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Margin deposit practices in focus as clearing firms gain clout

Karen Brettell
Tuesday, 26 Nov 2013 | 3:20 PM ET

NEW YORK, Nov 26 (Reuters) - When U.S. broker MF Global came under pressure from lenders, trading partners and clients two years ago, one of the biggest claims for its funds came from LCH.Clearnet, a company not very well known outside financial markets.

London-based LCH is one of the world's largest clearinghouses, a group of companies that are emerging as the new superpowers of the global financial system. They guarantee trades, making good on payments if a trading partner fails.

Rules that kicked in this year now require most trades in the $668 trillion global privately negotiated derivatives markets to move to these firms, which are already a common presence in bond and repurchase agreement markets.

That is concentrating more trading risks with clearinghouses than ever before, making them the new too-big-to-fail firms of global finance. It is also drawing new scrutiny on how they manage their exposures.

Federal Reserve governor Jerome Powell said last week that "concentrating risk in a central counterparty could create a single point of failure for the entire system."

To protect against this, international regulators are developing principles to mitigate the risks a clearinghouse or broader markets faces if a firm like MF fails. Some rules meant to reduce the risk of a clearinghouse failure are already surprising some market participants who claim the new rules are too rigid.

The U.S. Commodity Futures Trading Commission (CFTC) said earlier this month that it will require clearinghouses to back U.S. Treasury debt collateral, seen as the safest and most liquid collateral in the world, by credit lines to ensure that the securities can quickly converted to cash.

Lawrence Sweet, senior vice president at the New York Fed, said last week that Treasuries could still pose risks to clearinghouse liquidity because payment for sales of Treasuries is not settled until the next day.

A key factor in minimizing the risks of clearinghouse failures is that they can draw the funds they need to cover exposures within hours if necessary, by raising margins, liquidating trades and selling collateral, or drawing on credit lines.

But this can also have large consequences for companies and markets that come under pressure, as margin hikes that clearinghouses implement to protect themselves, can add to their stress.

"Clearinghouses do a good service to the overall market. But it makes it harder on an institution, especially a smaller counterparty that is having liquidity problems, because just as you are having liquidity problems your margins go up," said Scott Skyrm, a former repo trader and author of "The Money Noose," about MF Global's collapse.

Margins are deposits made by traders with a broker or clearing house to cover some or all of the credit risk of a failure by one of the parties to fulfill its obligations.

LCH demanded almost $1 billion in total from MF Global in 2011, as the firm's $6 billion bet on Portuguese, Spanish, Irish and Italian government bonds looked increasingly risky, and as fears over fears MF's liquidity accelerated.

Neither LCH nor its bank members, which contribute to a default fund at the firm, took any losses after MF failed in late October that year. LCH declined comment.

After MF's bankruptcy, LCH liquidated MF's bond positions. The quick sale created a gain for some buyers that bought the debt for less than its market value, at the expense of the MF's shareholders, Skyrm added.

SHIFTING RISKS

Most agree that clearinghouses make markets safer, mainly through higher margins, greater transparency of trade positions and by netting down gains and losses on similar trades.

Unlike banks, they do not take risks themselves, and they employ collateral, default funds and credit lines to ensure there is enough liquidity to step in when a member fails.

The margining and mutualization of risk among clearing members helps contain a company's failure, which could otherwise spiral into a chain of collapses as happened during the 2008 crisis, when the failure of Lehman Brothers required government intervention to shore up other teetering banks.

Still many banks, which stand to lose market share from increased client clearing, are focused on the risks involved with a greater role for clearing houses.

Goldman Sachs Chief Executive Lloyd Blankfein told CNBC in October that clearing would reduce the risk of a 20-year storm, but added "what happens in the 40-year storm or the 50-year storm that is so severe that puts the clearinghouse at risk... that's a lot of concentrated risk in one place at that point."

Kim Taylor, president of CME Clearing, part of the CME Group , when asked to respond to Blankfein's comments at a futures contract industry conference in Chicago earlier this month, said she finds some bank comments on clearing "disingenuous."

"We're ready for the 100-year storm and our sandbags are already filled," she said, adding that banks have tended to downplay the risks of bilateral trading, or that of trading among each other without a clearing guarantor in the middle.

Managers at major clearinghouses in interviews said they have a broad array of techniques to monitor and manage their exposures.

They can require firms clearing trades with them to reduce or transfer trading positions, or collateral backing the trades, if they are viewed as too concentrated, and as market liquidity changes.

Clearinghouses can also demand additional financial information from member firms to monitor their liquidity, and expel them if it is not forthcoming. The ultimate step to protect against a failure is to call a firm in default.

FUEL TO THE FIRE

Clearinghouses are not the only firms which can quickly drain the resources of banks and brokerages. A pullback by bank lenders, clearing and trade settlement agents and others all helped hasten MF's demise.

As more trades are concentrated with fewer firms, however, clearinghouse decisions will be increasingly influential. For these firms the balancing act between protecting themselves and adding to already stressed conditions is tricky.

Regulators have warned clearinghouses against imposing pro-cyclical margin policies, or those that can exacerbate stress once it begins, said people familiar with the conversations. But that is not always easy.

"To some extent it's unavoidable, you just want to make sure that you don't change the margin requirements suddenly," said Darrell Duffie, a finance professor at Stanford University. "The best thing to do is to have large haircuts from the beginning and then you don't have to raise them dramatically when things start to look tense."

When European nations including Spain and Italy were rocked by rapidly rising bond yields in 2011 and 2012, fixed income traders were fixated on trading levels where LCH was expected to hike the margins needed to clear those bonds, and to what degree increases could exacerbate those countries funding pain.

LCH has since revised its procedures and now increases margins on bonds at more regular intervals when their spread widens, reducing the risk of large "cliff" events that can have more deleterious consequences on markets, said people familiar with the firm's practices.

(Editing by Clive McKeef)