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Deutsche rumours raise market infrastructure concerns

Why is the story that some of Deutsche Bank’s investor clients have started shifting their accounts from the bank, as Bloomberg reports, particularly worrying?

A number of hedge funds, which use the bank’s prime brokerage service, have moved part of their listed derivatives holdings to other firms this week, according to an internal bank document leaked to Bloomberg.

Deutsche, like many other banks, acts as a clearing member of the central counterparties (CCPs) where trades in listed derivatives—primarily equity and interest rate futures and options—are cleared and settled. Clearing members act as intermediaries between clients, such as hedge funds, and the CCP.

And that’s the troubling part of the story. The whole point of a CCP is to interpose itself between trading counterparties, so that no one counterparty is exposed to the credit risk of the other (a panic over the prospect of widespread defaults in the non-listed, or “OTC” derivatives market, where such bilateral credit risks do occur, was the driver of the 2008/09 financial crisis).

It’s easy to understand why counterparties to AIG in 2008, concerned about the prospect of non-payment on bilateral trades, all demanded collateral from the failing firm, depleting its liquidity and driving it over the edge. But why might some of Deutsche’s hedge fund clients now be moving their business in centrally cleared derivatives, where any AIG-like counterparty risk concerns shouldn’t arise?

One problem, well explained by Scott Skyrm, is that in a number of recent failures of futures brokers/clearing firms, the firms dipped into supposedly segregated client assets (primarily cash) in the days prior to their collapse. Skyrm notes that, despite new regulations put into place after the failure of futures brokers like MF Global, Sentinel and Peregrine, client cash is still at potential risk.

In the UK, nervousness about the safety of clients assets held in custody has been inadvertently amplified by a 2012 court ruling.

As reported in a recent briefing on asset safety by consultancy Thomas Murray IDS:

“When Lehman Brothers’ UK entity went bust in 2008, it emerged that it had failed to segregate client from proprietary assets, leading to a multi-billion dollar shortfall in the UK client asset pool.”

“Conflicting claims by Lehman’s clients set in train a lengthy legal battle, which ended in the UK Supreme Court in 2012. At issue was the question of whether only those clients whose assets had been properly segregated were entitled to claim from the client pool, or whether all clients had a claim, irrespective of whether Lehman had followed correct procedures.”

“The UK Supreme Court took the latter view, even though this overturned longstanding principles of English trust law. The Supreme Court’s judgement meant that, henceforth, even if clients made efforts to ensure that their assets were properly segregated by an investment firm, in the case of the firm’s failure the properly segregated clients’ claims could be diluted through no fault of their own by the ability of non-segregated clients to access the pool of client funds.”

This judgement, meant to safeguard all clients, clearly incentivises a run on a bank that’s in potential trouble.

So you can see the potential for nervousness regarding client cash. But what about the holdings in futures themselves? In theory, listed derivatives positions ought to be immediately portable to a third party.

“If (and it’s a big if) you have individual segregation and portability, then you should not have to care who your clearing broker is—that’s the theory,” says Thomas Murray’s Tim Reucroft.

Under Europe’s Market Infrastructure Regulation (EMIR), clearing members of a CCP have to offer their clients a type of account called individually segregated, as opposed to “omnibus” accounts where clients’ holdings are commingled with those of other clients. This should guarantee the ease of movement of individual accounts’ holdings if a clearing firm fails.

“You just move somewhere else and it’s business as usual,” says Reucroft.

“But my guess is that a lot of the hedge funds will have opted for omnibus accounts, not individual segregation, since it’s too expensive.”

And Reucroft spots another potential risk elsewhere in the chain of post-trade market infrastructures.

“Imagine the scenario: the clearing broker goes bust, you port your positions to another bank—so far so good. But it’s turbulent times, your new clearing broker calls you more margin on your exchange-traded derivatives positions. Where does this come from? You sell equities or bonds to raise the cash, but your cash clearing broker is still the original bank and they’ve gone bust. There is no portability written into Europe’s Central Securities Depositary Regulation (CSDR). So now you go bust at your new clearing broker because you can’t meet the margin call. Dominos.”

So there’s a systemic risk aspect to the Deutsche/hedge fund story that merits close attention.