Smart contracts, structured product regulation and CCP member defaults

SMART CONTRACTS face challenge in cleared environment, summit hears

STRUCTURED PRODUCT innovation held back by oversight

CAPITAL RULES "should be eased" following FCM defaults

COMMENTARY: Prêt-à-porting?

The US Commodity Futures Trading Commission (CFTC) heard an interesting proposal at the end of last week – in the aftermath of the failure of a futures commission merchant (FCM), other members of the same central counterparty (CCP) should be temporarily exempt from bank capital requirements. This would allow surviving members to take on the failed FCM's portfolio without having to worry about raising more capital immediately.

There's something to be said for the idea. When an FCM goes under, the first order of business is to move its client positions over to the surviving members of the CCP – a process known as porting. Next the failed firm's portfolio is auctioned off, with surviving members compelled to bid. Keeping capital rules in place could stifle bidding, with the bidders unwilling to pay high amounts to acquire assets that come with a tricky additional capital requirement.

The CFTC, however, didn't go for it, instead suggesting that non-clearing member firms should be allowed to participate in the auction instead. And perhaps this is a mistake – though it's understandable that the CFTC would be inclined to push back against any attempts to weaken or suspend capital standards, particularly at a time when one FCM has collapsed and its peers are likely to be under similar strain.

But the auction process is not the only point of concern in the CCP member default process, and it is probably not the most severe. Many of the CFTC's recommendations surround the porting process, rather than auctions – an area in which failure could have far-reaching consequences. For months, regulators and market participants have warned the porting process will overwhelm the few traders available to carry it out. There may be too few surviving FCMs to take over the client portfolios of a failed member – a situation that could worsen once leverage ratio limits come in – and those under stress themselves may be even less willing to do so.

A great deal of attention has been paid to the risks of the CCPs themselves failing, and the situation here gives cause for guarded confidence, although the real test of dealing with a major CCP failure has yet to come. But the CFTC's recommendations highlight the importance, not least from a systemic contagion point of view, of properly stress-testing member default procedures at each CCP. Failure here could be much more damaging than a low-priced auction sell-off of a failed FCM's assets.

STAT OF THE WEEK

If any margin could be offset, whatever the frequency of delivery, that has an enormous funding impact. We are talking about a couple of billion dollars of relief for each bank coming from this change [to the Net Stable Funding Requirement rules]

QUOTE OF THE WEEK

"By 6am on Wednesday morning, [my client] was on the phone asking for a price to liquidate his position, believing that with Trump coming in the markets would go down. In the end, he decided not to do that. The markets were quite shaky early in the morning, and he'd already lost some money. So he kept it on for a bit, and then the markets rallied. He was very happy." – Julien Lascar, Societe Generale

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