Net Settlement and the CME’s Missing Collateral

Last Friday, I wrote about Net Settlement and its role in giving the US financial system the structure of a Ponzi scheme. In this entry, I want to give an example of the effect of net settlement using the CME and US futures market.

CME reports that its 2008 financial statements.

(emphasis mine) [my comment]

[from CME's 2008 financial statements:]

5. PERFORMANCE BONDS AND SECURITY DEPOSITS


CME clears and guarantees the settlement of CME, CBOT and NYMEX contracts traded in their respective markets. In its guarantor role, CME has precisely equal and offsetting claims to and from clearing firms on opposite sides of each contract, standing as an intermediary on every contract cleared. Clearing firm positions are combined to create a single portfolio for each clearing firm's regulated and non-regulated accounts with CME for which performance bond and security deposit requirements are calculated [Net settlement]. To the extent that funds are not otherwise available to CME to satisfy an obligation under the applicable contract, CME bears counterparty credit risk in the event that future market movements create conditions that could lead to clearing firms failing to meet their obligations to CME. CME reduces its exposure through a risk management program that includes initial and ongoing financial standards for designation as a clearing firm, initial and maintenance performance bond requirements and mandatory security deposits. Each clearing firm is required to deposit and maintain balances in the form of cash, U.S. Government securities, bank letters of credit or other approved investments to satisfy performance bond and security deposit requirements. All obligations and non-cash deposits are marked to market on a daily basis. Effective December 2008, the NYMEX performance bond and security deposit collateral has been fully integrated with the CME collateral portfolio. The NYMEX guarantee fund, which would have previously been used for any loss sustained by NYMEX due to the default of a clearing firm, was terminated, and NYMEX clearing firms have been included in the security deposit calculation.

...

Cash and securities held as performance bonds and security deposits at fair value at December 31, 2008 were as follows:

Securities and

(in thousands)

Cash

IEF Funds

Performance bonds

17,296,125

96,220,538

Security deposits

152,301

1,997,858

Cross-margin arrangements

204,441

188,348

Total

17,652,867

98,406,744

Cash an d securities held as performance bonds and security deposits at the CME on December 31, 2008 totaled 116 billion. Remember this number.

--------------------------------

Next, the CME explains how How Performance Bonds/Margins Work.

How Performance Bonds/Margins Work

Performance bonds — deposits required to ensure that a clearing member can cover potential losses with his or her trading positions — help to ensure that clearing members can meet their obligations to their customers and to CME Clearing. You can view a full listing of Performance Bond/Margin Requirements here.

As prices change throughout the life of a futures contract, the trading accounts where performance bonds are held are debited and credited accordingly - guaranteeing price performance and eliminating the risk of default on either side of the trade
[for CME clearing member, not brokerage customers]. Financial safeguards provided by CME Clearing protect the financial interests of both parties in a trade [MISLEADING], leading to sound markets and deeper liquidity - around the clock - everywhere in the world.

--------------------------------

Finally, here is the amount of margin that should have been posted on 47 of CME's most popular contracts (out of the thousands of products that clear at the CME). It is key to remember that these are only a small portion of the future contrasts that settle through the CME.

Open Interest

Initial

Initial Margin

Contract Names

on 12/30/2008

Margin

Times OpInt

OATS

16,205

675

10,938,375

3-MONTH EURODOLLARS - CHICAGO MERCANTILE EXCHANGE

6,683,953

1,012

6,764,160,436

SOYBEAN OIL

212,598

1,080

229,605,840

2-YEAR U.S. TREASURY NOTES

524,976

1,080

566,974,080

5-YEAR U.S. TREASURY NOTES

1,056,042

1,080

1,140,525,360

LIVE CATTLE - CHICAGO MERCANTILE EXCHANGE

211,365

1,080

228,274,200

TRANSCO ZONE 6 BASIS SWAP

50,282

1,210

60,841,220

INTEREST RATE SWAPS 5YR

50,407

1,215

61,244,505

CORN

802,641

1,350

1,083,565,350

LEAN HOGS - CHICAGO MERCANTILE EXCHANGE

153,839

1,417

217,989,863

10-YEAR U.S. TREASURY NOTES

1,034,318

1,485

1,535,962,230

HENRY HUB GAS SWAP

3,177,313

1,518

4,823,161,134

HENRY HUB PENULTIMATE GAS SWAP

1,145,478

1,518

1,738,835,604

WHEAT

247,329

1,620

400,672,980

WHEAT - KANSAS CITY BOARD OF TRADE

82,853

1,620

134,221,860

WHEAT - MINNEAPOLIS GRAIN EXCHANGE

28,765

1,620

46,599,300

SOYBEAN MEAL

117,355

1,620

190,115,100

TCO BASIS SWAP

99,784

1,870

186,596,080

INTEREST RATE SWAPS 10YR

28,713

2,025

58,143,825

COTTON NO. 2 - ICE FUTURES U.S.

125,564

2,200

276,240,800

SUGAR NO. 11 - ICE FUTURES U.S.

642,954

2,200

1,414,498,800

U.S. TREASURY BONDS

761,182

2,565

1,952,431,830

GULF # 6 FUEL 3.0% SULFUR SWAP

35,192

2,695

94,842,440

NY RES FUEL 1.0% SULFUR SWAP

24,956

2,695

67,256,420

NO. 2 HEATING OIL, N.Y. HARBOR

226,522

2,695

610,476,790

SWISS FRANC - CHICAGO MERCANTILE EXCHANGE

25,073

2,700

67,697,100

PALLADIUM

12,427

3,025

37,591,675

COCOA - ICE FUTURES U.S.

116,641

3,300

384,915,300

EURO FX - CHICAGO MERCANTILE EXCHANGE

120,499

3,375

406,684,125

NASDAQ-100 STOCK INDEX (MINI) - CHICAGO MERCANTILE EXCHANGE

229,980

3,500

804,930,000

SOYBEANS

278,773

3,712

1,034,805,376

COFFEE C - ICE FUTURES U.S.

122,856

4,400

540,566,400

COPPER-GRADE #1 - COMMODITY EXCHANGE INC.

74,252

4,725

350,840,700

PLATINUM

18,320

4,950

90,684,000

CRUDE OIL, LIGHT SWEET

1,169,215

5,400

6,313,761,000

WTI CRUDE OIL FINANCIAL

165,748

5,400

895,039,200

E-MINI S&P; 500 STOCK INDEX - CHICAGO MERCANTILE EXCHANGE

2,307,779

5,625

12,981,256,875

NATURAL GAS

671,730

6,075

4,080,759,750

NIKKEI STOCK AVERAGE - CHICAGO MERCANTILE EXCHANGE

31,551

6,250

197,193,750

NIKKEI STOCK AVERAGE YEN DENOM - CHICAGO MERCANTILE EXCHANGE

38,081

6,250

238,006,250

DOW JONES INDUSTRIAL AVG- x $5

53,437

6,500

347,340,500

GOLD - COMMODITY EXCHANGE INC.

300,448

6747

2,027,122,656

SILVER - COMMODITY EXCHANGE INC.

85,312

6,750

575,856,000

NASDAQ-100 STOCK INDEX - CHICAGO MERCANTILE EXCHANGE

19,121

17,500

334,617,500

S&P; 500 STOCK INDEX - CHICAGO MERCANTILE EXCHANGE

488,604

28,125

13,741,987,500

DOW JONES INDUSTRIAL AVERAGE

9,630

32,500

312,975,000

E-MINI S&P; 400 STOCK INDEX - CHICAGO MERCANTILE EXCHANGE

115,703

37,500

4,338,862,500

Total

23,995,766

73,997,667,579

Buyers Initial Margin

73,997,667,579

Sellers Initial Margin

73,997,667,579

147,995,335,158

On these 47 contracts alone 148 billion dollars of collateral should have been posted at the CME to protect all contract holders. However, because of net settlement, the CME has only 116 billion of collateral to back not only these 47 contracts, but also the thousands of other CME products.

Again, the reason for this lack of collateral is explained in my entry on net settlement: The clearinghouse's (CME's) goal is not to guarantee all futures contracts.

...
2) The clearing members post margin with the clearinghouse on a net basis. A member firm whose customers held an equal number of long and short contracts would post no margin with the clearinghouse, but
would retain its customers' margins in its own account.

3) A large price move could cause some of the clearing member's customers to default, threatening the solvency of the firm. If the FCM failed, would the clearinghouse guarantee performance of the contracts of the defaulted member's customers?
The answer is no.

4) The clearinghouse's goal is not to guarantee all futures contracts, but only to protect clearing members from the default of other members, which is why margins are collected from members only on their net exposure.

5)
The integrity of all futures contracts depends not only the solvency of the clearinghouse but also the solvency of the member FCMs.

Broker-Dealers trapped in short positions

Last time I explained how net settlement encourages the "looting" customer brokerage accounts.

Net Settlement allows and encourages broker dealers (especially insolvent broker dealers) to loot their customers' brokerage accounts by taking the opposite side of trades. Take an insolvent firm (Lehman, Bear Stearns, etc) which is critically short of cash and is finding it impossible to obtain unsecured financing. For this firm desperate firm, there is an easy (and incredibly reckless) solution: trade on its own accounts to zero out all its net derivative positions. For example, if its customers are net long gold futures, the the firm can take a short position in gold futures matching the size of the long position. Since the clearinghouse now sees an equal number of long and short contracts, margin backing gold futures will be returned.

I would like to add to this the obvious fact that any broker dealer which decided to abuse net settlement in this way would likely find themselves permanently trapped on the wrong side of the market. Consider, for example, a firm that shorted commodity futures (gold for example) at any point during the last twenty years. With commodity prices rising, such firm would find itself owing its customers amounts that would be impossible to ever repay. To simply stay afloat (not run out of cash), the firm would need to constantly increase its futures market customers in order to pay back those customers cashing out their profitable futures bets. In other words, this firm would be running a Ponzi scheme in every sense of the word.

Now look at the chart below of open interest in major commodity futures. Notice the constant and enormous growth in outstanding futures contracts. This growth is the predictable result of allowing insolvent broker-dealers to settle their contracts on a net basis.

This entry was posted in Background_Info, Currency_Collapse, Financial_Wizardry, Wall_Street_Meltdown. Bookmark the permalink.

4 Responses to Net Settlement and the CME’s Missing Collateral

  1. Mark says:

    148 vs 116 billion seems quite a lot.

    If dealers get caught on the wrong side of a contract, shouldn't that show up on the balance sheet??

  2. Trader says:

    By the way, Eric, where is your major article??

    People are waiting more than 1 year now.......

  3. Sebastian says:

    I thought you would write about Eyjafjallajökull as you wrote in your post about gold manipulation in mainstream media.

  4. Trader said...
    By the way, Eric, where is your major article??

    Well, the major article on the food crisis was published last December:

    *****2010 Food Crisis for Dummies*****

    Sebastian said...
    I thought you would write about Eyjafjallajökull as you wrote in your post about gold manipulation in mainstream media.

    I will write about Eyjafjallajökull, but planes started flying again, and I wanted to wait a day or two to better see the potential economic impact.

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