FIA- Default in a Day

Tickets to see the smash Broadway musical “Hamilton” may be the hottest ticket in Chicago, but for one day the FIA gave that show a run for its money as a seemingly beyond-capacity crowd packed the auditorium at the Chicago Federal Reserve Bank for a day-long program entitled “Default in a Day.” And while the event lacked the singing and dancing seen in “Hamilton,” the stars of the show and the importance of history were two of the big draws for “Default in a Day,” just as they are for the musical.

Getting the lay of the land

“Default in a Day,” sponsored by the Futures Industry Association (FIA), brought together regulators, exchange officials, FCMs, academics and customers to look at past examples and current conditions to examine how a major default of a customer or institution would be handled. The purpose of the conference was to walk delegates through the step-by-step process of managing a potential FCM default and then move beyond the standard waterfall analysis to give clarity and transparency to the process of getting an exchange back to a matched book.

The Chicago Fed

The day began with an overview of where things stand right now in “Default 101,” went on to examine past history as a possible indication of what might go down in the future in “We Were There,” and then looked at specific facets of the default process with sessions on “The Auction Process,” “Customer Porting and LSOC,” “Customer Claim Process,” and “CCP Recovery & Resolution.”

Where we are and where we’ve been

The first panel of the day was “Default 101,” which was chaired by Gary DeWaal of Katten Muchin Rosenman and featured Ed Gogol from the CME Group, Steven Kastenholtz of SG Americas Securities, and Jeff Ollada from Mizuho Americas. DeWaal began with a history of some major defaults over the past 25+ years and the other panelists weighed in with their perspectives on the current state of the industry. Kastenholtz described how there is a greater level of information and transparency in the markets today as more rules have led to enhanced due diligence on both sides of the FCM/customer relationship. Gogol gave a detailed outline of the enhanced efforts from the CME, which include more real time analysis of financial health, delineated and tested procedures for default auctions, and a dedicated recovery plan department. Ollada, for his part, discussed rule 1.55 disclosures which now provide customers transparency into the capital reserves of their clearing firm. Ollada also stressed that there is a large amount additional capital in the system beyond customer funds.

The next panel was something of a trip down memory lane as my longtime friend Bob Cox of the Chicago Federal Reserve Bank led a discussion called “We Were There,” with industry veterans Tom Hammond of ICE and Tim Doar, formerly from the CME. Hammond, Cox and Doar discussed the characteristics of nine different defaults from Volume Investors in 1985 to MF Global in 2011. Key takeaways included:

  • Many, but not all, of the defaults were fraud-related.
  • A lot of the bailouts were made in order to “protect the franchise”.
  • Each of these events had unique characteristics that required unique action in order to fix the situation: no cookie cutter approach is possible when it comes to a default.

At the end of the day, the comments from Cox, Hammond, and Doar highlighted the importance of institutional knowledge and experience in times of crisis and proved the maxim that “you can’t know where you’re going if you don’t know where you’ve been.”

Highlights from the Afternoon Sessions

Following a lunch break, the program turned to specific facets of the processes and actions that take place in the event of a default. First up was “The Auction Process,” which featured Susan O’Flynn from Morgan Stanley as moderator and Lee Betsill of CME Group, Biswarup Chatterjee from Citigroup and DRW founder and CEO Don Wilson as panelists. O’Flynn stressed a need to understand the tools that are available to the CCP during an event and the importance of practice “fire drills” to test capacity and ensure better reaction, understanding, and coordination. Biswarup, Beskill, and Wilson devoted their remarks to the nuts and bolts of the process, with Wilson calling for flexibility for CCPs to resolve crises as they best see fit.

The “Customer Porting and LSOC” panel was led by Jackie Mesa from FIA and featured Ruth Arnould of BAML, Goldman Sachs’ Patrick Sheehan, and Don Sternard from ICE Clear Credit. All of the panel agreed that porting is the better option compared to liquidating and that requirements for credit checks, compliance, and KYC/AML stipulations make it likely that it will be more difficult to find a “white knight” when an event occurs in the future.

Key Take Aways from “Default in a Day”

A sold out, standing room only crowd for an event that focused on the default process in the futures industry is a very unusual occurrence and one that can be attributed to a number of factors. For one, there have been a large number of changes in the past several years and a continued contraction in the number of FCMs has helped raise the level of anxiety in the industry. Second, the quality of participation in the event was top notch, with such industry veterans as Bob Cox, Tom Hammond and Tim Doar joining leaders from the FCM and trading community including SG Americas, Mizuho, BAML, JP Morgan, Citi, and DRW. Finally, compared to Hamilton, the ticket price wasn’t that bad!

Here are several of the key facts and take aways for FIA’s “Default in a Day”:

  1. While CCPs do a good job of planning and practicing for defaults through the use of stress tests, this isn’t the end of the story. It’s likely that unknown issues — the “black swans” — will be key in a future default situation and, for this reason, policies must leave room for flexibility in execution.
  2. With greater industry concentration, more capital requirements and KYC rules, it will be unlikely to find a white knight to bail out a firm in its entirety today. Alternatives will have to be considered and implemented and the CCPs need to be afforded flexibility in how they are able to resolve matters in difficult situations.
  3. Panelists felt that it was the customer’s responsibility to do due diligence on their broker and thought that they should have multiple relationships and backups in place in case of a shock.
  4. Tests and practice runs conducted by the CCPs are extremely important and helpful, particularly when it comes to standardizing records and procedures, but it shouldn’t lead to a false sense of security. In particular, Don Wilson pointed out that pricing of positions will certainly be radically different in a real world event.

Overall, “Default in a Day” was a very valuable contribution to the industry from the FIA, helping to bring clarity to a critically important facet of our business. This was one in a series of conferences and webinars that explore critical issues facing the derivatives industry. For a complete list of upcoming events, visit the FIA website.