Changes to how clearinghouses are used to back derivatives trades are putting brokerages on “a dangerous path” that threatens the futures business model, said Gary DeWaal, general counsel of Newedge USA LLC.
The risk to brokerages, known as futures commission merchants, or FCMs, began with the Dodd-Frank Act requirement to guarantee swap trades with clearinghouses, DeWaal said in an interview today at the Futures Industry Association annual conference in Boca Raton, Florida.
The rule, passed in January by the Commodity Futures Trading Commission, removed broker clients from sharing losses if a fellow customer bankrupted the firm. Revelations of $1.6 billion in unaccounted customer funds at MF Global Holdings Ltd. (MFGLQ), money that’s supposed to be protected in a broker default, brought calls for the swaps rule to apply to futures.
“We are making concessions that will undercut the system and that’s a very dangerous path,” said DeWaal, who is also a special adviser to the FIA, the industry and lobbying group that represents banks in the futures and swaps markets. The cost and risk of making up for a shortfall in a clearinghouse will fall to the brokers under the new swaps plan while making firms rely on competitors’ standards and operations that they don’t control, he said. “To a certain extent, as an FCM, we’re insuring moral hazard,” he said.
Adapting to Changes
Newedge is the second-largest futures broker by customer funds, behind Goldman Sachs Group Inc. (GS), according to the CFTC.
Banks, hedge funds and asset managers active in the $708 trillion over-the-counter derivatives market are adapting to changes mandated by the Dodd-Frank Act passed by Congress in 2010, including a requirement to process most swaps with a clearinghouse to cut counterparty risk.
The CFTC rule passed in January didn’t require collateral to be held by third parties and didn’t address misuse or loss of funds held by brokers. BlueMountain Capital Management LLC, Paulson & Co. Inc., Fidelity Investments and Och-Ziff Capital Management Group have pushed for greater safeguards on the collateral they must provide to back positions, according to letters filed with the CFTC. The CFTC rule takes effect Nov. 8.
“The futures industry is going through a soul searching, trying to come up with the right model that restores unwavering confidence,” said Richard Repetto, an analyst with Sandler O’Neill & Partners LP in New York. A CME Group Inc. (CME) plan to allow swaps collateral to be held by a custody bank would also be a blow to the business model the industry has used for decades, and would cut profitability, Repetto said.
“These FCMs feel very threatened that it would go to the model that CME is offering for swaps,” he said.
That’s because it would reduce the amount of interest a broker can earn on the customer money it holds. Record low interest rates have already curbed that earning power in recent years, said Allan Zavarro, the former global head of futures trading for ABN Amro Bank NV. When interest rates rise “there will be a great opportunity to earn money again,” he said. That’s why brokers “would do anything they can to not have third-party collateral agreements.”
The MF Global default, the new CFTC swaps clearing rule and the option for third-party collateral management are putting the focus on how best to adapt the derivatives model, said David Olsen, global head of OTC clearing for JPMorgan Chase & Co. (JPM)
‘Change the Landscape’
“The ability for customers to have their assets protected, especially with the enormous amount of collateral to be posted, is something all the panelists are focused on,” he said during a discussion of changes in the swaps market at the FIA conference.
Customers should have the chance to choose what level of protection their collateral is given, said Olsen, who was on the panel with representatives of CME Group, LCH.Clearnet Ltd., Credit Suisse Group AG (CSGN) and Pacific Investment Management Co.
“That’s going to be a big development and really change the landscape,” he said.
The banks are up against some of the largest investors in the derivatives market. Moore Capital Management LP, BlueMountain, Paulson, Tudor Investment Corp., and Och-Ziff have all said the swaps customer protection model should be applied to futures markets, according to letters filed with the CFTC. The possibility of such a change was explored in the first panel during a roundtable discussion at the CFTC on Feb. 29.
Och-Ziff “believes that, just like cleared swaps customers, futures customers should also have the benefit of full physical segregation,” Jeffrey Blockinger, the fund’s chief legal officer, wrote in a December letter to the CFTC.
The clearing process for futures “has been in place for many decades and has resulted in a unique set of processes, systems and technology,” he wrote. “Although this may caution against making immediate changes, it should not prevent the commission from seeking changes with the ultimate goal of providing all customers” the protection “offered by physical segregation.”
The existing system of collateral management should be strengthened rather than creating new “hybrid” models, DeWaal said. A practice of third-party custodians holding swaps collateral is the first “carve out” that brings a part of the private OTC market to the clearinghouse system being created, he said.
“The problem is, every time you do that, you carve out and give someone more protection, someone else is going to have to bear that risk,” he said.
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