Published On: Thu, Feb 16th, 2012
OTC | By Steve

Plumbers View of OTC on CCP

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Have not given it a whole lot of thought but here goes. Set up the CCP’s by product cluster, at least two per cluster, each with a maximum 50% share of market, each capable of carrying 100% of the load in a pinch. Let Office of Financial Regulation (OFR) or Federal Reserve Board (FRB) or Financial Stability Oversight Council (FSOC) be the regulator in the U.S.

I’ve always admired how payroll taxes in the U.S. are deposited at banks and swept efficiently to the Treasury with no recourse – a bad check for example still gets swept, sorry no refunds! Use the same concept here, each trading entity deposits into a special account. They are able trade but can’t withdraw funds. Each account is valued each night (with provisions for day trading risk limiting). Everything past cash and highly marketable treasury securities get an appropriate haircut for valuation. No complex assets are allowed in the accounts. If there is even a hint of trouble they sweep those assets right out of the accounts and collect them at the Treasury on behalf of the CCP to fund pro rata any trouble.

The CCPs are at cost entities, no profit, run as an industry utility. They set the minimum value for each trading entity in its group – based on risk – with the final total amount of all deposits approved and blessed by the government oversight group. The CCP requires and reviews the “Living Will” each member must annually file, again with oversight and auditing from the government. Transaction fees fund the CCP. Between the variable deposits, and the per transaction fees (based on volume) the “safety costs” line up fairly well with the systemic risk imposed.

The idea is to defease the full cost of systemic risk mitigation right back onto the industry itself. Government only steps in on a six sigma plus event that no one could possibly have envisioned. Prior to any taxpayer bailout, all firms in the industry, not just the failing one, take an immediate, painfully large hit.

Do not consolidate all the risk into too few CCPs. Frankly, I worry if DTCC may itself at some point be too big, and too much of a central point of failure. Pay the price and have clearing spread around geographically, technically, operationally and financially.
Have North America, EMEA, and Asia each “re-insure” each other, before any government, in any of those regions, do a bail out. Even then it’s at minimal cost to put the industry back into shape. The last thing we want is for the government to become the market maker of last resort and become direct owners of huge pools of complex assets.

Mandatory term limits on CCP heads and the government oversight regulators. No need to make any of those positions too cozy or incestuous. Staggered vacancies. Keep the whole thing clean. 100% transparent operations with ample granular level sunshine disclosure of all operations to the public.

BTW, with the new legal entity identifiers (LEI) and perhaps two new years into this it should be child’s play to choke off any trader who has filed for bankruptcy or a reorganization. Just shut off those LEIs intraday (i.e. the LEI registrar database simply broadcasts “this LEI is now suspended” to all subscribers.) All trades with that party then cease. The CCP then makes a very current assessment “do we need to draw in centrally any of the assets from our deposit accounts to mop up?”

There is no perfect solution. Increasing regulation will undoubtedly translate to a higher cost of doing business. The entire system here however might actually be a nice boost for the industry.

In the “old days” you had Beta exposure (direct correlation to the immediate trading market), Alpha (firm or credit specific factors) and Residual Risk. Nowadays we add an additional negative factor – exposure to the overall financial system’s systemic risk. With better regulation, and more fungible (and better understood) products that systemic risk factor exposure goes dramatically down. The entire market expected return grows. That’s the type of thing the entire industry could totally celebrate!

By Richard Labs – CL&B Capital Management

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