Featured Commentary - Five Minutes with Gary DeWaal, Newedge
Boarding the “Wrong Train”
Five Minutes with Gary DeWaal, Newedge
This is part one of a series of interviews the MarketsReformWiki team conducted at the FIA Boca Conference, examining various aspects of Dodd-Frank rules and other regulatory issues.
The Dodd-Frank Act and the bankruptcy of MF Global has created a slew of new rules as well as confusion in the marketplace. John Lothian & Co. editor-in-chief Jim Kharouf spoke with Gary DeWaal, group general counsel at Newedge, about where regulators are going wrong with their approach to Dodd Frank and solutions to the segregated funds problem exposed by MF Global. The answer, surprisingly, may come from China.
Q: We’re theoretically about half-way through the Dodd-Frank rulemaking process. Where do you see us in this process going forward?
A: We’re all committed to a train that I wish would stop so people could come out and take a look at it. As this process gets going, I have grave concerns that we’ve boarded the wrong train. And the further we go along on our journey, the harder it’s going to be to get back.
Q: What do you mean by the wrong train?
A: The Dodd-Frank train got intercepted by the MF Global train. They are surprisingly related. The MF Global situation has raised issues that frankly Dodd-Frank ignored. Let’s start from the beginning. Dodd Frank mandated central clearing for all, easily clearable OTC swaps. Dodd-Frank exempted commercial end-users, but the commercial end users were defined as effectively commodity end users. The problem is with the real money end users - the pension funds, who were not into commodities and didn’t want to be part of the process. They had solutions that worked in the bilateral markets as solutions based on their fiduciary obligations for their customers which they thought was satisfactory. And that included third-party custodial arrangements and other ways to protect client money.
They were now dragged into Dodd-Frank against their will. And so they not surprisingly said “if you want us to come along. You have to come up with protections for us.” And the CFTC said, “Okay,” and hence the idea for LSOC (legally separated, operationally co-mingled) for swaps was devised.
Then you had MF Global, which showed the system that Dodd-Frank was based on was clearing, and mutualization. And that was itself based on three pillars - segregation, capital and if all else fails, pro-rata distribution and that may not have been all that it was meant to be. But yet you had this big train called Dodd Frank relying on that system.
Q: So where does MF Global intersect with Dodd-Frank?
A: MF Global accelerated people’s desire to create special protections. So LSOC was implemented for swaps. And now we’re thinking about extending LSOC for futures. And we’re thinking about other customer protection systems - third-party custodial arrangements, guaranteed clearing participant arrangements by some of the exchanges, carve-outs of what would be the third pillar of the clearing process pro-rata distribution in case of insolvency.
Q: What does that all mean?
The clearing house system is all about mutualization of risk. The bilateral market is all about bilateral relations. Instead of dealing with the issue that some of the people do not want to be part of the trade, what we’re trying to do now is create a hybrid system of mutualization and bilateralism. Ironically, Dodd-Frank which was supposed to bring people into the mutualization is not only not doing that, it’s causing a change to a bilateral mutualization space. And that’s something we never had before.
Q: So will it increase customer protection?
A: No, not really. The whole reason you have mutualization of risk is that you’re trying to transfer risk. That’s the whole reason for commodity markets, to transfer risk from hedgers to speculators. There are other types of risk in the system which people don’t realize, such as broker risk. And if that risk is transferred, for example, from some people in say LSOC, where you are getting rid of fellow customer risk, somebody has to bear it because it doesn’t disappear. In LSOC, the risk is being shared by the non-defaulting members of that clearing house. Before, there was net settlement. Now you carve out the big guy causing the loss, and pay the winners, which causes other clearing members to bear the loss.
If you are going to protect customers individually at a clearing house, and carve them out, it means the rest of the people still subject to pro-rata have less of a pie. So imagine MF Global and five customers got 100 percent back. That means remaining customers would have gotten less than 72 percent, 66 percent, 65 -, 64 – or something less. Somebody is always going to pay for that transfer of risk. And I think what is going on right now is that people are not thinking through the implications of creating bilateral protection in a mutualized space.
So rather than concentrating on strengthening the basic pillars around segregation, the pillars around capital, the fairness appropriate, we’re trying to tinker with the system. And I actually think that is going to result in less customer protection for some people as well as economic impact at the FCM level. It’s going to force them to consolidate or reprice their businesses in ways that ultimately have a bad impact on liquidity.
Q: People are still trying to figure these out. So what is the easiest and best solution here?
A: The industry's suggestions around basic protections of seg, more disclosure to both the regulators and clients, certain tinkering with the regulations to ensure rules regarding foreign futures and options and customer protection are identical to domestic futures and options. Those are all good and important ideas.
I think enhanced disclosure to customers so they can better understand what they are dealing with makes sense. We are a real proponent of something we’ve seen in China, and would like imported to the United States, which is the China Futures Margining Monitoring Center (CFMMC). In China, we’re subject to this regulation, and every day we have to provide our seg calculations to this company that is effectively owned by the four exchanges in China. Everyday, it receives from our depositories just how much money we actually have. CFMMC runs analytics every day comparing what we have in seg to what depositories say we have in seg. If there is not a match, then the China Securities Regulatory Commission is immediately notified and action is taken.
We don’t have anything like that here. And here is a situation where we can learn from China, because they had the MF Global type problems in the early 2000s, which led to the CFMMC system in 2006. It’s been very effective. If we can import that to the US, this would be a major step for customers to understand and feel better that someone is looking at us each day independently. I think that would be a much better alternative.
Q: So who would execute that in the US, the National Futures Association (NFA) or someone else?
A: NFA would be an entity that could oversee this. We could replicate the model somehow, whereby all the exchanges would create ownership in a company that does it. To me, the basic concept should be done. And technically, it can work.
Q: So it’s not a matter of reinventing the wheel in terms of how firms collect and report information?
A: There are some small FCMs with banks which may not fit. Fine, but let’s not let the perfect be the enemy of the imperfect. Let’s start with domestic money, 4d. Let’s limit it to brokers with X amount of seg funds. Let’s just get the thing going. We need to restore confidence in this business. I think basically, it’s a good system. There are things we should be doing to strengthen the system anyway and that’s why the FIA came up with its recommendations, the NFA has come up with best recommendations and mandates for SROs and the implementation of the CFMMC would be three initiatives we should do ASAP.
Q: Do we need to rethink or revamp the way in which bankruptcy laws are administered in these types of cases, especially in the case of the MF Global situation where they were much more an FCM than a broker/dealer?
A: I’ve argued for years that the bifurcation of the regulatory system in the US makes us non-competitive. So the fact that we’ve had this mess in bankruptcy court is no surprise. I do think the issues related to the SIPC trustee overseeing the case are overstated. The SIPC trustee is applying part 190 of the commodity regime. The problem with MF Global is that there isn’t 100 percent of the money. If it was a commodity trustee, I think there would be similar questions. It’s easy to blame the overseer. What is needed is the international interaction of the bankruptcy regimes. People were really surprised to find out they could do a trade in Singapore, and as a result, they could be passing through four different bankruptcy regimes before they see a dollar. They had to pass through Singapore where the initial account is booked, then Hong Kong which is the booking center, then London which is the next booking center and then back to the US where the account is. That’s where the FIA’s enhanced disclosure document will help, because the problem is bankruptcy is very national. It’s clearly something IOSCO should look at and see if there is any way in coordinating the processes in bankruptcy. I don’t think it’s realistic that we’ll see harmonization globally, however.
I think there are solutions out there that make this a bit easier. But the two regulatory structures in the US are so antiquated. We need a single regulatory structure in the US. We need to look at all instruments as financial instruments and stop this silliness that there are securities and futures, and there needs to be different bankruptcies. It’s always an embarrassment internationally that we’re still there.