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?

More or Less?

Is the OTC derivatives market growing…or shrinking?  A recent Bloomberg BusinessWeek piece helps provide an answer.

The article reports on ISDA’s OTC Derivatives Market Analysis, Year-End 2012, which pulls together data from a variety of sources to show the impact of some key trends, like clearing, portfolio compression and netting, on the underlying market.

Over the past five years, OTC derivatives notional amount outstanding (excluding FX transactions) is up 6.7% from year-end 2007 to year-end 2012, according to the BIS.  If you eliminate the double-counting of cleared transactions (which occurs because one bilateral contract becomes two cleared contracts), it’s down 17.5%.

BUT:  if you then add back in the $214.3 trillion of notional that has been eliminated via portfolio compression over the past five years, the OTC derivatives market has increased 23%.

Shorter-term, the picture is a little different.  The total OTC derivatives market (excluding FX) declined 3.3% from year-end 2011 to year-end 2012.  After eliminating the double-counting of cleared transactions, the decrease was 10.9%.  If you take this number and add back in the impact of portfolio compression, the market was roughly flat year-over-year.

Another interesting stat from the Market Analysis has to do with the level of risk exposures in the OTC derivatives market.  At year-end 2012, gross market values (a more appropriate measure of risk than notionals outstanding) were 3.9% of notionals.

Netting significantly reduces those exposures; gross credit exposures after netting were 0.6% of notionals.  Factor in the widespread collateralization of OTC derivatives and the uncollateralized exposure after netting is about 0.2% of the notional outstanding.

We know that going through all of these numbers is a bit of a tough slog.  But it’s important to realize that sometimes there’s more to the story than what appears on the surface.

So the real answer is: more and less.

 

 

Unfriendly Fire

Everyone wants to be liked.  Even banks.  That’s one reason why a recent headline — Bank-Friendly Financial Reform – caught our eye.

It’s courtesy of Taking Note, the editorial page editor’s blog of The New York Times, and it leads a post that focuses on the cross-border application of derivatives regulations.

Truth be told, the piece is not very friendly to banks.  (But you knew that.)  It largely dismisses the legitimate concerns that have been expressed about the scope and timing of the US regulatory framework by numerous policymakers around the world.  The list includes the EC Commissioner for Internal Market and Services, finance ministers in Brazil, France, Germany, Italy, Japan, Russia, South Africa, Switzerland and the UK, and regulators and central bankers in Australia, Hong Kong and Singapore.

Instead, it espouses the curious viewpoint that the administration is not resisting these concerns forcefully enough…and that it might be “saying just enough to shield the administration from charges that it has generally stood by while the banks watered down reform…”

Really?  So that’s what’s been going on?  Washington has been just going through the motions on derivatives reform?

Hardly.

The situation regarding the cross-border application of derivatives rules is important to understand:

• The G20 (which, of course, includes the US) initiated a global process of reform that was intended to create a level playing field among regulators and across jurisdictions.  To achieve this, it’s important for all jurisdictions to remain aligned on the substance and timing of reform.

• European rules are expected to be as stringent and comprehensive as US rules.  Within the US, the SEC is also drafting a strong ruleset.  We expect that ISDA and market participants will continue to find plenty with which to disagree (and hopefully agree) on both counts.

• For one regulator to go it alone risks a number of adverse consequences:  significant legal and operational uncertainty; duplicative or incompatible requirements that create undue costs or are impossible to implement; destabilizing markets by favoring firms/trades in some jurisdictions over others; undermining efforts to develop a long-term, stable regulatory environment that is crucial for strong markets and financial stability.

Much work remains to be done to finalize and implement the new regulatory framework in the US, Europe and other jurisdictions.   International harmonization of these rules is vitally important to achieve the goals of greater financial stability and a more robust financial system – goals that everyone likes.

Sometimes More is Less

Earlier this week, the US CFTC approved rules governing the execution of swap transactions.  Among the major issues was a proposal to require market participants to seek five price quotes on trades done on a swap execution facility.  The Commission ultimately voted to mandate two “request for quotes” (RFQs), with the requirement eventually increasing to three.

The range of headlines (and stories) following the CFTC vote was interesting:

“US in Compromise on Derivatives Trade Rules” (Financial Times)

“Regulators Strike Compromise on New Derivatives Rules” (Wall Street Journal/Dow Jones)

“Big Banks Get Break in Rules to Limit Risks” (New York Times)

“Wall Street Wins Rollback in Dodd-Frank Swap-Trade Rules” (Bloomberg)

“CFTC adopts SEF rule, including RFQ3, voice broking” (Reuters)

Hmmmm.  Was it a compromise, a rollback, a break or something else entirely?  (It clearly was an adoption of a rule, as Reuters notes.)

Another point of interest:  in at least some of the articles, there’s a presumption in favor of requiring five RFQs.

Why?  How or why is it “good” to mandate that a derivatives user request a certain number of price quotes from different dealers?  And why five?

Shouldn’t this be up to market participants to decide?  Particularly since getting a quote is easy enough, given the different ways derivatives users can get or check prices (via phone, terminals, and dealer, broker and other trading systems)?

The flawed assumption is that the client is not qualified to decide for itself whether 2, 3 or 23 quotes are optimal.  It also ignores the fact that information has value for the recipient of the quote requests and the client might not want to offer that information to any more counterparties than is appropriate to the situation.

There’s something else that’s interesting:  it’s the presumption that these trade execution rules have anything to do with reducing risks in the financial system.  Trade execution is about market structure – not systemic risk.  If the goal of financial regulatory reform is to reduce systemic risk, shouldn’t we focus on issues that affect it, like regulatory capital, clearing, margining and regulatory transparency?

Shouldn’t we also avoid mandating “more” to customers when it really means less, and just leave it to them to decide how much is enough?

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