It should surprise no one that behind technical provisions of the financial reform legislation lurk important real world implications.
We are all aware of the bill's requirement that derivatives must be cleared unless a carve-out is provided. There is also a limitation on the source of these cleared transactions. By source, I mean the venue in which the two ultimate parties (buyer/seller, long/short) to a cleared trade may be matched together. Matching venues are important to liquidity and price discovery -- the elements of transparent pricing arrived at without manipulation. The original Agriculture Committee bill limits the venues to exchanges and "Trading Facilities," a term defined in the Commodities Exchange Act. The contrary position eliminates the Trading Facility limitation.
Of course, traditional exchanges are permitted venues. In this method, a customer seeks a derivative from its clearing institution (technically a Futures Commission Merchant, or"FCM"). Historically, the FCM takes the request to an open outcry pit at an exchange where people in strangely colored jackets behave hysterically. The FCM representative tries to find other FCM representatives who have a customer seeking the other side of the same transaction. In fact, both FCMs transact with the clearinghouse attached to or embedded in the exchange. Clearing eliminates direct credit exposure to the ultimate counterparty so that the basic deal is anonymous.
In the pits, there are opportunities to behave badly and profit from market intelligence. These are, of course, against regulations, but it would be naïve to believe that deterrence is 100% effective.
It should be obvious that people screaming in pits can be replaced by electronic systems. Nowadays, much of the exchange-based matching function is provided by electronic systems. One benefit is the elimination of the potential for gaming the system in the pits.
Trading Facilities, the other permitted matching venues for cleared transactions in the original bill, are similar to exchanges. They include electronic systems through which off-exchange buyers and sellers are matched. It is permissible for Trading Facilities to incorporate algorithms used to adjust bids and offers that do not match exactly. Users of the systems are aware of these algorithms and consent to the results. In the context of the pending legislation, the trade data for the buyer and seller would be transmitted to their respective FCMs for clearing. The critical point is that once the match is made, there is a live contract. The transaction is consummated without human intervention in an anonymous environment with transparent rules and little or no opportunity for gaming the matching process.
The change proposed to the original bill replaces "trading facilities" with "facilities." Effectively, this change permits individual brokers (people, rather than electronic systems) to use telephones, electronic bulletin boards and instant messaging to match buyers and sellers of derivatives and then forward the transactions to the clearing process. Brokers are permitted to participate in the class of transactions which are mandated for clearing. The difference is that human intervention in the basic pricing transaction is allowed. Anonymity is compromised since the broker knows the parties involved. Opportunities for intervention of influences extraneous to the basic deal are introduced. For instance, a broker might favor a customer who provides greater business flow, perhaps to the detriment of the other side to the trade who is also a customer. While this type of behavior is not permitted, it is obviously difficult to police.
Today, brokers often match derivatives in which the buyer and seller elect to clear rather than to transact bi-laterally. The clearing decision is often part of the matching process. For instance, the parties might prefer to transact bi-laterally, but one of them may have reached limits on the amount of credit exposure available for transactions with the other side. Clearing allows the consummation of the deal, even though it was not the preferred method.
Brokers do serve a purpose in the marketplace. One reason a trader may use a broker is referred to as "relationship." This can mean several things. A trader may transact through a broker to give him business so that the broker will be available and attentive when he is really needed to find a counterpart sometime in the future. A broker may also be used because of friendship or other social reasons, such as entertainment.
Brokers may also be necessary to find a match. There may be insufficient liquidity on electronic matching systems to get a transaction done. Electronic matching is passive. It requires both sides to post their desire to transact. Voice brokerage is active. The broker can initiate the proposal to transact with a potential counterparty. The most obvious legitimate reason to use a broker is to transact a derivative for which active efforts to match are required. These are derivatives for which the market is inactive, i.e., illiquid.
Is the access to liquidity a good trade off for the opaqueness of a brokered market? This is a tough question, but not just because the relative values of liquidity and opaqueness are imprecise. Fundamentally, the very premise of the question defies reason.
Remember, we are discussing broker matching of trades for which clearing is mandated. All of this raises a fundamental question: if a transaction is so illiquid that a broker is needed to actively solicit for counterparties, should it be cleared in the first place? The basic premise for clearing is that items cleared must be liquid. The systemic integrity of a clearinghouse is based upon the ability to predict reasonably the cost of replacing transactions lost in a default. Their statistics depend on a continuous, liquid marketplace. Without this, historic price data is not a good basis for estimating the cost of a forced transaction, especially in the stressed environment of a default.
Yet the industry and the lawmakers perceive an overlap between the clearing mandate and legitimate uses of voice brokers. This relentlessly leads to a conclusion that the new environment will involve increased systemic risk as clearing of illiquid transactions will increase.
This phenomenon exists already. Increased trading activity has consumed available credit extension capacity restricting the ability to consummate bi-lateral trades. Today, clearinghouses compete ferociously with one another for volume. New transactions have been added repeatedly, even though their liquidity is doubtful.
Passage of the financial reform requires a new and innovative examination of clearing itself. Sticking to the old ways of doing business runs the risk of another systemic threat, this time to the clearing systems. The threat is increased by mandated clearing. There are ways to address this problem. In short, limiting clearing system exposures beyond the statistically determined levels of collateral for certain transactions and techniques for distributing the excess risk back to the traders make sense.
Passage of the legislation is a good thing. Failure to follow up with innovative implementation could turn a good thing bad.
Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.