The ties that bind are hard to unwind

While regulators are tying themselves in knots over who should have known about MF Global’s demise, another debate is in full swing over unwinding client positions when a broker goes bust.
By None

I thought problems unwinding client positions at busted brokers was all cleared up after Lehman Brothers’ collapse. Are we better prepared three years down the track?

It would be nice to think so, wouldn’t it? But the bust-up of MF Global saw some very diverse responses from derivatives exchanges and their central counterparties (CCPs) around the world and client circumstances varied accordingly.

With Lehman, much of the trouble revolved around OTC derivatives contracts, hence the Group of 20’s focus on limiting systemic risk from this sector.

In MF Global’s case, most of the outstanding positions related to exchange-traded derivatives instruments, but a shortfall in the segregated accounts of clients has complicated the process of moving positions to another clearing member.

This situation seems a mire of conflicting rules and situations, depending where derivatives contracts were listed. Where are we now?

By 2 November, Deutsche Börse-owned Eurex was saying it had successfully liquidated the positions of its clearing member, MF Global – barely two days after it had gone into receivership.

According to its clearing conditions, when Eurex terminated the clearing agreement with MF Global on 1 November, the termination triggered the liquidation of corresponding client positions at Eurex by way of market transactions, even though the exposure was at all times fully covered by collateral placed by MF Global and at no time was there a need to draw on Eurex’s clearing fund.

“The implemented safeguards of Eurex Clearing have again proven to be effective, and underline our high standards in risk management,” asserted the clearing house, despite the potential inconvenience its actions caused to MF Global clients who may have preferred open positions to be moved to another member of the CCP. “In this critical situation, Eurex Clearing directly mitigated counterparty risks, thus contributing to the integrity and stability of markets.”

Eurex had legal obligations to liquidate and under the rules of its operation had no choice but to liquidate everything with MF Global’s name on it. Admittedly, having your position liquidated, while inconvenient, may be better than not having any idea what has happened to your position, but many traders would rather have had the choice.

And as two of the world’s largest exchanges are in merger talks, one forthcoming decision will be on the clearing rules adopted by Deutsche Börse/NYSE Euronext. Unlike Eurex, NYSE Euronext’s London-based Liffe derivatives exchange did not immediately liquidate positions, instead passing them over to other clearing members.

Last week Liffe and Anglo-French clearer LCH.Clearnet said they had facilitated the transfer of the positions of all non-clearing members who previously cleared through MF Global UK to new clearing members. LCH.Clearnet, acting as the default management provider, said it was managing the proprietary and end-customer business in a “careful and orderly manner in conjunction” with MF Global’s UK administrator, KPMG.

In the United States, CME Group – the largest futures exchange operator in the US and a ‘self-regulatory’ organisation for the sector – has come under fire for not releasing funds quick enough. CME Group maintains that upon the appointment of a trustee, it began to secure approval to transfer MF Global positions held at the exchange and all supporting collateral to other clearing members instead of liquidating those positions.

Due to uncertainty over the amount of MF Global-held segregated funds to support customer trading, the trustee has only allowed CME Group to partially transfer customer positions to new clearing member firms.

Commodity Futures Trading Commission (CFTC) commissioner Scott O’Malia has called on his agency to review its role in protecting customer positions and funds in the days leading up to and following the insolvency of an intermediary.

If unwinding is now a matter for the courts, at least now we’re seeing some movement, right?

Yes, but even the present plans for unwinding client positions have some clients feeling left out in the cold.

Some believe a court petition last week to release 60% of frozen client monies did not go far enough. Under the terms, customers with no cash accounts who were hedging their exposures in asset classes like commodities would be “without relief and without access to any of their cash”, according to Royce Corp, a metals trading firm who had positions open with MF Global. That means various positions will still be yet to be unwound if you didn’t have any ‘cash’ in your account. Not good for active traders.

Even beyond the courts, regulators are trying to discern their next move. O’Malia has said without disclosure of its proprietary trading to its customers, MF Global dramatically changed the risk profile of its proprietary operations and its incentives relating to customer intermediation.

In October, the CFTC proposed a rule designed to broaden access to derivatives clearing houses, opening access to brokers with at least US$50 million in net capital. Agency commissioners had voted 3-2 for the rule that O’Malia opposed.

So will bringing OTC trades on exchange really reduce systemic risk in the derivatives markets?

It should, but not without some major adjustments to current practice. Some industry notables muse that it’s likely we will see more buy-siders clearing their own trades. High-volume players could become members of futures exchanges to avoid another unwinding nightmare and exposure to yet another unexpected form of risk.

There’s no doubt the MF Global situation has further stimulated debate on the future role of CCPs. The markets noted another sign of things to come when LCH.Clearnet increased the margin required for Italian bond exposure, highlighting the potential costs and liquidity problems market participants could face as a wider range of instruments are centrally cleared.

The Anglo-French clearer’s risk department took the decision to raise the amount of collateral clearing members need to post against positions in Italian bonds, forcing market participants to find suitable liquidity that could be used to cover the increased collateral requirements, a situation that could become more common as a greater number of swaps are centrally cleared.

It seems CCPs have become the new credit ratings agencies and are able to influence macro-economic policy.

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