David at Deus Ex Macchiato = disturbed:
I went to a conference yesterday which started very well, but ended up about as scary as Romney’s economic policy. Why? Because a regulator from a minor European country (but who nevertheless is apparently influential at ESMA) suggested that it was official policy to substantially reduce the size of the OTC markets in general, and the inter-dealer market in particular.
Before the crisis, it wasn’t too hard for a corporate client to trade over-the-counter derivatives. They just had to find a bank willing to sign them up, agree some documentation, and they were good to go. For most corporates, banks were eager to help, so the client could probably find someone willing to meet their needs both in terms of what they want to trade and how they wanted to trade it.
If they didn’t want to post collateral, then that was fine. Certain trading arrangements had a cost, sure, but derivatives sales people are known for being accommodating (especially given that they get paid based on the deals that they close). No collateral? No problem, sir! Read more
The Basel III capital rules for credit valuation adjustments (CVA) create new, large capital requirements for over-the-counter derivatives trading with counterparties who don’t post daily cash collateral. Yesterday we saw how these rules were inspired by CVA losses on credit protection written by monolines like MBIA and Ambac. Today we’ll examine the unintended consequences of the new rules.
First we have to get a bit technical about how the CVA capital charges work. Sophisticated banks will be required to put their CVAs and eligible hedges into a value-at-risk (VaR) model. That model will use historical credit spread movements to estimate possible losses for the current CVA and its hedges. The capital charge is based on the one-in-a-hundred loss. Read more
Yesterday we saw how bank credit risk management imposed credit valuation adjustments (CVA) on over-the-counter derivatives trading to charge for the credit risk being taken. CVA is biggest where the counterparty does not post collateral, is not a good credit, and owes a lot of money under the derivative contract in question.
Act 1 Read more
In the first post of his series for FT Alphaville, Deux Ex Macchiato writer David Murphy introduces us to credit valuation adjustments (CVA) by providing some historical perspective. More on David and his background beneath the post.
Whenever you are promised cash in the future by someone who might not pay you back, you have credit risk. In derivatives trading, situations often arise where someone might owe you money in the future, perhaps because you have purchased an option from them, or because a coupon on a swap goes your way rather than theirs. This means that derivatives trading often includes taking some credit risk, along with the more obvious market risks. Read more
The story so far:
In Part 1, we reminded you of Morgan Stanley’s footnote in their fourth quarter earnings, whereby the bank stated that it had reduced its exposure to Italy by $3.4bn while benefiting from a positive hit to net revenue of $600m. All of this was as a result of restructuring certain derivatives transactions with the sovereign. Read more
As part of the Dodd-Frank Act, various types of participants in derivatives markets need to be defined. According to the jersey one ultimately gets as a trader of interest rate swaps, credit default swaps and so on, different regulations may apply.
(Where “security-based”, regulator equals SEC, otherwise CFTC.) Read more
Companies will be able to sell up to twenty times more derivatives than originally planned before they are counted as swap dealers by regulators, the FT says. In the original regulations, firms had only been allowed $100m before hitting the rules’ threshold, but this amount is now likely to be $2bn. While the amount could change further ahead of a key CFTC vote on the rules, energy and commodities firms have fought against being swept into the definition, which carries tough requirements on dealers’ capital and disclosures. Read more
Take a moment to imagine what it must be like to be an American regulator. There are plenty to imagine being: the OCC, the Fed, the CFTC, SEC, FDIC, and that thrift one, until it subsumed into the OCC. Got one?
Law firm Clifford Chance must be tired of fielding questions about what would happen to derivatives contracts should one’s eurozone counterparty exit the single-currency. So much so that they’ve put a document together covering 20 of what we imagine have been the most frequently asked questions.
FT Alphaville has waded through the legal mists, guided by Clifford Chance, to give you a bit more
pedantic detail than “it depends”. Read more
US financial regulators have raised the idea of extending investor safeguards proposed for certain derivatives to the futures markets as they probe missing customer funds at bankrupt broker MF Global. Investors in cleared swaps are set to receive stronger protection than futures traders in a vote by the CFTC on Wednesday, reports the FT, but two commissioners on the five-member body are now questioning the fairness of that approach and are opening the debate as to whether the same rules should apply to both swaps and futures, a move likely to provoke a backlash from the industry. Jill Sommers, a Republican and Bart Chilton, a Democratic commissioner, both told the newspaper they believed the regulator should consider whether futures customers should not receive the same protection as swaps users. Meanwhile, the WSJ reports that Jon Corzine, the former chief executive of MF Global, is looking for office space in New York City. Citing a person familiar with the situation, Mr Corzine is said to be interested in viewing the offices of John Carris Investments; reportedly for a space, not for a job. Read more
US financial regulators have raised the idea of extending investor safeguards proposed for certain derivatives to the futures markets as they probe missing customer funds at bankrupt broker MF Global. Investors in cleared swaps are set to receive stronger protection than futures traders in a vote by the CFTC on Wednesday, reports the FT, but two commissioners on the five-member body are now questioning the fairness of that approach and are opening the debate as to whether the same rules should apply to both swaps and futures, a move likely to provoke a backlash from the industry. Jill Sommers, a Republican and Bart Chilton, a Democratic commissioner, both told the newspaper they believed the regulator should consider whether futures customers should not receive the same protection as swaps users. Read more
Before the break, FT Alphaville took a look at abstraction and morality in modern finance. This prompted some rather interesting discussion, among which this post from Interfluidity:
Finance has always been complex. More precisely it has always been opaque, and complexity is a means of rationalizing opacity in societies that pretend to transparency. Opacity is absolutely essential to modern finance. It is a feature not a bug until we radically change the way we mobilize economic risk-bearing. The core purpose of status quo finance is to coax people into accepting risks that they would not, if fully informed, consent to bear. Read more
In Part one, FT Alphaville asked whether there was reason to doubt the netted derivatives exposures reported by banks. Here, we discuss how netting works (or doesn’t, ahem) when counterparties collapse.
Valuing swaps when the world is crumbling Read more
On Friday, Jeffrey Snider of Atlantic Capital Management argued that finance now exists for its own exclusive benefit. The thrust of his argument is that derivatives have allowed banks to escape the bounds of actual cash assets and the real economy.
He introduced his argument by dissecting Bank of America’s derivatives disclosure, pointing out the distance between the net derivative asset that is reported ($79bn) and the market value of said asset before netting ($2,172bn). From there he goes on to marvel at the size of the derivatives market, and question whether there’s any good reason for it to be so big. Conclusion being as above: it’s so big that the link to the real economy is more or less gone. Read more
Goldman Sachs has lost more than a dozen traders in North American bonds and derivatives as it switches from proprietary trading to client sales, Reuters says. The departures include Brian Mooney, a veteran interest rates derivative trader who has left for Merrill Lynch. Junior traders have also left for other investment banks and to hedge funds, seeing Goldman as becoming less prestigious. While the ‘Volcker rule’ under the Dodd-Frank Act allows prop trading in Treasuries and the interest rate swaps market in order to hedge positions, traders said they felt limited by risk managers. Read more
That’s a big deal for the structured finance world, though you might not know it. Read more
Attention over-the-counter (OTC) energy traders who think there’s no prominent high frequency trading (HFT) presence in their section of the market.
A Tabb Group research piece on how HFT practices are likely to creep into credit default and interest rate swaps once the market becomes centrally cleared, automated and standardised has made a striking discovery over the course of its data gathering. Read more
Just to be totally clear we’re talking plain vanilla derivatives like, say, interest rate swaps a bank might arrange on behalf of a company. But it seems they’ve taken on a more exotic flavour, of late.
From the clever Chris Whittall over at IFR: Read more
Pimco’s Total Return Fund upped its stake in non-US debt in May, holding 10 per cent of its $234bn in the assets versus six per cent in April, Reuters reports. The fund also maintained a negative nine per cent position in a new category of “liquid rates”, including US dollar interest rate swaps and other derivatives. Bill Gross’ now notorious ‘Treasury short’ is really a short swaps position, a source told Reuters last week. The revised data reflect that Pimco continued to hold US government debt in May, Bloomberg reports, following criticism of Pimco’s transparency, the WSJ says. Read more
Greece’s currency swaps with Goldman Sachs may have slipped your memory.
Luckily Eurostat, in a just-published review of its methodological visits to Greece in 2010, has a quick reminder. More importantly, it’s kind of the European statistic agency’s final word on the matter: Read more
Olivier Jakob, at Petromatrix (who we know we quote a lot, but only because he really does constantly come up with interesting points) alerts us to the fact that from Monday onwards investors will be able to trade euro-denominated contracts on certain Nymex energy products.
As he points out: Read more
For the commute home, where no-one criticises your fiscal policies,
- More on Goldman’s bearish commodities turn. Read more
Deutsche Bank suffered a blow on Tuesday when Germany’s top civil court ruled that the bank was in breach of its duties when it sold a complex interest rate product to a corporate client, reports the FT. Germany’s largest bank by assets will have to pay €541,000 ($770,000) in damages after the judgment, which could set a precedent for similar claims against the bank. Deutsche was sued by Ille Papier, a maker of hygiene products, which bought a “spread ladder swap” from the bank in 2005. The verdict from German’s federal court of justice is the first in a series of cases against Deutsche and other banks from clients who bought similar products. The WSJ says while the full implications of the verdict won’t be clear until the court publishes its opinion in coming weeks, the ruling will ripple across Germany’s banking sector and could force banks to divulge more information about their products. Read more
FT Alphaville has already cautioned about the chaotic effects the Japanese crisis is having on variance swaps. But here’s another potential (derivatives) spillover.
It’s the effect on “Power Reverse Dual Currency Notes” also known as PRDCs. Read more
US banks are urging regulators writing new rules for the derivatives markets under 2010’s Dodd-Frank Act to keep their hands off the banks’ swaps businesses in London and other overseas financial centres, the FT reports. The lobbying efforts highlight the fact that regulations are being written at different speeds in different countries, allowing for “regulatory arbitrage”, which officials have sought to stamp out. Read more
Get the little flags at the ready: on Tuesday JP Morgan Cazenove published the final installment of its trio of reports on regulatory arbitrage.
It is stirring patriotic sentiment up on Capitol Hill, with some lawmakers worried that the US’s comparative advantage will be blunted, according to Politico. Read more
US regulators will miss a July deadline set by Dodd-Frank legislation for some of the rules on newly policed swaps markets, the head of the main derivatives regulator has said. Gary Gensler, chairman of the Commodity Futures Trading Commission, said the regulator was still working towards the deadline, the FT reports. Bloomberg adds that Gensler also told the House Agriculture Committee that the CFTC doesn’t have the budget to enforce new derivatives regulations required under the Dodd-Frank Act. Read more