Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Wed, 15 Jul 2009

Lehman Risk, Segregation, Net Margins and Cash Margins

Lehman’s bankruptcy was a nightmare for those who had deposited margins with Lehman (particularly Lehman Brothers International Europe in London) for their derivative trades. Many of them ended up as unsecured creditors of Lehman and will have to wait for years to get back a few cents in the dollar. Margins deposited with Lehman US were protected by segregation rules which cannot be overridden by contract, but apparently many hedge funds chose to use LBIE in London to get higher leverage and signed away many of their rights.

Lehman risk is a significant risk for derivative exchanges because even when the risk containment processes of the exchanges work perfectly, the ultimate customer ends up with little or no protection at all. This is an important issue, but even after fruitful discussions with some UK lawyers on this matter, my understanding of the legal issues has been rather poor.

Now however we have access to a 158 page report submitted by derivative dealers to the New York Fed that is based on work by 13 lawyers from six countries on all the legal complexities involved in providing protection to ultimate customers. The report focuses on Central Counter Parties (CCPs) clearing CDS contracts but the principles are of broader application.

The key takeaways from the report are:

Finally, the report states upfront that “This Report does not address the risk of fraud, and assumes that the relevant CM has complied with its segregation and other obligations in respect of customer margin.”

Indian derivative exchanges use gross margins and enforce some degree of segregation of client assets, but I think that a lot can and needs to be done to improve customer protection against Lehman risk. I particularly like the idea of replacing cash margins with security interest in low risk securities.

Posted at 14:33 on Wed, 15 Jul 2009     0 comments     permanent link