OTC Derivatives: Is the DTCC Too Big To Fail?

At our firm we frequently receive calls from
clients and readers asking
about the likelihood of the passage by the Congress in Washington of
reform
legislation regarding over-the-counter (OTC) derivatives, financial
regulation
and/or mortgage securitization. Our answer is small to none given the
political
trends and the state of the lobbies in Washington, most specifically the
large
bank lobby that protects the Sell Side monopoly in OTC derivatives and
securities. The fact that Senator Richard Shelby (R-AL) is still
apparently not
comfortable with the entirely watered down House proposal to reform OTC
derivatives, for example, tells you all you need to know. Stick a fork
in it.

Regarding OTC derivatives, for
example, the proposed reforms
already are so feeble and ineffectual that whether they pass the
Congress or not
hardly matters. Financial services reform, you see, is less important
that
innovation in today’s global marketplace, innovations such as
centralized
clearing for OTC derivatives and quantitative easing for fixing the
related
problem of widespread global insolvency. And the pace of innovation in
the world
of OTC markets is accelerating with or without the consent of the
Congress
thanks to the hard work of the economists who populate the Federal
Reserve
Board’s division of supervision and regulation.

The latest signs of “innovation” on
Wall Street can be seen in
the announcement last week by the Fed Board of Governors approving the
application by something called The Warehouse Trust Company LLC to
become a Fed
member bank. Warehouse Trust proposes to operate a central trade
registry for
credit default swap (CDS) contracts and to offer related services,
including the
processing of lifecycle events for the contracts and facilitation of
payments
settlement. The membership status becomes effective when Warehouse Trust

purchases shares in the Federal Reserve Bank of New York.

Warehouse Trust is a wholly owned
subsidiary of DTCC Deriv/SERV
LLC (Deriv/SERV), which in turn is a wholly owned subsidiary of The
Depository
Trust & Clearing Corporation (DTCC). When it opens for business,
Deriv/SERV’s Trade Information Warehouse (TIW), which currently matches
95% of
all CDS trades, will be transferred to Warehouse Trust.

DTCC, in case you are not familiar,
clears most of the cash
securities volume in the free world. DTC is a limited-purpose trust
company
organized under the New York banking law, and is a member of the Federal
Reserve
System. It is owned by the banks that it serves. DTC, and Fixed Income
Clearing
Corporation and National Securities Clearing Corporation are registered
as
clearing agencies with the Securities and Exchange Commission. Got it?

The creation of Warehouse Trust as a
Fed member bank marks the
latest attempt by the large dealer banks and the DTCC to cover the
retrograde
OTC derivatives market in the clothes of modern respectability. The
solution to
all things bad in the world of OTC derivatives, you see, is centralized
clearing. DTCC has lent its considerable credibility to the large bank
cause
because, after all, its clients are large banks. Indeed, if you listen
to the
folks at the Fed, the DTCC and the large OTC dealer banks, the advent of

centralized clearing is just barely less momentous than the second
coming of the
Messiah.

One of the benefits of spending a lot
of time talking and
writing about centralized clearing as the solution to all known troubles
and
woes in the world of OTC derivatives and especially in CDS contracts is
that it
keeps the attention of the Big Media, the Congress and the regulators
away from
the front office and the process of creating and selling complex
structured
securities and derivatives. It is in the front office where the true
problems
reside, but notice that none of the OTC reform proposals nor the Volcker
Rule go
anywhere near the sales and trading desks at the large banks.

Based on our study of the Volcker
Rule, which proposes to strip
all of the largest banks of their proprietary trading arms, we know that
solving
the problem is not the real object of financial reform in Washington.
Just as
the Volcker Rule does no violence to the sales and syndicate function of
the
largest Sell Side banks, the proposed OTC derivatives reform legislation
leaves
the dealer monopoly in OTC intact and just barely improves the degree of

regulatory oversight of these closed, private markets.

In technology terms, fixing the back
office issues of OTC
derivatives or securitizations with innovations like Warehouse Trust is
akin to
announcing a new venture to build cars with internal combustion engines.
The
evolution of DTCC into the de facto back office of an equally de facto
market
known as OTC is nothing more than recreating the wheel of multilateral
exchanges
and joint and several liability of clearing members, albeit one inch at a
time.

The advantage of slow motion
innovation is that the large
dealer banks get to extend the date of true reform of OTC markets by
years and
pretend to be dealing with the systemic issues created by these
unregulated,
deliberately opaque OTC instruments, all the while harvesting
supra-normal
returns from these high-risk, high margin activities. Consider that all
of the
activities now conducted by TIW and that will be assumed by Warehouse
Trust are
considered routine at any of the multilateral exchanges, but at the Fed
and
among the large dealer banks, this is called innovation.

The sad fact is that a great deal of
the “reforms” imposed on
the OTC markets over the past several years have done nothing to improve
price
transparency or lessen the monopoly market power of the OTC dealers. To
the
contrary, under Tim Geithner, first at the Fed of New York and now the
Treasury,
the thrust of US policy has been to protect and enhance the monopoly
position of
the OTC dealers, all the while limiting “novation” or assignment of
contracts
(and thus secondary market trading) and price discovery.

None of the technical issues that
drove the Geithner OTC
reforms are even issues on a multilateral exchange. Indeed, since the
Fed of New
York began to focus attention on the back office issues surrounding OTC
markets,
the dealer grip on the OTC markets has arguably gotten tighter. When a
customer
faces a dealer instead of an open outcry market, the situation is unfair
by
definition and goes against basic American practice and experience, and
the law,
when it comes to the organization of financial markets.

To us, the whole object of the
strategy pursued by the OTC
dealers and abetted by the DTCC is to adopt enough of the operational
attributes
of a multilateral exchange to blunt criticisms of the OTC markets with
respect
to systemic risk issues, but leave in place the dealer monopoly and
odious front
office sales practices, the rape and pillage mentality that thrives
today among
Sell Side firms operating in the CDS markets. Just read the Sunday New
York
Times article by Louise Story and Gretchen Morgenson, “Testy Conflict
With
Goldman Helped Push A.I.G. to Edge,” to understand the relationship
between
American International Group (AIG) and its OTC dealer bank
counterparties.

The aspects of the OTC markets which
remain off the reform
table includes the bilateral relationship between the client and dealer
regarding credit and collateral, the lack of complete market price
transparency
and the lack of any significant secondary market trading, all to
maintain the
monopoly rents that the large OTC dealers earn from this activity.
Today’s OTC
markets have all of the attributes of a 1920s bucket shop and now the
hub of
this closed monopoly market is the DTCC, especially as the clearing
house
evolves inevitably into a central counterparty for all OTC trades.

And now the DTCC, through OTC
derivatives market evolutions
such as the creation of Warehouse Trust, is become the single point of
failure
in the world’s financial system by virtue of its role in the OTC
derivatives
market. Both DTCC and Warehouse Trust are Fed member banks, but the
former is
not considered a bank holding company because neither entity takes
deposits and
are thus not FDIC members.

However, in the approval order by the
Fed, DTCC commits to
submit to Warehouse Trust to Fed prudential supervision as though it
were an
FDIC insured bank. What a shame that the Fed did not instead require
DTCC and
Warehouse Trust to be FDIC members and thus subject them to the
discipline of
the joint and several liability of being federally insured depositories.
That
would put the entire banking industry on notice that they are on the
hook for
the OTC shell game rising atop the infrastructure of the DTCC. Duh!

The Fed does, after all, does have a
legal responsibility to
ensure the sound operation of member banks regardless of their status as
deposit
takers. The order states that “Warehouse Trust will be well capitalized
at the
time it commences operations, and it will maintain capital that is
sufficient to
allow for an orderly wind-down if confronted with the need to cease
operations.”
This is what economists call a “living will” by the way. The only
trouble with
the Fed’s thinking is that if Warehouse Trust ever had to be unwound,
then the
DTCC itself probably would be in trouble as well.

Since the Fed has allowed the
Warehouse Trust application to be
approved without imposing the de facto cross-guarantee of FDIC
membership on DTCC and all of its affiliates, it seems reasonable to ask
just
how the Fed would unwind this new member bank without destroying the
entire
western financial system. More important, why has the Fed put the entity
that
clears every cash equity and bond trade in the civilized world at risk
to also
be the central nexus and perhaps eventually even the counterparty for
all OTC
derivatives?

As the DTCC evolves from a
record-keeper today and into a
central counterparty for OTC derivatives and particularly CDS in the
future, the
question seems to be begged: Is the Warehouse Trust and DTCC now “too
big to
fail?” In the DTCC and Warehouse Trust, have we arrived at the
functional
equivalent of a multilateral exchange, via unauthorized public bailouts
and the
monetization of debt by our independent central bank, but in a decidedly
sloppy
and haphazard fashion?

Or as one former Treasury official
told The IRA: “You can’t
reiterate enough the point that DTCC is owned by the dealer firms and
thus the
NY Fed is actively and purposefully aiding and abetting the continued
OTC
monopoly at the expense of real reform.”

We’ll be talking about this further
and look forward to your
comments.