Comment and Discussion

Comment by Pat Parkinson:

Jim Moser's paper focuses on membership policies for exchanges, and that is certainly one element of risk management. He notes that, on the one hand, broader membership facilitates immediacy and mitigates the market risks associated with delays in filling orders, but, on the other hand, broader membership may expose exchange members to increased counterparty credit risk. And he uses queuing theory to quantify the terms of this tradeoff and analyze various ways of improving on it.

In the world of securities clearance and settlement, it is often said that time equals risk, and in that context this means that the longer is the duration between trade execution and settlement, the greater is the risk of credit losses from counterparty defaults. As I was reading the paper, it occurred to me that time equals risk also applied to my comments and that the longer I discuss this paper, the greater is the risk that you will become aware that I know nothing about queuing theory and not very much about the design of exchanges and determinants of immediacy. I have been in grocery store lines and in fact used to work in a grocery store, so perhaps I am overqualified. However, not knowing the relevance of my grocery store experience, I decided to manage the risk by discussing Moser's paper only briefly before offering my own overview of the current issues in securities clearance and settlement.

With respect to the paper, I would like to make just two comments. The first relates to the critical assumption that all exchange members face the same margin requirements. That is the assumption that creates the tradeoff between immediacy and credit risk. The exchange is assumed to set the margin requirement to cover the potential credit losses from the least creditworthy member, who, by definition or by construction, is the newest member. Thus adding members leads to higher margin requirements on existing exchange members, and this cost offsets the benefits of expanded membership in terms of greater immediacy. I find that assumption troubling: the costs of the policy clearly are significant, and, more important, they are readily avoidable simply by adjusting the margin requirements to reflect the creditworthiness of individual members—charging a higher margin requirement on the less creditworthy members than on the more creditworthy members.

To be fair, the paper argues that, although this may be true in principle, in practice exchanges do not always tailor their margin requirements to reflect the creditworthiness of individual members. In the over-the-counter derivatives markets, margin requirements are frequently, or even generally, tied to counterparties' creditworthiness. The amount of uncollateralized exposure that is permitted under a bilateral credit agreement decreases as the counterparty's credit rating is downgraded, so he gets less uncollateralized exposure.

Furthermore, some exchanges do vary margin requirements across members. One example is the Options Clearing Corporation. In addition to imposing margin requirements, which are based on trying to cover 95 or 99 percent of potential price movements, it conducts daily stress tests of the impact of much larger price changes on exposures to their members. And if the simulated potential uncollateralized exposure exceeds a certain specified percentage of that member's capital, the member has three choices: it can put up additional margin, it can put more capital into whatever subsidiary is carrying the positions, or it can pare back its positions, but basically one of the options is to put up more margin.

Other exchanges set different sets of margin requirements for two fundamentally different classes of members: the clearing members and the nonclearing members. That brings me to my second point: the importance of this distinction between clearing members and other clearing members in clearing arrangements for exchanges, whether they are futures exchanges or securities exchanges.

Moser notes that the exchanges' trading arrangements often involve a specialization of functions, and the same is true in clearing. Typically, only some members of the exchange also are members of the clearing organization. The clearing organization acts as the central counterparty to trades on the exchange and manages the risks of all the unsettled trades. [End Page...