Paddling Hard for Margin Implementation

This past month in derivatives markets has felt a bit duck-on-a-pond-like. On the surface, it all looks calm, the duck is serenely gliding along, with nothing more than the occasional quack to break the silence. Under the water, though, its webbed feet are paddling furiously. So it is with the derivatives market, as the largest banks prepare for the start of non-cleared margining rules from September 1.

A couple of articles have recently picked up on the all-out effort to prepare for the rules – this one from Bloomberg, and this one from Risk. Both describe the huge documentation and system changes that have to be put in place, and the rush to get all this completed by the implementation date. They also pick up on the cross-border complexities that have emerged as a result of the fracturing of the global implementation timetable.

The articles cover a big, big issue. From next week, a first-phase group of large derivatives users will be required to post variation and initial margin on their non-cleared derivatives trades. These requirements were originally intended to be rolled out in a coordinated way across jurisdictions, but a decision by the Europe Union to defer its start date in June, followed by Australia, Hong Kong and Singapore earlier this week, means the rules will only be implemented on September 1 in the US, Canada and Japan.

Exchanging collateral on derivatives trades may not seem such a big deal. In fact, the rules will trigger the biggest transformation of derivatives markets in decades. That’s because they touch virtually every aspect of the non-cleared derivatives space – from pricing, funding and documentation, to IT, custody and collateral management. It’s required massive changes to infrastructure, technology and documentation, which have needed to be developed, implemented and tested. And it’s all had to be done very, very quickly. US prudential regulators were the first to issue final rules at the end of October 2015 – a little more than 10 months ago – while Japanese regulators published theirs at the end of March.

Given much of the detailed preparation and implementation couldn’t begin until these final rules were released, it’s meant a huge amount of complex work has had to be squeezed into a matter of months. That includes applying and testing the ISDA SIMM, a common model that will be used to calculate initial margin in the non-cleared space (here’s a short explanation), and adapting existing collateral documents. ISDA has published new credit support annexes (CSAs) for variation margin and for initial margin under various legal regimes, but each phase-one firm will likely need to execute between 100-200 CSAs with other phase-one entities.

This process has been made all the more difficult by the fact there’s now a cross-border element to this. The splintering of the timetable adds to the compliance complexity and could disrupt cross-border trading – margin requirements may or may not apply depending on the status and location of the counterparty, whether it has a guarantee from its parent, and whether it is consolidated with the parent entity for accounting purposes, among other things.

No wonder, then, that the Bloomberg and Risk articles suggest preparations are coming down to the wire. There’s going to be plenty of hard paddling over the coming days, as banks work hard to ensure they have everything in place on time.

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Hot, Hot, Hot!

The Basel Committee on Banking Supervision’s rules for determining the amount of capital relief banks can achieve by hedging credit risk have most likely been called a lot of things by tired and frustrated risk managers over the years. ‘Hot’ is probably a new one.

That, though, is exactly how the Wall Street Journal describes hedges that result in capital relief in a recent article (The Hot Thing for Wall Street Banks: Capital-Relief Trades). The starting point is a report published by the US Office of Financial Research back in June, which considers the use of credit default swaps (CDS) by banks. The WSJ picks up on some of the points in this report, and contains a variety of views on the extent and use of so-called capital-relief trades.

It’s an interesting article on an interesting topic. So we thought we’d add a few additional observations, building on some of the comments we made in our last media.comment post.

First, banks need to continually monitor and manage the risk posed by their loan books and other exposures. Left alone, these loan books would likely reflect the geographic and sector characteristics of their client base. Without active management of their portfolios, banks would quickly reach concentration limits, restricting their ability to lend further. Managing risks such as these is a primary motivation for banks when deciding whether to hedge.

Second, as the WSJ article points out, regulators have long allowed banks to obtain capital relief if they hedge the risks they are exposed to. The reason is intuitively quite simple. If a bank makes a loan to Company A, it’s exposed to the risk that Company A may go bankrupt and not be able to repay the loan. It has to hold capital against that risk – the riskier the borrower, the more capital the bank has to hold. By putting on a hedge, the bank is less exposed to the credit risk of the borrower, and so is able to reduce the amount of capital it has to hold against the loan. Buying CDS protection is one of the many ways banks manage the risk of their loan books, but there are strict rules governing the amount of capital relief banks can obtain.

That’s not quite the end of it, though. Banks have to hold capital against the CDS protection they’ve purchased too. That is largely determined by the counterparty credit risk posed by the protection seller. But capital requirements for single-name CDS transactions have increased across the board under Basel III.

Capital isn’t the only line of protection. The vast majority of these CDS hedges will also be backed by collateral (unlike many of the original loans). This collateral is meant to cover the possibility of a loss arising from one of the counterparties failing to meet its obligations under the derivatives trade. Under new margin rules for non-cleared derivatives, these trades will be subject to mandatory initial margin as well as variation margin from next year.

Turning to the issue of transparency: how do we know how much capital relief US banks have obtained through their CDS hedges? There are various ways. For one thing, US banks submit quarterly filings to the Federal Reserve, which includes data on the amount of credit protection recognized for regulatory capital purposes. As we pointed out in our last media.comment post, this information is publicly available. Second, those banks that apply the internal ratings based approaches to Basel III – so, pretty much all the big Wall Street banks mentioned in the WSJ article – have to publicly disclose the impact of credit risk mitigation techniques on risk-weighted assets (RWAs) within their Basel Pillar III disclosures (see page 32 of this document). Smaller banks using the standardized approach aren’t required to report pre- and post-credit derivatives RWAs, but they do have to disclose a variety of other information related to credit risk mitigation techniques.

A final point. Regulators can also discover the identity of the counterparties that have sold the CDS protection to the banks. Under the Dodd-Frank Act, all derivatives trades have to be reported to a trade repository, giving regulators the ability to scrutinize these transactions down to the counterparty level.

Protection Racket

How many times have you read a story in a newspaper or magazine and thought, “The headline is pretty negative, but the story is OK”?

We thought (and hoped) that might be the case when we came across this New York Times Dealbook piece – authored by an outside contributor – that has this alarming headline: Derivatives Markets Growing Again, with Few New Protections.

We were wrong. Here’s why…

The piece cites statistics from the recently released BIS semiannual survey and notes that the notional value of over-the-counter (OTC) derivatives at year-end 2013 is 20% larger than year-end 2007.

That’s true.

But left unsaid is one of the primary drivers of that growth: an increase in central clearing of OTC derivatives. As the BIS survey states, clearing doubles the notional outstanding related to a transaction, as, for example, one $10 million trade that’s bilaterally negotiated becomes two $10 million cleared trades between each of the counterparties and a clearinghouse.

If you eliminate the effect of double-counting of cleared OTC interest rate derivatives, then (all else being equal) the size of the overall OTC derivatives market actually declined by a bit more than 10% from year-end 2007 to year-end 2013.

Here’s where another key trend – portfolio compression – comes into play. Compression has eliminated some $170 trillion (on a net basis) of OTC derivatives over the past five years. In other words (again assuming all else remains equal), the global OTC derivatives market would be larger by that amount if compression had not occurred.

Clearing and compression have been going on for some time, but it’s safe to say that there’s an additional sense of urgency to them amidst global regulatory reform. In fact, clearing mandates in major jurisdictions will ensure this is the case (although the reality is that the actual amounts cleared are well ahead of those mandated for clearing).

So it’s pretty evident that regulatory and market reforms are behind big changes in the OTC derivatives markets. This cuts against the first of the author’s main concerns, namely the market’s growth.

But it also speaks to the other concern – the claim that there are “few new protections.” After Dodd-Frank, EMIR and MIFID, after all of the new rules and regulations being implemented in the US and Europe and around the world, how can anyone say this?

Which brings us to our last point. The article reasons that management of OTC derivatives can be complex and opaque. It then uses two well-known scandals to show how large the losses can be from poor management. In both examples, though, those losses stemmed from illicit trading of listed, exchange-traded derivatives — not the OTC derivatives the author is so worried about.

So here’s a question: How do you protect against this type of logic?

Beware Blaming Bad Bond Bets!

The debate about speculation vs. investment has gone on at least since the Sumerians traded wine forwards five or six millennia ago. More recently − five or six decades ago −  one of our most famous value investors put it this way:

ben graham


“The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices.”

– Benjamin Graham
The Intelligent Investor

Graham’s words of wisdom come to mind after reading this piece from CNBC.com. It keys off a “study” by the Services Employees International Union about derivatives usage by municipalities.

The central premise: if a municipality (and by extension, a corporation, asset manager, pension fund, sovereign or other entity) decided to lock in rates a few years ago with an interest rate swap, it made a “bad bond bet.” That’s because rates stayed low, meaning there was no need to hedge and so the premiums spent on the hedge could have been spent elsewhere.

The logic (?) of this position is: it’s better to stay exposed to market fluctuations than to manage the risk of those fluctuations.

But isn’t that betting (or speculating)?

Well, yes, actually, it is.

But wait…what about the fact that terminating that hedge can mean big payments from a hedger to its counterparty? Isn’t that another sign that it’s just a bad bet?

Well, no, actually, it is not. Here’s why:

Assume a hedger issues floating rate debt and then does a swap to lock in a fixed rate (by paying fixed and receiving floating).

Rates then go lower, which means the cost of the floating rate debt declines. The hedger pays less in interest income on the debt.

At the same time, the hedger continues to make the same fixed rate payments on the swap (and continues to receive floating rate payments from its counterparty). The market value of the swap has changed, because the hedger’s fixed rate payments are more valuable now that rates have gone down.

So if the hedger wants to terminate the swap, its counterparty wants a larger termination payment to compensate for the loss of those fixed rate payments.

Keep in mind that the hedger is under no obligation to terminate the swap. Its decision to do so is voluntary.

So why would a hedger voluntarily pay a large termination fee to exit a swap?

The most likely reason: It has determined that it could save money by issuing new debt — and by calling in its existing debt and terminating its existing swaps.

So, to summarize: a hedge enables a hedger to optimize its financings while protecting against changes in rates. The effectiveness of the hedge is a function not just of its cost but also of the cost of the hedger’s debt. Termination payments reflect changes in value of the swap hedge and are made voluntarily when the hedger has determined that there’s financial value in calling old debt, terminating swaps related to that debt and issuing new bonds.

See How They Run

Are financial regulators still flying blind when it comes to derivatives exposures?

It depends on who you ask.

On the one hand, there’s the Financial Stability Board’s paper – OTC Derivatives Market Reform: Sixth Progress Report on Implementation. It states (on page 29) that the Depository Trust & Clearing Corporation’s (DTCC) trade repository has captured 99% of all interest rate derivatives contracts outstanding and 100% of credit default swaps outstanding, when compared to the Bank for International Settlements’ semiannual survey.

That’s pretty good – and it shows the tremendous improvement in regulatory transparency since the global financial crisis.

To see for yourself, have a look at ISDA’s new website – ISDA SwapsInfo.org – which takes all of the public information reported by DTCC and transforms it into user-friendly charts and graphs. You can view activity and notional outstanding by currency, product type and maturity. This includes, by the way, market risk activity for the range of credit derivatives products.

IRD 300dpi

It’s worth noting that the information available to the public on this site and through the DTCC warehouse is only part of the data available to regulators.

So that’s the good news. There is, however, “the other hand” to consider. And it includes a collection of stories like this one from Bloomberg View. These articles claim transparency is still not where it should be and much more work remains to be done.

And you know what? In some cases, they are spot on. There is, for example, an increased threat of fragmentation in trade reporting because of competing trade repositories in different jurisdictions. As the Bloomberg article notes, this could impede the goal of greater regulatory transparency.

It’s also true that data alone is insufficient to give regulators the information and knowledge they need and require. In fact, in some cases, data alone might do more harm than good by providing a false sense of security without providing a true level of understanding.

So what’s the bottom line here?

Improvements – real improvements – have been made in ensuring data regarding activity levels and risk exposures are appropriately reported. We have come a long way since 2008.

But now, derivatives industry market participants and regulators need to work together on an important goal. It’s to ensure the information being requested is on point, addresses key public policy and risk management needs, and is timely.

Otherwise, we won’t be flying blind…but we will be running around in circles.

Disgusted, Tunbridge Wells

Letters to the editor are a common feature of most news publications. Often they are penned by outraged readers. Sometimes they are not. According to the BBC, staffers at the former Tunbridge Wells Advertiser wrote their own to fill space: “One [staffer] signed his simply ‘Disgusted, Tunbridge Wells’, and a legend was born.”

We note this because of a recent letter we came across in the Financial Times. It, too, appears to have been written by someone with an unusual sense of humor (though this time, no newspaper staffer or pseudonym is involved).

The FT letter is entitled “Fragmented derivatives market may cut global risk.” It’s written in response to an article about the lack of global coordination of derivatives regulations: “US rules ‘endanger’ derivatives reforms.”

So what’s the beef?

It’s this – the letter articulates the view that geographic fragmentation is a good thing:

“So, the global derivatives market could fragment along regional lines. That might be anathema for some – yet might make for a safer, less globally connected and also more constrained market… the mere decline in the extent and inter-regional connectedness of derivatives trading could make for less global risk.”

And it does so apparently because global reform is the brainchild of special interests:

“Until recently, ‘reform’ implied action in the public interest. However, the adoption and globalisation of the reform agenda by special interests merits a second glance…”

It would be great if the derivatives industry could take credit for the idea that markets are global, but we must give credit where it is due. It’s not a particularly new idea. But it is one espoused by global policymakers. As the 2009 G20 Pittsburgh Summit Communique stated:

“Continuing the revival in world trade and investment is essential to restoring global growth. It is imperative we stand together to fight against protectionism… We will keep markets open and free… We will not retreat into financial protectionism, particularly measures that constrain worldwide capital flows, especially to developing countries.”

Economic theory posits that globalization increases economic growth and reduces poverty. As a recent issue of The Economist stated:

“According to Amartya Sen, a Nobel-Prize winning economist, globalisation ‘has enriched the world scientifically and culturally, and benefited many people economically as well’. The United Nations has even predicted that the forces of globalisation may have the power to eradicate poverty in the 21st century.”

We think the benefits of global financial markets also accrue to users of derivatives. It enables counterparties who do not want a particular risk to more easily and more cheaply find someone better able to manage that risk. That could be the firm next door or the firm across the ocean.

If derivatives markets were not global, then that risk would be transferred to someone locally – or not at all.

In either case, the risk is likely to be less effectively managed. Which ultimately means that risk in the system might increase, rather than decrease, if markets are fragmented. And while that may not be a reason to be disgusted, it’s certainly a reason to be dismayed.

15 X GDP = 0

What is a logical reaction to the following statement?

“In the last quarter of 2012 US bank and savings institutions held $223 trillion of derivatives – fifteen times our GDP.” (Emphasis is in the original.)

A: Become anxious and feel scared.

B:  Sigh…and wonder how it is possible that stuff like this still gets printed.

C: Look to see who wrote it. Discover that it was by a former US Senator who helped shape the financial reform legislation, and that it appeared in the American magazine Forbes. Become anxious. Wonder how stuff like this gets printed. Channel energy and write a media.comment blog post about it.

So here goes:

A recent column in Forbes, part of a larger series on “the failed promises of the Dodd-Frank financial reform package,” looks at the state of derivatives regulation.

It warns readers early on exactly what to expect, stating: “we can discuss derivatives without knowing exactly how they work.” Really?

And then it goes on to try and prove that point.

The column, which is supposedly about OTC derivatives regulation, states: “Had hundreds of billions of dollars worth of AAA-rated CDOs not lost most of their value in a matter of days, there would have been no crisis.”

Well, that’s almost right. As the statement infers, real estate was at the heart of the financial crisis. But real estate values (and the mortgage-based securities and CDOs based upon them) had been declining for some time, and did not lose their value “in a matter of days.”

The larger issue, though, is that CDOs are not OTC derivatives. They are securities. They are not included in the “scary” number cited above. And they are certainly not covered by OTC derivatives regulations. They are also not what the Forbes column is supposed to be about.

Maybe we do need to know how something works before we talk about it…

But moving on: the column rails against the requirements imposed regarding the number of quotes a firm must get before it can execute an OTC derivatives contract. It states: “The requirement had been reduced to require dealers to obtain votes from only five banks before executing a contract. Even that was watered down after more pressure from Wall Street; the final vote required only two bids.”

Two points here, one small, one large. First: “obtain votes?” Obviously an editing mistake.

Second, while the value of setting any minimum level of quotes is debatable, it’s important to remember that market participants are always free to get as many quotes as they like. How many quotes would you get before buying a car? Two? Five? You – the customer – can and should decide. Seems like a great concept to us.

Finally, to end where we began: What is there to say about the “fifteen times our GDP” comment? How about exactly what we have been saying for almost three decades?

Notional amounts outstanding indicate activity and not risk. Credit risk is better gauged by gross market value, which is 3.9% of notional (or $24.7 trillion), and even better yet by net market value, which is 0.6% of notional (or $3.6 trillion). Collateralization further reduces credit exposure, to about 0.2% of notional (or about $1.1 trillion).

These are still big numbers, but should be looked at in context. According to data from McKinsey and the BIS, the global stock of debt and equity outstanding includes $62 trillion of non-secured lending; $50 trillion of equity; $47 trillion of government bonds and $42 trillion of financial bonds.

Notional is admittedly a big number and it’s easy to use it to create scary headlines and stories. But we imagine most informed commentators know what it really represents. Which may mean that those who do conflate its meaning may have their own purposes in mind?