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.

Initial Thoughts on Initial Margin

A recent speech by the Federal Reserve Board’s Vice Chairman appeared to get the New Year off to an inauspicious start for OTC derivatives markets. Initial reports of the speech indicated that it called for tougher regulation and treatment of derivatives, including a requirement for initial margin.

Bah, humbug.

But then we actually read the transcript, and felt a little better. There are some key aspects to the speech that we agree with.

First, there’s recognition about the benefits of a robust variation margin (VM) framework and its role in achieving an important public policy goal:

“The [VM requirement] codifies current best market practice, since the largest derivatives dealers already exchange variation margin daily. However, and importantly, the framework extends this prudent risk-management practice to other derivatives counterparties. Requiring timely payment of variation margin will go a long way toward ensuring that an AIG-like event will not happen again [emphasis ours], since current exposures will not be allowed to build over time to unmanageable levels.”

Second, there’s acknowledgement of the impact that initial margin (IM) requirements will have on liquidity and on the cost and availability of OTC derivatives to end-users: “higher initial margin requirements will make it more costly for market participants to use derivatives to hedge risk.”

Another key point: the speech notes that “requiring less-liquid and highly customized derivatives to be cleared would likely increase systemic risk …” But that’s because the risk management practices of CCPs are not well-suited to manage such risks – and not because the risk of such instruments is unmanageable (for more on this, see our December letter to BCBS-IOSCO on Margin Requirements For Non-Centrally-Cleared Derivatives).

There are, to be sure, some points that we disagree with. And there are some that we really disagree with.

We don’t, for example, believe that IM will reduce systemic risk. If done improperly, it could actually be highly pro-cyclical and increase systemic risk.

And we also don’t see how margin requirements can “diminish the incentive to tinker with contract language as a way to evade clearing requirements.” This notion ‒ that IM is needed to enforce or incentivize clearing ‒ has taken hold in some circles to justify the imposition of IM, but we don’t think it lines up with the facts. Clearing has happened, is happening and will continue to happen because it is a cost-effective means of managing risk through standardized products.

As we stated in the letter to BCBS-IOSCO mentioned earlier: “If a transaction is not clearable, then no amount of IM can cause it to be cleared. If it is clearable, then legal mandates – and not punitive IM – should drive clearing. If a high level of IM is the tool used to try to incentivize clearing, not only would such a strategy fail, but there would be…. potential adverse ramifications.”

2013 looks like a year in which we will be talking a lot about margin requirements. We’re not sure if this will keep us merry and bright over the next 12 months, but it should keep us busy.

Back To The Future

Everyone in OTC derivatives is so busy preparing for the future that we wonder if it’s even worth going back in the past to reexamine some popular assumptions about the financial crisis.

But, in light of a couple of recent developments, we just can’t resist.

First off, witness the exchange that took place recently on CNBC’s Mad Money between host Jim Cramer and his guest, AIG CEO Robert Benmosche. They are talking about the events surrounding AIG’s financial difficulties in September 2008 (starts 8:27 into clip).

Benmosche: …the issue was not capital. The issue was cash. They didn’t have cash.

Cramer: Right, did they have the collateral for the…

Benmosche: They actually had the collateral, but the question was they had no window to go to, because they weren’t a bank until afterwards. Had the same been given to AIG that was given to other companies after AIG got the bailout—as you know, some of the investment houses were given access to the Fed window; other large institutional companies were given access to the Fed window. Had AIG had the same access, I believe that would have solved the liquidity crisis they had.

Cramer: So it wasn’t that bad off, then. It was just a question of the moment in time.

Benmosche: It was cash to meet collateral calls, because, in the end, the financial products that were put on the books, that were bought by the Fed—you saw the profits already—we believe almost all of that will accrete back to what it was supposed to be.

Cramer: That’s incredible.

Benmosche: It was a question of the markets had tanked, the way the accounting was done—which was changed, okay? But the accounting was very aggressive at that point in time, and so it required too much cash to be put up on things that, ultimately, would have worked.

(click for full CNBC transcript)

We prefer to leave the ultimate takeaways from this exchange (and there are several) to our readers. But there’s one worth pointing out. AIG’s actual final cash losses on the credit protection it wrote were not why it needed a bailout. Realized losses would not have caused its collapse.

It was, instead, the cash that had to be posted as collateral for those contracts that caused the company’s distress. This is a point echoed by a new paper from Harvard Professor Hal Scott and the staff of the Committee on Capital Markets Regulation:

To be sure, after AIG’s long-term debt was downgraded by each of the three rating agencies… AIG did not have enough liquidity to meet further collateral demands. Indeed, the downgrades coupled with subsequent market movements caused AIG’s collateral posting obligations to soar to more than $32 billion over the following fifteen days, compared to only about $9 billion of cash entering the week.

A turn not marked on the roadmap

Why is all of this worth rehashing four years after the fact? Because today, the policy debate regarding OTC derivatives is taking a turn that was not on the G20’s original roadmap. That map, as articulated in 2009, called for more clearing of standard, liquid swaps; appropriate capital standards across firms; and increased regulatory transparency. ISDA fully supports ‒ and has actively driven towards ‒ these G20 goals and regulatory efforts to reduce systemic risk.

So what’s the dangerous turn in the road? It’s about efforts to fashion capital and margin requirements for OTC derivatives that can’t be cleared. There are a number of different types of these instruments, used mainly by a variety of end-users in the ordinary course of their businesses, and they total 20% or so of the overall OTC market.

Some would like to see all OTC swaps centrally cleared. Clearinghouses, however, are the new too-big-to-fail institutions. They need to be protected. They must only clear liquid, standardized products. To jam them with less liquid, less standardized products could have potentially disastrous consequences. They must be kept pristine.

Uncleared derivatives are not necesarily any more risky than cleared swaps, it is just that they do not meet the (appropriately) very high bar at the clearinghouses. They do, however, have enormous social value. Examples include inflation swaps, widely used by pension funds globally and cross currency swaps, which are vital to the funding operations of corporations and governments.

It is also worth noting that the types of unclearable OTC derivatives used in the real economy generally have nothing to do with the type of CDS that AIG wrote. (Those were also unclearable and as a result have cast a shadow on the whole category of unclearable swaps.) But the desire to avoid AIG-type situations is potentially leading to a margin framework that could quite possibly end transactions in this important sector, essentially throwing the baby out with the bathwater, and in doing so perhaps perversely increasing risk in the system.

We, like regulators, want to build a framework that ensures AIG can’t happen again. And we believe that experience provides that the best way to do this for uncleared swaps is through a robust variation margin (VM) regime – one in which transactions are valued and collateral exchanged on a daily basis. Frequent exchanges of collateral between counterparties means that large credit exposures that could become destabilizing in periods of market stress can’t build up. Had this practice been followed four years ago, we would not be talking about the AIG situation today. AIG did not, as a matter of course, post daily VM to settle liabilities with its counterparties.

Another example from 2008 draws a stark contrast. Unlike AIG, Lehman Brothers did have robust VM arrangements with its counterparties. Those VM arrangements ensured that the Lehman default did not cause any systemic contagion.

However, while VM is clearly an effective part of the regulatory framework for swaps, policymakers are considering an additional step. They are proposing to impose a different kind of margin – initial margin. This can be thought of as a buffer, a safety cushion of extra collateral over and above any monies owed between parties. The goal, again, is to reduce the chances of systemic risk from a major default.

The Initial Margin paradox

Initial margin, or IM, does help reduce systemic contagion, but it does so at the cost of making market participants more likely to default, since the posting of initial margin consumes valuable liquidity resources at banks, and importantly, creates a future contingent liquidity draw of potentially terminal proportions. This is because IM requirements increase in response to increased market volatility. This procyclical funding draw will happen in the heart of a crisis, at the worst possible time for market participants.

Regulators could undercut the very goal of systemic resiliency that we are all trying to achieve. Our recent presentation makes this clear.

Professor Scott’s paper also makes it clear that AIG’s collapse did not pose systemic threats (questioning in another way the need for IM):

…it is widely believed that…AIG was saved because of the interconnectedness of its derivative positions with other important financial institutions. While it is relatively clear that derivatives helped to bring down AIG, there is no substantial evidence that its failure would have put its counterparties at risk of insolvency. Direct losses from in-the-money CDS positions held by counterparties would have been small relative to their capital.

In addition to these concerns, The IM proposals also can have significant adverse economic and financial consequences. As noted above, they could possibly put an end to the uncleared swaps market. Some commentators might welcome this, but such a position is quite frankly, absurd. Unclearable swaps are critical to the proper functioning of vital sectors of the economy, such as the US housing market and financing of corporations. They are an essential component of the lifeblood of the broader global economy.

We need to get this part of financial regulatory reform right. And to do so, we need to look back so we can move forward.