Latin American Capital Markets

DESIGNING A DERIVATIVES COMPLEMENTTO CASH MARKETS 367ilarly restricted. In principle, such limits do permit the markets to digest extreme priceinformation and protect overall liquidity in the market and thus may be appropriatein markets that are less deep and liquid.Capital-based Position LimitsCredit risk may also be addressed by imposition of capital-based position limits by eitherthe market itself or clearing firms or organizations. Such limits ordinarily imposehigher levels of margin above a predetermined level of exposure. The limits addressthe fact that the risk of default or credit risk is asymmetric even if market risk is neutralbecause the likelihood of nonperformance on a net position is greater where amember is carrying a concentrated exposure to a particular customer or in a particularcontract. U.S. futures clearing organizations assume no risk to the market, whichmay be the preferred clearing model from the perspective of clearing members. Regulatoryoversight encourages self-regulatory management of the risks assumed.SegregationThe use of segregation as a form of risk management varies across jurisdictions. Insome (for example, Japan), it is impossible to impose a trust on cash, so segregationcan only be maintained for customer securities. In some, commercials can opt out ofsegregation. And in some jurisdictions, segregation is only an accounting entry coupledwith a priority in bankruptcy. In the United States, although recent amendments providemore flexibility, segregation has been viewed as a market as well as a customerprotection and, therefore, opting out has not been permitted. In any case, segregationdoes not provide complete protection of either customer funds or the market. A customerdefault that exceeds the capital of the carrying firm can result in a shortfall ofrequisite funds to repay the firm's obligations to customers if customer margin is heldas a pool rather than identified with specific customers at the clearinghouse, as is typicallythe case.In practical terms, segregation is a means of distinguishing customer propertyheld by a broker from the broker's own property. Legally, segregation is the requirementthat all money, securities, and property deposited by customers of a broker withrespect to a futures position, and the accruals thereon, be accounted for separately andtreated by the broker and any depository and clearing or settlement system as belongingto the customer Required segregation is a common risk management and customerprotection feature of derivatives regulation because segregation is intended fullyCopyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub