Stress Tests and Credit Ratings: An Update

Regulating Derivatives : The Case for Incentives

Increased regulation of derivatives is coming. At least that was the consensus view of the participants at a recent breakfast discussion I attended “Regulating Derivatives in the Wake of the Financial Crisis”, hosted by FinReg21. The discussion was lead by former SEC Commissioner, Edward H. Fleischman who is currently the Chair of the International Securities Regulation Committee of the International Law Association, and Professor Stephen Figlewski, Professor of Finance at the NYU Stern School of Business and editor of the Journal of Derivatives. The participants included a representative cross cut of the legal and business communities involved in these instruments.

This isn’t a surprising conclusion given there are submitted bills and bills in formation in Congress and a Treasury plan on the table. Although there is overlap in the provisions of these competing plans there are some significant differences in several key provisions. In no particular order here goes my take on the key issues in this discussion.

1. Derivatives should only be used for hedging purposes. Translated that means derivative trading will end at least in this country. If only hedging is permitted then every hedger will be put in the difficult position of finding another hedger with the opposite exposure. Speculators serve a real economic purpose in providing liquidity and making markets more efficient. There are plenty of orderly, stable markets rife with speculators. Take the cash market for U.S. Government bonds, or futures for example, which gets me to point 2.
2. Most if not all derivatives should be exchange traded. This is one way of addressing the transparency issue. Exchange traded instruments are transparent and OTC derivatives for the most part are not. Therefore, requiring OTC derivatives to be exchange traded will make them transparent. Logical but impractical. The popularity of OTC derivatives is at least in part due to the market’s capacity to tailor instruments to reflect precise risk exposures. Tailored instruments do not succeed on exchanges because the number of participants interested in trading the same tailored exposure is likely to be quite small; certainly not enough to justify an exchange listing. Therefore some exclusion has to made for tailored derivatives; however implementing that exclusion is not so easy as will be discussed below.
3. Derivates should be cleared by a centralized facility (or facilities). This is a solid idea. Besides promoting transparency central clearing reduces counterparty risk assuming of course that the clearing agents are sufficiently well capitalized to actually guarantee the trades they settle. Confidence in the financial cushion provided by centralized clearing would benefit from having more than one agent; how many is optimal is a discussion for another time.
4. Derivatives should be standardized (at least as much as is practical). Standardization facilitates exchange trading, but since exchange trading is really not necessary for greater transparency and is not a realistic objective for the entire market, who cares. Standardization would also clearly facilitate central clearing and about this I do care. Although a non standard instrument could be centrally cleared it does not follow that all centrally cleared instruments could be non-standard. It would likely place too great a burden on the clearing agents.
5. Given that there is benefit to standardization how would it be implemented or enforced? Would teams of attorneys lay out in precise detail the terms and conditions of each standardized derivative? And even if they did how long would it take to re-engineer standardized derivatives and make them non-standard? Why you might ask would anyone favor non-standardized derivatives? See 6.
6. The answer is money. Opaque markets are more profitable than transparent markets, and therefore dealers will have a bias against transparency. Many recent innovations in fixed income markets are in part explainable as an ongoing march to create the next successful opaque, and highly profitable, market. OTC derivatives are a relatively recent manifestation of that motivation. There are OTC derivatives currently traded that appear to generate sufficient volume to support being exchange traded but there has been no groundswell of support from dealers to list them. Although I am not in favor of exchange trading requirements as discussed above centralized clearing, which I do favor, will also benefit from standardization. The question then is how to promote centralized clearing?
7. I prefer incentives to mandates. Capital requirements can be used to encourage market participants to favor clearing their derivative trades in a centralized facility. Make it more expensive to keep trades away from such facilities by specifying greater required capital for OTC derivatives that are not centrally cleared. Then dealers are incented to make their trades conform to standards required by a centralized clearing agent. Only when the cost of clearing is so great that it approaches the magnitude of the capital charge would a dealer be inclined to favor clearing direct rather than central clearing. That situation is likely to occur for those derivatives that must be tailored to work and are sufficiently different so that clearing is made complex. Further the cost of direct clearing would have to be significantly lower to compensate for the difference in capital requirements.
8. Centralized clearing is not my idea. It has floated through a number of proposals including the one authored by the administration. Academics and analysts have also gotten behind the idea. The hard part is how to set the differential capital requirements. Set them too high and the idea is a non-starter. Set them too low and there is no incentive to move to central clearing. Finding the Goldilocks levels for capital requirements is complex and possibly even intractable. Some regulatory authority cajoling in additional to capital requirements may be needed to ensure success. Regardless, the more we can rely on objective capital requirements that provide incentives to encourage centralized clearing for the vast majority of, if not all, derivatives so much the better.

Ben Wolkowitz Headstrong September 27, 2009

ISDA Mid-Year 2009 Market Survey Shows Credit Derivatives at $31.2 Trillion

Source :: http://www.isda.org/press/press091509.html

NEW YORK, Tuesday, September 15, 2009 – The International Swaps and Derivatives Association, Inc. (ISDA) today announced at its 2009 Regional Conference in New York the results of its Mid-Year 2009 Market Survey of privately negotiated derivatives.

“The derivatives business overall showed consistent growth in the first half of 2009, demonstrating the need for customized risk management solutions to help navigate the more uncertain economic landscape,” said Eraj Shirvani, Chairman, ISDA and Head of Fixed Income for EMEA at Credit Suisse. "This continued growth is a testament to both the utility of derivative instruments and to the industry's ongoing efforts to reduce risk and enhance operational efficiency."

"These survey results reflect the continued resiliency of the privately negotiated derivatives industry and its benefit to businesses globally," said Robert Pickel, Executive Director and Chief Executive Officer, ISDA. "The reduction in CDS outstanding highlights the great progress made through the industry's implementation of operational enhancements, in particular through its achievements in portfolio compression."

According to the Survey, notional amount outstanding of credit derivatives decreased by 19 percent in the first six months of the year to $31.2 trillion from $38.6 trillion. Over the preceding twelve months, credit derivative notional amounts decreased by 43 percent from $54.6 trillion at mid-year 2008. For the purposes of the Survey, credit derivatives comprise credit default swaps referencing single names, indexes, baskets, securitized obligations, and portfolios.

Notional amount outstanding of interest rate derivatives, which include interest rate swaps and options and cross-currency swaps, grew by 3 percent to $414.1 trillion from $403.1 trillion. This compares with a 13 percent decrease from $464.7 trillion during the second half of 2008. Over the preceding twelve months, interest rate derivatives decreased by 11 percent from $464.7 trillion in mid-2008.

Notional amount outstanding of equity derivatives, which consist of equity swaps, options, and forwards, remained relatively flat at $8.8 trillion. This compares with a 27 percent decreasefrom $11.8 trillion during the second half of 2008. The annual growth rate for equity derivatives to mid-2009 decreased by 26 percent to $8.8 trillion from $11.8 trillion at mid-year 2008.

The above notional amounts, which total $454.1 trillion across asset classes, are an approximate measure of derivatives activity, and reflect both new transactions and existing transactions. The amounts, however, are a measure of activity, not a measure of risk. The Bank for International Settlements (BIS) collects both notional amounts and market values in its derivatives statistics and it is possible to use the BIS statistics to determine the amount at risk in the ISDA survey results.

As of December 2008, gross mark-to-market value of all derivatives was approximately 5.7 percent of notional amount outstanding. In addition, net credit exposure (after netting but before collateral) is 0.8 percent of notional amount outstanding. Applying these percentages to the total ISDA Market Survey notional amount outstanding of $454.1 trillion as of June 30, 2009, gross credit exposure before netting is estimated to be $26.0 trillion and credit exposure after netting, but before collateral, is estimated to be $3.8 trillion.

The ISDA Mid-Year 2009 Market Survey reports notional amounts outstanding for the interest rate derivatives, credit default swaps, and over-the-counter equity derivatives as of June 30, 2009. All notional amounts have been adjusted for double counting of inter-dealer transactions. ISDA surveys its Primary Membership twice yearly on a confidential basis. In this survey, 86 firms provided data on interest rate swaps; 78 provided responses on credit derivatives; and 77 provided responses on equity derivatives. Although participation in the Survey is voluntary, all major derivatives houses provided responses.

^®ISDA is a registered trademark of the International Swaps and Derivatives Association, Inc.

Webinar : “Centralized Clearing of OTC Derivatives, How To Prepare for Coming Changes”

Please Join Headstrong and TowerGroup for a discussion on Centralized Clearing Of OTC derivatives.

Centralized clearing of OTC derivatives is one of the biggest change (and challenge!) the OTC derivatives industry has faced till date. It could potentially blur the line between these instruments and their listed counterparts. In this webinar we will debate the merits of centralized clearing, the unique IT & business challenges it poses, and probable solutions and approaches for business leaders.

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1. Trading & Business Strategy
2. Information Technology
3. Risk Management & Compliance

Please visit http://www.headstrong.com/webinar/invite-otc.html for more information.
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Centralized clearing of OTC derivatives

Not over-the-regulator anymore!

OTC derivatives are sighted by many as a primary player in the current credit crisis. Unlike listed derivatives that are backed by the credit worthiness of the clearing house, these bilateral contracts between counterparties have been a subject of debate for many years. Regulators argue the lack of transparency associated with these instruments makes it difficult to assess the systemic risk posed by them.

When the market for OTC derivatives was booming in 2007, there were few takers for what regulators, economists or risk managers had to say. But having witnessed one of the biggest risk management failures of our times, the financial industry’s focus has shifted dramatically to systemic risk management, regulatory oversight and sustainable exposures.

Why regulate OTC derivatives?

We agree with regulators that lack of transparency with OTC derivatives poses serious risk to the entire economy - a prime case in point being Lehman Brothers. Following the Lehman bankruptcy, close to US$400bn worth of credit default swaps (CDS) were presented for settlement. But once offsetting bilateral trades were netted, only US$6bn changed hand! These offsetting trades were invisible to the outside world. That's how 'connected' large financial firms are to each other. One shake, and a huge ripple effect is unleashed on the entire system. Another example is AIG. Without regulatory oversight, AIG accumulated a large exposure to OTC derivatives. It kept selling credit derivatives without setting aside commensurate capital, taking advantage of its AAA credit rating. Forget the systemic risk posed by such transactions, AIG discounted the impact of these uncovered trades on its own balance sheet (and had to pay for it!).

Besides credit and systemic risk, OTC derivatives present another concern for regulators. They believe valuation of these instruments - especially credit derivatives - is tricky. Each broker-dealer has its own proprietary valuation models. To some extent this is fair, given the subjective nature of these instruments. But with no active marketplace or exchange, traders find it difficult to get market data for valuation of similar contracts.

Centralized clearing of OTC derivatives

With the bankruptcies of Lehman and Bear Sterns behind them, and after injecting close to US$ 2.5 trillion as bailouts in the system, regulators and Congress are pushing for stringent rules and guidelines in the OTC derivatives market. Both SEC and CFTC have recently testified before Congress on regulation in OTC markets and have suggested centralized clearing for OTC derivatives. This is not a new idea - many private players offer centralized clearing of OTC derivatives today. But none of these ‘clearing houses’ are regulated the way exchanges are regulated. Notable examples are ICE Trust, CME, NYSE and Euronext (Bclear).

Congress is yet to finalize the eventual mechanism for centralized clearing of OTC derivatives. However, the three probable models are as follows:

• Trade Information Warehouse (TIW) e.g. DTCC Trade Information Warehouse
  
  Each trade involving OTC derivatives is reported to a central TIW or Trade Information Warehouse. This will assist in managing systemic risk as regulators can identify concentration with respect to instruments, industry, individual firms and so on.
  
  DTCC is pushing hard to get approval from Congress that will establish its trade repository as the single, nationwide TIW. Its Chairman & CEO recently spoke of the proposal at an event of United States Chamber of Commerce.

• Centralized Clearing Party (CCP)
  
  Two parties agree on a trade and then approach a centralized clearing party (CCP) for clearing the opposite positions of each trade. This ensures the freedom of customization associated with OTC derivatives is not compromised and yet credit risk is mitigated. In this model:
  - The CCP in turn reports all trades to a TIW
  - Each counterparty posts requisite margin with the CCP
  - The CCP performs mark-to-market activities and makes margin calls
  

• Exchange based model
  
  In this model, OTC derivatives are standardized to trade on an exchange. As the case with listed derivatives, the exchange will promote liquidity of the instruments. In fact, this model effectively erases the distinction between OTC and listed derivatives.
  
  As an example of how this would work, consider a customized CDS with a notional value of US$10M @ 200 bp (a non-standard rate). To ‘standardize’ this contract, it would be broken into two contracts; one with a notional value of US$ 7.5M @ 100bp (standard rate) and the second with a notional value of USD 2.5M @ 500bp (standard rate).
  
  Potential issues with this approach:
  - While simpler to achieve with vanilla derivatives, standardization of exotic derivatives and swaps will be difficult.
  - This is an expensive approach for infrequently traded instruments.
  

Of all these models, we believe the CCP model will find most favor with market participants. Mainly because it would ensure credit and systemic risk mitigation while maintaining the USP of OTC derivatives – namely, their flexibility and customizability. The TIW model will help keep a tab on large players accumulating unsustainable exposure levels but does little to mitigate credit risk . The exchange model provides all the benefits of the CCP model, but hampers innovation in high notional value exotic derivatives.

Arguments in favor of a CCP

Credit risk: With the introduction of a CCP or centralized clearing party, OTC derivatives would be virtually credit-risk free as each trade would be backed by the clearing house. Plus, each participant would post margins and daily mark-to-market would reduce credit risk in the event of default.

Systemic risk: CCP will prevent large players from accumulating unsustainable exposures by mandating margin and collateral requirements. Also, the clearing house will report each trade to a Trade Information Warehouse, which in turn will report large exposures taken by any single counterparty to regulators. With a larger view of the entire market, regulators will be in a position to manage systemic risk better. They could require firms with abnormal exposures to either liquidate a fraction of their positions or post extra collateral/ margin with the clearing house.

Valuation risk: Buy-side is already pushing for third-party, neutral valuation of OTC contracts before putting pen to paper. There are players like Markit who specialize in providing reference (pricing) data for OTC derivatives. There is thus a concerted effort by the industry to have some kind of standardization in valuation of OTC contracts. We believe an eventual CCP will tie up with leading market data providers to standardize the valuation process. It would not be surprising if the CCP itself offered valuation services or verification of price quoted by sell-side. Currently clearing houses reject trades if prices quoted are much higher than prevailing market rates (or rates derived from prevailing market data).

Operational Risk: CCPs will tackle operational risk on three fronts:

• Trade Booking: Front office operations (especially trade capture) in OTC derivatives are error-prone. A high percentage of errors or breaks are due to improper trade data and detail capture. Reasons include the highly subjective nature of trades and the use of manual spread sheets for booking trades. Additionally, there is no standard protocol for communication. The use of FpML has gained popularity but many firms still rely on proprietary standards for product definition. The opportunity cost of errors made by the front office is very high, as it impacts all subsequent processes in the workflow, including confirmations, mark-to-market and so on. The later an error is detected the higher the cost of resolutions. According to a survey by ISDA, more than 50% of errors occur in the front office and specifically during trade booking.
  
  We can expect some automation as well as standardization in the trade capture process, once a government-regulated CCP is introduced. The current private CCPs like ICE Trust already provide many value-added options and interfaces for brokers to enter trades e.g. file upload on FTP site or through a UI. Plus, FpML is likely to become the standard language for trade capture and communication between various entities.
  
  Standardization & automation will help firms on multiple fronts. It will reduce operational risk by reducing the number of errors. And it will reduce per-trade processing cost substantially.
  
  
• Confirmations: This has been an industry-wide problem. Even today, confirmation rates are close to 60%, no more. Most of the current private CCPs provide T+0 confirmations with a success rate of 90% - testimony to the CCP model. More and faster confirmations reduce the number of conflicts related to contract terms besides providing early identification of errors in trade capture.
  
  
• Collateralization: This will witness large scale reforms under the CCP regime. Currently counterparties post bilateral collaterals with each other. Collateral is netted only at the counterparty level. The level of automation is low, and there’s high usage of cash (up to 90%). With CCP as the central counterparty, each clearing member will have to post collateral with the clearing house only.

The crux is that besides a central counterparty for backing trades, the CCP model, by its very nature, catalyzes and enforces standardization of processes and operations, resulting in significant workflow ‘reforms’.

Arguments against the CCP model

Introduction of a CCP would change the face and body of the OTC world. Despite the benefits and cost advantages associated with a CCP, many market participants have raised serious doubts over its success. Some of these arguments include:

• All products won’t fit into the central clearing house model and rightly so. For instance, there is a shift towards exotic products because of decline in the margin of vanilla derivatives. A CCP would be hard-pressed to satisfactorily clear such products e.g how will it set the amount of collateral required?
• Clearing is good, but what about settlement of products that last over 30 years, like IR swaps? Settlement risk continues in such cases.
• Implementing a one-size-fits-all solution will not fit the bespoke nature of OTC transactions.
• With all the expectations from the CCP model, wouldn’t it be too much for a single entity to achieve, in too little time?
• Costs are bound to increase with transaction fees being charged by the CCP. The standardization of valuation and contracts will also reduce margins significantly. Would the reduced credit and systemic risk make up for this reduced return?
• And the biggest concern of all: the introduction of a CCP will in fact increase concentration risk. Although no exchange has ever defaulted in the history of trading, this fact does contribute to the same systemic risk the CCP was set up to reduce.

Conclusions
As things stand today, it is highly probable Congress will introduce a bill for centralized clearing of OTC derivatives, and more specifically credit derivatives. We also believe regulators will create an all-together new entity instead of appointing any of the existing private players like ICE Trust or CME as the CCP.

References
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aZchK__XUF84
http://www.nytimes.com/interactive/2009/02/04/business/20090205-bailout-totals-graphic.html
http://forums.silverseek.com/showthread.php?t=2216
http://www.adsatis.com/docs/isdareview/omg_credit_ccp_workshop_-_nyse.pdf
http://www.adsatis.com/docs/isdareview/omg_ccp_questions_cme_response.pdf
http://whitepapers.stern.nyu.edu/summaries/intro.html
http://www.isda.org/c_and_a/pdf/ISDA-Operations-Survey-2009.pdf
Risk is out, Safety is in: Central clearing of Credit derivatives, TowerGroup, Jan 2009
Managing OTC derivatives Risk, Building capabilities to tame the Giant, Celent, Sep 2008
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What are OTC derivatives?

A derivative is a financial product whose value is 'derived' from an underlying asset (hence the name). The underlying asset can be anything of value - stock of a company, an index like the S&P, or a commodity like gold, wheat or oil. Based on where they are traded, derivatives can be classified as OTC (Over the Counter) or Listed (trading on exchanges). OTC derivatives are private, tailor-made contracts between counterparties. Listed derivatives are more structured and comprise standardized contracts where the underlying assets, the quantities and the mode of settlement are defined by the exchange.

Since listed derivatives are backed by the full faith of the clearing house, they have been the 'traditional' instrument of choice for traders. But OTC derivatives are fast gaining in popularity. Being private contracts between two counterparties, OTC derivatives can be tailored and customized to suit exact risk and return needs. On the flip side, of course, lack of a clearing house or exchange results in increased credit or default risk associated with each OTC contract.

Presented below is a broad classification of different types of OTC contracts, based on the underlying asset or commodity that drives the value of the instrument.

• Interest rate derivatives: The underlying asset is a standard interest rate e.g. the London Interbank offer rate, or the rate on US treasury bills. Examples of interest rate OTC derivatives include Swaps, Swaptions, and FRAs.
  
• Credit derivatives: The underlying is the credit quality, risk or credit event of a particular asset or counterparty. One example is Credit Default Swaps (CDS) on fixed-income securities, which make payments if the underlying bonds are downgraded by credit rating agencies or if the company that issued the bonds defaults.
  
• Commodity derivatives: The underlying are physical commodities like wheat or gold. Examples are forwards.
  
• Equity derivatives: The underlying are equities or an equity index. Examples: Equity swaps or forwards
  
• FX derivatives: The underlying is foreign exchange fluctuations.
  
• Fixed Income: The underlying are fixed income products - including mortgages

Vinod Jain

Vinod Jain is a Business Specialist in the Derivatives Domain Consulting Group at Headstrong. He specializes in business process, change management and IT consulting for middle office and back office derivatives processing. He has worked extensively with buy side and sell side firms in Europe and US. He has done consulting for Bank of America Merrill Lynch, Credit Suisse, New York Stock Exchange, Bank of New York Mellon etc. He analysis the industry trends and events through research and thought papers.