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?


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?

# # #

ET Phone Home

ET Phone Home…There have been many jokes, quips and witticisms about the unfortunately named extraterritoriality (ET) issues related to OTC derivatives rules in the US.

Some have even been funny.

But not everyone is smiling about ET, as this story by Dow Jones/The Wall Street Journal points out:

“European Union and U.K. regulators urged the U.S. to delay new rules for swaps contracts and reconsider how they apply to foreign banks and transactions.  The complaints add to a chorus of concerns, including from Japanese, French and Swiss regulators, that the U.S. is overstepping its jurisdiction.”

What, exactly, is the beef?

According to a letter from the European Commission that’s quoted in the article, the US rules could “lead to duplication of laws and to potentially irreconcilable conflicts of laws for market operators.”

This is a theme we have sounded before.  It’s also one that policymakers from Asia are voicing.  Earlier this week, five regulators from three Asia-Pacific jurisdictions (Hong Kong, Singapore and Australia) jointly signed a letter to the CFTC voicing their concerns.  As their letter states:

“…we are concerned that some of the proposed requirements as they currently stand may have significant effects on financial markets and institutions outside of the US. We believe a failure to address these concerns could have unintended consequences, including increasing market fragmentation and, potentially, systemic risk in these markets, as well as unduly increasing the compliance burden on industry and regulators.”

Is there a solution in sight?

Perhaps.  As Hong Kong’s Secretary for Finance Services and The Treasury separately wrote to US policymakers:

“…we call for greater coordination internationally on implementation of OTC regulations, particularly those with cross-border implications.  We hope the CFTC, SEC and the US Treasury will defer the application of the US rules and regulations over non-US persons and work with the international community on a coordinated framework on regulatory cooperation in cross-border OTC transactions.  We also hope the US authorities would provide greater clarity to the Proposed Guidance and to recognize the OTC derivatives regulatory regimes of overseas jurisdictions on the basis of international standard.”

The lines are open.  Regulators are standing by.

A Gathering in Boston

A flurry of stories over the past week have reported (including this one in the FT) on an interesting meeting recently held in Boston that was attended by leading buy-side and sell-side market participants. The meeting apparently focused on liquidity and electronic trading in the bond markets.

“But, oddly, participants at last month’s meeting in Boston were not especially gung-ho about electronic trading. Some of the largest asset managers do not believe that transparency is automatically their friend. If they want to shift a big block of bonds, a skilful dealer might be able to do it without moving the market. This is more difficult if you’re sending an order electronically for the world to see.

Unlike equities, debt instruments are not homogenous. There is not always a ready market with buyers and sellers. Banks, as responsible (and often reluctant) market makers will take an asset and hold it for some time.”

Now, as noted, the meeting was about bonds, and not OTC derivatives, and most of it does not concern us. But the parallels between some of the issues faced by both markets are strikingly familiar.

What are those parallels?

The buy-side – asset managers and others – want and need flexibility in executing their transactions. This usually means ensuring they have the right combination of price, speed and anonymity, depending on the particular firm and the particular transaction. The market-making function of banks provides this flexibility. Restrictions that would limit either the ability of firms to receive or the ability of market-makers to provide that flexibility are a real cause for concern for all market participants.

As we have stated, and shown in previous research, the OTC derivatives markets are very price competitive and dealers play an important market-making role in them. Derivatives users have access to prices from a variety of dealers in a variety of ways. Proposed changes to a system that works – and works well – need to do more than preserve the status quo (or why do them in the first place); they need to add incremental value.

Psst! I’ve Got a Secret

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

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.

Ignorance Is (Not) Strength

A Year of Me-Firsts, and of Lessons Relearned in Sunday’s New York Times recounted “some truly illuminating moments” from 2011:

“A favorite was the pronouncement that if Greece were to default on its debts, it     wouldn’t really count as a default at all. That determination meant that investors who had bought insurance against a possible default would be out of luck. Their policies wouldn’t pay off as expected.

Who ginned up this nondefault default? A secret committee of bankers who call the shots in the world of credit default swaps. These people happen to work for big banks that probably sold the insurance and, as a result, would be on the losing end if a Greek default were actually called a default.

It sure is good to run the Wall Street branch of the Ministry of Truth.”

The Orwellian reference certainly seems apropos.  But not perhaps for the reason originally intended.  The fact is, ignorance is not strength:  none – not one — of the statements in this excerpt are true.  Isn’t that a little Orwellian?

We’ll go through each in turn, but before doing so want to point out an important fact.  The sovereign CDS exposures of four firms that sit on the ISDA EMEA Determinations Committee were made public as part of the European Banking Authority’s 2011 EU Capital Exercise.  The total of their net exposure on Greece?  $276 million.  One firm had net exposure of $3 million; none had net exposure of more than $100 million.

What this means:  It takes 12 of 15 votes to declare that a credit event has – or has not – occurred.  Five of those 15 votes belong to the buy-side.  When it comes to Greece, at least four more of those votes belong to firms without a substantial net CDS exposure to that sovereign name.

Now to our line-by-line analysis:

A favorite was the pronouncement that if Greece were to default on its debts, it wouldn’t really count as a default at all.

There was no such pronouncement.  What ISDA actually stated at the time and which remains true today is:

“The determination of whether the Eurozone deal with regard to Greece is a credit event under CDS documentation will be made by ISDA’s EMEA Determinations Committee when the proposal is formally signed, and if a market participant requests a ruling from the DC. Based on what we know it appears from preliminary news reports that the bond restructuring is voluntary and not binding on all bondholders. As such, it does not appear to be likely that the restructuring will trigger payments under existing CDS contracts. In addition, it is important to note that the restructuring proposal is not yet at the stage at which the ISDA Determinations Committee would be likely to accept a request to determine whether a credit event has occurred.”

That determination meant that investors who had bought insurance against a possible default would be out of luck. Their policies wouldn’t pay off as expected.

CDS protection buyers and sellers expect their CDS contract to pay according to its terms.  Those terms make clear that for a Restructuring credit event to occur it must be in a form that binds all holders of the “restructured” debt.  While the DC has the final say, a voluntary exchange in which some bond holders can choose to keep their original holdings would not appear to be binding on all holders.

It’s important to remember that those Greek debt holders who do not agree to an exchange keep their existing debt and remain entitled to repayment of principal and interest according to its terms.  Similarly, an owner of CDS protection on Greek debt continues to be protected if a credit event were to occur later (for example, if the Issuer were to miss a coupon or principal payment).   The CDS protection buyer can, of course, trade out of the position the same way a bond holder could sell his/her bonds; given the direction of Greek CDS prices this would result in a profit.  The market does indeed continue to see the value of CDS contracts.

Who ginned up this nondefault default? A secret committee of bankers who call the shots in the world of credit default swaps.

How can a committee be a secret if the names of its members are publicly available?  (Answer:  it can’t be – and it isn’t.)  The firms on each of the DCs are posted on the web.  So too are their votes.

In addition, the structure of the DC ensures that its determinations enjoy a broad consensus based on the public facts at hand and the CDS Definitions.  Of the 15 DC members, 10 are sell-side and 5 are buy-side.  12 of 15 votes are required for the DC to make a determination (whether that determination is that a credit event has occurred or has not occurred).  Otherwise the determination goes to a panel of outside experts.

These people happen to work for big banks that probably sold the insurance and, as a result, would be on the losing end if a Greek default were actually called a default.

As noted above, four of the banks on the ISDA EMEA Determinations Committee were included in the European Banking Authority’s recent 2011 EU Capital Exercise.  Of these four, one is from the UK, one is German and two are French.  (Of the six other banks on the EMEA DC, four are US and two are Swiss; these were not included in the EBA exercise.)

The four banks’ sovereign CDS exposures – the protection they sold and the protection they bought — were publicly reported as part of the EBA exercise.  Each of the four was slightly long in its net exposure on Greece, meaning they had sold a bit more CDS protection than they had purchased.  The total of their net exposure on Greece was $276 million.

Truth be told, 2012 looks like it will also be a year in which some lessons need to be relearned.

Naughty or Nice?

We were hoping for a quiet holiday season, until we read this piece in The Observer (the Guardian’s sister publication, which is believed to be the oldest Sunday newspaper in the world). It’s about the debate over commodity prices, speculation and position limits (which limit positions that investors can hold in certain commodities). Here’s what it asserts: 

“The City is at it again… This time it’s about rules to check rampant speculation in commodity markets. Rules that could cut prices for food and raw materials in some of the poorest countries in the world… Financial speculation is widely acknowledged as contributing to a global food price crisis, as well as soaring commodity prices more generally… Position limits are essential to prevent the emergence of dominant traders who can distort the market; and to slow price increases.”

We scoured the article for evidence to support this thinking.  But like a disappointed child on Christmas Day, we found no such gifts. 

There is, though, plenty to support the opposite view. As then-US CFTC Commissioner Michael Dunn stated earlier this year, “To date, CFTC staff has been unable to find any reliable economic analysis to support either the contention that excessive speculation is affecting the markets we regulate or that position limits will prevent excessive speculation.”
Consider also the research that exists – by IOSCO, the IMF and the G20 Study Group on Commodities. They all point to market fundamentals and not speculation as the primary driver of commodity price increases. Similar conclusions were reached by the CFTC Inter-Agency Task Force on Commodity Markets, the European Commission and the US Government Accountability Office.

But wait, there’s another assertion to unwrap. 

The article states that the US is moving toward tighter regulation of commodity trading and uses this to buttress its arguments against speculation and for position limits. The truth is actually a little different. 

In its vote to approve position limits, the majority of the five Commissioners actually opposed the substance of the rule. Two – Commissioners O’Malia and Sommers – cast dissenting votes. And although he voted for them, Commissioner Dunn publicly stated: “Position limits, at best a cure for a disease that does not exist… may harm the very markets we’re trying to protect.” 

Despite all of this, we know that there will always be those who may prefer fiction and not fact. Especially now, during the Christmas season, when everyone wants to believe that there really is a Santa Claus. So in that spirit we wish all of our readers a very happy holiday season and look forward to writing on new topics next year.

Note: Last month, ISDA and SIFMA filed lawsuits challenging the CFTC’s Rule on Position Limits. Information regarding that action can be accessed here.

Let the Sun Shine In

Sunday’s New York Times contained yet another column on the OTC derivatives markets. This time, the commentary focused on transparency, as well as on the amendments regarding electronic trading platforms proposed by Representative Scott Garrett and others.

The article notes there are two aspects to the transparency debate. The first – regulatory transparency – “has pretty much been accomplished.” Trade and position details are being reported to a centralized trade information warehouse to which regulators have access.

To which we say: Thank you.

The article goes on to contend that another issue remains: “a lack of transparency in the market as it relates to swaps customers hasn’t been addressed.”

The column relies on some estimates provided by a small trade group to support its contentions. These estimates are supposedly part of a study of transaction costs and potential cost savings that the group conducted. Has anyone seen this study? We have not, though we have asked to see it. So too has Rep. Garrett, who was told it would be provided during a recent congressional hearing. (We also note that letters from BlackRock and the Investment Company Institute supporting the proposed amendments were read into the record in that hearing, but were not mentioned in the Times piece.)

It’s ironic that while one trade group’s elusive report is treated as credible, the research that ISDA has conducted and publicly released finds no place in the column. Our research – and we understand that third parties can and should consider the source of the research – finds that swaps prices are incredibly competitive in the most liquid parts of the market. It also finds that the potential price improvements that infrequent swaps users may receive from the CFTC’s electronic execution rules are dwarfed by the higher costs that these rules will impose on all market participants (see Costs and Benefits of Mandatory Electronic Execution Requirements). We’d be happy to shed some light by arranging a simple demonstration of live pricing that is available to derivatives end-users.

Finally, the column considers neither how swaps trade now nor the pricing information that exists. End-users can call firms (as many as they like) for quotes. They can review the price screens that these firms provide to them. They can look up prices on their Bloomberg terminals. They can access existing electronic platforms for price information.

In other words, as it relates to swaps customers, there really isn’t “a lack of transparency in the market.”