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.

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?

# # #

Crossing the Line

Question:
What do 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 have in common?

Answer:
They have all written to the US CFTC to express their concerns about cross-border derivatives regulations.

Why are they concerned?  As the finance ministers recently wrote:

“We are already starting to see evidence of fragmentation in this vitally important financial market, as a result of lack of regulatory coordination. We are concerned that, without clear direction from global policymakers and regulators, derivatives markets will recede into localised and less efficient structures, impairing the ability of business across the globe to manage risk. This will in turn dampen liquidity, investment and growth.”

To anyone who has watched this issue unfold over the past two or three years, such concerns are no surprise.  It is, though, a bit of surprise to see how The New York Times describes the situation.  Witness this page one headline from the Wednesday, May 1 paper: “Banks Resist Strict Controls of Foreign Bets”

There are (at least) three things wrong with these seven words:

1)      There’s nary a mention of the concerns of some of the world’s leading policymakers in the headline.

2)      No one is resisting strict controls.  The issue, as the finance ministers point out, is that “We share a common commitment with respect to OTC derivatives reform, and are implementing rules across very different markets with different characteristics and different risk profiles, to support this global initiative… An approach in which jurisdictions require that their own domestic regulatory rules be applied to their firms’ derivatives transactions taking place in broadly equivalent regulatory regimes abroad is not sustainable. Market places where firms from all our respective jurisdictions can come together and do business will not be able to function under such burdensome regulatory conditions.”

3)      Bets?  Even better, foreign bets?  How and why are derivatives transactions characterized as bets?  Is capping your interest rate exposure a bet?  Is hedging your currency exposure a bet?  Is protecting your credit exposure a bet?

We’re an international organization, and especially sensitive to these sorts of things, but even so, doesn’t this seem a touch xenophobic?  If the letter mentioned above had been co-signed by a US Treasury Secretary and sent to his EC counterpart, would it have been described in the same way?

But wait, there’s more.

Further down in the article, there’s this description of the “bitter international campaign” being waged by Wall Street and the world’s top finance ministers (as if they are working in concert):

“The effort…is just one front in the battle still being waged nearly three years after Congress passed the Dodd-Frank law, which revamped financial regulations in the United States in hopes of curtailing risky trading practices blamed for the global financial crisis in 2008.”

We’re the first to admit that the financial system needed strengthening (and we have made good progress doing so), but let’s not forget what the financial crisis was all about.  It was, first and foremost, about bad real estate decisions and bad mortgages. That was true in the US just as it was true in the UK, Ireland, Portugal, Spain and other hard-hit nations.

Unfortunately, The Times’ treatment of the important issue of cross-border derivatives regulation really crosses the line.

TIME for an April Fool joke? If only….

It’s Easter Monday. Europe is closed. The US wishes it were.  Along comes this scary headline…which is even scarier because it’s from a column in TIME written by a contributor: Why Derivatives May Be the Biggest Risk for the Global Economy.

We furiously click through the link to get to the entire article. We read through it, drawing nary a breath. We see claims (with absolutely no attribution or substantiation) that the OTC derivatives market is bigger than the BIS says it is. Which means the risks are even greater than many had supposed.

We are puzzled.

And then we come to the piece de resistance, the giveaway:

“…in theory, at least, the total losses could add up to more money than there is in the entire world.”

A moment of clarity descends upon us. We “get” it.

It’s April 1. The column is an April Fool’s Day prank.

It has to be…because the story simply makes no sense. The venerable TIME would never run a column that confuses its facts so badly. It mixes up notional amounts outstanding with the level of OTC derivatives risk outstanding (which is properly measured by market value). If you do a $100 million interest rate swap, you agree to exchange payments based on the $100 million notional amount. You don’t actually exchange the $100 million.

We know people sometimes find OTC derivatives confusing, but we had imagined that by now just about everyone gets this point (or at least everyone with the yank to write a column in TIME). Notional does not measure risk. In fact, the amount at risk in OTC derivatives typically averages about 4% of the notional outstanding. And it’s less after you factor in collateralization and netting (about 0.2% of notional).

Unfortunately, the misguided notions on notional are not all that’s wrong with the column. It also fails to recognize the significant growth in central clearing, the progress made in increasing regulatory transparency, the continuing efforts in collateral management – all of which help to reduce risk.

We’re glad April Fool’s Day only comes once a year.

Nothing to Hide

John and Sally like to trade with each other. They have conducted five derivatives trades. In three of the trades, John owes Sally $1 per trade. In the other two, Sally owes John $1 per trade. How much do John and Sally owe each other?

A. John owes Sally $3.
B. Sally owes John $2.
C. John owes Sally $1.

The correct answer – in jurisdictions in which the counterparties have signed ISDA Master Agreements and in which netting is legally enforceable – is C. And C is what firms that follow the US GAAP rules report on their financial statements (the “FASB approach”). Under IFRS rules, they would report A and B.

As the example makes clear, netting is a simple concept. Yet it remains subject to misunderstanding, as this recent article indicates.

Readers will recall we wrote on a similar topic not that long ago, so we won’t repeat our basic argument on the accounting treatment of netting here. But we do think it is important to point out a few additional facts.

First, as we stated in a paper on netting in 2010:

“the effect of the netting agreement is to treat all transactions done under it between two parties as a single legal whole with a single net value.”

This point is worth repeating because all transactions under an ISDA netting agreement will net to a single amount upon a counterparty event of default.

Another point worth repeating relates to the legal strength of the netting agreement. ISDA currently has 55 legal opinions on the enforceability of the Master Agreements netting provisions. And the close-out netting provisions of the ISDA Master Agreement have never, to our knowledge, been found to be unenforceable in instances in which ISDA has published an opinion confirming such enforceability.

In other words, netting is the law, netting works and netting accurately reflects the risks between counterparties. That’s why we believe the current FASB approach – which provides financial statement users with the net amount of exposure – is more accurate and transparent.

One final point: the first quarter of 2013 is the first period in which derivative market participants will provide expanded derivative disclosures. US GAAP filers already provide detailed derivative netting disclosures; and will provide further derivative netting information that would be achieved upon a counterparty event of default that cannot be recognized on the balance sheet today. IFRS filers will be required to provide detailed disclosures for the first time. So it will be interesting to see in the IFRS financial statements how much netting currently is being done and is already incorporated in them.

We’re sure there will be yet another round of comparisons between the two accounting approaches in the weeks to come. And that’s a good thing – it’s yet another opportunity to explain what netting is, how it works, and why ISDA has spent so much time and energy on it.

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.