From the November 01, 2008 issue of Futures Magazine • Subscribe!

Clearing the air

When exchange clearing members come under stress, the clearinghouse gets active, so we talked to Kim Taylor, managing director and president of CME Clearing House Division, to see what steps were taken once Lehman Brothers Holdings declared bankruptcy on Sept. 15.

The first thing Taylor points out is that Lehman’s regulated clearing member entity didn’t declare bankruptcy. “The broker dealer/FCM did not declare bankruptcy until it was put in a package in a sale to Barclays,” Taylor says. “We had a clearing member who continued to be in good standing with us in terms of meeting all of its obligations. Their regulatory capital provisions, their customer segregated funds protections enabled the regulated entity to function in an orderly way during the period when you would expect the business to be wound down or sold. That process worked all week. And by the end of the week, Barclays had agreed to purchase certain assets of the regulated entity including the futures customer [accounts].”

In situations of stress the clearinghouse is also a clearinghouse of information. “We make sure that there is information about the status of the broker dealer because the clearing member of the CME remained in good standing. But we do acknowledge that the clearing member is operating in a state where its parent is impaired and so you have to anticipate that it might not be able to operate on a long-term basis,” Taylor says, though she adds that Refco’s regulated entity operated for six weeks in this condition.

The regulated entity has capital requirements driven by the extent of exposure to its customers. It must have sufficient capital to meet the needs of its business. It also requires, in the case of futures, that dollar for dollar, any money provided to the firm from futures — or any money the FCM owes customers based on open positions, be on hand.

“That segregated funds protection is a very important, [it] helps customers in the regulated markets have a better outcome, in a situation like with Lehman, than customers in the nonregulated markets,” Taylor says, adding that if you had money with a Lehman customer trading OTC derivatives without the benefit of daily mark to market, those customers are expected to take quite a significant loss on those deposits because they are general creditors of Lehman.

She says that futures customers either had the opportunity to transfer funds to another clearing member or have the positions and money moved by the clearinghouse.

She says when a parent of a clearing member goes bankrupt the regulatory community and the Designated Self Regulatory Organization (CME Group in this case) keep a very close eye on the balances of the firm to ensure that customer funds leave with the customers. They also were aware of the larger crisis and had their ears to the pavement.

“We watch a variety of things about all of our clearing members. We watch what is happening with their [short-term interest rates], we watch what is happening with their debt, we watch what is happening with their credit default swaps. All of those things can be indicators of how the market feels about the clearing member,” Taylor says. “We had Lehman on daily financial reporting during the troubled period and we coordinated with other regulators. We monitor that for all of our clearing members, but when there is a potential for an unusual situation, we have a higher level of scrutiny that we apply.”

And when the worst case occurs, the clearinghouse stands ready to move customer funds out of harm’s way. “Our goal if there were to be a bankruptcy or default of a clearing member, based on house business, would [be to] pick those up and try and facilitate a move of the whole pool of customers to another clearing member. Or if we couldn’t facilitate that, we would facilitate the customers transferring out one by one to wherever they wanted to go.” Speed is important. “The preference is for there to be an outcome that is prompt so that the customers’ access to the market, their ability to hedge their exposure, their interest to the funds are not disrupted.”

In the case of AIG, the clearinghouse was faced with a member who needed to liquidate positions in a hurry. “Basically AIG came to us with a liquidation plan for their house exposure when they were having trouble in the market that day (Tuesday Sept. 16) and they requested a little flexibility to better manage the liquidation of their exposures. We agreed to allow them to do block trades in products where we normally do not allow block trades.”

Block trades are trades that are allowed to be privately negotiated bilaterally because of size. Then they are reported to the exchange within a certain amount of time.

Taylor says the ability to share information is key to a successful outcome. “We have a lot of different information sharing mechanisms that are in place. The Treasury and the Fed, the CFTC and the SEC, FINRA, the other domestic clearinghouses. In a time where there is potential stress in a firm, if you want money to move, information has to move.

Taylor said the exchange stands ready to offer a clearing facility for outstanding OTC CDSs. “We have been very public about the fact that we are operationally ready to migrate existing CDS contracts and begin clearing those contracts within a matter of a couple of weeks. ” True to her word, CME announced a couple days later a joint venture with hedge fund Citadel Investment Group LLC to launch a trading facility for CDSs within 30 days.

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