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.

A Sensible Approach

We admit it. We like headlines like this one − It’s Time for Sensible Regulation of Derivatives – which we first came across on The Exchange, a Yahoo! Finance blog.

But as it’s a blog (like media.comment), we weren’t too excited – until we saw that one of the authors was Martin Neil Baily, former chairman of the US Council of Economic Advisors. Dr. Baily (who served in the Clinton Administration) and his co-authors (who served in the Obama Administration) support derivatives activities:

“The bulk of derivatives are interest rate swaps, credit default swaps on corporate bonds and municipal and state bonds, commodity price derivatives, and currency swaps. These markets did not break down in the crisis and did not contribute to it.”

The authors also support prudent derivatives regulation, and “want to get that regulation right.” They are concerned, though, about some aspects of regulatory reform.

“It is worth asking if the myriad of rules put into place in Dodd-Frank to regulate derivatives can work together effectively and coherently. Congress, and the Financial Stability Oversight Council, should ensure that the different regulatory bodies work together to craft consistent rules of the game. Tackle the problems that emerged in the derivatives market and improve the economy’s stability, while still reaping the economic benefits derivatives can and do provide.”

It stands to reason: to develop effective derivatives regulation, we need to accurately understand the problems we are trying to solve. What are those problems? As Dr. Baily noted last month in a Brookings Institution conference on the purposes, structure and regulation of the financial industry:

“I think derivatives maybe have been…overstated a bit in their influence on the crisis. Like many historical crises…the one we’ve been going through I think was fundamentally caused because financial institutions bought and held bad assets…”

He went on to note:

“…I don’t think derivatives are the main story and I think all derivatives should not necessarily be viewed as toxic as Buffett said…”

One of the major issues related to derivatives in the financial crisis, he said, was “We didn’t know enough about the derivatives that were out there, who was holding them, what the implications would be…there was a real lack of information.” This concern helped give rise to the establishment of trade repositories to which market participants report their transactions, providing regulators more and better and deeper transparency on exposures and activities than ever before. (The need for regulatory transparency is why we oppose fragmentation of trade reporting and repositories, as outlined in our recent letter.)

The other major issue noted by Dr. Baily was AIG’s credit default swaps. As we have written elsewhere, the AIG situation reflected a failure to adequately measure and manage liquidity and collateral requirements. Had a robust variation margin framework been in place, AIG’s bail-out likely would have been averted.

Sensible indeed.