Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Daily Archives: April 17, 2010

Lehman and the Derivative Exchanges

The unredacted Volume 5 of the Lehman examiner’s report released earlier this week provides details about how CME handled the Lehman default by auctioning the positions of Lehman to other large dealers. The table below summarizes the data given in the report.

Asset Class Negative Option Value Span Risk Margin Total Collateral Price paid by CME to buyer Loss to Exchange Percentage Loss to Exchange Loss to Lehman
Energy Derivatives 372 261 633 707 74 12% 335
FX Derivatives -4 12 8 2 -6 -72% 6
Interest Rate Derivatives 93 130 223 333 110 49% 240
Equity Derivatives -5 737 732 445 -287 -39% 450
Agricultural Derivatives -5 55 50 52 2 4% 57
Total auctioned by CME 451 1195 1646 1539 -107 -6% 1088
Natural Gas Derivatives sold by Lehman itself 482 129 611 622 11 2% 140
Grand Total 933 1324 2257 2161 -96 -4% 1228

The negative option value is as the close of business before the Lehman bankruptcy and the loss to Lehman is computed as the excess of the price paid by CME to the buyer over this negative option value. Futures positions are presumably assumed to have zero value after they have been marked to market. On the other hand, CME incurs a loss only if it pays a price in excess of the collateral provided by Lehman. For comparison purposes, the same computation is done for the positions sold by Lehman itself, though, in this case, the exchange does not make any profit or loss.

What I find puzzling here is that in the case of interest rate derivatives, CME had to pay the winning dealer a price of about 1.5 times the collateral available. Had it not been for excess collateral in other asset classes, the CME might have had to take a large loss. Was the CME seriously undermargined or was the volatility in the days after Lehman default so high or was this the result of a panic liquidation by the CME?

We do have an independent piece of information on this subject. LCH.Clearnet in London also had to liquidate Lehman’s swap positions amounting to $9 trillion of notional value. LCH has stated here and here that the Lehman “default was managed well within Lehman margin held and LCH.Clearnet will not be using the default fund in the management of the Lehman default.”

A number of questions arise in this context:

  • Did LCH.Clearnet charge higher margins than CME? It is interesting in this context that only a few days ago, Risk Magazine quoted LCH as saying that one of its rivals (IDCH) charges too low a margin: “bordering on reckless.” But LCH did not make this claim about CME.
  • During the week after Lehman’s default, was there a big difference in the price behaviour of the swaps cleared at LCH and the bond futures and eurodollar futures cleared at CME?
  • Was Lehman arbitraging between swaps and eurodollar futures so that its positions in the two exchanges were in opposite directions? In this case, price movements might have produced a profit at LCH and a loss at CME.
  • Were the proprietary positions of Lehman at CME more risky than its (customer?) positions at LCH which might have been more balanced?
  • Did the “panic” liquidation by CME exacerbate the loss? LCH hedged the position over a period of about a week and then auctioned off a hedged book.
  • Did dealers trade against the Lehman book after the CME disclosed the book to potential bidders a couple of days before the auction? Or did each dealer think that the others would trade against the book? This problem did not arise at LCH because only hedged books were auctioned and the unhedged book was not disclosed to others.

In the context of the ongoing debate about better counterparty risk management (including clearing) of OTC derivatives, I think the regulators should release much more detailed information about what happened. Unfortunately, in the aftermath of the crisis, it is only the courts that have been inclined to release information – regulators and governments like to regard all information as state secrets.

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SEBI, IRDA and the courts

I wrote a column in the Financial Express today about letting the courts resolve disputes between two financial regulators.

When I wrote a month ago “At a crunch, I do not see anything wrong in a dispute between two regulators… being resolved in the courts,” (‘Fill the gaps with apex regulator’, FE, March 19); I did not imagine that my wish would be fulfilled so soon. The dispute between Sebi and Irda regarding Ulips seems to be headed to the courts for resolution. There is nothing unseemly or unfortunate about this development. On the contrary, I believe that this is the best possible outcome.

An independent regulator should be willing and able to carry out the mission laid down in its statute, without worrying about whether its actions would offend another regulator. Its primary loyalty should be to its regulatory mandate and not to any supposed comity of regulators. Equally, if a regulator intrudes on the mandate of another, the other regulator or its regulatees should have no compunctions in challenging it in a court of law.

In any case, the idea that regulators share cordial relationships with each other is a myth. Turf wars are the rule and not the exception. In the UK, for example, after Northern Rock, the Bank of England and the FSA began to talk to each other only through the press, it was obvious to all that the relationship was extremely bitter. In the US, during the crisis, severe strains were evident between the Fed and the FDIC. The relationship between the SEC and the CFTC has, of course, been strained for decades.

In the financial sector in particular, we want strong-willed regulators to act on the courage of their conviction. Since many of their regulatees probably have outsized egos, perhaps it does not hurt to have a regulator with an exaggerated sense of self-importance. We do not want regulators who are too nice to their regulatees. It follows then that we cannot wish that regulators be too nice to each other either.

What we need instead is a mechanism to deal with the problem of regulatory overreach—democracies thrive on checks and balances. Regulatory overreach is a problem, even when it does not involve another regulator at all. Instead of hoping that regulators will always exercise self-restraint, we need a process to deal with the consequences of regulators overstepping the line.

The best mechanism is a robust appellate process—appellate tribunals and beyond them, the regular judiciary. Regulators, too, must be accountable to the rule of law and an appellate process is the only way to ensure this. The judicial process is as capable of resolving disputes between two regulators as it is of resolving disputes between the regulator and its regulatees.

In the context of the dispute between Sebi and Irda, many people have argued that a bureaucratic process of resolving disputes is preferable to a judicial process. There is, however, little evidence for such a view from around the world. Bureaucratic processes are less likely to provide a lasting solution and more likely to produce unseemly compromises that paper over the problem.

The two-decade-long dispute in the US between the SEC and CFTC about equity futures provides an interesting case study to demonstrate this. In the early 1980s, the SEC and the CFTC came to an agreement (the Shad Johnson accord) dividing up the regulatory jurisdiction of stock index futures and index options, but they were unable to agree on the regulation of single stock futures. Futures on narrow indices were left somewhere in the middle, with the CFTC having regulatory jurisdiction but the SEC having a veto power on the introduction of the contract itself.

In the late 1990s, when the SEC barred the Chicago Board of Trade (CBOT) from trading futures on the Dow Jones Utilities and Transportation indices, CBOT took the SEC to court and won. The court sternly declared that, “SEC is not entitled to adopt a ‘my way or the highway’ view by using its approval power—as a lever.” With the Shad Johnson accord in tatters, the two regulators were finally forced to sort out the regulation of single stock futures—a matter that they had not been able to settle by bureaucratic processes for two decades.

It is evident that the resolution of the single stock futures dispute would not have happened without judicial intervention. For two decades, inter-regulatory coordination mechanisms in the US, like the President’s Working Group on Financial Markets were not able to resolve the matter—it was too convenient for both regulators to agree to disagree.

An important advantage of judicial resolution is that regulatory conflicts that have the most serious impact on the markets are more likely to be litigated than those that are less damaging. It is, therefore, more likely that the final outcome would be socially and economically efficient. There are no such incentives to guide a bureaucratic solution towards the social optimum.