What Price Transparency?

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Price transparency in the OTC derivatives markets was one of the most widely discussed – and widely reported – topics at ISDA’s 27th Annual General Meeting last week. Here’s the Financial Times on the issue:

A theme of the ISDA conference, which includes large dealers as well as users of derivatives, is that while central clearing reduces systemic risk, regulators should not impose new rules on how derivatives trade, because it could disrupt those established markets and reduce trading volumes.

“Listed and over-the-counter markets are completely different, and it’s important that lawmakers and regulators keep this in mind,” said Mr O’Connor.

He added that the industry was open to more public reporting, but with restrictions such as not revealing the size of very large trades or delaying trade reporting. “We’re not anti-public reporting,” he said.

Mr Gensler said that public transparency after trades was key to reducing systemic risk, by making it easier for clearing houses to ask traders to post additional margin during the day.

So who’s right?

Enter Craig Pirrong, the “Streetwise Professor.” Professor Pirrong disagrees that pre-trade transparency helps to reduce systemic risk: “CCPs will obtain the prices of deals cleared through them, that they can use to determine marks on a periodic basis. Moreover, they have access to information from member firms that will permit marking deals to market. Pre-trade transparency is particularly irrelevant in this context.”

It’s a view echoed by those in the know. As the FT noted,

Michael Davie, head of LCH.Clearnet’s SwapClear platform, agreed that regulators, clearers and market participants must know what is going on, but public reporting isn’t essential.  “Transparency for transparency’s sake, why is that inherently a good thing? In broadly subscribed retail markets it’s incredibly important, but how many people are doing 10-year Czech krona swaps?”

So to sum up: price transparency is not a systemic risk issue. ISDA supports taking steps that reduce those risks, as evidenced by the progress made in clearing and compression and in building trade repositories. The former reduce counterparty risk and the latter increase regulatory transparency.

When it comes to market structure changes, however, we believe the benefits of those changes should outweigh their costs. We don’t think the impact of the rules relating to mandatory trade execution in the US meet that benchmark. The evidence indicates that prices in major segments of the OTC derivatives markets are very competitive and are accessible in many ways (via dealer quotes and screens). These markets are already liquid, competitive and transparent — qualities that are absolutely necessary for markets to function efficiently and effectively.

Speculating on Position Limits

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Amidst the clamor over high gas prices in the US, the editorial pages of The Wall Street Journal and The New York Times both weighed in today on the issue of those prices and whether they are being influenced by speculation.

The Journal’s editorial commented on a briefing held by the Administration in Washington on Tuesday and stated:

“Nowhere in his remarks did the President claim that speculation is doing any harm. He did not cite any negative impact on the oil market. He did not say that speculators are manipulating oil prices, nor did he describe in even the vaguest terms the individuals or institutions that might be involved. He didn’t cite any research. Mr. Obama didn’t even, well, speculate about whether oil prices would be higher or lower if not for unnamed actors who may or may not be affecting the markets.”

The Times, not surprisingly, had a different take. It stated that: “Research…indicate[s] that …excessive speculation, mainly by Wall Street index-fund traders, is needlessly driving up prices…”

What is “excessive” speculation? And what exactly does the Times have a problem with: your garden-variety speculation or excessive speculation?

No matter. The Times editorial goes on to say:

 “…it is important that the administration’s working group on oil and gas price fraud — formed a year ago by Attorney General Eric Holder Jr. — finally weighs in on the question of how, and how much, manipulators and speculators are pushing up prices. The group’s silence raises questions about how serious the White House really is about addressing this issue.”

We all agree that illegal market manipulation is wrong and needs to be policed and prevented. But could it be that the reason for the delay is that there is insufficient evidence to support the idea that speculation is distorting commodity markets?

The editorials go on to discuss the lawsuit that ISDA (along with SIFMA) filed against the CFTC’s position limits rule. (The lawsuit is currently pending in the US District Court for the District of Columbia.) These rules are intended to curb speculation.

The Journal writes that: “…the commission now must defend in court a rule it enacted last fall to curb speculation… the regulator has to find a way to carry the argument without the evidence to support it.”

It notes then-Commissioner Michael Dunn’s statements when the position limits rule was passed:

“ ‘No one has proven that the looming specter of excessive speculation in the futures markets we regulate even exists,’ said then-Commissioner Michael Dunn before the CFTC voted on the new rule last October… Mr. Dunn, a Democrat, provided the swing vote in favor of new limits on the size of trading positions only because he believed the Dodd-Frank law left him no choice.

“But even though he voted for the rule, Mr. Dunn said that ‘position limits may actually lead to higher prices for the commodities we consume on a daily basis.’ Less liquidity makes it more difficult for market participants to hedge their risks, which could raise costs for everyone.”

The Times says this:

“The Dodd-Frank financial reform law directs the Commodity Futures Trading Commission to implement new ‘position limit’ rules, which would curb speculation by limiting the share of the market that traders can control at any given time. Unfortunately, the rules recently proposed by the C.F.T.C. are weak, watered down by disagreements between the Democratic and Republican appointees on the commission. The new rules have already been challenged in court by industry groups that represent banks and derivatives dealers.”

Just to be clear, the basis of our lawsuit was two-fold. First, we believe the position limits rule may be harmful to commodities markets, and to end-users, by reducing liquidity and increasing price volatility. As we stated then: “The evidence is overwhelming that position limits are, at best, unnecessary and may, at worst, negatively impact commodity markets and users. Numerous studies have been conducted by government agencies and others into commodity price volatility and little, if any, support exists for the idea that speculation causes that volatility or that position limits curb speculation.”

We also believe the CFTC’s decision-making process in enacting the rule was procedurally flawed. The rule was adopted without making findings as to the necessity and appropriateness of the position limits, as required by statute. Furthermore, the CFTC failed to conduct any meaningful cost-benefit analysis and lacked a reasoned basis for its rule.

To summarize, there are several questions here: Does speculation distort commodity prices? Will position limits help curb speculation? Did the CFTC properly follow the law in enacting its position limits rule? We believe the answer to each question is no, and that the prevailing evidence supports our position.

Half Empty or Half Full?

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An article in the Financial Times on Monday treated us to another take on the empty creditor hypothesis. Professors Marti Subrahmanyam (NYU) and Pablo Triana (ESADE) write that:

“Bond or loan holders using CDS to gain credit protection qualify as empty creditors: if the borrower gets into trouble, the CDS, if triggered, would cover any losses on the underlying position; if the borrower honours its obligation, the investment is made whole (minus the cost of the CDS protection).”

So what’s the problem? In the opinion of the authors, it’s this:

“Empty creditors are lenders (to a corporation or government) that cease to be concerned about whether the borrower fares well or poorly. Their interests are not aligned with those of other creditors, who prefer that the debtor does well, so that the debt is repaid…

“In a more extreme scenario, the empty creditor may benefit even more by “over-insuring” – purchasing a proportionately larger amount of CDS protection than the debt owned (there is no real limit on the amount of CDS “protection” investors can buy). Obviously, those who did not enter into CDS are not indifferent to bad news as they have a more asymmetric pay-off.”

Our research department wrote a piece that addresses many of these issues a few years ago. We won’t repeat the entire argument, except to highlight a few key points from that piece.

The first relates to whether CDS do indeed lead creditors to prefer bankruptcy over restructuring. It posits that if the ability to hedge using CDS tends to make restructurings less likely than a bankruptcy filing, the correlation between number of defaults and restructurings as a percent of defaults should be lower when CDS are available than when they are not. The paper stated:

“The data show that the correlation between number of defaults in a given year and restructurings relative to defaults in the same year is about 9 percent over the entire sample period. But restricting attention to the period of liquid credit default swap markets, which arguably began in 2003 with the publication of the 2003 ISDA Credit Derivative Definitions and the subsequent initiation of trading in the CDX and iTraxx credit indexes, the correlation jumps to 90 percent. While correlations within small data sets should be interpreted carefully, the correlation statistics presented here would not appear to support the empty creditor hypothesis, according to which the availability of credit default swaps would make restructurings less likely.”

But wait, there’s more:

“Further evidence comes from the list of restructurings that occurred during 2008 and the first half of 2009… During that time, twenty-one firms underwent out-of-court restructurings; credit default swap protection was available on eleven of them (52 percent). And of the restructurings that occurred during that period, four subsequently filed for Chapter 11 bankruptcy; of those four, two had liquid CDS available and two did not. Again, the evidence thus far does not appear to support the empty creditor hypothesis.”

The second point we would make has to do with what the FT article referred to as “over-insuring” and our paper described as “negative economic ownership.”  Again, our paper stated:

“…one may reasonably question the plausibility of the second hypotheses on the basis of how the credit default swaps market treats distressed credit. If an investor were actually to try to build up a negative economic ownership position through overhedging, the strategy would be expensive and unlikely to yield a high return.

…[a]n overhedging strategy is likely to be profitable only if an unusually prescient hedger were to foresee accurately the failure of an investment grade company while the company’s credit default swaps still traded at a low spread. In such a case, the gain might be regarded as a windfall but would not lead to behavior that might affect the functioning of credit markets. And if the anticipated bankruptcy did not occur, the large hedge position could lead to large losses.

…Further, it is not clear how the investor would have been in a position to influence the likelihood of a bankruptcy, and thereby make a positive return more likely, other than by failing to support a restructuring if one were proposed. And as shown already, the evidence regarding restructurings does not support the contention that credit derivatives have had a negative effect on restructurings.”

A final thought: it’s interesting to note that a recent paper by Professor Subrahmanyam (“Does the Tail Wag the Dog?  The Effect of Credit Default Swaps on Credit Risk”) also addresses the empty creditor issue in considerably more detail. The paper is the first empirical work to “formally address the empty creditor concern.”

There is nothing in that paper to change our view that there are many factors influencing the likelihood of an out-of-court restructuring even before considering the effect of hedging using credit default swaps. And beyond the evidence we have provided – which thus far does not appear to support the empty creditor hypothesis – the new evidence they offer is interesting but not conclusive, as there are so many other factors in play. There’s still plenty of doubt regarding whether the empty creditor hypothesis is valid or its impact is negative.

Lessons Learned

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A week has passed since the auction for Greek CDS. Perhaps it’s now time to reflect on the credit event process. Toward that end we wanted to share our thoughts in a combined derivatiViews and media.comment post, and we also encourage our readers to offer their views.

In our minds, the most striking thing about the entire situation was the wholesale shift in sentiment regarding the potential risks of a credit event. In the space of a few months, it went from being a big issue to a non-issue (though it really should not have been an issue at all). We – and anyone who looked at the DTCC’s trade repository website – knew all along that the level of Greek CDS exposure was relatively small. In addition, while it was published in aggregate on the DTCC’s site, it was known on an individual firm level to regulators. The credit event truly was a non-event.

One of the major reasons why it was a non-event is because of the significant amount of work that ISDA and the Determinations Committees have put into ensuring that the credit event process is fair and robust. This process has been tested many times since it was introduced a few years ago and continues to work well for all market participants.

Our biggest disappointment throughout the process was the lack of understanding by some of two important points about the credit event process. The first point relates to the structure, composition and workings of the Determinations Committees. Apparently, the fact that the names of the individual firm representatives serving on the DCs are not disclosed makes them “secretive” to some. This is despite the fact that the names of the firms serving on the DCs are public, their votes are public, and the rules governing how the DCs function are public. It’s important to note that the individual firm representatives can and do change from credit event to credit event; there is no “list” per se.

The second point relates to the nature and definition of a credit event. As we said repeatedly, particularly here, a contract is a contract. One can speculate about what might be or what should be – and many did. But we repeatedly urged people to read and understand the contract as written. If they had, then there would have been little surprise that the DC could really not act until the collective action clauses (CACs) were invoked by the Greek government. This important step meant that the Greek restructuring was binding on ALL holders, which is a condition required for a credit event to occur under the restructuring clause. In addition, until the Greek government acted – and posted their action in the official government gazette – the CACs were not officially invoked. This too is required before a credit event can be declared. That’s because the DCs do not vote prospectively on credit events.

The Greek credit event also demonstrates to ISDA that we have more work to do. Some market participants legitimately raised the question of whether the package of obligations issued in exchange for old Greek bonds should be considered in the Greek credit event auction, arguing that this was the “right” economic result. Yet among those obligations were certificates issued by the European Financial Stability Facility, not the Greek government, so the package was not considered in the auction.

The fact that the package was not included in the auction was picked up in the blogosphere as evidence that CDS are somehow fundamentally flawed. We beg to differ with that broad characterization.

We believe that it is important to adhere to the terms of contracts as written and agreed between parties as to do otherwise would adversely impact the market. Also, we knew there would be good deliverables for the auction. But we at ISDA also have a long track record of learning from and adapting to market experiences, particularly ones as significant as this.

We are also committed to considering changes going forward, not just for new contracts, but where there is market consensus for a change, for existing contracts as well. One need only look at the 2009 Big Bang Protocol for evidence, when the structure for CDS for both new and existing CDS was agreed broadly by market participants.

Whether, when and how to change the contract to address this recent experience is already being debated by market participants. As we have on many occasions before – for CDS and for the whole range of OTC derivatives – ISDA will play a central role in facilitating the evolution of products that we believe are an essential part of the fabric of the credit markets and of the financial system as a whole.

Stay tuned!

Psst! I’ve Got a Secret

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Today we were treated to two news stories in two newspapers on one topic:  the process for determining whether a credit event has occurred with respect to Greek sovereign CDS.

On the one hand, there’s The Washington Post:  “For Greece, a critical conference call between London and New York.”  (A follow-up story is here.) On the other hand, there’s The Wall Street Journal’s “Hushed Up: Secret Panel Holds Fate of Greek CDS.”

An important part of the credit event process – and an important element in each story – are the ISDA Determinations Committees (DCs).  The DCs are 15-member panels of representatives from banks and investment firms.  A supermajority (12 of 15) of each DC’s members is required to make a determination.  Here’s how the Post describes the process and the DCs:

“The banks and other investors who buy and sell the swap contracts have agreed to the arrangement as a way to centralize what had been an ad hoc, company-to-company process of deciding whether a credit default swap payment was warranted.

“The committees are set up with competing interests in mind. The group meeting in London and New York on Thursday includes representatives of major European institutions like Deutsche Bank, as well as private investment funds like Blue Mountain Capital, that might have different points of view.

“A supermajority of 12 committee members is needed to make a determination either way, and if the panel deadlocks the issue would be sent to a new group of three outside arbiters. Some 59 cases have gone before ISDA committees so far without follow-up litigation, and only one has been referred to an outside panel.”

Contrast this with the Journal’s take.  First, there’s the headline about a “Secret Panel.”  The DCs are said to be “secretive” and “rarely elaborate on decisions.” “No outsiders can participate in the meeting…No transcript will be made public. When a decision is announced, expected before Monday, the committee doesn’t have to provide an explanation. There is no opportunity for investors to appeal.”  Critics “question the impartiality of the process.”

It’s a bit of a mystery why the story characterizes the process as so “secretive.”  The names of the firms on the DC are public, as are their votes.  The process by which the DC members are selected, and the rules governing the DCs, are also public.  Their decisions are publicly announced.  At times, public explanations for those decisions are provided, but often this does not appear to be necessary (such as when the vote is 15-0).

In addition, the process, as the Washington Post article notes, was built to address conflicts of interest.  The credit event/DC process has worked extremely well for 3+ years.  It has handled dozens of credit events without incurring a single legal challenge.  If a supermajority isn’t reached, the decision goes to a panel of outside experts.  A supermajority has not been reached only twice in all the times the DCs have agreed to consider a question.

In sum, we think the credit event/DC process is fair, transparent and well-tested.  There’s simply no evidence to the contrary.  Perhaps after today this non-secret secret will be a secret no more.

Note: ISDA’s EMEA Determinations Committee determined today that a credit event has not occurred with respect to recent questions on the Hellenic Republic restructuring. A copy of the press release is available on ISDA’s website.

A Not-So-Noble Idea

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Joseph Stiglitz, the economics professor and Nobel laureate, doesn’t much like OTC derivatives. He thinks, for example, that banks should be banned from trading them.

So it’s not a big surprise that he sees OTC derivatives – specifically CDS – as a problem in the negotiations over the Greek debt crisis.

But it is a big surprise – and a big disappointment – that his argument reprises the same erroneous and outdated information that one expects of lesser pundits.

To explain: A recent column in The Guardian, “European Central Bank in a fix over Greek debt“, explores the reasons behind the ECB’s apparent insistence that any Greek debt restructuring be deemed voluntary, so as not to trigger a CDS credit event. Professor Stiglitz cites three possible reasons for the ECB’s stance. The one he apparently finds most convincing is that:

“By insisting on it being voluntary, the ECB may be trying to ensure that the restructuring is not deep; but, in that case, it is putting the banks’ interests before that of Greece, for which a deep restructuring is essential if it is to emerge from the crisis. In fact, the ECB may be putting the interests of the few banks that have written credit-default swaps before those of Greece, Europe’s taxpayers, and creditors who acted prudently and bought insurance.”

As we have said many times and in many places, the $3.2 billion in net exposure of Greek sovereign CDS is relatively small. Plus: that $3.2 billion is the aggregate amount of all the individual net exposures, so the exposure of any one firm is less. Plus, plus: the exposures firms have to each other are marked-to-market and largely collateralized. Plus, plus, plus: the recovery value of a defaulted reference entity’s obligations further decreases the amount of cash that a protection seller would pay out to a protection buyer (so the aggregate cash payout following a credit event is less than $3.2 billion).

What does all of this mean? Simply that Greek sovereign CDS exposure is too small to be much of a factor in the Greek drama that is currently being played out.

We would have thought that Professor Stiglitz and his research staff surely know all of this? And that regulators have access to trade volumes and exposures through the CDS trade repository? And also that the EBA’s capital exercise, which detailed the CDS exposure of 65 European banks (including those from the UK, France and Germany) as of the end of the 2011 third quarter, showed that the total net CDS exposure of those firms was $545 million, all of which is already marked to market at approximately 30%?

The final oddity of Professor Stiglitz’s column relates to his views on the ISDA Determinations Committees, the group responsible for assessing whether a credit event has occurred. Here, too, we would have thought that the professor’s research team would have informed him of a few key facts. Namely, that the role of the DC is outlined in the legal contract to which CDS counterparties agree; that members of the DC are listed publicly on ISDA’s website; and that firms on the DC may be net buyers or sellers of CDS protection. As the EBA data show, the four firms included in the exercise who sit on the ISDA EMEA DC have a very small net Greek sovereign CDS exposure.

Pay It Forward

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An editorial in today’s Financial Times on the Greek debt situation contained this little gem:

“It is a false concern that triggering CDS may set off market contagion. The market is too small – and perverting the course of the swaps’ rules actually carries the bigger risk…”

To which we at ISDA say: Amen! We’ve been making similar points, and believe greater clarity about the CDS market is important, particularly as the Greek debt story continues to play out.

This story from CNBC will also help improve clarity. It outlines how the CDS credit event process works in a clear fashion. (One small note for viewers: the DC consists of 10 sell-side and 5 buy-side members).