FM: You formerly headed BOTCC. What is you opinion of the mandate to clear most OTC swaps? Is there a risk as well as an opportunity in moving these products onto a clearinghouse?
NK: One of the things we have seen in the world of finance is that company to company traded credit default swaps (CDS) have proven to be quite dangerous to say the least. There is a question of if we can clear them on an exchange, could we see the exposure. I have not read anything about anybody calling for a position limit in swaps. I understand the drive; the drive is to make that market transparent rather than opaque. Specifically in the area of CDS, the main question always asked is how do you margin CDS? If we are discussing corn and the market is $5 and you are short from $4.90 I know you are out 10¢ a bushel, so you will need that margin plus the initial margin. I have a mechanism to daily margin your account. The CDS is quite another animal. The problem is we know those things are discontinuous. One party buys the insurance and another sells it, so it is like a piece of insurance and then it rests. There aren’t a large number of buyers and sellers making a market. And in the end it either defaults or is doesn’t, it is binary. The rational margin on that CDS is somewhere between zero and full value. I understand why it should be done but I would be curious how do you really margin these things.
The issue with the writer of the swap, the seller, is that it is even more important to understand his balance sheet as to his availability to withstand a complete requirement to pay. The best [solution to] that is too make him put up 100%, but that would probably drive away business. I have never been able to understand the model for margining. It has to be done differently than the traditional clearinghouse mechanism. The traditional clearinghouse mechanism relies on a functioning market to price the underlying and what really makes it work is you make people come up with the money every day.
FM: They are off exchange because they don’t want to put up the money.
NK: That’s right. We laugh when we say that, but they don’t want to put up the money. They also are not sure how it should be fairly priced. If you put these things on exchanges, you will have clearing members that will be on both sides of the market. If you got enough trade in it, then you will be pricing it. But those that are short it, you better be sure that they have the wherewithal to meet the ultimate cost.
FM: One of the criticisms mentioned by futures commission merchants (FCMs) of the CME’s plan to clear OTC products, particularly CDS, is that funds to back them would be commingled in the clearinghouse with funds backing the rest of their portfolio. Would you prefer a separate structure?
NK: That is some comfort but I would rather say, were I still making that decision, I [would want to] understand their model for margining, pricing and maintaining financial integrity. If I understood that and agreed to it, then I would rather go with the business model that works. I understand that you could separate them, but, as a practical matter, if you blew up one clearinghouse, I don’t think that is going to bode well for the remaining [clearinghouses].
FM: How has the grain markets changed over the years?
NK: Significant moves in the past were export driven; commercials were the significant drivers. They have been diminished by an expansion of domestic consumption. A second example of that would be the large amounts of managed capital which goes in and out of the grain markets. That has different features, [there is] the long-only feature, but there is the capital that avails itself of the market on the upside and the downside. And while the grain markets have [always] been international markets, electronic trading [has allowed] the whole world the same access to these markets at all times. They are much more robust. You have access to them regularly from Beijing, or wherever, just as if you were sitting in Chicago. That makes them deeper markets and I think they are better markets.
FM: We have spoken to some managers who say that despite the huge increase in volume in agricultural markets because of electronic trading, it is actually more difficult to execute size because of certain trading algorithms. Have you found that to be the case?
NK: I haven’t had that experience. I can tell you in executing options size, you can do a much better job with futures on the screen. The options markets themselves are much deeper and tighter because those that are trading options have access to the underlying through the screen. That tightening of the availability takes so much friction out of the markets and makes it a much better and more responsive market.
FM: Talk about the two managed futures programs you offer: Swinford and Willis.
NK: Swinford is a very traditional, fundamental trader. His background is in the swine industry and farming, and he concentrates in trading hogs and cattle. He also trades the grain markets. It is a fundamentally driven program from Mike Swinford. The [Tom] Willis program is quite a different approach to markets. Willis uses a technical approach to trade a diversified group of markets [this is a separate program from what Willis does as part of Mesirow Financial]. Kottke is the CTA and they are traders under us. They execute through our people on the floor and on the screen.