Commentaries

Keeping Wall Street’s hands off the collateral

The idea of prohibiting derivatives dealers from reusing and redeploying the trillions of dollars in collateral they’ve taken in from trading parnters is gathering steam.

Earlier this week, I advocated an outright ban on this Wall Street practice called rehypothecation. I noted that one of the flaws with the Obama administration’s plan for regulating derivatives is that it’s silent on the issue of whether derivatives dealers can continue to reuse the collateral they get as guarantees on trades anyway they see fit. 

In the Lehman Brother bankruptcy, one of the big unresolved issues is tracking down collateral Lehman took in as guarantees on derivatives trades and then used as collateral for its own transactions.

Last week, Gary Gensler, chairman of the Commodities Futures Trading Commission, sent a letter to a number of congressmen urging changes in Obama administration’s derivatives plan. One thing Gensler advocated was a measure that would require derivatives dealers to segregate customer collateral in seperate accounts just the way futures dealers must do. Gensler says doing so would make it easier to deal with the failure of a derivatives dealer.

And now Americans for Financial Reform, an umbrella group of nonprofits, municipalities and union, has sent a letter to Sen. Chris Dodd, chairman of the Senate Banking Committee, endorsing much of what Gensler has called for including the segregating of customer collateral. The group’s letter refers to both Gensler and my column in noting:

The rehypothecation of a customer’s collateral makes the unwinding and returning of these “escrowed” funds to traders in bankruptcy proceedings almost impossible, thereby adding fuel to the fire that instititutions involved in complex financial transactions are “too big to fail.”

Now, I should point that a recent IMF report notes that since the Lehman Brothers bankruptcy more customers have requested that their collateral be segregated.  (A hat tip to Zerohedge.com for pointing this out to me). But memories are short and in time this change in behavior could revert back to form.

The liquidity canard

It’s often said on Wall Street that the more liquidity there is in a given market, the better things are for investors trading stocks, bonds or commodities. And while there’s a lot of truth to that, there are times when too much liquidity can be just the wrong tonic.

After all, Wall Street’s churning-out of one subprime-mortgage backed security after another pumped a lot of liquidity into the U.S. housing market, and that simply encouraged a lot of reckless — even fraudulent — lending.

That’s why I’m not impressed with the securities industry’s main defense of computer-driven high-frequency trading, which essentially is that all this lightning-fast trading provides liquidity and better prices for investors.

It’s a hard argument to swallow when you consider that many high-frequency trading programs are simply engaged in trading the same stock thousands of times a day in less than penny increments. Now maybe all those rapid-fire automated trades are getting better prices for some investors. But when a broker excessively buys and sells securities to generate higher commissions, it’s called churning, and that can result in an investor lawsuit or a regulatory sanction.

Indeed, when fast-fingered day traders were doing much the same thing as today’s high-frequency traders — albeit without the benefit of a sophisticated algorithmic program to guide them — Wall Street’s biggest firms were quick to dismiss them as either amateurs or rogues who were causing unnecessary volatility in the price of tech stocks.

So with critics raising legitimate concerns about the potential of a rogue algorithm sparking an unintentional market meltdown, the notion that high-frequency trading is OK because it creates more liquidity simply won’t wash.

If the main purpose of all that extra liquidity is to simply make fat profits for high-frequency traders at Goldman Sachs, UBS, GETCO, Citadel Investment Group and Interactive Brokers, that’s liquidity the markets can do without.

Wall Street’s $4 trillion kitty

The Obama administration’s plan for reining in derivatives leaves unchecked one of Wall Street’s dirty little secrets: the ability of a derivatives dealer to redeploy cash collateral that gets posted by one of its trading partners.

On Wall Street, this practice of taking collateral and reusing it is called rehypothecation. In essence, it’s a form of free money for derivatives dealers to use as they please — even to repost it as collateral to finance their parent company’s own borrowings.

And we’re talking big bucks. The International Swaps and Derivatives Association recently reported that derivatives dealers have taken in $4 trillion in collateral from their trading partners. That’s an 86 percent increase over the $2.1 trillion in cash collateral those same dealers reported having on their books in early 2008.

Now it’s not surprising that investment firms took in more collateral from their trading partners over the last year, when the financial markets were in turmoil. Cash collateral is one way for derivatives dealers to protect themselves against the risk of a trading partner defaulting on one of these sophisticated financial contracts.

There’s nothing wrong with a dealer taking legitimate steps to insure an orderly unwind of a busted trade.

But Wall Street firms should not have free license to reuse this collateral any way they see fit. The Obama administration should revise its proposal to require derivatives dealers to hold all cash collateral in segregated escrow accounts that can’t be reused or touched by the dealer.

The same rule should also apply with any collateral that is posted with a regulated exchange on which a derivative contract gets traded.