Bloomberg News

Swaps ‘Armageddon’ Lingers as New Rules Concentrate Risk

December 21, 2012

Swaps ‘Armageddon’ Lingers as New Rules Concentrate Risk

The word "Clearing" appears on a door at the entrance of the clearing floor of the CME Group Inc.'s Chicago Board of Trade offices in Chicago. Photographer: Daniel Acker/Bloomberg

On a good day, 27-year-old Bobby Timberlake at CME Group Inc. (CME:US) in Chicago rounds up $2.5 billion from the world’s biggest traders and banks such as JPMorgan Chase & Co. (JPM:US) to cover their losses in the $639 trillion derivatives markets.

What happens on a bad day will test new rules in the Dodd-Frank Act designed to prevent a repeat of 2008’s credit crisis. Starting in March, as much as 79 percent of derivatives trades known as swaps must be backed by collateral and go through clearinghouses such as CME Group. Traders may have to post $927 billion with Timberlake and his peers at LCH.Clearnet Group Ltd. and IntercontinentalExchange Inc. (ICE:US), whose role as middlemen is to ensure participants get paid.

This arrangement can withstand almost any shock, including defaults by four of the biggest lenders, according to the clearinghouses. Some bankers and researchers aren’t convinced. They warn unprecedented amounts of risk will be concentrated in a handful of clearinghouses -- some newly eligible for emergency Federal Reserve loans. If they fail, taxpayers who financed $1.2 trillion of bailouts last time could be on the hook again.

“Clearinghouses have been oversold as a way of preventing Armageddon,” said Craig Pirrong, a former futures trader and now a finance professor at the University of Houston who has studied the system. While a clearinghouse is “highly unlikely” to collapse, “I just don’t think that realistically you can exclude the possibility that taxpayers could be at risk.”

Shifting Risk

About 40 percent of existing swaps are already being cleared by firms such as London-based LCH and Atlanta-based Intercontinental. Another 39 percent are covered by the new rules, according to consulting firm Tabb Group LLC, doubling at a single stroke the trading entrusted to clearinghouses.

The goal of this massive shift in risk is to avoid meltdowns like the ones in 2008 that triggered American International Group Inc. (AIG:US)’s $182 billion bailout after the insurer couldn’t make good on its trades and almost destroyed the world’s biggest banks.

To keep the system working safely, clearinghouses count on the collateral they collect, then on reserves in guaranty funds and the power in emergencies to demand billions more in cash from their members, which include global titans such as Deutsche Bank AG (DBK), Citigroup (C:US) Inc. and Barclays Plc. (BARC)

The collateral put up for swaps trades covered by Dodd-Frank typically equals only 0.5 percent of their notional value, according to Morgan Stanley. (BAC:US)

Systemic Threat

The risk is that a powerful new crisis burns through those firewalls and leaves cash-strapped banks unable to come to the rescue, triggering a Fed bailout. Lloyd Blankfein, chief executive officer of Goldman Sachs Group Inc. (GS:US), has said clearinghouses could be the world’s biggest systemic threat, and the Fed acknowledged in an August Federal Register notice that participants or the whole financial system could be damaged.

“They are the new too-big-to-fail, so you want to be sure the new too-big-to-fail have enough support,” said Supurna VedBrat, co-head of market structure and electronic trading at BlackRock Inc. (BLK:US), the world’s largest money manager. “The risk management of the individual clearinghouses is essential.”

Derivatives help investors hedge or speculate on commodity prices, interest rates or, in the case of credit-default swaps, the financial health of firms or nations. “Swaps” is Wall Street’s shorthand for bets in which investors swap payments back and forth with each other during the life of a derivative as prices rise and fall on the specified asset. Some contracts can last for a decade or more.

Expanded Role

Clearinghouses cut risk by collecting collateral at the start of each transaction, monitoring daily price moves and making traders put up more cash as losses occur. Traders have to deal through clearing members, typically the biggest banks and brokerages. Unlike privately traded derivatives, prices for cleared trades are set every day and publicly disclosed.

The role of clearing was expanded by the 2010 Dodd-Frank Act based on the track record of clearinghouses during the 2008 credit crisis. The idea took hold after Lehman Brothers Holdings Inc. failed in 2008 and LCH settled $9 trillion of derivatives linked to interest rates held by the New York-based investment bank. LCH needed only about two weeks and 35 percent of the collateral Lehman had posted, said Dan Maguire, head of U.S. operations at LCH’s SwapClear service.

Profitable Business

Customers include the world’s largest lenders. The biggest swaps dealer in the U.S. is JPMorgan with $72 trillion in derivative assets, according to regulatory data, followed by Bank of America Corp. with $64 trillion and Citigroup’s $55 trillion. There’s no comparable ranking for banks globally.

The biggest clearinghouses are LCH, the world leader for interest-rate swaps; Intercontinental or ICE, which runs two leading credit-swap clearinghouses, and CME Group, which ranks No. 1 in futures.

Running commodity exchanges and clearing trades can be hugely profitable, with profit margins at CME Group topping 50 percent. The firm, which owns the Chicago Mercantile Exchange, had a total staff (CMEUS:US) of 2,700 and a $1.8 billion profit last year on revenue of $3.3 billion. Intercontinental, with more than 1,000 people and led by 57-year-old founder Jeffrey Sprecher, earned $521.7 million from $1.3 billion of revenue.

Both are publicly listed (ICE:US) and ICE just announced an $8.2 billion takeover of NYSE Euronext, illustrating the growing importance of derivatives in world financial markets. LCH, with 1,000 people and majority-owned by banks, is being sold to the London Stock Exchange.

Stepping In

The Dodd-Frank rules could mean as much as $1 billion in new annual revenue for clearinghouses, New York-based Morgan Stanley estimates. Barclays clears more than $1 trillion a month in swaps now and expects that to increase 10-fold, said Ray Kahn, head of the bank’s over-the-counter derivatives clearing in New York.

As middlemen, the clearinghouses calculate how much collateral is needed as prices change, and demand more from participants whose holdings lose value. If losers don’t pay up, the clearinghouse breaks the transaction to prevent risk from building and uses collateral to make the other customer whole.

If that isn’t enough, the clearinghouse steps in with guaranty funds -- about $10.1 billion combined for the three firms, supplied by bank and brokerage members.

“It lowers risk,” Gary Gensler, chairman of the Commodity Futures Trading Commission, said in an interview. “It’s far better to have the discipline of a central clearinghouse performing these functions than banks.”

Rescue Powers

Supporters included U.S. Treasury Secretary Timothy F. Geithner, said a former official involved in the talks. The near-failure of Bear Stearns Cos. that year included a run on the firm by customers. Geithner, who led the Federal Reserve Bank of New York at the time, concluded clearinghouses would have helped because they can move client positions from an ailing bank member to a healthy one, said the official, who requested anonymity because talks were private.

AIG was another example of what happens when clearinghouse techniques aren’t used. As New York-based AIG sold credit-default swaps, it rebuffed demands for collateral to back its privately traded derivatives. The insurer didn’t have the cash in 2008 to make good when the bets soured, leaving the world’s biggest banks facing catastrophic losses. The crisis deepened because private trading made it hard to see how interconnected financial firms had become, according to regulators.

Natural Fit

Lehman’s failure prompted Geithner to sell a bigger role for clearinghouses to President Barack Obama, according to the former official. The proposal didn’t get much debate as Dodd-Frank took shape, said Robert Holifield, who was deputy chief of staff for Gensler at CFTC.

“Clearing just seemed like a natural thing to do,” said Holifield, now a senior policy adviser at the law firm Alston & Bird LLP. “I don’t remember a lot of pushback.”

Under the new rules, CME Group and Intercontinental were deemed systemically important. This lets them get emergency Fed loans if collateral they hold can’t be sold at reasonable prices and emergency funds from bank members don’t materialize.

Two months after Obama signed the Dodd-Frank bill in July 2010, Blankfein of Goldman Sachs told a finance and regulation conference in Brussels that the regulatory push might make clearinghouses “the biggest systemic risk in the world.”

“We have to make sure that something that we do to reduce the risk in a once-in-a-20-year storm doesn’t increase the risk in a once-in-a-50-year storm,” Blankfein said.

Disaster Scenario

Tiffany Galvin, a spokeswoman for Goldman Sachs, said Blankfein’s comments reflect the firm’s current views. Andrea Priest, a spokeswoman for the New York Fed, and Susan Stawick at the Federal Reserve Board of Governors, declined to comment for this article.

The need for a Fed rescue isn’t out of the question, said Satyajit Das, a former Citicorp and Merrill Lynch & Co. executive who has written books on derivatives. Das sketched a scenario where a large trader fails to make a margin call. This kindles rumors that a bank handling the trader’s transactions -- a clearing member -- is short on cash.

Remaining clients rush to pull their trading accounts and cash, forcing the lender into bankruptcy. Questions begin to swirl about whether the remaining clearing members can absorb billions in losses, spurring more runs.

Customer Panic

“Bank customers panic, and they start to withdraw money,” he said. “The amount of money needed starts to become problematic. None of this is quantifiable in advance.” The collateral put up by traders and default fund sizes are calculated using data that might not hold up, he said.

The collateral varies by product and clearinghouse. At CME, the collateral or “margin” for a 10-year interest-rate swap ranges between 2.89 percent and 4.06 percent of the trade’s notional value, according to Morgan Stanley. At LCH, it’s 3.2 percent to 3.41 percent, the bank said in a November note.

The number typically is based on “value-at-risk,” and is calculated to cover the losses a trader might suffer with a 99 percent level of confidence. That means the biggest losses might not be fully covered.

It’s a formula like the one JPMorgan used and botched earlier this year in the so-called London Whale episode, when it miscalculated how much risk its chief investment office was taking and lost at least $6.2 billion on credit-default swaps. Clearinghouses may fall into a similar trap in their margin calculations, the University of Houston’s Pirrong wrote in a research paper in May 2011.

Stress Levels

“Levels of margin that appear prudent in normal times may become severely insufficient during periods of market stress,” wrote Pirrong, whose paper was commissioned by an industry trade group.

What’s more, clearinghouses can’t use their entire hoard of collateral to extinguish a crisis because it’s not a general emergency fund. The sum represents cash posted by investors to cover their own trades and can’t be used to cover defaults of other people.

Clearinghouses can turn to default funds to cover the collapse of the two largest banks or securities firms with which they do business. They have the power to assess the remaining solvent members for billions more, enough to cover the demise of their third- and fourth-largest members.

Guaranty Funds

LCH held $22.3 billion in collateral and a guaranty fund of $4 billion at the end of September. Intercontinental’s two clearinghouses in the U.S. and the U.K. held $17.9 billion in collateral and $5.08 billion in guaranty funds. CME Group had $7.9 billion in collateral and $1.82 billion in guaranty funds. Morgan Stanley estimates as much as $927 billion in new collateral will be needed.

Even with those safeguards against default, “the possibility of reaching such a point cannot be ruled out,” the International Organization of Securities Commissions, which represents regulators in more than 100 countries, said in July.

The Clearing House Association LLC, a trade group representing the largest commercial banks, issued a report Dec. 18 that said clearinghouses should put more of their own money at risk, cap the liability of members if another one defaults and warned that emergency measures to shift losses onto healthy members might create systemic risks. The group also said clearinghouses should minimize risk when investing collateral.

Liquid Assets

At CME, guaranty funds can be deposited only in U.S. Treasuries, cash and select money-market funds, according to Suzanne Sprague, executive director of risk management. The company also has said it pledged $100 million of its own cash to be used in a default on contracts tied to rates or credit.

In emergencies, CME Group can tap as much as $7 billion in a credit line from banks including Deutsche Bank, Citigroup, UBS AG and Wells Fargo & Co. (WFC:US) CME Group increased the credit line this year in anticipation that its swaps clearing business will expand, and the buffers at all three firms are expected to increase as they handle more trades.

“In a catastrophic situation, you can imagine some of that liquidity might not be there,” said Mike Kobida, executive director of collateral services at CME Group. “We know that if there was an event where we needed liquidity tomorrow, the Fed would be there.”

To get a Fed loan, clearinghouses could offer collateral they held that proved hard to sell in a crisis, such as corporate bonds, Kobida said. The result is a secured loan, not a public handout, he said, echoing comments from bankers who point to billions of dollars earned by taxpayers on crisis-era bailouts. It took the U.S. four years to make back its investment in AIG with a $22.7 billion profit, in part because the Fed assumed control of some of the insurer’s hard-to-sell financial assets.

‘Way Safer’

On balance, clearing is “way safer” than private transactions, Randall Costa, managing director at Citadel LLC, whose Chicago-based hedge fund trades in derivatives, said in an interview. “Banks go down every year,” said Costa, who testified on clearing before federal regulators in March. “Clearinghouses have almost never in history gone down.”

As the new law was translated into practice, some industry standards were relaxed by regulators. The CFTC in November 2011 published a 146-page report on how the new derivatives clearinghouses would operate, detailing compromises among the agency, banks, money managers, insurance companies and the clearinghouses themselves.

One decision watered down capital minimums. LCH previously required clearing members to have at least $5 billion in capital. Smaller members might not be able to help absorb a large default, LCH told the agency in 2011.

CFTC Budget

Instead, the CFTC told clearinghouses to set the floor at $50 million. This allows smaller firms to handle their own trades and avoid paying the largest banks fees that would raise costs. The agency cited support from Citadel and Jefferies Group Inc., the New York investment bank.

The CFTC regulates trading and is supposed to monitor the clearinghouses as they take on more business. House Republicans curtailed the agency’s budget, limiting it to $205 million for fiscal 2012 -- about $100 million less than the White House requested. Obama requested $308 million for 2013.

The CFTC doesn’t have the resources or technology to keep track of the swaps market, which is eight times larger than the futures market, Gensler said in the interview.

“It’s like having eight times as many NFL games without any more referees,” he said. The goal is to increase technology spending by 70 percent and staffing by 40 percent, Gensler said.

The CFTC rules also stopped short of requiring what some customers said they’d like to see: a blueprint for action if losses blow through all the backstops.

Default Plans

“None of the major clearinghouses are providing sufficient detail on their default-management plans,” said Darrell Duffie, a finance professor at Stanford University who has studied derivatives markets. “They don’t want to talk about that.”

Dale Michaels, CME Group’s managing director of credit and market risk management, is anticipating the Fed will act and said his firm is already developing a default plan. Brookly McLaughlin, a spokeswoman for Intercontinental declined to comment. Nicholas Lincoln, LCH’s group head of market risk, said the company is “working closely with market participants” to provide information on risk management.

In non-public meetings this year at the New York Fed, Citigroup and JPMorgan pushed CME Group, Intercontinental and LCH to reveal more about their finances and risk-management policies, people with knowledge of the matter said. Lenders also want to know more about whether collateral is being calculated correctly, according to an executive at a large dealer. They asked not to be named in order to speak candidly.

Past Failures

Banks want to make sure they “don’t find out at the moment of maximum fail potential” that clearinghouses haven’t kept enough capital, said Paul Galant, a Citigroup executive who leads the New York Fed’s Payments Risk Committee.

Failures aren’t unprecedented. Caisse de Liquidation of Paris became insolvent in 1974 after a speculative bubble in the sugar market and didn’t reopen for two years, according to a Bank of England report. In 1983, defaults on palm oil contracts led to a trading halt on the Kuala Lumpur Commodity Clearing House, the Bank of England said.

The “Black Monday” stock-market crash of Oct. 19, 1987 triggered a $2 billion rescue by banks, brokerages and the Hong Kong government to save the Hong Kong Futures Guarantee Corp., according to a May 1988 report for the city’s governor.

Federal Reserve Chairman Ben S. Bernanke, 59, did his own research into the performance of clearinghouses on Black Monday. As an economics professor in 1990 at Princeton University, Bernanke recounted in a paper how the Chicago futures markets issued more than $4 billion in margin calls on Monday and Tuesday of that week.

Bernanke’s Analysis

The Fed bailed out the market by plying banks with funds and encouraging loans to securities firms so they could meet the margin calls. The Fed acted as an “insurer of last resort” to futures markets when it seemed the crash might “exhaust the insurance capability of the clearinghouse,” Bernanke wrote. “Much more serious problems could have emerged than actually did, so luck was with us.”

Disaster-prevention plans at LCH, which handles about half of all contracts linked to interest rates, include “fire drills” twice a year that test whether current and prospective members could handle a default even larger than Lehman’s, Maguire said.

LCH dates from 1888 when the London Clearing House was formed to handle commodities trades. While individual members defaulted in the past, the guaranty fund never had to be tapped, according to Maguire. The purpose of clearing isn’t to prevent defaults, he said, it’s to make them as inconsequential as possible to other members.

Testing, Testing

“Every day, we’re planning that somebody’s going to default,” Maguire said. “A large part of why this works is because we tested and tested and tested it.”

Kim Taylor, president of CME Clearing, said the firm watches the markets closely and can improvise when needed to curb risks. On Black Monday in 1987, for example, the exchange issued three intra-day margin calls, the first time a clearinghouse had done that according to Taylor, as the Dow Jones Industrial Average began its 23 percent dive.

“It was a brand-new process we instituted on the fly” and a reflection of how clearinghouses can react in real time to calamities, she said.

CME Group’s clearing unit employs about 250 people (CME:US), including about 30 who track risk. Duties include checking credit reports and customer statements while monitoring newswires for troubling reports or market movements, according to Sprague.

Timberlake’s job is to head off any drama by making losers put up cash every night if their holdings lost value, working a shift from 5 p.m. to about 3 or 4 the next morning.

“The model isn’t Bobby made a diving save; the model is Bobby checked some very boring numbers,” said Timberlake, a former trader at Gambit Trading LLC outside Chicago who studied industrial engineering and economics. “It’s a lot of preventative medicine.”

To contact the reporters on this story: Matthew Leising in New York at mleising@bloomberg.net; Bradley Keoun in New York at bkeoun@bloomberg.net.

To contact the editors responsible for this story: Rick Green at rgreen18@bloomberg.net; David Scheer at dscheer@bloomberg.net; Alan Goldstein at agoldstein5@bloomberg.net


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