What Is In A Name: Is A Clearinghouse Just A Clearinghouse

Some "purists" seem to have taken offense at our earlier suggestion that standalone clearinghouses (DTCC) could be impaired in some quasi-principal risk taking form. We respectfully disagree and present some perspectives from the conversion of the ICE Trust into the central clearing counterparty for CDS transactions (which will be lucky to ever see even clear even a fraction of the CDS transactions that the DTCC does... which could very well be the Fed's thinking).

Recall that in 2009, the Fed approved the ICE Trust to become a central counterparty and clearing house for CDS transactions. As a "counterparty" it is without question that the ICE trust bears risk of principal. However, the Treasury's OCC issued an interpretive letter allowing a bank to act as a clearing agent in the ICE Trust CDS Clearinghouse. And herein lies the rub, which certainly applies to DTCC: according to the OCC a "clearing agent's" purpose is to substitute its credit for its customers and assume, with respect to the exchange, clearinghouse, and customers, the risk of default. This definition clearly endows the entity with the risk for losing money.

Clearing is a form of extending credit, one of the main functions of banking institutions. A clearing agent substitutes its credit for that of its customers. A clearing agent is liable to a clearinghouse for performance on all submitted contracts, and assumes, with respect to the exchange, clearinghouse, and counterparties, the risk of default. The clearing function is akin to two other traditional bank credit functions, providing bankers’ acceptances and letters of credit. The credit function provided by a national bank in its clearing capacity is part of the business of banking, because a principal business of a bank is to extend credit.

What is not lost to the Fed, and what explains today's action, is that if a clearing house and a clearing agent are regulated by the Fed or the Treasury, then presumably they can be seized if things go sideways in another risk escalation episode. At that point, however, there will be no freely available excuse that the only choice was bankruptcy or bailout.

Yet to settle the debate, things are more nuanced. What is needed, is for a law firm to issue an opinion letter from a major law firm that a bankruptcy court can't apply "substantive consolidation" to throw the DTCC swap clearing entities and the DTCC stock/bond clearing entities into a single bankruptcy, thereby throwing all assets of the various entities (the DTCC org chart is only matched by that of Enron) and thus put virtually every outstanding single stock/bond trade at risk.

Comments

[JohnKing]

a principal business of a bank is to extend credit

Oh, I forgot that.

[carbonmutant]

a principal business of a bank is to extend credit

      It used to be...

[reload]

It does read as if a bit more powder is being stuffed into the keg. But what is not clear is how margin will be set, and what `assets` will be accepted as margin.

[Shameful]

Well super, now I can have nightmares about Uncle Ben writing a check to every insane gambler on the planet at par out of my pocketbook...glad it's the evening so I can have a drink to settle myself.

[VegasBD]

Ill drink to that. =)

[Anonymous]

You're making it too complicated. ICE Trust US is the clearinghouse; DTCC, in the CDS context at least (as opposed to equities and cash gov't bonds), is simply a record keeper. (Details available here: https://www.theice.com/ice_trust.jhtml.) And yes, ICE will likely clear almost everything "of record" in DTCC's CDS warehouse once its CDS rollout is complete (index side nearly done; single-name just begun).

If you want to argue that the Fed would view ICE Trust US -- and other clearinghouses, such as CME's -- as "systemic," and therefore on the TBTF list of financial "assets" at which it will arbitrarily throw vasts sums of taxpayer money, fine. It's a reasonable argument that many are making. Let's just get the facts straight first.

[Rainman]

An unholy alliance of an unaudited Fed and its subsidiary CDS "record keeper" means there is nothing simple at all about this arrangement. It's an obscure scheme to eventually throw an added bone crushing liability on the backs of the taxpayer. That's making it simple for me with what few brains I may have left.

If they were brokering guns, corn or ammo  I'd feel differently.

[Double down]

The game never ends and yet the winner takes all!! 

Print baby print 

[funsell (not verified)]

Bernanke needs to go

[Chopshop]

EuroCCP: Four Main Recommendations For Reducing Systematic Risks Among Interoperating Central Counter-Parties (CCPs)

Equity market participants in Europe want the ability to choose their central counter-parties (“CCPs”) and gain the benefit of concentrating their clearing business.  For market participants to have such choice, their chosen CCPs must have access to multiple trading venues across Europe, which requires interoperability among multiple competing CCPs.  Although interoperability may introduce new risks and complexities, market participants cannot fully realise the benefits of competition without inter-operation among multiple CCPs.  When multiple CCPs inter-operate, each CCP becomes a counter-party to the other inter-operating CCPs and requires additional financial resources to cover its exposure from the possible failure of any of the other linked CCPs.

EuroCCP believes that existing approaches to risk management, used for bilateral interoperability, may be inadequate to manage multi-CCP arrangements.  Alternatives that are both scalable and sustainable and cover normal as well as extreme market conditions should be considered.

EuroCCP has four main recommendations:

1) Each CCP should augment its own existing default fund to cover potential close-out losses in the event of an inter-operating CCP’s default.  Under this arrangement, each CCP includes the exposure created by inter-operating CCPs in the calculation of its default fund and collects any additional amount required from its own participants, retaining the funds in the usual manner that it holds its default fund.  This approach does not require CCPs to give margin or default fund contributions to each other, but it does require mutual adoption by all inter-operating CCPs.  Most importantly, this approach does not disturb existing industry structure and can be quickly implemented.

By stipulating that each CCP augment its own default fund rather than contribute to other CCPs, each CCP’s risk management remains self-contained.  There is consequently no systemic contagion, and each regulator needs to monitor only the CCPs in its own jurisdiction.

We do not recommend that CCPs exchange margin because this practice would create credit risk, legal risk and liquidity risk.  With multiple CCP links, for example, it is quite possible that a CCP may collect little or no margin from a participant but be obliged to pass on a substantial amount of margin to the inter-operating CCPs.  We also do not recommend that CCPs be required to use their own capital or borrowed funds to give to other CCPs as margin.

2) An Interoperability Convention among all inter-operating CCPs should replace confidential bilateral agreements as soon as practicable.  A convention or similar agreement will provide to CCPs, their participants, regulators and trading venues a greater degree of transparency of how risks are managed and a heightened level of certainty of how problems will be handled when they arise.

3) Commercial barriers to interoperability should be removed.  While risk management must be addressed to make interoperability safe, the investment necessary to do so will yield inadequate returns if commercial barriers are allowed to prevent full and effective competition among CCPs.  At present, market participants must still connect to CCPs appointed by the trading venues and potentially incur higher operating and margin costs than if they could freely choose the CCPs they prefer.

4) Longer term, we suggest further consideration of inter-CCP netting, whereby a netting agent would be established to determine each CCP’s net securities and cash position against the other CCPs.  While it would take time to build and gain agreement on a common netting agent, this approach could substantially reduce liquidity and settlement risk.

This paper is intended to encourage discussion of the issues surrounding interoperability among CCPs, trading firms and regulators in Europe ....

http://www.zerohedge.com/article/euroccp-four-main-recommendations-reducing-systematic-risks-among-interoperating-central-cou

[cougar_w]

[Some "purists" seem to have taken offense at our earlier suggestion]

Now now, don't get yer undies in a bunch.

If one accepts that the DTCC might be on the hook for clearances, and that some unnamed playerz might be able to capitalize on that, then there could be a problem v-v the past tendency on the part of the FED to use CDS payouts as a conduit to aforementioned playerz.

Fine.

But the FED can already do that on the $20B scale, and did for GS. But they'd have to print a lot of dohlars to backstop the notional $40T (with a T)  some odd the DTCC clears, if they were going to underwrite the entire planet. And I still think they'd have their heads handed to them.

My bigger concern (on reflection) is that the DTCC looses independence and becomes an overt political tool, and a strategic nuke in the bargain. The FED could do more selective damage by "mishandling" clearances than by actually backstopping bad gambles, and in the process merely appear stupid rather than criminal, again reference GS+AIG for how "oops my bad" plays out in the media and Congress.

I guess the illusions just pile up on each other, in the end.

cougar

[Anonymous]

…mmust keep that (cds) market goinnnnnn(liquiddddddddd)……..

[boooyaaaah]

Finally Tyler Finally

DTCC explained in animation

http://www.deepcapturethemovie.com/

[carbonmutant]

I think the bigger story here is the market intel that the FED gains on who is betting how much on whom globally. The value of that information may be worth more than the derivatives. The forecasting intel alone could be sold for $Billions.

"Information about money is more valuable than money." -Walter Wriston

[Anonymous]

You may already be a winner!

[Anonymous]

Chillax guys, I can assure you no dark conspiracy lurks in the heart of the insanely boring clearing and settlements systems of the world. They extend limited credit for mostly administrative purposes. The only purpose is to reduce Herstatt risk.

That said they are very much the panopticon of the financial world, knowing who traded what with who. You want to follow the money watch the pipes.

[crosey]

I like the angle that has been proposed, namely, that information about money is more valuable.

Another thought, a dark thought, that I have rolling around in my head this morning focuses on control.  If you control the clearinghouse, do you not also control trading, de facto?  Suppose volatility gets extreme (again)...can you not stop trading by not clearing transactions?  Analogy...you don't have to own the trains, just the track they run on.

Interested in your thoughts on this.

[Anonymous]

To reiterate an earlier comment; the DTCC doesn't clear swap trades. The DTCC TIW (Trade Info. Warehouse) is a repository of trade records for CDS (limited adoption on other types). In the US, ICE and the CME will clear swap trades, in Europe ICE, Eurex and Swapclear have the business.

No conspiracy to see here... move along.

[Anonymous]

(I am #226502 from earlier)

I do think the actual infrastructure of trading systems does warrant a little more coverage. Virtually every financial transaction goes through the the 2 (or 3?) SWIFT data centers, a full record of who owns what at any time is held by the Euroclears and Clearstreams of this world to some extent (taking into account nominees, omnibus accounts etc). Look for 'Plumbers and Wizards' by Peter Norman.

[Tom123456]

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