If left standing when the music stops, you may still be trying to get your assets back years later.
While a deterioration in a bank’s creditworthiness may lead to a rather pleasurable accounting profit, it can have a negative impact too. As IFR’s Christopher Whittall and Helene Durand point out, clients don’t like it so much that their prime broker’s credit spreads are widening out and some have been reacting by shifting their trades elsewhere.
“We’ve definitely seen some clients re-assigning business. When competitors’ CDS have gone dramatically wider, we’ve got calls from clients saying they might like to assign swaps to us and asking for quotes,” said one senior fixed income banker at a European bank. “Clients are monitoring counterparty credit risk much more actively because many got so badly burnt post-Lehman in terms of the cost of moving their swaps around.”
At least someone is concerned about the institutions still being a going concern..
Here are some of the widening credit spreads:
(RBOS-RBOSplc – RBS, MWD – Morgan Stanley, GS – Goldman Sachs, BACORP – Bank of America)
It isn’t Lehmanesque at the moment though but clients are more sensitive to counterparty risk issues these days, hence they monitor the situation more closely, and, in at least some cases, they have been willing to act on their concerns.
Of course, there are some banks that deny any mass novations are going on. Back to the IFR article:
“We have had a lot of people coming to us who are interested in assigning trades and we have completed some deals. We are looking at risk and exposures, and our own exposure as well – in this market we have to stay conservative. There will be more stuff coming to market, so we’re not in a rush to buy back risk,” said one head of rates at a major bank.
“Overall, I think [these types of scenarios] will accelerate the push towards central clearing [which reduces counterparty credit risk],” he added.
It’s also mentioned in the article that banks are being a bit more picky about what new clients they take on, particularly when the client in question has only a one-way CSA (meaning that it isn’t required to post collateral with the bank when the bank is in-the-money).
FT Alphaville also hears that the pickiness is down to a shortage of reasonably-priced liquid assets that can be used as collateral at central counterparties (CCPs). A hedge fund client, for example, may only have hard-to-value assets that are relatively illiquid. When the client accesses a CCP via a clearing member, the clearing member will often effectively offer collateral transformation services to the client since the collateral required by the CCP is of a higher standard and liquidity than what the client has. No wonder the banks are hungry for liquidity swaps.
Other than the “push towards central clearing” making the banks with tighter credit spreads more picky about what business they want, what else can be expected to change?
Here’s a neat visualisation of what the overall change looks like — provided by Riccardo Rebonato, head of front-office risk management and quantitative analytics at RBS in London, as quoted in Risk (via Satyajit Das in Wilmott Magazine):
“We are moving away from a network system that can survive the failure of a single thread, to a hub-and-spoke system that must be 100% resilient. If the hub is ever allowed to fail, the aftermath of Lehman’s default is going to look like a picnic. So we are placing a lot of reliance on regulators to get these standards right and ensure CCPs are really robust.”
Well, at least Lehman wasn’t a CCP then. And if only we’d known to bring our wine and cheese on September 15, 2008.
On the robustness point though, it’s going to be interesting considering the counterparty monitoring that CCPs themselves are going to have to do, which makes them dependent on valuation and risk models, themselves reliant on having prices as inputs. Seeing as we are talking about an over-the-counter market, having prices isn’t always straight-forward. David Goldman, a former credit strategist describes CDS prices thus (again via Das):
“The business looks like the window of a Brezhnev-era Soviet butcher shop. Mouldy scraps hanging in the window. Old women lining up at 4am to try and buy credit protection on General Motors. What are reported as trades are really ways to establish prices to satisfy the auditors.”
Ah, accounting games again.
Assuming, however, that CCPs get prices and models for each asset class going, they’ll then have to model the correlation between all the financial products being cleared. Perhaps the really frightening point here is that in order to decrease the overall quantum of counterparty risk in the ether, the ideal situation is to have one, single massive point of failure CCP. Hence the need to monitor (ever-changing) correlation, valuation and the resulting counterparty risk, etc.
At the other end of the CCPs though are the major over-the-counter derivatives dealers, of which there are relatively few already and as Das points out:
The heavy investment required to establish the infrastructure to clear trading platforms and contracts through the CCP will mean that a few large derivative dealers will quickly dominate the business. Other dealers will inevitably be forced to clear and settle trades through these dealers, creating counterparty credit risk, perversely increasing systemic and concentration risk.
Why are we moving towards clearing again?
A framework for clearing OTC derivatives will emerge, if only because finance ministers, central bankers, and regulators have invested too much political capital in the proposals. Whatever is implemented may be reminiscent of French philosopher Jean Paul Sartre’s words: “Once you hear the details of victory, it is hard to distinguish it from a defeat.”
FT Alphaville does not find this encouraging.
So clients are getting itchy feet, moving to banks that are perceived as less risky, the move to central clearing is lurching forward, in theory decreasing overall counterparty risk, but making the system far more concentrated, and the edifice depends on financial models accurately tracking the entire thing.
And don’t get us started on jump-to-default risk and how quickly a counterparty can collapse. We’re saving our AIG parallels for later.
Related links:
Counterparty risk back with a bang – IFR
Will a Central Counter Party Tame Derivatives Market Risks? – Naked Capitalism
Standard CSA: Industry’s solution to novation bottleneck gets nearer - Risk