Talk:Derivatives

From Riski

Revision as of 20:05, 12 October 2009 by Cate Long (Talk | contribs)
(diff) ←Older revision | Current revision (diff) | Newer revision→ (diff)
Jump to: navigation, search

"Since the late-90s, I’ve emphasized in my academic writing the importance of accurate price information in making clearing efficient-or even possible. It is therefore encouraging to see this article in the FT make the same point. It is important to note, though, that although this is an important part of the story, it is not the whole story.

First, good pricing information is a necessary, but not sufficient, condition for clearing to be the most efficient way of organizing a trading market.

To set the right margins and give the right incentives, a central counterparty (”CCP”) not only has to have a good snapshot of the value of an instrument at an instant in time, it has to understand the risks of that instrument. It also has to understand the balance sheet risks of the firms that trade it. It has to understand the interaction between the price and balance sheet risks. Many times, dealers are going to have better information on all of these things, and hence are going to price counterparty risk more accurately. Moreover, CCPs usually have to choose a one-size-fits-all margin, which is problematic when member firms are heterogeneous (as is the case today). In contrast, dealers can price default risk in a discriminating way.

In this regard, it is interesting to note that both the CBOT and the LME resisted adopting clearing for years (adopting it in the end only under intense regulatory pressure) despite the fact that each operated a highly liquid and transparent centralized market. Obviously, price transparency was not the obstacle to clearing in these instances - other factors were also relevant.

Second, although clearinghouses are repeatedly touted as producers of information, they are also consumers of information. True, they can improve transparency about positions and some risks. But to work effectively, they need information on prices that is generated by the actions of other market participants. The ICE tradeable quote mechanism the article mentions is one way of generating this information, but it is necessarily the case that instruments that are traded more frequently in more liquid markets can be valued more precisely than those that trade infrequently. By centralizing price information, a CCP arguably has access to the best information on value. But if there is little information to centralize because trading activity is infrequent, the CCP must operate in the dark.

These considerations direct attention to another issue. Legislators and regulators are moving towards forcing “standardized” derivatives to be cleared, but are stumbling over the definition of “standardized.” The focus on what contractual features constitute a standardized product is a red herring. What is important in determining the costs and benefits of clearing a particular instrument are its price behavior, the riskiness of the firms that trade it, the liquidity of the markets on which it trades, and crucially, information about these factors. These things are inherently heterogeneous; the contractual terms of two instruments (e.g., CDS on two different names) may be very similar, but the relevant economic considerations that determine their suitability for clearing may be quite different indeed.

In sum, the FT is to be praised for focusing attention on the importance of informational considerations in determining the feasibility of clearing. Price information is crucial, but other information is vital as well. Hopefully this article represents the beginning of a trend to move beyond the rah-rah that has surrounded clearing in the aftermath of the financial crisis, and to cast a more critical and discerning eye on the information CCPs need to do their job efficiently."

Craig Pirrong is Professor of Finance, and Director of the Global Energy Management Institute at the Bauer College of Business, University of Houston. He blogs at the Streetwise Professor.

  • Grodzki Says `Game May Be Over' in Credit-Default Swaps The Head of Credit at Legal and General Investment Management, Georg Grodzki, comments on the Department of Justice probe into Markit and the change of dealer behavior in the CDS markets (Bloomberg News, running time 3:30

Historically, the trading of sovereign CDS was limited to emerging markets, reflecting the credit risk associated with the government debt of these countries. However, an actively traded CDS market in industrialised sovereigns has now emerged as a result of the financial crisis and growing investor concerns relating to the solvency of developed economies.

The Markit iTraxx SovX family of indices has been designed to meet investor demand for a transparent and standardised tool to monitor the sovereign CDS market and gain access to the asset class on both a regional and global basis. The creation of this alternative investment tool is expected to bring more investor demand for sovereign credit.

NEW YORK (Reuters) - Following the Obama administration's plan for regulating over-the-counter derivatives, the head of the world's largest derivatives exchange said on Monday he wants the freedom to decline clearing some illiquid contracts.

CME Group Inc (CME.O), which operates the CME Globex electronic trading platform and the Chicago Mercantile Exchange, is positioned to benefit as the U.S. government proposes to mandate all "standardized" OTC derivatives be cleared through central counterparties to avoid a repetition of the bank runs that contributed to the failures of Bear Stearns and Lehman Brothers.

Trading in OTC derivatives, instruments that derive their value from other assets, exploded in size in recent years, with many large firms -- such as insurer American International Group -- charging into the market.

"We have to be careful to manage the risk profile of what we clear and there will be a range of things that we would not be comfortable clearing," CME's chief executive, Craig Donohue, told Reuters. "The devil is in the details."

  • Soros on CDS

Credit default swaps are "instruments of destruction" that should be outlawed, billionaire investor George Soros said on Friday. Soros said the asymmetry of risk and reward embedded in CDS exerted so much downward pressure on the bonds underlying the contracts that companies and financial institutions could be brought to their knees.

  • SR-FINRA-2009-012

34-59955 "Notice of Filing and Order Granting Accelerated Approval of Proposed Rule Change, as Modified by Amendment No. 1, to Implement an Interim Pilot Program with Respect to Margin Requirements for Certain Transactions in Credit Default Swaps, May 22, 2009 Comments due: June 18, 2009 Submit comments on SR-FINRA-2009-012


"Survey of the OTC Derivatives Market in Australia


Moved from main page for rearranging:


Criticisms

Derivatives are often subject to the following criticisms:

Possible large losses

The use of derivatives can result in large losses due to the use of leverage, or borrowing. Derivatives allow investors to earn large returns from small movements in the underlying asset's price. However, investors could lose large amounts if the price of the underlying moves against them significantly. There have been several instances of massive losses in derivative markets, such as:

  • The need to recapitalize insurer American International Group (AIG) with $85 billion of debt provided by the US federal government[1]. An AIG subsidiary had lost more than $18 billion over the preceding three quarters on Credit Default Swaps (CDS) it had written.[2] It was reported that the recapitalization was necessary because further losses were foreseeable over the next few quarters.
  • The loss of $7.2 Billion by Société Générale in January 2008 through mis-use of futures contracts.
  • The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long natural gas in September 2006 when the price plummeted.
  • The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998.
  • The bankruptcy of Orange County, CA in 1994, the largest municipal bankruptcy in U.S. history. On December 6, 1994, Orange County declared Chapter 9 bankruptcy, from which it emerged in June 1995. The county lost about $1.6 billion through derivatives trading. Orange County was neither bankrupt nor insolvent at the time; however, because of the strategy the county employed it was unable to generate the cash flows needed to maintain services. Orange County is a good example of what happens when derivatives are used incorrectly and positions liquidated in an unplanned manner; had they not liquidated they would not have lost any money as their positions rebounded.Template:Fact Potentially problematic use of interest-rate derivatives by US municipalities has continued in recent years. See, for example:[3]
  • The Nick Leeson affair in 1994

Counter-party risk

Derivatives (especially swaps) expose investors to counter-party risk.

For example, suppose a person wanting a fixed interest rate loan for his business, but finding that banks only offer variable rates, swaps payments with another business who wants a variable rate, synthetically creating a fixed rate for the person. However if the second business goes bankrupt, it can't pay its variable rate and so the first business will lose its fixed rate and will be paying a variable rate again. If interest rates have increased, it is possible that the first business may be adversely affected, because it may not be prepared to pay the higher variable rate.

Different types of derivatives have different levels of risk for this effect. For example, standardized stock options by law require the party at risk to have a certain amount deposited with the exchange, showing that they can pay for any losses; Banks who help businesses swap variable for fixed rates on loans may do credit checks on both parties. However in private agreements between two companies, for example, there may not be benchmarks for performing due diligence and risk analysis.

Unsuitably high risk for small/inexperienced investors

Derivatives pose unsuitably high amounts of risk for small or inexperienced investors. Because derivatives offer the possibility of large rewards, they offer an attraction even to individual investors. However, speculation in derivatives often assumes a great deal of risk, requiring commensurate experience and market knowledge, especially for the small investor, a reason why some financial planners advise against the use of these instruments. Derivatives are complex instruments devised as a form of insurance, to transfer risk among parties based on their willingness to assume additional risk, or hedge against it.

Large notional value

  • Derivatives typically have a large notional value. As such, there is the danger that their use could result in losses that the investor would be unable to compensate for. The possibility that this could lead to a chain reaction ensuing in an economic crisis, has been pointed out by famed investor Warren Buffett in Berkshire Hathaway's annual report. Buffett called them 'financial weapons of mass destruction.' The problem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets. Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes a leading indicator.

(See Berkshire Hathaway Annual Report for 2002)

Leverage of an economy's debt

Derivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real economy to service its debt obligations and curtailing real economic activity, which can cause a recession or even depression.[4] In the view of Marriner S. Eccles, U.S. Federal Reserve Chairman from November, 1934 to February, 1948, too high a level of debt was one of the primary causes of the 1920s-30s Great Depression. (See Berkshire Hathaway Annual Report for 2002)

Benefits

Nevertheless, the use of derivatives also has its benefits:

  • Derivatives facilitate the buying and selling of risk, and many people consider this to have a positive impact on the economic system. Although someone loses money while someone else gains money with a derivative, under normal circumstances, trading in derivatives should not adversely affect the economic system because it is not zero sum in utility.
  • Former Federal Reserve Board chairman Alan Greenspan commented in 2003 that he believed that the use of derivatives has softened the impact of the economic downturn at the beginning of the 21st century.Template:Fact

Treasury plan for derivatives

The US Treasury plan for regulating OTC derivatives

  • -- Mandatory clearing of OTC derivatives through CCP
  • -- Highly standardized products would move to exchanges
  • -- All OTC participants subject to "robust" prudential regulation and supervision
  • -- Requires OTC derivatives be cleared if a CCP accepts for clearing


The next theme that the proposal addresses concerns the supervision of all OTC derivatives dealers and others whose activities in those markets create large exposures to counterparties. It is recommended that these entities be subject to "a robust regime of prudential supervision and regulation."

Specifically, Treasury recommended more conservative regulatory capital requirements on OTC derivatives (which would be more stringent than existing bank regulatory capital requirements for OTC derivatives), business conduct standards, reporting requirements, and conservative rules for initial margin against counterparty credit exposure. It does not appear that parties will need to be regulated financial institutions to trade in derivatives as long as they are subject to the reporting, margin and business conduct standards to be put in place.

As part of the overall Treasury proposal, the U.S. Federal Reserve Board (the Fed) would be given supervisory and regulatory oversight of any firm whose failure could pose a threat to financial stability due to its combination of size, leverage and interconnectedness (referred to in the proposal as a "Tier 1 FHC"), regardless of whether such firm owns an insured depository institution. Through its expanded powers, the Fed would be able to impose these new capital and regulatory requirements on all Tier 1 FHCs engaged in derivatives activities.

As mentioned above, it remains unclear how standardized trades will be distinguished from those that are customized. The practical implications of this distinction include whether a trade is subject to mandatory margin.

The recommendation that CCPs be expected to impose robust margin requirements, and the effort to ensure that customized OTC derivatives not become a means of avoiding the use of CCPs, suggests that the conservative margin requirements being proposed will be imposed on customized OTC derivatives in this regulatory regime on a comparable basis to the margin rules of CCPs.

Certainly, any difference would create an arbitrage opportunity that legislators likely would seek to avoid. On the other hand, imposing margin requirements eliminates an important facet of having a so-called customized trade. Again, it remains to be seen whether variations in margin standards would be permitted and under what circumstances.

At this juncture, the extent to which margin requirements and capital requirements will overlap has not been specified. It seems that perceived derivatives risk exposure will be addressed in the case of Tier I FHCs and other regulated financial institutions through more conservative regulatory capital requirements, but not necessarily to the exclusion of margin rules. The question lingers whether OTC derivatives participants that do not fall into the category of Tier 1 FHCs and are not otherwise regulated financial institutions, assuming they will still be allowed to directly enter into derivatives transactions, will be subjected to stricter margin requirements given that they may not otherwise be required to set aside capital for their derivatives trading activities.


Again consistent with Secretary Geithner's May 13 letter, the financial system reform framework reiterates the recommendation that the CEA and the securities laws be amended to authorize the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) to impose recordkeeping and reporting requirements on all OTC derivatives. It is the view of the Treasury Department that such requirements will make OTC derivative markets more transparent and efficient. Some such requirements would be deemed to be satisfied either by clearing on a CCP or reporting transactions to a regulated trade repository. Then, the CCPs and trade repositories would be required to make aggregate data on open positions and trading volumes available to the public and make party-specific data available on a confidential basis to the CFTC, SEC, and the institution's primary regulators. It seems that Treasury is committedto a system to ensure dissemination of prices and other trade information to the market. The extent to which parties will be allowed to compete in derivatives markets in the future on the basis of price and whether the same level of price transparency will be required for customized trades are still open questions.

Manipulation issues

Finally, as in Secretary Geithner's May 13 letter, the OTC derivatives proposals in the financial system overhaul outline recommend that legislators amend the CEA and securities laws in any way necessary to ensure that the CFTC and the SEC have "clear, unimpeded authority" with respect to policing market abuses involving OTC derivatives and that the CFTC has authority to set position limits on OTC derivatives that "perform or affect a significant price discovery function with respect to regulated markets." This point still does not contain specifics; instead, legislators may make this authority broad and apparently unfettered. It is no clearer now than it was in May how derivatives that "perform or affect a significant price discovery function with respect to regulated markets" will be identified and correlated with the regulated markets to which they are purportedly related. The assumed means to the goal of preventing market abuses was that information provided to regulators (whether on a voluntary or mandatory basis) by the combination of CCPs, trade repositories and market participants would create the picture needed to establish such correlations. The gap in how the various products will be categorized and what will distinguish trades that are voluntarily reported versus those that are reported by mandate remains.

New developments in the regulatory environment

First, as derivatives practitioners well know, current law limits the types of parties that may participate in unregulated derivatives. Treasury's view is that the limits are not sufficiently stringent. In this regard, the CFTC and SEC are reviewing the current participation limits to recommend how to amend existing laws to tighten those limits or to impose additional disclosure requirements or standards of care with respect to marketing derivatives to less sophisticated counterparties such as small municipalities. This objective is interesting because, while the press has focused somewhat on smaller OTC derivatives market participants, neither Mr. Geithner's prior statement nor any of the current Congressional bills have honed in on issues relating to "unsophisticated" market participants. Little detail has been provided as to additional indicia, beyond current requirements, of sophistication for this market.

Another issue that remains unresolved is regulatory turf. As many participants in the derivatives markets are painfully aware, the present U.S. regulatory regime with respect to derivatives is mind-numbingly complex. Part of this complexity is due to the sometimes confusing and overlapping authority of the SEC and CFTC. As noted in the proposal:

[o]ne result of this jurisdictional overlap has been that economically equivalent instruments may be regulated by two agencies operating under different and sometimes conflicting regulatory philosophies and statutes .... In many instances the result of these overlapping yet different regulatory authorities has been numerous and protracted legal disputes about whether particular products should be regulated as futures or securities.

Therefore, one of the stated goals in the proposal is the elimination of these jurisdictional uncertainties and the assurance that economically equivalent instruments be regulated in the same manner regardless of whether it is the SEC or CFTC that has jurisdiction over the instrument or market.

Treasury is recommending that the CFTC and the SEC complete a report to Congress identifying all existing conflicts in statutes and regulations regarding similar types of financial instruments. This report would be due by the end of September and would need to explain why the current differences are necessary for investor protection, market integrity and price transparency, or make suggested changes to eliminate the differences. Moreover, if the two agencies cannot agree on the explanations and recommendations by the deadline, Treasury has proposed that unresolved issues be referred to a new Financial Services Oversight Council, which would then be required to resolve the disagreements and provide Congress with its recommendations within six months of that council's formation.

This is an important new development because, until now, it was uncertain whether the political appetite existed to address head-on the turf battles that have existed for years between the CFTC and the SEC. For some time, there had been discussions of merging the CFTC and the SEC, and early in the year there was much speculation in this regard. The Congressional bills that have been introduced thus far and Secretary Geithner's May letter recommended an increasingly intertwined role for both those regulatory bodies in virtually every function described. Conspicuously absent from Mr. Geithner's original proposal was any suggestion that the two regulatory bodies be combined.

When news spread that the Obama Administration had abandoned the merger idea in apparent recognition that such an effort would significantly delay work on the substance of reforms aimed at the financial system, derivatives market participants were left with the old problem of trying to determine which regulatory body would regulate any particular derivative and whether or not certain derivatives are commodities, securities, both or neither. The prospect of old power struggles among Congressional leaders with committee oversight of various financial products loomed large, only to be complicated as products such as carbon emissions derivatives are introduced into the U.S. market. In the May outline, the Treasury Secretary stopped short of suggesting that U.S. securities and commodities laws be amended to redefine derivatives as either securities or commodities. Doing so would have given the SEC and CFTC the most explicit means of regulating derivatives transactions. With this in mind, the new directive that the two agencies identify and resolve conflicts is a very important recognition of the need to harmonize, once and for all, conflicting and overlapping regulations.

Key points for the OTC derivatives market

Notwithstanding the harmonization of CFTC and SEC authority, a critical problem remains — that is, the regulatory arbitrage that will be created by a U.S. regulatory regime that is different from that continuing or established in other jurisdictions. A recognition of the fact that much of the derivatives market is truly global and fungible seems to be lacking from the policymaking agenda. Because of this, the market's own efforts to reach the public policy goals that have been outlined by the Treasury Department and the various Congressional bills may stand the greatest chance of achieving desired reforms while preserving OTC derivative markets in the United States.

On June 2, ISDA, through the ISDA Board Oversight Committee, the Managed Funds Association, the Operations Management Group (OMG), and the Asset Management Group of the Securities Industry and Financial Markets Association submitted to the President of the Federal Reserve Bank of New York (the New York Fed) a letter outlining the commitments of market participants to significantly reduce systemic risk and increase transparency. The letter noted the industry's goal of fairly balancing interests of dealers and customers and is in line with the goals expressed by Secretary Geithner earlier in the year. With respect to credit derivatives, the letter committed participants to continuing to strengthen settlement and recounted the milestones met in relation to auction hardwiring and CDS clearing. As for equity products, participants set deadlines for implementation of centralized reporting of July 31, 2010, and for T+4 matching of 95 percent of electronically eligible transactions between OMG members by September 30, 2009. The industry indicated that it would seek to expand the number of interest-rate products eligible to be centrally cleared and implement a centralized reporting infrastructure for standardized products by year-end. Finally, market participants stated that they would identify and pursue additional advances in collateral management and complete a market-wide proposal for margin dispute resolution by September of this year. While meaningful measures in their own right, these commitments also demonstrate the considerable inherent technical issues and complexities of making various OTC derivative products "electronic eligible" so as to facilitate the desired netting/settlement and reporting benefits.


Source: Mayer Brown

Retrieved from "http://freerisk.org/wiki/index.php/Talk:Derivatives"