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.

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.

The Net-Net on Netting… and Risk

We’re the first to admit it: accounting isn’t easy… and that includes derivatives accounting. But it’s not exactly rocket science, either.

So we always feel mixed emotions (equal parts sympathy and dismay) when an article tries to cover an important derivatives accounting issue. A case in point: the recent Bloomberg story, US Banks Bigger Than GDP as Accounting Rift Masks Risk. The article is basically a criticism of the current US accounting treatment of OTC derivatives. We published a paper on this not long ago.

The US Financial Accounting Standards Board (FASB) permits the netting of exposures between counterparties on financial statements. This treatment mirrors the fact that in a number of jurisdictions, “netting IS DA law” (as we like to say around here). This means that netting is legally enforceable – a fact of law – and recognized as such by courts, regulators and market participants.

As a result, the accounting, legal and regulatory views on netting for US-based companies are aligned. So the outlier in this situation is actually the International Accounting Standards Board’s rules. These rules ignore the legal and regulatory consensus on netting and require firms to report their gross positions.

One result of all of this is that non-US firm balance sheets are larger than US firms’. We believe this ballooning of the balance sheet is artificial by virtue of the inclusion of both gross derivative assets and gross derivatives liabilities. The net amount is a better reflection of risk. For this reason, financial statements based on the FASB rules are more transparent.

Another result of the differences in approach is that firms deal with investors who are familiar with one, the other, or both sets of accounting rules. So firms also publish in their annual financial statements information that would be required if they followed the other set of accounting rules. In other words, firms that reflect net exposures in their balance sheets disclose the gross numbers in the footnotes.

That concludes the sympathy part of the emotional equation. Now on to the dismay part.

Despite what the Bloomberg story’s headline claims, risk is not being masked by the FASB rules. What’s being masked (in the story, at least) is the role of netting in reducing risk. In addition, in commenting on the size of derivatives exposure, the article could have made it clear that it was referring to notional amounts outstanding, which are not an accurate reflection of risk. As the BIS has published (and as can be seen in our
most recent Market Analysis), the gross market value of outstanding OTC derivatives (at June 30, 2012) was about 4% of notional. After factoring in the impact of netting, credit exposure was 0.6% of notional. Collateralization reduces that credit risk even further.

So, net-net, netting does not mask anything. It actually presents the true face of risk.

It’s what you didn’t say….

A number of stories last week – like this one – chronicled the fact that regulations stemming from Dodd-Frank on the OTC derivatives markets have begun to take effect.

These stories quite frankly come as a bit of surprise.  But it’s not because of what they say.  It’s because of what they don’t say.

Let us explain.

Over the past two years we have seen and heard countless times statements along these lines:

“Representative Barney Frank, who was the co-author of the Dodd-Frank Act, says the law will help prevent a repeat of the financial crisis.”  (New York Times)

“The Dodd-Frank financial reform overhaul last year aimed to curb the excessive Wall Street risk-taking that nearly leveled the financial system.”  (Reuters)

These statements reflect that financial regulatory reform globally, and Dodd-Frank in the US, was intended to be fundamentally about reducing systemic risk: making the financial system safer and more robust, ensuring financial institutions took risk and capitalized against it appropriately and ending bailouts of too-big-to fail institutions.

In the OTC derivatives markets, this mostly meant increasing the use of central clearing, ensuring appropriate margins for uncleared swaps and improving regulatory transparency.

Significant progress has been made in all of these areas.  More than half of the interest rates swaps market is now cleared. Regulators have transparency into market-wide and individual firm risk exposures. The vast majority of OTC derivatives positions are collateralized.

This has all been done in advance of the imposition of the new rules. As a result, the system is much safer and stronger than two or three years ago. Further progress is on the way, and it will be safer and stronger still.

Most of this remains unsaid. Much of the focus last week was instead on non-systemic issues that are not central to the fundamental goals of regulatory reform.