCC is serving a positive purpose here by providing a central location for the Feds or CFTC or whomever to be able to track activity without having to gather it up separately from every counterparty.

Independent valuations and MTM's that are used by counterparties performing their portfolio rec's are all part of the evolving dialogue.

Anyway, DTCC has performed remarkably well to date. Don't think you're advancing the salient parts of your argument by dragging them into question. Do the banks own DTCC? Yes...the commercial banks in particular, just like they own SWIFT.

In closing, love your work, have learned a lot about a lot of things but think you're well of base here.

Tue, 02/09/2010 - 21:10 | 224308 Cursive
Cursive's picture

Thanks, Chris.  Always an education.

Or as one former Treasury official told The IRA: "You can't reiterate enough the point that DTCC is owned by the dealer firms and thus the NY Fed is actively and purposefully aiding and abetting the continued OTC monopoly at the expense of real reform." 

We'll be talking about this further and look forward to your comments. 

Looking forward to your future comments.

Tue, 02/09/2010 - 20:49 | 224289 Anonymous
Tue, 02/09/2010 - 20:35 | 224273 Anonymous
Anonymous's picture

The thrust of all this nonsense is that it is impossible to invest anymore in "modern" financial markets like NY or London.

The first country that opens a real, stock only, no futures/options, trading place with full ownership disclosures and full settlement at the time of trade will reap a whirlwind of international investment seeking real old fashioned stock investing in companies that do things.

That would be real innovation.

Until then my best investment is in a solar panel on my roof and a vegetable garden in my backyard which I know really exists without leverage, that can't be sold short, and whose return I see directly on my monthly electricity bill and grocery bill.

Let the gamblers go play with themselves in NY and London.

vivzizi

Tue, 02/09/2010 - 17:36 | 224058 tom a taxpayer
tom a taxpayer's picture

RC Whalen - Thanks for this eye-opening look into mind-boggling machinations.

Tue, 02/09/2010 - 12:32 | 223349 Anonymous
Anonymous's picture

I have always wondered why anyone would buy shares when-

1. All you might really end up owning is an IOU from a naked short sale.

2. Legal title rests with the chillingly named Cede & Co, which is owned by the banksters.

The end result being that your so-called investment leaves you an unsecured creditor of a brokerage, which is in itself an unsecured creditor of Cede & Co, wholly owned by insolvent banks. And now the assets of Cede & Co are to be used to paper over the quadrillion dollar derivatives crater!?

As someone once said (wish I could remember who) "No matter how cynical you get, it is hard to keep up."

Tue, 02/09/2010 - 20:37 | 224281 harveywalbinger
harveywalbinger's picture

Eloquently stated.  

I admire your tinfoil hat sir.  

Tue, 02/09/2010 - 19:01 | 224172 Anonymous
Anonymous's picture

Indeed, this may be the ultimate vehicle with which to confiscate all pension funds, etc. Perhaps it is the doomsday mechanism to make sure that the powers that be won't be forced out? Long term holdings of equities are like playing roulette. Lucky this time, let's see about next time.

This is precisely why I keep my trades very short (in for 5-10 min max) and always end in cash at the end of the day. Even that has its risks, but at least my broker doesn't sweep to the now unprotected money market funds. Slush your profits out every so often and use them for what you really want.

Tue, 02/09/2010 - 12:26 | 223338 Anonymous
Anonymous's picture

I have always wondered why anyone would buy shares when-

1. All you might really end up owning is an IOU from a naked short sale.

2. Legal title rests with the chillingly named Cede & Co, which is owned by the banksters.

The end result being that your so-called investment leaves you an unsecured creditor of a brokerage, which is in itself an unsecured creditor of Cede & Co, wholly owned by insolvent banks. And now the assets of Cede & Co are to be used to paper over the quadrillion dollar derivatives crater!?

As someone once said (wish I could remember who) "No matter how cynical you get, it is hard to keep up."

Tue, 02/09/2010 - 20:49 | 224290 calltoaccount
calltoaccount's picture

The DTCC is a fraud enabling hell hole of corruption: 

 

Congress passed the Securities Exchange Acts of 1933 and `34 to restore greatly diminished public confidence in our capital markets and mandated the SEC: “having due regard for the public interest, the protection of investors, and the safeguarding of securities, to facilitate the establishment of a national system for the prompt and accurate clearance and settlement of transactions in securities.”

But incredibly, the SEC has done just the opposite by empowering the Wall Street owned and operated black box Depository Trust and Clearing Corporation to create a Three card Monte style, bait and switch, non-settlement, non-delivery of securities system that facilitates the unlimited sale of securities that the seller is never required by anybody to actually deliver, so that the transaction is never properly “settled.”  Known as naked short selling or failure to deliver, the scam has the same effect as counterfeiting because by definition and design, it dilutes the actual value of real shares by  overpowering the natural laws of supply and demand.

The government’s long toleration of this fraud at the very core of the system has enabled Wall Street banks, broker-dealers and hedge funds running all kinds of hot, dirty and foreign money along with their own, to reap huge, often tax free profits, by selling and never delivering unlimited quantities ofphantom stock, options, bonds, and even US Treasuries, with total impunity.  Over the years, the practice has destroyed countless companies and crushed the hopes and dreams of millions of investors worldwide.  Yet the SEC, self-proclaimed as “the investors first line of defense against securities fraud” and “the pre-eminent gold standard of enforcement of securities laws,” has not brought a single enforcement action to stop it or punish the perpetrators.  Is it any wonder the bad guys have come to feel invulnerable?

Even more incredible (and more profitable for Wall Street insiders), the “Stock Borrow Program” of the Depository Trust’s National Securities Clearing Corporation (NSCC) subsidiary allows the exact same parcel of shares to be loaned and reloaned over and over again to create an ever-metastasizing cancer of freely tradable “security entitlements.”  These illusions of ownership overhang the market (just like naked shorted shares) artificially depressing share prices,  They are not backed by an equal number of duly authorized certificates, and lack the full bundle of ownership rights a buyer thinks they are getting with their purchase (ie. voting rights, having dividends taxed at preferential rates, etc.).   Most investors looking at their monthly statements have no idea they may not reflect actual shares bought, received and held in their account, but only IOUs from their trusty brokers, who consistently violate the duty of fair dealing owed their clients by failing to insist on delivery of shares they were paid a commission to purchase for them.  That’s because to keep the scam going, the SEC-approved system quietly provides incentives for them not to.

 http://calltoaccount.wordpress.com/ 

 

Tue, 02/09/2010 - 12:07 | 223296 jmc8888
jmc8888's picture

It's derivatives and their faulty statistical models that got us  here.  As long as we employ them as is, they're all worthless.  Why should anyone pay the insurance? It should be obvious at this point 1 penny of insurance during a gambling bet shouldn't pay off a billion dollars.  I mean it's that obvious.  So when people rig it, let the bets fail.

 

They'll only be worth something if someone agress to bail out the CDS's you own.  Which of course is really a loan against the person you are screwing anyways...making it even more impossible to come out of.

 

What we're watching is another Federal funds through AIG to Squid again.  Except this time the start of it will be ECB to Greece to JPM/Squid, etc  or ECB to Santander to RBS to QoE

 

Yes lets punish them by letting them rape them.  Real smart.

 

Of course everything is going to blow up anyways, but being blown up diliberately by the same guys who put these countries in this mess...again......kinda hard to take imo.  Here buy these, you can afford it.........ok now I'm going to buy a bunch of THOSE because I know they can't ha ha. Suckers. 

 

The rats will soon be clawing at each other quite viciously. 

 

 

Tue, 02/09/2010 - 11:40 | 223243 Cyan Lite
Cyan Lite's picture

The CDS market needs to be regulated just as equity options are.  I wouldn't even mind bringing CDS into the retail market in $1000 increments.  I'm sure one has thought of this potential money-making scheme.  But it has some merits.  Back when GM went broke, there was all the talk that most of the bondholders were mom-and-pops who were using it for retirement income.  Why not allow them to buy essentially "put" options on those bonds in case of default? Personally, I'd be glad to buy several hundred thousands worth of bonds if I know I can buy CDS's against the entire portfolio from a A-rated organization or higher in exchange for a lower yield spread.

If anything, it'll allow retailers to start looking towards purchasing more bonds, which means it'll be easier for the big banks to underwrite larger issues.

Tue, 02/09/2010 - 10:25 | 223148 Anonymous
Anonymous's picture

Isn't the SEC supposed to prevent all this CRIMINAL nonsense?

Tue, 02/09/2010 - 11:35 | 223231 seventree
seventree's picture

Yes but instead SEC has evolved into a publicly funded criminal defense organization, dedicated to hiding anything that would embarass whatever Administration happens to be in power. Mainly by selective willful blindness to the obvious (see Madoff, BofA-Merrill, etc).

In all fairness, they were fearless in taking down Martha Stewart, hard. Let evildoers beware.

Tue, 02/09/2010 - 18:40 | 224146 illyia
illyia's picture

If you cannot read this, it is your own protection preventing it.

 

http://www.edwardharle.com/news/265_service_of_cmkmcmkx_3.87_trillion_suit_vs._sec

Tue, 02/09/2010 - 23:30 | 224441 illyia
illyia's picture

Link to 3.8 T suit against SEC

http://viewer.zoho.com/docs/paKdda

Actually works, right now.

Tue, 02/09/2010 - 10:10 | 223122 Anonymous
Anonymous's picture

Wow. They will establish these cds rather than eliminate them.
Impossible to invest anymore, too many timebombs.

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