Summary
I think it is safe to say that the CDS Market will be “standardized” as much as possible after the events that lead up to the Credit Bubble last fall. However, going about this process is more complicated than many believe. What is striking is the difference between where the US and the EU want to place power. As politicians, who do not fully understand the inner workings of the Markets, are making decisions there are some gapping holes in their plan.
Analysis
Putting regulatory power into the hands of Clearing Firms seems dangerous. For starters, Clearing Firms are businesses that like to see volume trading as they receive the bulk of their profits from commissions. At the same time, no Clearing Firm wants to be taken down if one or more of its customers fail, therefore, they do watch Account Risk carefully.
What is uncertain is how prepared are these firms to really take on this task.? Clearing Firms are far more sophisticated than they were 10 years ago when they had clerks in the back office entering trades off of cards from the floor. At the same time, they are not highly sophisticated entities and view Risk Management more from an individual account perspective than a firm wide macro perspective. If a trade is “hot” meaning many high volume traders are all working in the same Market, a Clearing Firm can quickly accumulate a large position in that Asset Class.
Clearing Firms also tend to be specialized to either clear Futures or Options. Additionally, Clearing Firms tend to cater to a particular Market segment such as Institutions or Market Makers. They are not Members of every exchange. For example, I clear through Crosslands LLC but I am a NYMEX member. Through an alliance FC Stone clears my trades on the NYMEX on behalf of Crosslands. In some ways, the Clearing Arena is very dissected, on the other side, it is made up of complex agreements for the benefit of not only Exchange Membership but also Cross-Margining for Clearing Members. Additionally, the Risk Management Systems of these firms are directly a result of how they do business. Many are simply not prepared for the additional responsibility.
Most concerning, are the Self Clearing Firms. Firms such as Merrill Lynch and Goldman Sachs own huge Clearing Entities through which they process their own trades. By sending the regulation back to the Clearing Firm, in many instances, you are sending the regulation right back to the Trading Firm itself.
Unless there is a major over haul of the Clearing Business, I do not believe that the plan to regulate through Clearing Firms will solve any of the abusive behaviors that lead to our current situation.
What is uncertain is how prepared are these firms to really take on this task.? Clearing Firms are far more sophisticated than they were 10 years ago when they had clerks in the back office entering trades off of cards from the floor. At the same time, they are not highly sophisticated entities and view Risk Management more from an individual account perspective than a firm wide macro perspective. If a trade is “hot” meaning many high volume traders are all working in the same Market, a Clearing Firm can quickly accumulate a large position in that Asset Class.
Clearing Firms also tend to be specialized to either clear Futures or Options. Additionally, Clearing Firms tend to cater to a particular Market segment such as Institutions or Market Makers. They are not Members of every exchange. For example, I clear through Crosslands LLC but I am a NYMEX member. Through an alliance FC Stone clears my trades on the NYMEX on behalf of Crosslands. In some ways, the Clearing Arena is very dissected, on the other side, it is made up of complex agreements for the benefit of not only Exchange Membership but also Cross-Margining for Clearing Members. Additionally, the Risk Management Systems of these firms are directly a result of how they do business. Many are simply not prepared for the additional responsibility.
Most concerning, are the Self Clearing Firms. Firms such as Merrill Lynch and Goldman Sachs own huge Clearing Entities through which they process their own trades. By sending the regulation back to the Clearing Firm, in many instances, you are sending the regulation right back to the Trading Firm itself.
Unless there is a major over haul of the Clearing Business, I do not believe that the plan to regulate through Clearing Firms will solve any of the abusive behaviors that lead to our current situation.
This author consults with leading institutions through GLG
Analyses are solely the work of the authors and have not been edited or endorsed by GLG.
