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Last Friday, I
wrote about Net Settlement and
its role in giving the US financial system the structure of a Ponzi scheme.
In this entry, I want to give an example of the effect of net settlement
using the CME and US futures market.
CME reports that
its 2008 financial statements.
(emphasis mine) [my
comment]
[from
CME’s 2008 financial statements:]
5. PERFORMANCE BONDS AND SECURITY DEPOSITS
CME clears and guarantees the settlement of CME, CBOT and NYMEX
contracts traded in their respective markets. In its guarantor role,
CME has precisely equal and offsetting claims to and from clearing firms on
opposite sides of each contract, standing as an intermediary on every
contract cleared. Clearing firm positions are combined to create a
single portfolio for each clearing firm’s regulated and non-regulated accounts
with CME for which performance bond and security deposit requirements are
calculated [Net settlement]. To the extent that funds are not
otherwise available to CME to satisfy an obligation under the applicable
contract, CME bears counterparty credit risk in the event that future market
movements create conditions that could lead to clearing firms failing to meet
their obligations to CME. CME reduces its exposure through a risk
management program that includes initial and ongoing financial standards for
designation as a clearing firm, initial and maintenance performance bond
requirements and mandatory security deposits. Each clearing firm is
required to deposit and maintain balances in the form of cash, U.S.
Government securities, bank letters of credit or other approved investments
to satisfy performance bond and security deposit requirements. All
obligations and non-cash deposits are marked to market on a daily basis.
Effective December 2008, the NYMEX performance bond and security deposit
collateral has been fully integrated with the CME collateral portfolio. The
NYMEX guarantee fund, which would have previously been used for any loss
sustained by NYMEX due to the default of a clearing firm, was terminated, and
NYMEX clearing firms have been included in the security deposit calculation.
…
Cash and securities held as performance bonds and security deposits at
fair value at December 31, 2008 were as follows:
|
|
|
Securities and
|
(in thousands)
|
|
Cash
|
IEF Funds
|
Performance
bonds
|
17,296,125
|
96,220,538
|
Security
deposits
|
|
152,301
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1,997,858
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Cross-margin
arrangements
|
204,441
|
188,348
|
Total
|
|
17,652,867
|
98,406,744
|
Cash and
securities held as performance bonds and security deposits at the CME on
December 31, 2008 totaled 116 billion. Remember this number.
--------------------------------
Next, the CME
explains how How Performance Bonds/Margins Work.
How
Performance Bonds/Margins Work
Performance bonds – deposits required to ensure that a clearing member
can cover potential losses with his or her trading positions – help to
ensure that clearing members can meet their obligations to their customers
and to CME Clearing. You can view a full listing of Performance Bond/Margin
Requirements here.
As prices change throughout the life of a futures contract, the trading
accounts where performance bonds are held are debited and credited
accordingly - guaranteeing price performance and eliminating the risk of
default on either side of the trade [for CME clearing
member, not brokerage customers]. Financial
safeguards provided by CME Clearing protect the financial interests of both
parties in a trade [MISLEADING], leading to
sound markets and deeper liquidity - around the clock - everywhere in the
world.
--------------------------------
Finally, here is
the amount of margin that should have been posted on 47 of CME’s most
popular contracts (out of the thousands of products that clear at
the CME). It is key to remember that these are
only a small portion of the future contrasts that settle through the
CME.
|
Open Interest
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Initial
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Initial Margin
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Contract Names
|
on 12/30/2008
|
Margin
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Times OpInt
|
OATS
|
16,205
|
675
|
10,938,375
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3-MONTH
EURODOLLARS - CHICAGO MERCANTILE EXCHANGE
|
6,683,953
|
1,012
|
6,764,160,436
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SOYBEAN OIL
|
212,598
|
1,080
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229,605,840
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2-YEAR U.S.
TREASURY NOTES
|
524,976
|
1,080
|
566,974,080
|
5-YEAR U.S.
TREASURY NOTES
|
1,056,042
|
1,080
|
1,140,525,360
|
LIVE CATTLE -
CHICAGO MERCANTILE EXCHANGE
|
211,365
|
1,080
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228,274,200
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TRANSCO ZONE 6 BASIS SWAP
|
50,282
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1,210
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60,841,220
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INTEREST RATE SWAPS 5YR
|
50,407
|
1,215
|
61,244,505
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CORN
|
802,641
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1,350
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1,083,565,350
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LEAN HOGS -
CHICAGO MERCANTILE EXCHANGE
|
153,839
|
1,417
|
217,989,863
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10-YEAR U.S.
TREASURY NOTES
|
1,034,318
|
1,485
|
1,535,962,230
|
HENRY HUB GAS SWAP
|
3,177,313
|
1,518
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4,823,161,134
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HENRY HUB
PENULTIMATE GAS SWAP
|
1,145,478
|
1,518
|
1,738,835,604
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WHEAT
|
247,329
|
1,620
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400,672,980
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WHEAT - KANSAS
CITY BOARD OF TRADE
|
82,853
|
1,620
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134,221,860
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WHEAT - MINNEAPOLIS GRAIN EXCHANGE
|
28,765
|
1,620
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46,599,300
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SOYBEAN MEAL
|
117,355
|
1,620
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190,115,100
|
TCO BASIS SWAP
|
99,784
|
1,870
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186,596,080
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INTEREST RATE SWAPS 10YR
|
28,713
|
2,025
|
58,143,825
|
COTTON NO. 2 -
ICE FUTURES U.S.
|
125,564
|
2,200
|
276,240,800
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SUGAR NO. 11 -
ICE FUTURES U.S.
|
642,954
|
2,200
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1,414,498,800
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U.S. TREASURY BONDS
|
761,182
|
2,565
|
1,952,431,830
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GULF # 6 FUEL 3.0% SULFUR SWAP
|
35,192
|
2,695
|
94,842,440
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NY RES FUEL
1.0% SULFUR SWAP
|
24,956
|
2,695
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67,256,420
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NO. 2 HEATING
OIL, N.Y. HARBOR
|
226,522
|
2,695
|
610,476,790
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SWISS FRANC -
CHICAGO MERCANTILE EXCHANGE
|
25,073
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2,700
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67,697,100
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PALLADIUM
|
12,427
|
3,025
|
37,591,675
|
COCOA - ICE
FUTURES U.S.
|
116,641
|
3,300
|
384,915,300
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EURO FX -
CHICAGO MERCANTILE EXCHANGE
|
120,499
|
3,375
|
406,684,125
|
NASDAQ-100
STOCK INDEX (MINI) - CHICAGO MERCANTILE EXCHANGE
|
229,980
|
3,500
|
804,930,000
|
SOYBEANS
|
278,773
|
3,712
|
1,034,805,376
|
COFFEE C - ICE
FUTURES U.S.
|
122,856
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4,400
|
540,566,400
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COPPER-GRADE #1 - COMMODITY EXCHANGE
INC.
|
74,252
|
4,725
|
350,840,700
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PLATINUM
|
18,320
|
4,950
|
90,684,000
|
CRUDE OIL, LIGHT SWEET
|
1,169,215
|
5,400
|
6,313,761,000
|
WTI CRUDE OIL FINANCIAL
|
165,748
|
5,400
|
895,039,200
|
E-MINI S&P
500 STOCK INDEX - CHICAGO MERCANTILE EXCHANGE
|
2,307,779
|
5,625
|
12,981,256,875
|
NATURAL GAS
|
671,730
|
6,075
|
4,080,759,750
|
NIKKEI STOCK
AVERAGE - CHICAGO MERCANTILE EXCHANGE
|
31,551
|
6,250
|
197,193,750
|
NIKKEI STOCK
AVERAGE YEN DENOM - CHICAGO MERCANTILE EXCHANGE
|
38,081
|
6,250
|
238,006,250
|
DOW JONES INDUSTRIAL AVG- x $5
|
53,437
|
6,500
|
347,340,500
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GOLD - COMMODITY EXCHANGE INC.
|
300,448
|
6747
|
2,027,122,656
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SILVER - COMMODITY EXCHANGE INC.
|
85,312
|
6,750
|
575,856,000
|
NASDAQ-100
STOCK INDEX - CHICAGO MERCANTILE EXCHANGE
|
19,121
|
17,500
|
334,617,500
|
S&P 500
STOCK INDEX - CHICAGO MERCANTILE EXCHANGE
|
488,604
|
28,125
|
13,741,987,500
|
DOW JONES INDUSTRIAL AVERAGE
|
9,630
|
32,500
|
312,975,000
|
E-MINI S&P
400 STOCK INDEX - CHICAGO MERCANTILE EXCHANGE
|
115,703
|
37,500
|
4,338,862,500
|
|
|
|
|
Total
|
23,995,766
|
|
73,997,667,579
|
|
|
|
|
Buyers Initial
Margin
|
73,997,667,579
|
|
|
Sellers Initial
Margin
|
73,997,667,579
|
|
|
|
147,995,335,158
|
|
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On these 47
contracts alone 148 billion dollars of collateral should have
been posted at the CME to protect all contract holders. However, because of
net settlement, the CME has only 116 billion of collateral to
back not only these 47 contracts, but also the thousands of other CME products.
Again, the reason
for this lack of collateral is explained in my entry on net settlement: The clearinghouse's (CME’s) goal is
not to guarantee all futures contracts.
…
2) The clearing members post margin with the clearinghouse on a net basis. A
member firm whose customers held an equal number of long and short contracts
would post no margin with the clearinghouse, but would
retain its customers' margins in its own account.
3) A large price move could cause some of the clearing member's customers
to default, threatening the solvency of the firm. If the FCM failed, would
the clearinghouse guarantee performance of the contracts of the defaulted
member's customers? The answer is no.
4) The clearinghouse's goal is not to guarantee all
futures contracts, but only to protect clearing members from the
default of other members, which is why margins are collected from members
only on their net exposure.
5) The integrity of all futures contracts depends not only the solvency of
the clearinghouse but also the solvency of the member FCMs.
Broker-Dealers
trapped in short positions
Last time I
explained how net settlement encourages the “looting” customer
brokerage accounts.
Net
Settlement allows and encourages broker dealers (especially insolvent broker
dealers) to loot their customers' brokerage accounts by taking the opposite
side of trades. Take an insolvent firm (Lehman, Bear
Stearns, etc) which is critically short of cash and is finding it impossible
to obtain unsecured financing. For this firm desperate firm, there is an easy
(and incredibly reckless) solution: trade on its own accounts to zero out all
its net derivative positions. For example, if its customers are net long gold
futures, the the firm can take a short position in gold futures matching the
size of the long position. Since the clearinghouse now sees an equal number
of long and short contracts, margin backing gold futures will be returned.
I would like to
add to this the obvious fact that any broker dealer which decided to abuse net
settlement in this way would likely find themselves permanently trapped on
the wrong side of the market. Consider, for example, a firm that shorted
commodity futures (gold for example) at any point during the last twenty
years. With commodity prices rising, such firm would find itself owing its
customers amounts that would be impossible to ever repay. To simply stay
afloat (not run out of cash), the firm would need to constantly increase its
futures market customers in order to pay back those customers cashing out
their profitable futures bets. In other words, this firm would be running a
Ponzi scheme in every sense of the word.
Now look at the chart below of open interest in major commodity futures.
Notice the constant and enormous growth in outstanding futures contracts.
This growth is the predictable result of allowing insolvent broker-dealers to
settle their contracts on a net basis.
Eric de Carbonnel
Market Skeptics
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