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?

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.

It’s what you didn’t say….

A number of stories last week – like this one – chronicled the fact that regulations stemming from Dodd-Frank on the OTC derivatives markets have begun to take effect.

These stories quite frankly come as a bit of surprise.  But it’s not because of what they say.  It’s because of what they don’t say.

Let us explain.

Over the past two years we have seen and heard countless times statements along these lines:

“Representative Barney Frank, who was the co-author of the Dodd-Frank Act, says the law will help prevent a repeat of the financial crisis.”  (New York Times)

“The Dodd-Frank financial reform overhaul last year aimed to curb the excessive Wall Street risk-taking that nearly leveled the financial system.”  (Reuters)

These statements reflect that financial regulatory reform globally, and Dodd-Frank in the US, was intended to be fundamentally about reducing systemic risk: making the financial system safer and more robust, ensuring financial institutions took risk and capitalized against it appropriately and ending bailouts of too-big-to fail institutions.

In the OTC derivatives markets, this mostly meant increasing the use of central clearing, ensuring appropriate margins for uncleared swaps and improving regulatory transparency.

Significant progress has been made in all of these areas.  More than half of the interest rates swaps market is now cleared. Regulators have transparency into market-wide and individual firm risk exposures. The vast majority of OTC derivatives positions are collateralized.

This has all been done in advance of the imposition of the new rules. As a result, the system is much safer and stronger than two or three years ago. Further progress is on the way, and it will be safer and stronger still.

Most of this remains unsaid. Much of the focus last week was instead on non-systemic issues that are not central to the fundamental goals of regulatory reform.

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.

No Evidence? No Problem

“To the market’s credit, there is no evidence that the process has become corrupted by big banks.”

That’s what an article in The New York Times Dealbook says about how credit events are determined in the CDS market.

The comment, unfortunately, is buried deep within the article. It’s easy to miss.

Most of the 800-word piece focuses on how the credit event process has the potential to be flawed. Its basic premise is that the ISDA Determinations Committees (DC) and credit event process appear to operate in a cartel-like fashion.

We stress “potential” and “appear to” for two reasons. First, the article doesn’t actually allege any wrongdoing. As noted above, it acknowledges that there is no evidence to this effect. Rather, the article merely posits that because of the way it operates, there is the possibility that problems might occur.

We’re not sure exactly how the DC process is or can be cartel-like. There are effective mechanisms built into it to ensure it isn’t and can’t be. Most notably, each DC is composed of 10 sell-side and 5 buy-side firms, and an 80% supermajority vote of the 15 members is required to make a credit event determination. Neither the sell-side nor the buy-side alone can force a decision its way; a broad market consensus is necessary.

What other flaws does the article cite?

One has to do with the claims that the DC “operates as a quasi-Star Chamber.” It would be great if we could cast Michael Douglas or Hal Holbrook (the stars of the 1983 movie of that name) in the lead DC roles. But we’re not sure the DC process would qualify as a theme for a remake of the movie. Virtually every part of the process is public: the rules governing the DC; the composition of the DCs; the determination requests made by market participants; the aggregate DC votes; the individual votes of DC members; the auction process and prices; adjustment amounts paid by firms as part of the auctions, and so on.

Another potential problem cited by the article isn’t a problem at all: it’s a source of strength. It has to do with the fact that DCs can be asked to consider and vote on a credit event multiple times as the facts of a situation change.

For example, in the recent situation involving Greece, the ISDA EMEA DC was asked to determine whether a credit event had occurred prior to the execution of the bond exchange. It determined at that time that it had not. Shortly thereafter, the deal was officially executed and the DC was again queried. It then ruled that a credit event had occurred.

This is hardly an example of “details shifting.” It is, rather, a prime example about how specific facts about specific situations involving specific Reference Entities can and do change. Prior to the use of the collective actions clauses (CACs) by Greece, there was no credit event. Following their use, there was.

In other words, facts matter. That’s why it is hard to say that one DC decision is precedent-setting for another.

The article opines that the DCs make decisions without having to publish their reasoning. It fails to note that most decisions are unanimous or close to it, obviating the need for explanations given that the consensus is so widespread. It does, though, note that ISDA and the DCs are currently discussing enhanced disclosures.

The “biggest concern” cited by the article is about potential conflicts of interest. These concerns stem from the fact that DC member firms may have an economic interest in the cases they are asked to rule on.

Two important points need to be made here. The first is that the DC rules incorporate the idea that market expertise – as evidenced by trading volumes – is a good thing to have on the DCs. So it’s no surprise that the DCs will be asked to make determinations on Reference Entities in which they have exposures. The second point is that regulatory disclosures and regulatory transparency provide an important check on any potential conflicts. Regulators have the ability to see a DC member’s exposures and benchmark it against its DC voting. This ability is enhanced under Dodd-Frank, which requires firms to report their OTC derivatives trades to trade repositories. This important check on the integrity of the process is cavalierly dismissed in the article.

At the end of the day, the article says that although there’s no evidence of wrong-doing, “trusting it to remain that way doesn’t seem like a good plan.”

The truth is, the DC process has always been built on the concept of “trust, but verify.” It was built with structural safeguards – checks and balances — to protect its integrity. Those safeguards are working. That’s why “there’s no evidence” of any problems with the process.

That, at least, is something we can all agree on.

Any Given Sunday….

Another Sunday, another New York Times column on “you guessed it – derivatives.” This one purports to show how derivatives are costing mass transit riders higher fares and lower services. The story goes like this:

“Bankers have embedded interest-rate swaps in many long-term municipal bonds. Back when, they persuaded states and others to issue bonds and simultaneously enter into swaps. In these arrangements, the banks agreed to make variable-rate payments to the issuers – and the issuers, in turn, agreed to make fixed-rate payments to bond holders.”

At which point we need to stop to point out that the example is actually wrong.  We think what the column meant to say was that “the issuers, in turn, agreed to make fixed-rate payments to the bank.” This would be a classic example of an issuer doing a floating rate bond issuance and then swapping into a fixed rate to lock in its exposure. But we digress:

“These swaps were supposed to save the public some money. And, for a while, they did.”

Oh, maybe this won’t turn out so badly?  But then:

“Then the financial crisis hit – and rates went south and stayed there. Now issuers are paying bond holders above-market rates as high as 6 percent. In return, they are collecting a pittance from banks – typically 0.5 percent to 1 percent.”

To recap: the swaps saved issuers money. They effectively lowered the issuers’ interest payments. This remains true today. But now apparently those savings are not enough. Given the level of interest rates today, the column posits that muni issuers could be saving even more.

Well, if that’s the case, why don’t the states and municipalities refinance their debt and issue new bonds with lower interest rates? The problem, according to the column, is that:

“Well, if you think it’s costly to refinance a home mortgage, try refinancing a derivatives-laced muni.  The price, in the form of a termination fee, can be enormous.”

Banks do charge fees for terminating swaps, based on the market value (or replacement cost) of those transactions. Lower rates could and probably did increase the value of those contracts.

But how is this different from what issuers would face if they had just issued fixed-rate debt in the first place (with no swap)? They would have garnered none of the interest expense savings. And they would have to compensate bondholders in the form of a premium if they now wished to refinance higher–rate debt with lower-rate debt. (That’s why there’s generally a premium paid by issuers who issue callable debt.)

The article then goes on to say:

“Corporations rarely do deals like these, because they generally avoid making long-term bets on interest rates. But bankers sold the idea to public borrowers.”

It’s not clear what exactly is meant by “deals like these,” but here are a few facts. All of the top companies – and thousands of large, mid-sized and smaller firms – in the US and around the world use interest rate swaps. This suggests that corporations frequently seek to lock in their financing costs.

So now we get to the crux of the column:

 “…the banks are taking advantage of our generosity by gouging us on these toxic deals.”

What, exactly, is toxic about helping municipalities manage their interest rate risk and save money?

Collateral: The Rest of the Story

Recent media articles in two of our favorite publications (The New York Times, The Wall Street Journal) raise interesting points about an important derivatives risk management practice: collateralization of exposures. Both stories essentially question whether net derivatives exposure accurately captures the risks of a firm’s derivatives activity. They say that net exposure assumes (among other things) that collateral management is rigorous, and they wonder whether it really is.

Fair questions. But we wish the stories had gone one step further and sought answers to them by examining the data and the initiatives that exist or are underway in this area.

According to ISDA’s Margin Survey, 73% of OTC derivatives exposures are collateralized. The chart below shows that collateralization is highest for hedge fund exposures and lowest for governments and supranationals.

Collateralization levels by counterparty type

What do firms post as collateral? Cash represents around 81% of collateral received in 2010. Government securities constitute 10% percent and the rest is comprised mostly of corporate bonds, equities and government agency securities.

Looked at by product type, 93% of all credit derivatives trades executed by firms responding to the survey were subject to collateral arrangements during 2010. 70% of all OTC derivatives transactions were subject to collateral agreements during this period. This includes transactions with end-users and spot FX transactions, which due to the nature of these trade types, are not generally collateralized.

The 14 largest reporting firms, representing the world’s largest derivatives dealers, reported higher rates of collateralization. For this group, an average 96% of credit derivatives trades were subject to collateral arrangements during 2010. Overall, 80% of all OTC derivatives transaction executed by the large derivatives dealers were subject to collateral agreements.

The data confirm that collateralization is an important component in managing the derivatives exposures of market participants worldwide. That’s why ISDA and our members are engaged in a broad set of collateral-related initiatives — including research, documentation, best practices and practitioner guidelines.

We also believe it’s important for policymakers to have an accurate understanding of collateralization. That’s one reason why ISDA has called for the development of a single, global Counterparty Exposure Repository. This repository would provide an aggregated risk view for regulators of the net mark-to-market exposure for each counterparty portfolio, the corresponding collateral and the firms’ calculation of net exposure after the application of collateral.

“There you go again….”

Back in the 1980 presidential campaign, Ronald Reagan used this phrase to great effect to fend off criticism that was untrue or exaggerated. Today, it’s a phrase we think about saying often, particularly when it comes to news reports about the OCC’s Quarterly Report on Bank Trading and Derivatives Activities.

The 2011 second quarter edition is just out and, as usual, it’s creating some misperceptions that need to be clarified. The New York Times, for example, reported on it and said that “The nation’s four biggest banks… are the biggest players, holding roughly 95 percent of the industry’s total exposure to derivatives.”

As we’ve noted in the past, the OCC report only covers part of the US market. The data includes derivatives exposures of US dealers and US subsidiaries of non-US dealers. But it does not include exposures arising from transactions between a US firm and a non-US dealer.

Even more importantly, the OTC derivatives market is global, with competitors from all geographic sectors. On a global basis, the five largest US-based dealers held 37 percent of total derivatives notional according to an analysis ISDA did last year. The G14 group of dealers (the 14 largest) held 82 percent of total notionals outstanding.

The depth and breadth of competition in OTC derivatives is also supported by data from SwapClear, which requires members to have at least $1 trillion in notional outstanding. There are at last count 38 separate dealer/members who meet this criterion.

This leads us to ask: which other global markets have as many firms competing for business as this one?

Sunday NY Times – Neither Here Nor There

Press coverage of the European debt crisis and its potential impact on the US is a favorite topic of the media these days.  A case in point is “Suddenly, Over There Is Over Here,” a column in The New York Times Sunday Business section on September 18.

According to the column, there are two major risks facing US investors from the problems in Europe.  Only one concerns us here:  “…the potential for losses incurred by financial institutions that wrote credit insurance on European government debt and the European banks that own so much of that paper.”

How much could these losses total?  According to DTCC, and as the article notes, the net CDS exposure on Greece, Spain, Portugal and Ireland is $23.6 billion.  Does that mean that nearly $24 billion could change hands if ALL of these countries defaulted?  Well, no.  That’s because exposures are marked-to-market and roughly 90% of that market value is secured by collateral.  In addition, the amount the protection sellers pays to the protection buyers is further reduced by the recovery value of the bonds upon which protection was sold.  For sovereigns, that could be in the range of 40% to 50%.

So if we do the math, the actual cash payout on all the CDS on Greece, Spain, Portugal and Ireland would be less than $1 billion:

Net CDS notional on four sovereigns:               $23.6 billion

Less 90% collateralization of mark to market exposure
(
assuming MTM is 40% of par)                        13.6 billion
Less recovery value of bonds referenced by CDS
 (assuming recovery value is 40% of par)             9.4 billion
                                                   ————-
Total cash payout                                  $ 0.6 billion

   
This doesn’t mean, by the way, that the losses by CDS sellers would be less than $1 billion.  The actual losses incurred would be the amount of protection sold less the premiums received and the recovery value of the bonds on which protection was sold.   But it does mean that the actual cash paid out by institutions in the event of a loss is likely to be a very manageable number.

You can also apply this calculation to estimate what the payouts would be on financial institutions that deal in CDS.  The net notional outstanding on the world’s 10 largest financial institutions is about $37.5 billion. 

Now contrast the figures on sovereign CDS with the size of the government bond markets for the four sovereigns:

   Greece:     $   484 billion
   Spain:          896 billion  
   Portugal:       219 billion
   Ireland:        154 billion
—————-

   Total:      $ 1.753 trillion
(Data: Bloomberg, September 20, 2011)

Obviously, the CDS market is a tiny fraction of the size of the underlying sovereign debt market.

One additional point about the story requires clarification.  The article states that CDS “instruments trade in secret.”  The fact is:  a CDS trade repository that captures virtually all CDS trade activity is up and running (and has been for several years).  Some of this information is public (you can access it here).  More granular information is available to regulators.  As a result, transparency in the CDS market – as well as with other segments of the OTC derivatives markets – is significantly improved over the past few years.  In fact, Dodd-Frank and other regulations do not require providing additional public information on counterparty positions and exposures. 

Finally, the article states that “the huge market in credit default swaps remains unregulated and remains in the shadows.”  In light of the facts regarding trade repositories and with the passage of Dodd-Frank, we can only say:  “Really?”