Net Settlement And The Shortfalls Of Clearinghouse Guarantees*

Ben S. Bernanke (Current Federal Reserve Chairman) explains the shortfalls of clearinghouse guarantees.

Read the passage below as many times as you need to understand it.

(emphasis mine) [my comment]

Clearing and Settlement during the Crash
Ben S. Bernanke

Princeton University

This article is a reexamination of the clearing and settlement process in financial markets (particularly the futures market) and its performance dur­ing the 1987 stock market crash. …

…
In practice, the most important device for ensuring performance on trades is the collection of margin. While in stock markets margin is effectively a “down payment” on the purchase of securities (with the rest of the purchase being financed by credit from the broker), in futures (and options) markets the margin is more correctly thought of as a “performance bond.” The purpose of the bond is to ensure that the trader will be able to cover his position in the event of a large price move (but not, obviously, for any possible price move).
…
Margin collection is actually administered in a pyramid structure. [A useful illustrative example is given in Edwards (1984, pp. 227ff).] Futures commission merchants collect margin from their own customers. Nonclearing member FCMs in turn have to post margin with a clearing member. This collection of margin from nonmember FCMs is on a gross basis; that is, the amount collected depends on the total number of contracts traded by the nonmember FCM and its customers, not on the nonmember FCM’s net exposure. Effectively, then, all margins collected by nonmember FCMs are passed through to and held by clearing member firms.

The clearing members in turn post margin with the clearinghouse. This is usually on a net basis, that is, the margin depends on the open position of the member FCM; 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. The clearinghouse itself always has a zero net position, since the net long positions of some clearing members will cancel out the net short positions of others.

…
As long as daily losses per contract resulting from price changes are smaller than posted margin, the performance of contracts is automatically assured. The clearinghouse only has to transfer funds from winners to losers, incurring no exposure itself. However, if losses are so large that margins are not sufficient, and if losing traders decide or are forced to default, then there is a danger that the clearinghouse may have to make good nonperforming contracts.

[Key Point] An interesting question is how far the clearinghouse’s guarantee of performance extends. Under a net margin system, the clearinghouse collects margins from members only on their net exposure (their net long or net short position with the clearinghouse). This suggests that the clearinghouse’s goal is not to guarantee all futures contracts, but only to protect clearing members from the default of other members. [Key Point]

To illustrate this distinction by an example, consider a clearing member FCM with a balanced portfolio of longs and shorts: This member has no open position and thus would post no margin with the clearinghouse. It is nevertheless possible that 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? [No] Edwards (1984, pp. 231-232) claims that the answer is no; he goes on to suggest that this may be the most efficient arrangement, since it gives customers and FCMs some incentive to monitor each other’s financial condition. Other sources are more ambiguous about whether the clearinghouse would assume any responsibility in this case; for example, the Brady Report (1988, pp. VI-28) points out that the Chicago Mercantile Exchange maintains a trust fund that could be used on a discretionary basis to help customers of a failing FCM. Evidently, though, not only the solvency of the clearinghouse but also the solvency of the member FCMs is a necessary condition for the integrity of all futures contracts.

My reaction: Read the passage above as many times as you need to understand it.

1) The most important device for ensuring performance on trades is the collection of margin. In futures (and options) markets the margin is more correctly thought of as a "performance bond."

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) 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.

4) Consider a clearing member FCM with a balanced portfolio of longs and shorts: This member has no open position and thus would post no margin with the clearinghouse.

5) 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.

6) The integrity of all futures contracts depends not only the solvency of the clearinghouse but also the solvency of the member FCMs.


KEY POINT

I am repeating this because it is so important: The integrity of all futures contracts depends not only the solvency of the clearinghouse but also the solvency of the member FCMs. If you trade futures/options through an insolvent broker-dealer (nearly all of them are insolvent at this point), you are exposing yourself to massive counterparty risks.


Unhealthy Impact of Net Settlement

Net Settlement helps weak or insolvent firms survive. In fact, preventing settlement failures (ie: the collapse of these insolvent institutions) has been the driving force behind the move towards net settlement.

1) Clearinghouse guarantee allowed insolvent broker-dealers to continue operating.

Normally weak or insolvent financial institutions become insolated as counterparties refuse to do business, causing them to fail. This is healthy. However, Net Settlement eliminates the need for firms to assess the credit of each of their counterparties through its clearinghouse guarantee.

2) “looting” customer brokerage accounts

Net Settlement allows and encourages broker dealers (especially insolvent broker dealers) to loot their customers' brokerage accounts take 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.

Results of netting in futures (and options) markets

The chart below shows amounts receivables from customers (Margin Debt) and payables to customers (free balances, derivative margin, etc). The difference between the two is provides a good estimate of how much derivative margin (futures, options, etc…) has been borrowed by broker-dealers.

Net Settlement in equity settlement

The Sanity Check reports that Continuous Net Settlement (CNS) in equities.

Continuous Net Settlement (CNS) and Illusory FTD Reporting
Written by: bobo
8/28/2006 3:23 AM

The Continuous Net Settlement System (CNS). A system implemented by Wall Street to speed transaction processing, which nets sales against purchases, and against the accounts of DTCC participants.

What does it have to do with the magnitude of the Fail To Deliver (FTD) problem?

Turns out, a lot.

Because of the netting, many delivery failures never show up as such at the DTCC, and consequently are never reported. The DTCC literally doesn't know they exist. How can that be?

Here's an example created for me by Dr. Susanne Trimbath, PhD, an authority on the clearing and settlement system:

In other words, Prime Broker A could have, say, 1 million long shares of NFI in their account, and during the course of the day, several of their big hedge fund customers could fail 400,000 shares, and those would never show up as FTDs because the CNS system would net the fails against their securities in their account, essentially netting the fails against shares in their DTC account. [another way to think of this is that failures to deliver create automatic short positions for the broker dealers]

Here's how it was further clarified for me by Dr. Trimbath:

"For your question, you need to follow through to the DTC account, where shares are taken automatically for CNS settlement by NSCC. Here, we’re talking about a hedge fund that failed to deliver to Prime Broker A, a specific trade that failed delivery. However, because the “free” shares are taken from Prime Broker A’s account there is no reported failure to deliver at NSCC.

If, for example, the failure is in IBM, and Prime Broker A has a ton of shares hanging around the house account, then those get swept up for delivery and there is no failure in CNS. There is a failure in the system somewhere, but the DTCC never sees it. Prime Broker A should be tracking it, we hope, to be sure they get the shares... But there are no SEC rules about Prime Broker A reporting that. (From what I’ve seen in NYSE audits, the Prime Broker A's of the world aren’t keeping very good records on this sort of thing, frankly).

Now what if those are NFI, and Prime Broker A doesn’t have a ton of shares hanging around the house account? Now, there’s nothing to get swept out for settlement and you get a reported FTD from NSCC. This helps explain why smaller companies show up on threshold lists more often, despite the fact that over-voting of shares occurs in HP/Compaq, for example."

OK, so I get it. CNS nets against the NSCC accounts of the participants, and the only FTDs that are reported are trades over and above whatever each participant has on account, after all trades for the day are netted against each other.

So realistically, delivery failures hidden by the CNS system could be much larger than what shows up as FTDs at the DTCC, given that 90+% of all trades are netted. Literally, most of the issued shares of a company on account at the DTCC via brokers could be used up in netting BEFORE the first FTD showed up as we think of them, or as they would show up on a FOIA request.

Now think about that for a second.

We know that EVERY company has an over-voting problem. So by definition, more votes are being cast than shares exist. Margin lending, without distinguishing lent security entitlements, accounts for some of that - the brokers just allow the lent share investor, who has no right to vote as his shares were lent out - to vote anyway.

My reaction: Once again, the NSCC’s Continuous Net Settlement (CNS) is designed to protect clearing members from the default of other members, not retail investors.

NSCC’s CNS essentially nets the failure to delivers against shares in their DTC account, in effect automatically creating short positions for the broker dealers. The ease with which the NSCC allows broker-dealers to short sell customer securities is seductive and its effects visible.

Visible impact of NSCC netting

Wapedia reports that the National Securities Clearing Corporation was established in 1976.

• National Securities Clearing Corporation (NSCC) - The original clearing corporation, it provides clearing and serves as the central counterparty for trades in the US securities markets.

Established in 1976, it provides clearing, settlement, risk management, central counterparty services, and a guarantee of completion for certain transactions for virtually all broker-to-broker trades involving equities, corporate and municipal debt, American depositary receipts, exchange-traded funds, and unit investment trusts. NSCC also nets trades and payments among its participants, reducing the value of securities and payments that need to be exchanged by an average of 98% each day. NSCC generally clears and settles trades on a "T+3" basis. NSCC has roughly 4,000 participants, and is regulated by the U.S. Securities and Exchange Commission (SEC).

Now have a look at what happened to broker-dealer short positions after NSCC started netting equity trades in 1976.

In 1970, broker-dealer short positions in securities and commodities totaled 707 million. In 2004, these broker-dealer short positions grew to 558 billion. That is a 78,956% increase.

Net Settlement Abuses Have Turned US financial System into a Ponzi scheme

Net Settlement is only part of what has given the US financial system the structure of a Ponzi scheme. Another big part is the Federal Reserve's daylight overdrafts and the repo market, which I will write about in another entry.

Edward J. Kane on Google Books explains the Ponzi scheme.

The name Ponzi commemorates the brainstorm and abbreviated financial career of an infamous conman, Charles Ponzi, who operated in Boston around 1920. In a Ponzi scheme, a fund-raising enterprise operates with little or none of the earning assets that a sound enterprise requires to generate a projected stream of cash flows with which to service lenders and investors. Instead, the enterprise relies on expanding its liabilities faster than its interest and dividend payments expand. The enterprise pays interest or dividends each period to its old clients—not from earnings but from funds that are provided by new lenders and investors. As long as new funds can be attracted into the scheme fast enough, the enterprise’s managers can meet corporate obligations as they come due and pay themselves handsomely at the same time. This can only be done, of course by making seductive promises of high returns and making the scheme’s subscribers believe these promises to be reasonable.

The flaw in any Ponzi scheme is that in the end the promises being made have no collective chance of being kept. Until a day of reckoning dawns, however, the sponsors’ false promises are mistaken for truth and participants in the scheme appear to prosper. The apparent prosperity of the enterprise tends to disarm critics of the scheme by giving them the appearance of individuals who lack imagination or vision.

A Ponzi scheme is a classic case of value created in the marketplace by asymmetries in the distribution of information. The scheme’s sponsors know that they are running a con game, but subscribers do not. Keeping subscribers and potential critics from learning or guessing this hidden information becomes increasingly difficult the longer the scheme goes on. Once economically unsound elements in the scheme begin to surface—as inevitably they must—public confidence and the value of subscribers’ claims to future cash flows can collapse rapidly.

Eric de Carbonnel

 Market Skeptics

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