Protection Racket

How many times have you read a story in a newspaper or magazine and thought, “The headline is pretty negative, but the story is OK”?

We thought (and hoped) that might be the case when we came across this New York Times Dealbook piece – authored by an outside contributor – that has this alarming headline: Derivatives Markets Growing Again, with Few New Protections.

We were wrong. Here’s why…

The piece cites statistics from the recently released BIS semiannual survey and notes that the notional value of over-the-counter (OTC) derivatives at year-end 2013 is 20% larger than year-end 2007.

That’s true.

But left unsaid is one of the primary drivers of that growth: an increase in central clearing of OTC derivatives. As the BIS survey states, clearing doubles the notional outstanding related to a transaction, as, for example, one $10 million trade that’s bilaterally negotiated becomes two $10 million cleared trades between each of the counterparties and a clearinghouse.

If you eliminate the effect of double-counting of cleared OTC interest rate derivatives, then (all else being equal) the size of the overall OTC derivatives market actually declined by a bit more than 10% from year-end 2007 to year-end 2013.

Here’s where another key trend – portfolio compression – comes into play. Compression has eliminated some $170 trillion (on a net basis) of OTC derivatives over the past five years. In other words (again assuming all else remains equal), the global OTC derivatives market would be larger by that amount if compression had not occurred.

Clearing and compression have been going on for some time, but it’s safe to say that there’s an additional sense of urgency to them amidst global regulatory reform. In fact, clearing mandates in major jurisdictions will ensure this is the case (although the reality is that the actual amounts cleared are well ahead of those mandated for clearing).

So it’s pretty evident that regulatory and market reforms are behind big changes in the OTC derivatives markets. This cuts against the first of the author’s main concerns, namely the market’s growth.

But it also speaks to the other concern – the claim that there are “few new protections.” After Dodd-Frank, EMIR and MIFID, after all of the new rules and regulations being implemented in the US and Europe and around the world, how can anyone say this?

Which brings us to our last point. The article reasons that management of OTC derivatives can be complex and opaque. It then uses two well-known scandals to show how large the losses can be from poor management. In both examples, though, those losses stemmed from illicit trading of listed, exchange-traded derivatives — not the OTC derivatives the author is so worried about.

So here’s a question: How do you protect against this type of logic?

Mondays always get me down

A decent weekend. Not much going on…

And then, on Monday morning, bam! Breaking news from The Wall Street Journal: “Big U.S. Banks Make Swaps A Foreign Affair”. The story basically posits that US banks are using their overseas affiliates to write some swaps with non-US counterparties without a parent company guarantee. This means that the transactions would not fall under the purview of US regulators.

Sounds troubling.

But as the infomercials say: Wait! There’s more!

A lot more.

First, the transactions would in fact fall under the purview of regulators in the jurisdictions in which they are done.

Second, on the major systemic risk issues (clearing, trade reporting, margining), there is likely to be little to no substantive difference between major jurisdictions.

So this clearly is not a case of regulatory arbitrage. It’s really about the fact that some customers do not want or have the capacity to understand and comply with regulations in two different jurisdictions. These non-US customers prefer doing business with non-US firms. They don’t want to trade on SEFs. So the US firms are structuring their businesses to meet this demand.

Most people know all of this, as the Journal article acknowledges.

So what’s really the issue? Apparently, it’s the fact there are some differences between jurisdictions in the timing and substance of trade execution rules. So some see the shift to trading overseas as a way for firms to avoid trading on SEFs, which they view as a bad thing, because:

“For US regulators, the new rules aim to bring swaps trading into the open and protect the US financial system from firms amassing huge derivatives positions in non-US markets.”

But that’s not the role of SEFs – that’s what clearing and trade reporting are all about. And as we noted, on these issues there’s not much if any difference between jurisdictions.

One final thought: the article begins with a chart that purports to show concentration in the derivatives markets. The data in question, however, is for the US only and includes only US banks. As we have written, the derivatives markets are truly global, and a look at our report here shows a more accurate picture.

Misperceptions like this… that’s why we’re hangin’ around, with nothing to do but frown….

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.

Not So Fast, Let’s Stop and Think

Today’s New York Times contains an interesting story — “Strong and Fast Markets, But No Time to Think” — that reflects on the trading glitches that roiled equities markets on Wednesday.

The article discusses the evolution in securities trading over the past quarter century. It states that this change has largely been positive, but also points out potential pitfalls.

Chief among them: “…the improved markets also are more prone to disaster.” Why? Partly because “Market makers have been largely replaced by high-frequency traders who use computers that can react to orders in nanoseconds.”

As evidenced by yesterday’s problems, or those related to the “flash crash” in May 2010, no trading system is perfect.

There is an interesting parallel here to the OTC derivatives markets. Current policy proposals might significantly change their structure and the role that market makers play in them. These proposals could transform OTC derivatives from an institutional market with low trading volumes and large notional amounts per trade to a quasi-retail market with vastly higher trading volumes and small notional amounts per trade.

We’re not sure what purpose this would serve. Given the price competition and the extremely tight spreads in the most liquid part of the OTC derivatives markets, the impact on trading costs would appear to be minimal.

It is true that smaller end-users might benefit from lower costs, but any benefit here is likely to be more than offset by the higher costs that larger end-users might incur.

Simply stated, there is very little evidence to support the idea that the proposed changes in the structure of OTC derivatives trading would benefit market participants.

As a result, we do not think these market structure changes were the intent of the G-20 Communique issued in Pittsburgh in 2009 that formed the basis of the legislative proposals that have since advanced in key jurisdictions.

To the contrary, we believe that the overriding goal of post-crisis public policy initiatives is to build a stronger financial system and reduce systemic risk.

Efforts to increase central clearing of trades and to improve regulatory transparency do just that, which is why we and market participants are on board with and helping to drive progress in these areas.

Efforts to change how one market works should clearly be backed up by substantial evidence that those changes will bring improvement. For OTC derivatives, that evidence has been a slow train coming.