I fell into a burning ring of fire,
I went down, down, down and the flames went higher.
And it burns, burns, burns
The ring of fire, the ring of fire.
When Dodd Frank was passed, the Act focused on two fixes for systemic risk:
- Fix Too Big to Fail (TBTF).
- Fix over-the-counter (OTC) derivatives.
Martin Lowy, Jason Cawley, myself, and several others provide an extensive discussion of TBTF, nicely summarized by Lowy's TBTF? Fuggedubboudit!
This post is the first of several that will focus on the many ways financial market failure would be magnified by poor regulations, laws, and products in markets for OTC derivatives.
There are two significant types of OTC derivatives: interest rate swaps (IRSs), and credit default swaps (CDSs). This and following posts focus on interest rate swaps. Almost nothing that is true of interest rate swaps is also true of credit default swaps. The fact that they are lumped together by Dodd Frank and the rest of the legal and regulatory apparatus surrounding swaps is an egregious error.
CDS are neither liquid nor capable of being futurized (usefully) and thus should not be placed under the purview of the Commodities Futures Trading Commission (CFTC.). CDS' legitimate function, if any, is the transfer of credit risk. They belong in part under Fed jurisdiction; in part, under SEC jurisdiction. There is much to be said about CDS and their regulation, but not in this post.
One no longer needs to look far to find the OTC IRS market. Five institutions are more than 90% of the market. [C.f. the quarterly derivatives report of the Office of the Comptroller of the Currency (NASDAQ:OCC).] IRS swaps are largely in the hands of four US banks [Bank of America (NYSE:BAC), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), and JPMorgan Chase (NYSE:JPM)] and the OTC IRS Clearing Counter-parties. There is one remaining major remaining OTC Clearing Counterparty (LCH:Clearnet, subsidiary of the London Stock Exchange, in the midst of a contentious merger with Deutsche Bourse, compounded by Brexit chaos). CME Group (NASDAQ:CME) was once a factor, but lethargy there prevailed, resulting in the volume gravitating in the direction of LCH:Clearnet.
IRS are in many ways inefficient, distorting the effects of credit risk throughout the financial system. Originally intended to reduce the interest rate risk, both actual and reported, of non-dealer banks and corporations, they do a fine job of this objective.
Unfortunately, almost from the outset of trading, it became clear that the IRS instrument had many flaws. These flaws may be summarized thus. IRS' fail as a vehicle in trading in the inter-bank market.
To make matters worse, it is apparent that the dealers' entire focus is now on use of IDS swaps in the interbank market. The customer market has been strangely neglected, unless you consider Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). This is also true of government's focus, evident in Dodd Frank and other government initiatives. The result is a Rube Goldberg machine of a derivatives market with many possible points of failure. This article begins the process of listing the points of failure in the inter-bank market and how they create future possible disasters.
Point of failure 1: Derivatives exemption of the stay in bankruptcy.
As a result of a slow invasion of the bankruptcy code by the swaps dealing community, enacted under cover of darkness during those halcyon days when some experts, such as then Fed Chair Alan Greenspan, thought derivatives were the greatest thing since sliced bread, the collateral backing swaps may be seized, valued by the swap creditor, and liquidated without a nod to the bankruptcy judge. And the use of the word swap in the code is so broad that it includes instruments not yet created but that a banker might decide to call a swap in the future.
A very brief history of the gradual invasion of the bankruptcy code by the dealers. The following is borrowed from an excellent history by Schwarcz and Sharon (S&S), to be found here. The invasion of the bankruptcy code had its relatively innocent beginnings in an act with the purpose of ending legal actions by commodities traders whose brokers closed out their positions when the trader in question failed to meet her margin call in accordance with exchange rules. the purpose of the act was to replace meritless law suits with directed judicial decisions. To make a very long story short, four amendments later, we have the exemption in its final form, for now.
As the meandering path of this legislation unfolded,the central focus of expanded exemptions became systemic risk. There was not -- and as far as I can tell -- still isn't, any concern for the likely effect that all this special treatment might dramatically increase the size and broaden the function of the derivatives markets, thus increasing systemic risk.
Along the way, the meaning of derivative was dramatically expanded, repurchase agreements (OTCPK:REPO) included, and their definition expanded. (I can't help but picture a political party's convention speech that tells the American people they need an expanded exemption of the stay in bankruptcy for derivatives and repurchase agreements.)
Perhaps the ultimate irony is that the most dramatic, and to me astounding, expansion of the exemption of the stay in bankruptcy was legislation passed as a result of the President's Working Group on Financial Markets Report of 1999, intended to be a response to the Long Term Capital Crisis! What we got in the ensuing legislation is a truly rich definition of a swap. To quote S&S:
First, it [the new bankruptcy code] expanded the Code's definitions of "securities contract," "commodities contract," "forward contract," "repurchase agreement," and "swap agreement" to include a long list of specific types of known derivatives, as well as any other similar agreement or transaction, any combination of the defined derivative transaction, any option to enter a derivative transaction of the kind defined in the specific clause, a master agreement that provides for the defined derivative transaction, or any security agreement or arrangement or other credit enhancement related to the defined transaction. The purpose was to enable the safe harbor to encompass any future version of existing derivative transaction and 'to avoid the need for future amendments.'"
In the instructive case of Lehman Brothers, the process of striping Lehman its collateral was a fait accompli at the futures clearing house, CME Group, and at the OTC IRS Clearing Counterparty (LC:Clearnet) four days following Lehman's decision to file for bankruptcy. We know the CME clearing member Barclays (NYSE:BCS) raked in about $4 billion, $3 billion of which was exchange-required margin, as a result of a CME-held auction prior to the bankruptcy filing. The outcome of Barclays' assumption of Lehman's OTC swaps position at LCH:Clearnet was a substantially larger sum of opaque dimensions, but sufficient to draw a complaint from the lawyer for Lehman's estate that the LCH:Clearnet settlement was materially responsible for the anemic payout to the Lehman estate of about $0.23 on the dollar (so far).
Why the dealers and Congress say we need the exemption of the stay.
What is to be said for this extraordinary exemption of derivatives from the standard stay in bankruptcy?
First and foremost, the standard claim you will find in the financial reports of derivatives dealers, to wit:
Derivative notional amounts are reference amounts from which contractual payments are derived and do not represent a complete and accurate measure of Citi's exposure to derivative transactions.
Taken from Citi's 3rd Quarter, 2015 10-Q, but typical of any dealer quarterly report, accurately indicates notional principal amount is of little significance in the presence of the exemption from the stay in bankruptcy, But this assertion would not be accurate without the exemption.
If a derivatives counterparty filing for bankruptcy were to receive protection of collateral or netting of long and short positions in bankruptcy, a back-of-the-envelope calculation provided earlier here, puts the potential exposure of LCH:Clearnet, alone, in the neighborhood of $2 Trillion. This would be a catastrophe for the global financial system, resulting in an immediate need for the government to lend further trillions to both LCH:Clearnet and each of the four dealers.
In short, we have managed to put ourselves in a position where there is no alternative to exemption of derivatives from the stay.
Is there an alternative?
This outcome was unnecessary. If there had been no exemption from the stay, the private sector would have been forced back upon its own devices. In the early 90's there were the beginnings of a cottage industry in futures-like replacements for the repo and for the interest rate swap, primarily at the now CME Group-owned COMEX futures exchange. This movement was squelched by the dealers of the time, for a variety of reasons that benefited the dealers' bottom line at the expense of increased systemic risk.
In the case of repurchase agreements there was a well-founded fear among the dealers that exchange-traded repo would become homogenized, putting an end to the lucrative dealer trading of "specials," repurchase agreements in specific Treasury issues whose prices could be easily manipulated by cliques of dealers.
In the case of interest rate swaps, the COMEX made the decision to try futures in municipal bonds instead, a mistake that might have spelled the eventual absorption of COMEX by CME Group.
In any event, the shelter of the exemption from the stay in bankruptcy removed any incentive for the dealers themselves to support this effort.
Why is the exemption from the stay in bankruptcy a problem
The results of the Lehman Brothers bankruptcy remind us of one of the few fundamental scientific laws of finance. To wit:
Risk cannot be created or destroyed. It can only be transferred between parties.
The implication is one of the key lessons the financial market didn't learn when the Lehman bankruptcy proved the rule. When you remove $2 Trillion from the risk of swaps commitments of dealers, you don't in any way reduce that risk. You simply transfer it to the other claimants of the failing party.
Why the dealer banks are able to sell debt and shares given the likely pillage of a failing dealer bank by its cohorts in the clearing houses is beyond me. Perhaps they expect the taxpayers to swallow this mess. Perhaps they're right.
Other points of failure in the derivatives markets will be considered in coming posts.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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