CME Group Inc. (CME), concerned that a new U.S. rule undermines the use of Treasuries as collateral at clearinghouses, is proposing a workaround that would make greater use of client cash.
The owner of the world’s largest derivatives market is seeking permission to alter how funds pledged to guarantee trades are accessed when a member defaults, according to a Dec. 18 filing with the U.S. Commodity Futures Trading Commission. Under the plan, cash from other clearinghouse members would be more readily available to offset losses, particularly in cases where it might take too long to liquidate collateral such as Treasuries.
The Chicago-based company is responding to a CFTC rule, passed last month with the backing of the Federal Reserve, that requires Treasuries pledged as collateral for swaps and futures trades to be backed by a “prearranged and highly reliable funding arrangement” to ensure prompt payment during times of stress. That could raise trading costs because clearinghouses would need to arrange credit lines or require more cash collateral from banks.
“We believe that the proposed rule should satisfy the liquidity concerns voiced by the Fed,” Kim Taylor, president of CME Group’s clearinghouse, said in an e-mailed response to questions. “Our rule addresses the ‘prearranged and highly reliable’ requirement conceptually with the least adverse impact on clearing members and their customers.”
The CFTC was seeking to toughen safeguards in a market blamed for worsening the 2008 global financial crisis. While U.S. debt is considered among the safest investments, policy makers are concerned liquidating them will require too much time -- up to a day -- during a crisis, a government official familiar with the Fed’s stance said last month. The 2008 crisis developed so rapidly that the Fed had to give out more than $2 trillion in emergency aid.
The derivatives industry opposed the backstop to Treasury collateral, saying it was unnecessary because U.S. government securities can be turned into cash fast enough. Fed officials have told banks and exchanges that the CFTC’s new collateral rule means U.S. debt must be covered by credit lines, three industry executives briefed on the matter said last month.
The plan outlined by the CME would alter how it repays counterparties in the event of a default by a member bank, which act as intermediaries between derivatives users, such as hedge funds and asset managers, and the clearinghouse. Clearing members contribute billions of dollars to an emergency pool of capital used to cover losses if the defaulting bank’s contributions aren’t enough to cover its financial obligations.
The rule modification wouldn’t affect how CME Group initially responds to a shortfall. It would only kick in the event of a “liquidity event,” meaning the troubled bank’s Treasuries and other deposits failed to cover losses. CME Group would then tap other banks’ cash collateral, using it to address the shortfall, while agreeing to replace the cash within 29 days.
If the cash shortfall persists, CME Group wants the ability to repay banks that are Fed primary dealers with Treasuries, according to the rule filing. Those primary dealers, who trade directly with the central bank, could then convert the securities into cash at the Fed, Taylor said.
“We talked to a number of clearing members and regulators to determine what solution might satisfy the concerns and also create the least adverse impact for clearing members and their customers,” she said. “Our conversations with regulators indicated that they were looking for an outcome in which the clearinghouse didn’t access the discount window directly, but still used it effectively through primary dealers.”
Sorting out how to keep clearinghouses solvent is critical, said Will Rhode, director of fixed income research in New York at Tabb Group LLC, a financial-markets research and advisory firm.
“This is a massive deal because it’s coming down to the fact that somebody’s going to have to step in” to prevent a major clearinghouse from failing in times of stress, he said during an interview. “The potential of a clearinghouse default is equivalent to several Lehmans,” he said, referring to the 2008 collapse of Lehman Brothers Holdings Inc., one of the largest swap dealers at the time.
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