More CCCP Than CCP – Danger of a Rigged OTC Casino

Just as the Patriot Act, felonious wiretapping and Iraq invasion plans were put in process prior to 9/11 by a handful of Nixonian operatives determined to reshape the United States government and Middle East geopolitical map, one begins to sense that some big financial players have carefully crafted plans to be rolled out as “solutions” to any convenient financial crisis that yields cries for reform.

One such plan that strikes me as worrying is a master plan for reforming global OTC derivatives markets toward a single central counterparty (CCP). The planners are the big institutions that provide leadership to these markets – the New York Fed and its core constituency of top tier derivatives dealers. They have been meeting for some time, at least four occasions that have been disclosed, and are now rolling out their plan for centralised clearing of OTC derivatives.

One doesn’t have to be a conspiracy theorist to see that it is sensible for this small coterie to plan and execute a long term strategy that promotes their collective self-interest. It stands to reason that they would rather be more powerful than less powerful, more profitable than less profitable. It is not unreasonable to suggest that one means of preserving power and profits requires imposing “solutions” to each “crisis” that institutionalise their influence over markets they dominate.

The proposals that have me wondering would initially concentrate clearing of credit default swaps and ultimately see all negotiated transactions centrally cleared and margined. The CCP will use the otherwise defunct Clearing Corporation based in Chicago and be owned by the same handful of banks that dominate 90 percent of trading.

Tim Geithner, president of the New York Fed, is the godfather of this plan. He first outlined it in a BIS report on OTC derivatives clearing and settlement in March 2007. Since then ISDA, the trade body for OTC derivatives dealers, has formalised the plan as a target architecture for OTC derivatives operations. Geithner recently hosted a meeting for the chosen seventeen shareholders of the CCP at the New York Fed to push the plan into realisation, setting a deadline for proposals of July 31st that leaves no scope for opposition or alternatives.

While I am happy to concede that there are real risks that are unaddressed in OTC derivatives markets, I am less happy to embrace a solution which would institutionalise huge power to manipulate these markets in the hands of banks which are themselves core dealers and prime brokers in these markets, accounting for 90 percent of trades.

If these seventeen banks, or a smaller subset of these banks, were to collaborate rather than compete, then they would be in a position to manipulate prices, manipulate credit, manipulate leverage, and manipulate margin calls for every traded commodity and every market counterparty. That would allow them to dictate who gains and who loses over time in these ill-transparent and under-regulated markets. If that manipulation were only exercised periodically and unpredictably, they would have very little risk of ever being challenged, investigated, prosecuted or sanctioned.

Think of the possibilities if such infrastructure were in unscrupulous hands. A target country would find their export commodities devalued until their resources were sold at bargain prices to the “right” multinational owners. A target counterparty would find their credit constrained at just the time when margins were raised or collateral devalued, making them a takeover patsy at a knockdown price and guaranteeing a swift profit to the lucky acquiror.

As in any casino, a team of sharks working together only has to shift the odds from 51-49 favouring the house to 51-49 favouring the sharks to win big money consistently. If they’ve co-opted the floor manager to look the other way, the likelihood of being challenged is massively reduced. If they own the casino, and are themselves the dealers, they can rig the tables to whatever odds they prefer to meet quarterly profit targets. If they co-opt the casino commission, hey baby, no worries. What happens in Vegas stays in Vegas.

The Geithner CCP proposal strikes me as mandating a casino where the seventeen dealers at the seventeen tables own the casino, control credit, control the odds, control the deal and can determine who wins and loses. If your only choice is to go from one rigged dealer-owned table to another rigged dealer-owned table run under common management, that isn’t much of a choice.

Oh, look! Geithner himself will regulate this CCP to give you that warm, cozy confidence that everything is on the level.

I have some other concerns about the proposal as well.

First, the determination to ressurect the defunct and lifeless Clearing Corporation rather than use an existing, proven clearinghouse like the CME or LCH-Clearnet is intriguing. The CME and LCH-Clearnet each have established track records of prudent and conscientious derivatives risk management and margin calculation, and have high standards of independent, objective risk modelling and asset pricing. For a market with as many pitfalls as credit derivatives, one can only wonder at the rationale that would favour an untried, uncapitalised, untransparent alternative. I am not the only one to find the determination of the dealers to shun existing clearinghouses surprising, as it has also raised eyebrows and suspicions in Chicago and London.

Second, it isn’t clear that a CCP will be any less prone to undue influence or flawed models than the rating agencies, monolines or other industry infrastructure which were involved in promoting the financial Ponzi schemes of the past decade. As the measurement of value and risk for credit derivatives will presumably use some variant of the flawed, opaque and error-riddled models that banks have used themselves, the scope for either accidental mis-pricing or deliberate manipulation is rather larger than for transparently traded and transparently priced exchange contracts in physical commodities or liquid financial indices.

Third, the move to a CCP seems to be without rationale or support in the context of the evolution of the OTC markets as negotiated markets for players able to judge and manage their own interests. At present the negotiated derivatives industry is largely ill transparent, operationally inefficient, difficult to regulate, prone to poor risk management, under capitalised and under margined. All of that contributes to a deservedly bad press and a lot of well merited concern about the scale of exposures and risk of systemic contagion. But reforms and industry efforts aimed at improving all aspects of derivatives trading, pricing, operations and supervision have to date respected the essential nature of the industry as bilaterally negotiated.

It is some leap to go from the current distributed, negotiated market mess to mandating a central counterparty clearing system. It is a leap further to suggest that there be only one CCP, with no choice or competition in CCP services from existing providers of complex derivatives clearing and margin operations and no invitation to them to develop appropriate services. It is a leap further still to suggest that the CCP be owned by seventeen for-profit dealers and prime brokers who are all facing a crisis in capital and profitability. To put it mildly, one might have some concerns about the independence of CCP governance and oversight. With the New York Fed as the principal cheerleader and proposed regulator for the CCP, it begins to look more CCCP than CCP.

Many of the objectives of risk identification, pricing improvement, liquidity improvement and counterparty risk management could be just as well addressed using distributed solutions and methods developed organically from the existing workings of the derivatives industry. This has been the traditional focus of ISDA efforts, leading the way in open standards for derivatives confirmations and distributed technologies for bilateral derivatives pricing, valuation, reconciliation, risk management and margining. Recent advances in secure financial networks and interoperability have put distributed solutions within cost-effective reach of even second and third-tier market counterparties.

Instead of a casino owned by the seventeen dealers who run seventeen tables, imagine instead a huge poker tournament where everyone is free to play with everyone else, forming tables and choosing dealers by whatever means they prefer. Any player can demand a new pack be dealt at any time. Any player can leave a table and take a seat at another table at any time. Any player can form a new table with themselves as dealer. Any player can ask any dealer or any other player for credit. Any player can propose an amendment to the rules, which if popular, will be adopted by other players at other tables.

In OTC derivatives today, if counterparties don’t agree on exposure valuations or collateral valuations, they margin on the basis of the least agreed amount and reconcile to figure out why there’s a difference. Counterparties can negotiate on what will be acceptable for margin, when it has to be delivered, whether there are large or small haircuts, and other operational matters. If one counterparty has a problem in its own operations or with an agent (and just about everyone uses agents in making payments or delivering collateral), then there is a custom of forebearance and tolerance while problems get sorted out. The danger of a CCP is inflexibility – no arguments, no negotiations, no slack. If a member doesn’t deliver exactly what is demanded exactly on time, the member is put into instantaneous default and is out of business. That’s fine when that’s what you’ve agreed to by trading on an exchange, and that’s what you’ve built your systems for, but maybe isn’t appropriate to every transaction in the negotiated off-exchange markets.

The difference between the negotiated margin and CCP is important. With the distributed model it is much harder to rig the odds or the outcomes to favour a handful of dealers over the great majority of punters in a way that will be sustainable over time.

For the wired crowd out there, one could frame it as the contest between Linux open standards and Windows proprietary standards. It’s as if Geithner is saying that open standards haven’t led to consistent adoption and applications, so there is a need to create and mandate Microsoft.

If you trust Geithner and his chosen seventeen banks to act in the best interests of all the millions of global economic and financial actors of the world who are affected by and deal in the global OTC derivatives markets, go ahead and back the CCP. If you have reservations about whether to trust them now or in future, you might want to consider looking around for an open, distributed solution that achieves the same fundamental objectives of improving OTC derivatives market transparency and risk management without the risks of a rigged casino.

You have until July 31st. Good luck.

16 Responses to "More CCCP Than CCP – Danger of a Rigged OTC Casino"

  1. Alessandro   July 11, 2008 at 3:07 am

    LB you know you reached a status in the blogsphere when people post those ‘first!’ comments.First! ;)

  2. London Banker   July 11, 2008 at 3:51 am

    I’m letting my inner conspiracy theorist run riot this morning. @ AlessandroThanks for confirming my elevated status in the blogosphere. It’s all the compensation I get.

  3. Anonymous   July 11, 2008 at 6:24 am

    An interesting article. The banks are certainly concerned about keeping OTC trades from being regulated and ultimately losing revenue if they get pushed ‘on exchange’ – revenue protection.Adopting TCC as the CDS clearinghouse was specifically about about control, why else would they build an OTC clearinghouse from scratch rather than use an existing one?However, consider that OTC clearing is only accessable to the large dealers, so I’m not sure who you are worried about getting squeezed and manipulated. Unlike ETD business, smaller users are not allowed in – there may be a time when larger dealers clear for 3rd parties like on ETD however that would then bring the element of pricing (via margin) competetion to ensure 3rd parties have choices.The banks want a clearinghouse to reduce their RWA costs, the regualtors want it to reduce systemic and counterparty risk exposure – essentially the same thing but so long as the relief is granted banks don’t really care what it looks like on the inside. The regulators need to ensure that detailed workings such accurate pricing mechanisms, risk and a default management procedures are in place.What is certain is that the Fed focus will remain on OTC markets for some time to come.

  4. Indian Banker   July 11, 2008 at 6:53 am

    Alessandro is not in a club of one.Fourth ;-)Seriously, LB, you are one of the best in econ/fin blogosphere.I hope you noticed, 12% Inflation news in INdia today (and industrial Production slumping as well).Where are are the EM/Asian economies headed ?

  5. Guest   July 11, 2008 at 9:30 am

    Piati (5th) or Shestoy (6)Interesting post as always. I am sure you are aware that CCCP is Russian and stands for Soyuz Sovetskikh Sotsialisticheskikh Respublik, the not too small country in the East, currently the special friend of the UK government..Greetings from Moscow anyway!

  6. MA   July 11, 2008 at 11:43 am

    @ HloweDid you catch the run XLTC??? 37%!!!!!!!!!!!!!…if not, you can still catch 5% (that goes for the rest of you too… LB, JMa, Alles, OR, ESTr, JLC, NR, etc…While there might be other more profitable plays out there (especially if there’s a market bounce) this one pretty much guaranteed. Selling @ 30.4. Merger price signed @ $32.Excel Tech (a laser company) is irrationally feeling the bad market MoJo today which has caused a little drop. (but the fact remain: $32)As you can see… I had a good feeling about this:@ Hlowe“People” can be silly. In bubble runs, just having the right name can pay off. If there is a solar energy run, the car “solaris” will likely catch a wave or 2 of stray stupidity.With that said… I love spreadsheets. (thank you Microsoft.) …and I love “tech”. …put them together and you have something that Dr Evil would love too! Kinda like Solaris. It’s Ironic. The ChainsawWritten by cardinal puff on 2008-06-23 12:07:27Assuming you read LB post that week, you’d know “chainsaw” was me.Yours truly, Smurfette. Aka -Rich H Aka – Miss America (or in my baseball circle Aka “the chainsaw”)Written by Miss America on 2008-06-20 12:22:19Miss America

  7. London Banker   July 11, 2008 at 2:53 pm

    @ AnonymousYour analysis is helpful, but I remain unconvinced that there weren’t better alternatives to TCC and narrow ownership. Something doesn’t smell right. Besides, with global infrastructure two is always the right number, to ensure competition, innovation, sufficient liquidity and fair dealing. One is always corrupt, sclerotic and too likely to hold the market hostage to narrow special interests.@ Indian Banker and Guest from MoscowMany thanks.@ Miss AmericaAs ever, you are the Master. Your wisdom was wasted on me as I gave up trading in January, but I’m still much impressed that you are so consistently right.

  8. Miss America   July 11, 2008 at 4:43 pm

    Thanks LB,Pretty powerful stuff you unloaded last night on NR’s blog. It was quite a rant/view.After reading it, I gave myself a smack for being an American.Sometimes you can boil my blood a little when you get too far out there on the USA beatdown… but that one was spot on.(I haven’t even gotten a chance to read your entry above yet, I printed it and figured I’d save it and a couple others for my ride home.) …so I apologize for posting on your blog without having read your post …but I just didn’t want to waste any time getting the XLTC news up so that people could make a few bucks. I hope I was not too cryptic in my original posts from June 23rd??? I was particularly fond of the “something that Dr Evil would love too” as it’s a “laser” company.Have a nice weekend.The chainsaw, RH, MA

  9. AfA   July 11, 2008 at 5:33 pm

    LB, did I ever mention that I love you?One question though. I really don’y see how could a CCP be implemented as a clearinghouse to take place of OTC derivatives settling?The OTC market developed and, you said, accounts for 90% of trades. These trades took place in order to escape from the police of already-existing regulated markets. Why would any counterparty who is looking for a fit-size contract go to the CCP? Why would a counerparty who wants to achieve a rediculously high leverage or escape regulation enter a deal with the CCP? Unless of course all these deals (outside the CCCP) become illegal.

  10. jo6pac   July 11, 2008 at 8:35 pm

    Just when I think I might get out this mess alive. I’ve been a wondering what was going to happen with all of that paper, thanks for the heads up. The fox is watching the hens, I feel so much safer.jo6pacEverything is on schedule, please move along.What no postcards from the trip?

  11. Hazleton   July 12, 2008 at 12:07 am

    @London BankerIf you are not trading, where are you parking your money? Nothing seems safe anymore, not even putting it under the mattress :-)

  12. psyops   July 12, 2008 at 1:56 am

    …And I said: OK. Who is this really? And the voice said:This is the hand, the hand that takes. This is thehand, the hand that takes.This is the hand, the hand that takes.Here come the planes.They’re American planes. Made in America.Smoking or non-smoking?And the voice said: Neither snow nor rain nor gloomof night shall stay these couriers from the swiftcompletion of their appointed rounds….thnx LB for your thoughtful piecepsyops

  13. London Banker   July 12, 2008 at 2:47 am

    @ AfaThe top tier of 17 banks will own and be clearing members of the CCP. Everyone else who does 90 of trades with them will have to margin according to clearing house terms with the clearing members. They can enforce this as counterparties by collectively agreeing to impose it as a term of doing business on the market. They can certainly impose this as prime brokers to hedge funds who are dependent on them operationally and financially. @ Jo6PacThe postcard was last week: A Baltic Travelogue of Little Importance HazletonHaving a little cash under the mattress is not a bad idea. Otherwise I’d rather not give advice in these febrile and unpredictable times. Let’s just say I’m glad I’m in Europe.@ PsyOpsThere’s a t-shirt that’s increasingly popular over here by a young artist named Banksy. It’s perfect for you.

  14. London Banker   July 12, 2008 at 2:55 am

    @ Chainsaw/Rich H/MADon’t look at PsyOps’ t-shirt. You won’t like it.

  15. Anonymous   July 13, 2008 at 8:33 pm

    nothing like an untested agenda. a good reason for using TCC rather than CME or LCH is because of competition. pick a weak player and get a better price. why does OTC need a CCP – efficiency if nothing else. rather than having dozens of credit counterparies, you have 1 – the clearing house. also, if i understand correctly, banks get (ceterus paribus) preferential capital risk weighting under basle 2 for centrally cleared exposure. why is this so – because the capital adequacy and systems integrity of the clearing house is very well regulated. in the case of the TCC by the CFTC.sorry lb, i think you are off base on this one.

  16. Concerned Trader   July 15, 2008 at 9:11 am

    Unlike cash instruments OTC derivatives do not generate cash balances from which banks can earn a margin, so why would these banks even want to create an expense and pay for clearing when it just means more money off their dwindling net incomes? I imagine they are still going to trade OTC using their shi*ty bilateral agreements while clearing some of the trades through Clearing Corp to keep regulators at bay. ISDA (International Swaps and Derivatives Association) has a document that outlines how the terms of should follow, but these banks and hedge funds negotiate their own bilateral agreements that suit their needs. What strikes me as most interesting about this is that it neglects the real reason behind the defaults, which is a lack of ability to value these swaps that is likely a result of no transparency. If this is their legitimate answer to the need for a scalable, standards-driven OTC derivative trade processing platform then we are all in trouble because our biggest and "best" investment banks are run by even greedier and ignorant people than I originally suspected.Exchanges like CME are transparent and NEUTRAL, they don’t care about the trades you make as long as you have the margin to cover them. Put it on an exchange!