Friday, May 29, 2009

DTCC seeks US oversight of ‘trade warehouse’

Posted in the Financial Times by Jeremy Grant:

The Depository Trust & Clearing Corporation, the US clearing and settlement system, on Thursday said it had applied to bring its “trade warehouse”, which stores information on credit derivatives trades, under the oversight of US federal regulators for the first time.

The move is another sign of how the post-trade businesses that underpin much securities and derivatives trading are responding to demands by US authorities to increase transparency and accountability in the wake of the financial crisis.

This week LCH.Clearnet, Europe’s largest clearing house, said it would extend its over-the-counter derivatives clearing services to asset managers, pension funds and hedge funds. It was seen as one of the earliest responses to demands from the Obama administration to ensure that more OTC derivatives were processed through clearing houses, which ensure that trades are completed if one party to a trade defaults.

The DTCC’s trade warehouse acts as a central repository, or registry, for trades that are negotiated in the OTC, or privately negotiated, derivatives markets.

As part of a sweeping plan for tighter supervision of such markets Tim Geithner, US Treasury secretary, two weeks ago said the Obama administration would ask Congress to amend legislation to require that OTC trades be “reported to a regulated trade repository”.

Such trade repositories should “make data on individual counterparty’s trades and positions available to federal regulators”.

The DTCC’s trade warehouse is not regulated.

Peter Axilrod, head of the derivatives processing business at DTCC, said the post-trade group had decided to apply for the warehouse to become a “limited purpose trust company” that would be regulated by the US Federal Reserve and New York state banking department.

He said it would be easier for regulators to work on global regulatory collaboration on transparency and post-trade issues if the infrastructures involved in storing information on derivatives trades were regulated.

“All of the signs we are getting from regulators are that the warehouse is such an important part of the infrastructure for CDS that it should be regulated. So we thought we should take the initiative,” Mr Axilrod told the Financial Times.

The idea was to avoid a “long process that might involve legislative changes [in Congress]”.

Mr Axilrod said: “It [the warehouse] will now be a key part of the credit derivatives infrastructure globally and becomes concrete enough for regulators to include in their discussions about what a collaborative framework might look like for the credit derivatives market.”

The new trust company would also establish a subsidiary in Europe to “facilitate the offering of regulated warehouse services in Europe”. The European Commission has said it wants to see the establishment of a trade warehouse for CDS, similar to the one in the US.

Thursday, May 28, 2009

The Risk of Tranches Created from Residential Mortgages

Posted on by John Hull and Alan White:

Abstract: This paper examines the risk in the tranches of ABSs and ABS CDOs that were created from residential mortgages between 2000 and 2007. Using the criteria of the rating agencies, it tests how wide the AAA tranches can be under different assumptions about the correlation model and recovery rates. It concludes that the AAA ratings assigned to the senior tranches of ABSs were not unreasonable. However, the AAA ratings assigned to tranches of Mezz ABS CDOs cannot be justified. The risk of a Mezz ABS CDO tranche depends critically on the correlation between mortgage pools as well as on the correlation model and the thickness of the underlying BBB tranches. The BBB tranches of ABSs cannot be considered equivalent to BBB bonds for the purposes of subsequent securitizations.

Download paper (259K PDF) 25 pages

Tuesday, May 26, 2009

U.S. Financial Regulations Need Overhaul, Panel Says

Posted on Bloomberg by Ian Katz:

U.S. financial regulations must be “entirely reorganized” by merging agencies such as the Securities and Exchange Commission and the Commodity Futures Trading Commission, adding to the Federal Reserve’s powers and setting rules for derivatives, an industry group said.

The Committee on Capital Markets Regulation urged creating a Financial Services Authority to replace separate banking, securities and commodities regulators. The panel’s 57 recommendations also include raising capital rules for big banks to cut systemic risk and bringing hedge funds and credit-default swaps under regulatory oversight.

“Our regulatory structure must be entirely reorganized in order to become more integrated and efficient,” the group led by R. Glenn Hubbard, dean of the Columbia Business School, and John Thornton, chairman of the Brookings Institution and former president of Goldman Sachs Group Inc., said today in a report.

Congress is planning to overhaul rules after global firms reported more than $1.47 trillion of writedowns and credit losses since 2007, and the U.S. has committed more than $200 billion to prop up more financial firms. The panel said its proposals are “broadly similar” to recommendations made by the Bush administration and other groups since March 2008.

President Barack Obama is developing proposals that may strip powers from the SEC, according to people familiar with the plan. White House spokeswoman Jennifer Psaki declined to comment on the committee’s report. SEC spokesman John Nester declined to immediately comment on the recommendations.

‘Wiser Heads’

The panel “wants to remain relevant in a world where they are not,” Harvey Goldschmid, a former Democratic SEC commissioner, said in an interview. “Wiser heads are now at work. One hopes they will come up with the right answers, including preserving and enhancing the SEC.”

Before the collapse of credit markets, “we had too many cooks not knowing what the other cooks were doing,” Hal Scott, a Harvard Law School professor and director of the committee, told Bloomberg Television today. The panel’s objective is to ensure that regulators understand all financial risks, he said.

The committee recommended higher solvency standards for institutions with more than $250 billion in assets, “given the concentration of risks to the government and taxpayer.” Ten banks including JPMorgan Chase & Co. and PNC Financial Services Group Inc. exceeded the threshold as of March 31, Fed data showed.

Centralized Clearing

The committee also proposed greater centralized clearing for credit-default swaps and increased capital requirements for swaps that don’t go through a clearing system. JPMorgan, Goldman Sachs Group Inc., Credit Suisse Group AG and Barclays Plc sent the U.S. Treasury a plan, written in February, saying the Fed should extend bank regulation practices to companies and hedge funds, according to a document obtained by Bloomberg News and confirmed by the Treasury.

Corporations, energy companies and hedge funds don’t face capital and margin levels now, while banks do under central bank oversight.

On May 13, U.S. officials called for increased oversight in the $592 trillion unregulated market to reduce risk to the financial system. Derivatives such as credit-default swaps contributed to the failure last year of Lehman Brothers Holdings Inc. and a U.S. takeover of American International Group Inc., leading to the seizure of credit markets.

The Financial Services Authority would regulate all aspects of the industry, including safety and soundness, and might take the consumer and investor protection role from the SEC. The agency could be created in a merger of bank regulators including the Federal Deposit Insurance Corp., the SEC and the CFTC.

‘Woefully Ineffective’

“The crisis has shown that the most precarious sectors of our financial system are those already subject to a great deal of regulation -- regulation that has proved woefully ineffective,” the group said in its recommendation.

Hedge funds should be required to submit to regulators confidential reports “with information relevant to the assessment of systemic risk,” the committee said. The reports would include information addressing the fund’s liquidity needs, leverage and concentration of risk.

The panel said fair-value accounting should require companies to add disclosures that help investors distinguish between the market and credit information used to set values. Fair-value, known as mark-to-market, forces companies to value many securities each quarter based on market prices.

The Financial Accounting Standards Board last month eased the rule after banks including Citigroup Inc. and Wells Fargo & Co. said it didn’t work when markets are illiquid.

The committee is a nonpartisan group of 25 executives including Nasdaq OMX Group Inc. Chief Executive Officer Robert Greifeld, MFS Investment Management Chairman Robert Pozen and WL Ross & Co. Chairman Wilbur Ross, and academics such as Robert Glauber, visiting professor at Harvard Law School.

Daniel Doctoroff, president of Bloomberg LP, the parent company of Bloomberg News, is a committee member.

Wall Street Derivatives Proposals Adopted in Treasury Overhaul

Posted on Bloomberg by Matthew Leising:

Wall Street’s largest banks are getting what they want in the U.S. Treasury’s plan to regulate over-the-counter derivatives by making all market participants adhere to the same capital requirements.

Goldman Sachs Group Inc., JPMorgan Chase & Co., Credit Suisse Group AG and Barclays Plc sent the Treasury a plan written in February saying the Federal Reserve should extend bank regulation practices to companies and hedge funds, according to a document obtained by Bloomberg News and confirmed by the Treasury. Corporations, energy companies and hedge funds don’t face capital and margin levels now, while banks do under central bank oversight.

“The banks appear to wish to maintain the intra-dealer market and raise barriers to new entrants to keep the OTC business as compartmentalized as possible and to protect their profitable market conditions,” said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York. “The Street’s lobbyists appear to be asking for a ‘club’ structure in OTC trading.”

On May 13, U.S. officials called for increased oversight in the $592 trillion unregulated market to reduce risk to the financial system. Derivatives contributed to the failures last year of Lehman Brothers Holdings Inc. and American International Group Inc., leading to the seizure of credit markets and causing more than $1.4 trillion in writedowns and losses amid the worst financial crisis since the Great Depression.

‘Little Impact’

The Treasury hears from many interested participants while crafting policy, said spokesman Andrew Williams. Derivatives are contracts whose values are tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.

“This proposal had little impact on our final result,” he said. “Our proposal calls for dramatically increased transparency and the enhancement of regulatory powers to prevent market manipulation that go well beyond anything in that draft.”

Bruce Corwin, a spokesman for Zurich-based Credit Suisse, Goldman Sachs spokesman Michael DuVally and JPMorgan spokesman Brian Marchiony declined to comment on the bank draft. Representatives of London-based Barclays didn’t immediately return calls and messages for comment left after normal business hours.

Treasury Secretary Timothy Geithner sent a proposal to Congressional leaders on May 13 laying out his plan to police the market where swaps based on interest rates, currencies, commodities and a company’s ability to repay debt are traded.

‘Robust Regime’

“All OTC dealers and other firms who create large exposures to counterparties should be subject to a robust regime of prudential supervision and regulation,” the proposal said. These included “conservative capital requirements,” “reporting requirements,” and “initial margin requirements.”

The bank-written plan, titled “Outline of Potential OTC Derivatives Legislative Proposal” and dated Feb. 13, said the systemic regulator “shall promulgate rules” requiring “capital adequacy,” “regulatory and market transparency” and “counterparty collateral requirements.”

Hintz said Wall Street revenue from trading fixed-income, commodities and currency swaps in the over-the-counter market may be reduced by 15 percent under the Treasury’s changes. “Limiting potential competition” in the market “may not be an unreasonable position to take” by the banks due to the potential loss of income, he said.

“Better the devil you know than the devil you don’t,” said Robert Webb, a finance professor at the University of Virginia in Charlottesville, describing the bank’s preference for their current regulator.

Shifting Views

The banks sought sole authority for the Fed over the market and limited the role of the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission, according to the document. The three agencies currently share information in the $28 trillion credit-default swap market.

Geithner’s proposal didn’t specify what agency or combination of agencies should oversee the market.

Investment banks fought regulation of OTC derivatives for more than a decade because the contracts provide a significant portion of bank earnings. As much as 40 percent of the profit for dealers Goldman Sachs and Morgan Stanley comes from the trading, according to fixed-income research firm CreditSights Inc. JPMorgan made $5 billion in profit last year from trading in fixed-income OTC derivatives, according to people familiar with the earnings.

Systemic Risk

The Obama administration favors the Fed becoming the new systemic risk regulator to oversee financial companies that could pose a danger to the banking system, according to participants in a May 8 White House meeting.

While the central bank has been favored to take the job since a proposal by former Treasury Secretary Henry Paulson last year, lawmakers and some regulators have shifted away from that view. Federal Deposit Insurance Corp. Chairman Sheila Bair and SEC Chairman Mary Schapiro earlier this month recommended that a council of regulators assume the role.

Geithner’s plan goes further in many aspects than what the banks laid out in their draft.

The Treasury Secretary is proposing mandatory guaranteeing of private contracts with clearinghouses for standardized OTC contracts such as interest-rate swaps or indexes of credit- default swaps and increased electronic trading to improve price transparency for customers. He also wants required reporting of positions and trades.

No Endorsement

The bank proposal doesn’t endorse clearing of OTC derivatives. In annotations to the draft it states: “Note that the proposed outline does not propose any specific OTC derivatives clearing requirement.” It also says reporting requirements on trade data should be made to regulators “upon request.”

Webb said any regulation over the market should be applied evenly. “It’s not clear requiring everyone to have the same capital requirements is necessary,” he said. He added that banks have worked closely with the Fed for many years.

“You’re going to see some close ties between the industry and the regulator,” he said.

Tuesday, May 19, 2009

Geithner plan fuels cost fears

Posted in the Financial Times by Aline van Duyn and Francesco Guerrera:

Companies using trillions of dollars of derivatives contracts to hedge interest rate, currency and commodity price risks could face higher costs under the proposed overhaul of US rules on derivatives, industry officials say.

Derivatives are widely used by the world's biggest companies to manage all kinds of financial risks. Most of these hedging activities are done between companies and banks in the over-the-countermarket.

Tim Geithner, US Treasury secretary, last week unveiled sweeping reforms, including a proposal to require clearing of all standardised derivatives through regulated central counterparties. Another proposal calls for making derivatives dealers and "other firms" - which may include non-financial companies - subject to capital charges against their positions.

Industry bodies say the reforms would lead to higher collateral costs. In order to buy or sell derivatives, companies usually have to put up collateral to cover any potential payments.

The collateral is often set against credit lines that the companies have with banks or is offset against assets. This means that companies - unlike bank users of derivatives - do not usually have to put up cash as collateral. The proposed changes might require them to hand over cash instead.

"Highly rated companies with bank credit lines are not posting liquid collateral for derivatives," said John Herrick, principal at Treasury Strategies, which advises companies on corporate treasury management. He added: "Companies are going to resist that like crazy."

David Hirschmann, a senior vice-president at the US Chambers of Commerce, said he had heard from a number of the trade group's members who had concerns over the application of the rules and the requirements to post collateral.

Of the $396,000bn face value of interest rate derivatives contracts outstanding at the end of June 2008, $38,000bn of these were with "non-financial customers", according to the Bank of International Settlements.

"A lot of large and medium-sized manufacturers rely on over-the-counter derivatives to manage their risks," said Dorothy Coleman, vice-president of tax and domestic economic policy at the National Association of Manufacturers.

The Geithner proposals still have to be approved by Congress.

Let battle commence

Posted in the Financial Times by Gilian Tett and Aline van Duyn:

Last Wednesday night, David Clark, a London-based banker, received a nasty shock. Reports from Washington suggested the US government would soon impose restrictive new regulation on the derivatives world – a move Mr Clark believes could severely damage financial business in London and New York.

He duly prepared a furious statement on behalf of the Wholesale Market Brokers’ Association, a lobbying group he leads. But when, a few hours later, he saw the proposals from Tim Geithner, US Treasury secretary, Mr Clark had second thoughts. “What Geithner has written may not be so bad,” he says, adding there is now “uncertainty” about what will happen next.

No wonder. Until recently, the technical detail of derivatives excited only financial geeks. Now it is turning into a political hot potato with potentially big implications for bank profits. After the first wave of policy reforms unleashed by the administration of Barack Obama in response to the financial crisis, focused on short-term crisis measures, such as the “ stress tests” of the health of banks, the next frontier is a fight about how the financial industry is structured – and run.

And what makes the once arcane issue so emotive is that they are not just central to the banks’ modern business model but also raise questions about the degree to which financial players should be free to innovate, without state control.

A public debate about derivatives is long overdue. For while politicians – and consumers – largely ignored this sector during the first seven years of the decade, an extraordinary revolution has quietly unfolded in recent years.

When the trading of “derivatives” – instruments whose value “derives” from something else – took off on a large scale three decades ago, it was a marginal corner of finance. By the start of this decade, the Basel-based Bank for International Settlements estimated there were about $100,000bn of outstanding deals. By late 2008 there were nearly $600,000bn, 16 times global equity market capitalisation (and 10 times global gross domestic product).

Bankers insist that these astonishing numbers are misleading, since many outstanding contracts offset each other in economic terms. Indeed, the BIS estimates that, after such netting, the “real” net market value of derivatives deals was “only” $34,000bn last year.

Nevertheless, the presence of those $600,000bn overlapping deals is important, since banks typically collect a fee on every (gross) contract written. Moreover, these deals have trapped banks and other financial players in a complex web of counterparty risk.

In the equity market, most trading occurs on a regulated exchange where deals can be publicly monitored by every­one. Trades are then “cleared” on a central platform, which completes a deal even if one counterparty collapses. Some derivatives deals – such as government bond futures – are traded on similar exchanges in Chicago and London. However, BIS data suggests four-fifths of outstanding derivatives trades have been cut in the so-called “over-the-counter” world, via private deals.

That means in many cases there is no centralised system to monitor prices or deals nor any third party to ensure a trade is completed if a counterparty fails. And while the industry has tried to mitigate this “counterparty risk” by encouraging traders to post collateral when they cut deals, these arrangements are not always seen as robust.

When Lehman Brothers collapsed last autumn, for example, markets froze because investors were unsure whether their deals would be completed. Worse, because trades were private, neither regulators nor investors knew where the risks lay. As a result, the US government was convinced the insurance group AIG – which had credit derivatives deals with dozens of other banks – could not be allowed to collapse.

As Mary Schapiro, chair of the Securities and Exchange Commission, says: “OTC derivatives, particularly credit derivatives ... contributed to the financial mess we are cleaning up today.”

The proposals Mr Geithner, Ms Schapiro and others have unveiled try to tackle these problems in four ways. First, they demand all “standardised” derivatives are centrally cleared to remove counterparty risk, even if they are not traded on an exchange.

Second, they “encourage” the industry to use regulated exchanges in addition to clearing platforms (because it is only on exchanges that investors get equal access to trading and price data, rather than being forced to rely on a small club of dominant banks).

Third, the Obama administration wants all institutions to record every derivatives trade to enable supervisors to prevent market abuse. Fourth, it wants to tighten rules on capital and collateral provision to ensure all derivatives players have buffers to absorb any losses. That is a radical step because, while banks already face such rules, hedge funds, companies and insurance groups such as AIG do not.

More striking still, the administration wants to impose a sliding scale of capital charges to “steer” behaviour. Derivatives deals conducted on regulated exchanges will attract lower charges than OTC deals.

To some, the measures look timid. Christopher Whalen, a US financial analyst says the way to remove systemic risk is to force all trades on to transparent exchanges. Banks, he says, will fight this as OTC activity is a dominant source of profits for some. Deals cut on exchanges typically produce a few basis points of commission but OTC trades can produce revenue of several percentage points.

“Despite the appearance of reform, the Treasury proposal ... still leaves the OTC market firmly in the hands of the large derivatives-dealer banks,” says Mr Whalen. “Without the excessive rents earned by JPMorgan Chase and the remaining legacy OTC dealers, the largest banks cannot survive.”

Frank Partnoy, a former derivatives trader, now an academic, thinks the proposals fall short because they cover only “standardised” deals – not the complex contracts that wreaked havoc at AIG and elsewhere. “By bifurcating the market into some derivatives that are standardised and disclosed, and some that are not, there is a [loop] hole that can only get bigger,” he says.

Although the administration has not defined “standardised”, a narrow definition may capture less than half of all recent deals. In credit derivatives most index trades and deals on single company bonds can be considered standardised by some measures. Bundles of derivatives, such as collateralised debt obligations, cannot.

The banking industry, by contrast, complains the reforms go too far. Most senior financiers are willing to move some activity on to a clearing platform. Indeed, this shift was under way before last week’s announcement – ventures offering clearing functions for credit derivatives started operating this year. Some large brokers, such as Icap, also accept the idea of limited exchange trading – not least because Icap runs an electronic exchange.

However, bankers oppose the idea that all activity should be channelled to an exchange, claiming it would crush innovation and reduce liquidity, because banks would no longer have a profit incentive to cut deals.

“Forcing OTC products on to exchanges ... would result in increased risks and costs for end users,” says Mr Clark of the WMBA, which says British pension funds have saved themselves £40bn recently by hedging with derivatives. Or as Anthony Belchambers, head of the Futures and Options Association, says: “This kind of regulatory pressure will distort free-market competition and restrict product diversity.”

In reality, it is unclear how far the administration plans to drive activity on to exchanges. Washington is still trying to steer a careful line between populist politicians who can sense public anger and the powerful financial lobby. Senior US officials hope a sliding scale of charges will be less controversial than a ban. After all, they point out, market-based “incentives” sit more easily with US free-market ideals than government diktat.

But nobody in Washington expects the debate to be won fast. And what makes Mr Geithner’s plan doubly controversial is that its implications go way beyond Washington itself.

When he met reporters last week Mr Geithner paid lip service to the “very important process” of global co-ordination. However, Washington appears to have engaged in scant consultation with Europe before last week’s announcement. The European Commission is now preparing measures to impose centralised clearing on credit derivatives, which it may extend to OTC derivatives. US finance officials assume European measures will ape US moves but this is not guaranteed.

In the meantime, bankers in London are preparing to exploit any transatlantic regulatory gaps. “Only 25 per cent of all OTC trading actually happens in America,” one senior London-based banker says. “So we don’t think what Geithner says is going to change anything for us ... and even if [Brussels] does the same, activity will just go to Singapore or Switzerland instead.”

Sentiments like that explain why US politicians distrust the derivatives world. They also illustrate the nightmarish difficulty reformers face. After all, several times in the past three decades, US politicians have tried to clamp down on derivatives – and each time the Wall Street lobby has fought back.

Some observers, such as Willa Bruckner, a partner at Alston & Bird law firm and veteran of earlier battles, hope this time will be different. In the past the industry convinced regulators it was able to regulate itself. “But because of the magnitude and the breadth of this crisis, these arguments are not so convincing now,” she says.

Not everybody agrees Mr Geithner truly has the stomach for change. The one thing that is crystal clear is that “the [banking] industry is girding for battle, [hiring] armies of lobbyists and lawyers,” as Mr Whalen says. Stand by for a long – and potentially bitter – derivatives war.


Written off by many when the alternative trading platforms arrived, big exchanges now find they are again places of value

“Thank you Tim Geithner and friends” was the gushing endorsement from one exchanges analyst when the US Treasury secretary unveiled plans for sweeping changes to the over-the-counter derivatives markets last week, writes Jeremy Grant.

For years, a tug-of-war has raged between the big derivatives exchanges, from their home turf in Chicago, and the OTC markets, represented by dealers at the Wall Street banks. The inventors of financial futures in the Windy City in the 1970s were appalled at the emergence a decade later of products developed by the banks that looked suspiciously like copies of their own inventions. They wanted all derivatives traded on-exchange.

The two sides reached a deal in 2000 with the Commodity Futures Modernisation Act. The exchanges agreed not to oppose an exemption of the OTC markets from oversight by the US futures regulator, while the OTC players would not oppose a “light touch” regulatory regime that the exchanges had been seeking for their part of the markets. But rivalry persisted, especially as OTC derivatives overtook the size of exchange-traded markets at the Chicago Mercantile Exchange, now CME Group.

Fast forward to the collapse of Lehman Brothers last September. Things started to go the exchanges’ way when Mr Geithner – then chairman of the Federal Reserve Bank of New York – insisted that OTC contracts should be processed as far as possible through a clearing house, to safeguard the financial system against the fallout from another catastrophic default.

Now, with a stipulation by the administration of President Barack Obama not only that OTC derivatives should be cleared but also that “standardised” OTC derivatives should be moved on to exchanges, the exchanges appear to have won a victory in that battle – hence the ringing endorsement from the analyst, who covers CME.

A sense that the exchanges have been unexpected beneficiaries from the financial crisis has been heightened elsewhere. A mere 18 months ago in Europe, analysts were predicting that competition unleashed by the European Union’s Markets in Financial Instruments Directive would leave exchanges badly damaged by upstart trading platforms such as Chi-X and Turquoise. Yet this week, as the London Stock Exchange introduces Xavier Rolet, a former Lehman banker, as its chief executive, the rivals have yet to hole the exchange below the water line.

None of the five platforms in existence is making money, even as they collectively claim more than 20 per cent of trading in the shares of companies that make up the FTSE 100 index. In addition, the LSE says many users of the OTC equity markets have started shifting orders on to the exchange, where trades are cleared through LCH.Clearnet.

However, it is too soon to write off important players in the OTC markets. Susan Milligan of The Options Clearing Corporation, which clears for all seven US options exchanges, says the exchange-traded and OTC derivatives markets have long had a symbiotic relationship as traders use them to arbitrage one against the other. That means one market’s gain is not necessarily the other’s loss, making it hard to conclude that a regulatory push to shift contracts on to more formal structures is wholly damaging to the OTC markets. “There has been a long-standing push and pull between the [OTC] dealers and the exchanges but if you look at the CME’s volumes, one of the reasons that’s down is there aren’t as many OTC contracts being traded,” she says.

The inter-dealer brokerages that act as intermediaries in the OTC derivatives markets, negotiating contracts on the phone or electronically on screens, will find their phone broking businesses hurt by the new regulatory environment. But those with large electronic businesses – Icap, Tullett Prebon, GFI Group and BGC Partners with its eSpeed platform – could benefit. The US administration wants “standardised” OTC contracts to be traded not only on “regulated exchanges” but on “regulated transparent electronic trade execution systems”. That could be taken to mean the brokers’ systems, although the detail will have to be thrashed out in Congress.

Icap has not wasted time in developing post-trade services for OTC markets – making it more “exchange-like”. It has also joined a 12-member bank consortium that is bidding for LCH.Clearnet, a move that would give the broker an interest in an operation that already clears swaths of the interest rate swaps markets.

Michael Spencer, Icap’s chief executive, says: “All the arrows have pointed in this direction for some time. We had anticipated that there would be a push to clear certain [OTC] products.”

Yet the non-exchange side cannot rest easy as long as the regulatory pressure to make markets “safer” persists. The big fear among inter-dealer brokers is of a blind rush to push everything on-exchange even though non-exchange venues could fulfil the Geithner requirements – such as more clearing through LCH.Clearnet, which is not exchange-owned.

Monday, May 18, 2009

Credit Default Swap Auctions

Abstract: The rapid growth of the credit default swap (CDS) market and the increased number of defaults in recent years have led to major changes in the way CDS contracts are settled when default occurs. Auctions are increasingly the mechanism used to settle these contracts, replacing physical transfers of defaulted bonds between CDS sellers and buyers. Indeed, auctions will become a standard feature of all recent CDS contracts from now on. In this paper, we examine all of the CDS auctions conducted to date and evaluate their efficacy by comparing the auction outcomes to prices of the underlying bonds in the secondary market. The auctions appear to have served their purpose, as we find no evidence of inefficiency in the process: Participation is high, open interest is low, and the auction prices are close to the prices observed in the bond market before and after each auction has occurred. We qualify our conclusions by noting that relatively few auctions have taken place thus far.

The paper can be downloaded here.

BIS Regular OTC Derivatives Market Statistics

The BIS is releasing today its semiannual statistics on positions in the global OTC derivatives market for end-December 2008. The statistics cover the notional amounts and gross market values outstanding of the worldwide consolidated OTC derivatives exposure of major banks and dealers in the G10 countries.

The total notional amount of over-the-counter (OTC) derivatives contracts outstanding was $592.0 trillion at the end of December 2008, 13.4% lower than six months earlier. The decline is the first since collection of the data began in 1998. Credit market turmoil and the multilateral netting of contracts led to a contraction of 26.9% in outstanding credit default swaps (CDS). The second half of 2008 also saw the first significant decline of OTC derivatives contracts outstanding in the interest rate market (8.6%) and in the foreign exchange market (21%).

Despite the drop in amounts outstanding, movements of financial market prices in the second half of 2008 lifted gross market values 66.5%, to $33.9 trillion. Gross market values measure the cost of replacing all existing contracts and are thus a better measure of market risk than notional amounts outstanding.

The statistical release cites the following trends in the second half of 2008:

  • CDS volumes continued to contract
  • Commodity derivatives markets declined by two thirds
  • The market value of interest rate products almost doubled

Comprehensive explanatory notes in the release define the coverage of the statistics and the terms used in presenting them.

FASB Rule Will Force Banks to Move Assets Onto Books

Posted on Bloomberg by Ian Katz:

Citigroup Inc. and JPMorgan Chase & Co. will be required starting next year to add billions of dollars of assets and liabilities to their balance sheets under rules approved by the Financial Accounting Standards Board.

The rules, effective for annual reporting periods after Nov. 15, were approved by FASB’s five-member board today during a meeting at the panel’s headquarters in Norwalk, Connecticut. The board, which writes U.S. accounting rules, is overseen by the Securities and Exchange Commission.

Lenders recorded profits before the U.S. subprime mortgage market collapsed in 2007 by selling pooled loans to off-balance- sheet trusts, which repackaged the pools into mortgage-backed securities. Banks then sold those securities to other off- balance-sheet vehicles they sponsored, concealing from investors that the securities were backed by deteriorating mortgages.

“The desire to provide additional transparency to investors was the key driver behind today’s decisions,” FASB spokesman Neal McGarity said in an e-mail.

U.S. regulators said the 19 lenders subjected to stress tests completed this month would have to bring about $900 billion of assets onto their balance sheets because of the FASB changes, according to a Federal Reserve report released April 24. The Fed based its calculation on data provided by the banks.

“This change may have a significant impact on Citigroup’s consolidated financial statements as the company may lose sales treatment for certain assets,” Citigroup said in its annual report released in February. Citigroup spokesman Jon Diat declined to comment.


In March, JPMorgan estimated in its annual report that the “impact of consolidation” could be as much as $70 billion of credit card receivables, $40 billion of assets related to so- called conduits and $50 billion of other loans, including residential mortgages. Conduits are off-balance-sheet entities that purchase long-term debt and use those securities as collateral to sell short-term debt. JPMorgan spokesman Brian Marchiony declined to comment.

The rule change will hurt banks and the economy by discouraging lending, said Wayne Abernathy, executive vice president at the American Bankers Association in Washington. “It will affect fee income and the economy’s ability to rebound on the lending side,” he said in an interview before the vote.

The FASB vote today eliminates the so-called Qualifying Special Purpose Entity, a type of trust that was exempt from balance-sheet treatment.


In July, FASB postponed by at least a year the effective date of the changes after banks and trade groups complained. The Securities Industry and Financial Markets Association and the American Securitization Forum said the measure may make companies appear to be short of capital during regulatory reviews.

Investors are wary of a company’s unknown obligations as the world’s biggest banks and brokerages reported more than $1.4 trillion in writedowns and credit losses since the start of 2007, some stemming from losses in off-balance-sheet vehicles.

Sunday, May 17, 2009

Disclosure move aims to revive ABS market

Posted in the Financial Times by Ralph Atkins and David Oakley:

The European Central Bank is pushing for an increase in the amount of information that has to be disclosed about asset-backed securities as part of efforts to revive a market that has collapsed since the start of the credit crisis in August 2007.

The ECB wants more details on these securities to be passed to ratings agencies, including data on the individual loans that back them. These are mainly mortgages, but also include credit card, corporate and car loans.

It hopes this will rejuvenate the European market by boosting confidence in the ratings, which in turn should encourage investors to buy the securities because a lack of transparency has been deterring them.

There have only been 11 asset-backed deals in Europe this year, worth €5bn ($7bn), including one by Porsche. In the first seven months of 2007, there were 241 deals in Europe, worth €199bn, according to Dealogic, the data provider.

Asset-backed-securities-graphicA revival in the securitisation markets would help the broader economy as it would provide banks with more money to lend.

However, analysts say the ECB should also push for full public disclosure of the loans that back these securities – as in the US – and not just to the ratings agencies. The US market has been hit too, but has seen more signs of recovery. This year there have been 130 deals, worth $80.6bn.

Hans Vrensen, head of European securitisation research at Barclays Capital, said: “Without better public disclosure, including loan-by-loan data, the European asset-backed securities markets will remain at a competitive disadvantage to the US markets.

“Improved transparency in the European markets is key to retaining existing as well as attracting new investors. Investors are more likely to buy asset-backed securities if they are able to fully analyse the risks they are taking on.”

The move by the ECB also reflects concerns about the risks it is bearing by accepting asset-backed securities as collateral when providing liquidity to eurozone banks.

Since the credit crisis started, eurozone banks have increasingly used asset backed securities as collateral to raise cash from the ECB as they could no longer sell on the assets in the market.

Last month the ECB revealed that asset-backed securities accounted for 28 per cent of the collateral put forward by banks in 2008 – up from 16 per cent in 2007.

On asset-backed securities used in its operations, the ECB says it is “working with rating agencies on the enhancement of the surveillance performed by rating agencies with a view to introducing loan-by-loan information”.

It adds in its monthly bulletin: “It is hoped by improving transparency in the surveillance process, market participants can regain confidence in the work performed by ratings agencies in the securitisation markets, thereby allowing their reactivation.”

Reforming Credit Default Swaps and OTC Derivatives

Posted by members of the Hebert Gold Society on the Insitutional Risk Analyst:

Despite bringing the world economy to its knees and costing taxpayers hundreds of billions of dollars in bailouts for events such as Bear Stearns, Lehman Brothers and American International Group (NYSE:AIG), the Masters of the Universe who run the largest Wall Street firms of have learned not a thing when it comes to credit default swaps ("CDS") and other types of high-risk financial engineering. Indeed, not only are the largest derivative dealers fighting efforts to reform the CDS and other derivative instruments that caused the AIG fiasco, but regulators like the Federal Reserve Board and US Treasury are working with the banks to ensure that a small group of dealers increase their monopoly over the business of over-the-counter ("OTC") derivatives.

Why such a desperate battle for the OTC derivatives markets? For the world's largest banks, the OTC derivatives markets are the last remaining source of supra-normal profits - and also perhaps the single largest source of systemic risk in the global financial markets. Without OTC derivatives, Bear Stearns, Lehman Brothers and AIG would never have failed, but without the excessive rents earned by JPMorgan Chase (NYSE:JPM) and the remaining legacy OTC dealers, the largest banks cannot survive. No matter how good an operator JPM CEO Jamie Dimon may be, his bank is DOA without its near-monopoly in OTC derivatives -- yet that same business may eventually destroy JPM.

The key thing for the public and the Congress to understand is that the "profits" earned from these unregulated derivatives markets are illusory and do not cover the true risk of OTC derivatives. Put another way, on a systemic basis, risk-adjusted profits from OTC derivatives are not positive over time. As with the current crisis, the net loss from the periodic collapse of what is best described as gaming activity gets off-loaded onto the taxpayer, thus OTC derivatives must be seen as any other speculative activity, namely a net loss to the economy and society. But unlike taking a punt on a pony at the racetrack, bank dealings in OTC derivatives vastly increase systemic risk, make all banks unstable and threatens the viability of the real economy.

As we told Tim Rayment of The Times of London in his article, "Joseph Cassano: the man with the trillion-dollar price on his head," in our view AIG never had the possibility of generating sufficient income to cover its CDS contracts, thus honoring these gaming debts of AIG at face value as Tim Geithner, Ben Bernanke, et al., have done using public funds is ridiculous, even criminal. As we've said before, AIG should be in bankruptcy so that all creditors may be treated fairly - but "fairly" means a steep discount to par value without the subsidy from the Fed.

Unfortunately, the Treasury and the Fed are so captured by the large banks that they will never admit the truth of what you have just read - at least so long as Geithner and Bernanke, respectively, are still in charge of the Treasury and Fed. These two fine public servants stuffed the Fed of New York with the $30 billion cost of JPM's acquisition of Bear Stearns, then used the Fed's balance sheet to float trillions of dollars more in toxic waste and bailed out AIG and its dealer counterparts for good measure. But the good deeds of Geithner and Bernanke are not yet finished. Next comes the "reform" of the OTC derivatives markets.

By no coincidence, the Geithner Treasury just announced an initiative to improve the regulation of OTC derivatives. SIFMA and the large OTC dealers are making cautious noises of disapproval, but be not fooled by this Kabuki on the Potomac. As with past legislative efforts to "reform" the banking industry or protect taxpayers from large bank bailouts, the Washington game is already rigged. In that regard, read Tim Carney's comment on Treasury Secretary Tim Geithner, "Loophole Secretary," in the May 2009 issue of The American Spectator.

One part of the proposal finally would improve the availability of CDS prices to the public, but in reality this "innovation" of public price transparency has been fought by the dealers for years and is small concession now. Buyers of CDS still cannot seen the best price in the markets. You have to canvas your counterparts. And of course the bid ask spread on a given contract is different with every dealer.

Despite the appearance of reform, the Treasury proposal announced last week still leaves the OTC market firmly in the hands of the large derivatives dealer banks. The industry is girding for battle to make sure that the dealers keep the ball in terms of overall control of the OTC markets. Armies of lobbyists and lawyers have been marshaled by JPM, the near-monopoly player in trading and non-dealer clearing in the OTC derivatives market with nearly 50% market share and the organization with the most to lose from true regulation. It is a monument to the kindness of JPM CEO Jamie Dimon and the bank's board that they have employed a number of lobbyists formerly in the service of Fannie Mae, Freddie Mac, etc.

Since the legacy GSEs, including the Federal Home Loan Banks, are buried in mounting losses and seemingly are headed for liquidation, there is not much need for lobbyists. But the New GSEs such as JPM require representation. If you have not done so, read the March 17, 2008 interview with Robert Feinberg, "GSE Nation: Interview with Robert Feinberg", where our friend and long-time observer of Washington predicted much of the response to the financial crisis, namely the embrace of the GSE model by Washington as the explicit template of choice for America. And since the largest GSEs earn a disproportionate portion of profits from unregulated OTC derivatives, managing the reform process is obviously of paramount concern.

The immediate objective of JPM and the dealer community is to counter attempts to truly regulate and, most important, make standardized commodities of OTC derivatives, even as the dealers clothe the new regime proposed by Tim Geithner for clearing and trading OTC contracts in the language of reform, transparency and efficiency. Terms like innovation, productivity and competitiveness are again heard in the halls of Congress after a several months hiatus, this in connection with arguments that OTC derivatives help to manage, rather than create, risk.

But the fact is that for JPM, Citigroup (NYSE:C), Goldman Sachs (NYSE:GS) and other dealers, the OTC derivatives markets are the last remaining source of supra-normal profits - and also perhaps the single largest source of systemic risk in the global financial markets. Without OTC derivatives, Bear Stearns, Lehman Brothers and American International Group (NYS:AIG) would never have failed, but without the excessive rents earned by JPM and the remaining legacy OTC dealers, they cannot survive either.

Let's go back to the beginning of the story. Swaps started out in the early 1980s as a way for companies to manage financial risks. Originally swaps were private contracts, agreed to between two sophisticated parties like a bank and a large multi-national corporation. Although often described as complicated, swaps actually work on a simple principle: one party will trade the variable price of something, such as an interest rate or the price of oil, for a fixed price for that same product - that is, certainty.

For example an oil refiner might agree to pay a fixed price of $50 per barrel for oil, in exchange for a bank agreeing to pay the market price for a barrel of oil. A swap agreement will provide that every six months or so for the next several years the parties will exchange payments based on their respective obligations; the refiner paying $50 to the bank, and the bank paying the then-current price of oil.

The parties to a swap agreement like the one described above enter into such a contract because the customer (the oil refiner) has a real risk it is trying to manage (the price of oil). The bank facilitates the transaction to help its customer manage financial risk, which is what banks are supposed to do. But notice that at least one party to this illustrative transaction actually had an economic interest in the underlying commodity or the basis of the derivative contract.

As long as private swap contracts remained individual and unique, custom tailored agreements between banks and their customers, there were few problems. In fact the ability of a company to transfer its financial risks to a bank was widely seen as a good development: the company could focus on its core business without having to worry about events beyond its control. These benefits were so obvious that the market for swaps grew rapidly with the full blessing of regulators and politicians alike. By 1999 the market had grown to have a notional value of $88 trillion dollars.

But a potential problem loomed: the participants in these markets felt U.S. law was unclear as to whether the contracts were legal. This led the Clinton Administration and Congress to change U.S. law to provide special protection for swap agreements. Called the Commodity Futures Modernization Act of 2000, this law was designed to protect the ability of banks and sophisticated institutions to continue to enter into privately negotiated swap agreements. But as so often happens in Washington, the law also unleashed the growth of fully interchangeable, unregulated markets which by some measures have rendered many of the worlds largest financial institutions technically insolvent.

Originally banks created swaps to help their customers manage financial risks. The contracts were a customer service, designed to enhance a bank's existing relationship with its corporate clients. But early on the banks realized they could make huge profits from small differences in the prices they charged different customers entering into the agreements. Thus was born the deliberately opaque and secretive inter-dealer world of CDS, the market between and among the dealers themselves, which has become an engine for manufacturing the appearance of profits - even while increasing systemic risk.

As the demand for swaps increased, banks learned they could effectively take the fixed value they received from one customer and pass it onto another, keeping a small piece of the action. In effect the banks turned into riskless middlemen, profiting by matching buyers and sellers. This was, in part, the opportunity that would lure AIG, a huge seller of credit default swaps, to its destruction. (See our previous comment on AIG, "AIG: Before Credit Default Swaps, There Was Reinsurance", April 2, 2009.

But to maximize their profits, the banks needed to make sure all their contracts matched. So they changed the private, customized nature of swaps into standardized contracts that could be easily traded throughout the financial system. There was nothing new about this type of business. In fact stock exchanges operate on exactly the same principle. But exchanges are fully regulated, with collateral and margin requirements enforced by the clearing members.

Moreover, to protect customers and the public, exchanges make sure everyone plays by the same set of rules and receives the same treatment. That means equal access to such important protections as the ability to see what the market price is for a security and the assurance that the market will honor your trade even if your counterparty can't. The swaps market, originally designed for a world where banks negotiated private agreements with their customers, has none of these basic market protections and arguably is deceptive by design, placing customers at the mercy of the large derivatives dealers.

In 2005, the New York Fed began to fear that the OTC derivatives market, at that time with a notional value of over $400 trillion dollars, was a sloppy mess - and it was. Encouraged by the Congress and regulators in Washington, the OTC market was a threat to the solvency of the entire global financial system - and supervisory personnel in the field and the Fed and other agencies had been raising the issue for years - all to no effect. This is part of the reason why we recommended to the Senate Banking Committee earlier this year that the Fed be completely relieved of responsibility for supervising banks and other financial institutions.

Parties were not properly documenting trades and collateral practices were ad hoc, for example. To address these problems, the Fed of New York began working with 11 of the largest dealer firms, including Bear Stearns, Merrill Lynch, Lehman, C, JPM, Credit Suisse and GS.

Among the "solutions" arrived at by these talks was the creation of a clearinghouse to reduce counterparty credit risk and serve as the intermediary to every trade. The fact that such mechanism already existed in the regulated, public markets and exchanges did not prevent the Fed and OTC dealers from leading a multi-year effort to study the problem further - again, dragging their collective feet to maximize the earnings made from the existing OTC market before the inevitable regulatory clampdown.

For example, in the futures markets, a buyer and seller agreeing to a transaction will submit it to a clearing member, which forwards it to the clearinghouse. As the sell-side counterparty to the buyer and the buy-side counterparty to the seller, the clearinghouse assumes the risk that a party to the transaction might fail to pay on its obligations.. It can do this because it is fully regulated and by well capitalized. As the Chicago Mercantile Exchange is fond of saying, in 110 years no futures clearinghouse has ever defaulted.

While the NY Fed believed that a central counterparty was necessary to reduce risks that a major OTC dealer firm might default, the banks firmly resisted the notion. After all, they make billions of dollars each year on the cash and securities which they required their hedge fund, pension fund and other swap counterparties to put up as collateral. Re-pledging or loaning these customer securities to other clients is very lucrative for the dealers and losing control over the clients collateral would dramatically impact large bank profits.

A clearinghouse would eliminate the need for counterparties to post collateral and a lucrative source of revenue for the dealer firms. So they bought the Clearing Corporation, an inactive company that had been the clearinghouse for the Chicago Board of Trade. If they had to clear their trades, the dealer firms reasoned, at least they would find a way to profit by controlling the new clearing firm. Such is the logic of the GSE mindset.

Meanwhile, other viable candidates for OTC derivatives clearing were eager to get into the business, such as the Chicago Mercantile Exchange and the New York Stock Exchange. Both had over 200 years experience in clearing trades and were well suited to serve as the impartial central counterparty to the banks and their customers.

If the NYSE and CME were to trade derivatives, the big banks knew they would not be able to control their fees or capture the profits from clearing. Therefore, they sold The Clearing Corp. to the Intercontinental Exchange, or ICE, a recent start-up in the OTC derivatives business which had been funded with money originally provided by, you guessed it, the banks.

In the deal with ICE, the banks receive half the profit of all trades cleared through the company. And the large OTC dealer banks made sure, through their connections with officials at the Fed and Treasury, that ICE was the winner chosen over the NYSE and CME offerings. That's right, we hear that Tim Geithner personally intervened to make sure that ICE won over the NYSE and CME clearing units.

Note that the FRBNY forced the approval of ICE through as "bank," another obvious power grab (include it with the insurance companies, etc). Some internal Board staff argued that this closed, Sell-Side counterparty was not the optimal market solution, but instead allowed the preservation of the dealer oligopoly in CDS. For the dealers, it was the least bad solution that gave Geithner, the Theo Lubke and FRBNY something they could tout as progress. But what it has done is taken too-big-to-fail banks (which aren't) and bound them together in a too-big-to fail central counterparty for CDS!.

Why is ICE styled as a NY state bank again? The Fed waived bank capital requirements. In fact, this "special" bank doesn't even have to report the ratios to the Fed as do other banks, an amazing concession which allows everything to be kept secret. If ICE didn't want to be a bank, it shouldn't have asked for a bank charter, but the Fed's accommodation of ICE and the dealers that control it should forever put to rest the notion that the Fed board is able to act independently when it comes to safety and soundness regulation.

If this new central counterparty is so transparent, when are ICE and the dealers going to publish the margin methodology and the central guarantee fund methodology? We understand that each counterparty uses the same portfolio (parametric) VaR method to calculate required margin. The same VaR calculation at a somewhat higher confidence then gives the guarantee fund contribution requirements.

Doesn't anyone remember that VaR is countercyclical and is reliant on historical volatilities and correlations? This "new" system is game-able from day one. Dealers facing margin calls could actually sell more protection in names that have been historically negatively correlated to reduce margins. That's right... sell more protection on an absolute basis to reduce the margin requirements.

But don't worry; the crack NYFRB team is looking at the models -- just like they were looking at C models and rated everything satisfactory. The good people the NYFRB had in charge of market risk supervision in recent years never built or ran a commercial VaR model in their lives. Maybe these are the same folks who kept asking us about the Economic Capital model in the IRA Bank Monitor, even after we showed them the page in the textbook.

We hear that the FRBNY supervision "SWAT team" has been a rotation of non-experts, apparently purposefully, who are very similar to the crowd around Secretary Geithner at Treasury in Washington. And neither the FRBNY nor the Treasury ever listen to people inside the Fed that have actual market experience. These are academic, monetary economists by and large, not technocrats. Power, control and information rule the day -- not competence nor concern about the effectiveness of policy.

After the VaR based guarantee fund there is a "commitment" by each ICE dealer to pony up more in case the guarantee fund is fully drawn. A commitment from banks under severe stress to save each other -- how much is that worth? A bank in that situation has to make the best business decision for its shareholders, and that could very well be to walk away from any commitment to dump billions into ICE because a competitor fails.

Has the Fed learned nothing? At least each of the sell-side counterparties in the group knows the parameters of the margining and how it could go awry. The outside world, the un-favored counterparties to the dealers, have no idea how good or bad the margins and commitments might ultimately be for them. It's in Fed they trust - because they have no choice. An open exchange with a set of transparent rules, margin requirements, and price discovery is the optimal solution. Why the Fed would push through something else is clear -- it is in bed with the dealers.

Confused yet? The Fed and the dealer banks sure hope so, because it makes it less likely you will fully grasp their stranglehold on the OTC markets. In order to ensure that the OTC business never left their grasp they made sure the ICE-TCC entity was formed as a bank, regulated by the NY Fed; the harder for their regulator to object.

Then to top it off, the banks told the regulators that they would report all their trades through a so called central trade repository, the Trade Information Warehouse. This entity is owned by an outfit called the Depository Trust Clearing Corporation; all you need to know about DTCC in the global clearing system is that it too is controlled by the banks. Indeed, the DTCC is a Fed member bank. While many of the initiatives taken by the DTCC over the past half decade to improve the OTC markets are laudable, they must all be seen in the context of the DTCC's place within the community of dealer banks.

Moreover, to protect their monopoly in derivatives, the banks are lobbying Congress and the Obama Administration to require that anyone that wants to engage in the OTC derivatives business must be, wait for it . . . a bank. The banks are selling this idea under the rubric of creating a "systemic risk regulator," a powerful federal agency with the power to see across markets and participants in order to identify and forestall systemic risk. Reaching new heights of disingenuousness, the OTC dealer banks propose that the Federal Reserve, their regulator and the agency that missed every sign leading up to the present financial collapse, the cheerleader for the banks, become the systemic risk regulator.

By proposing that anyone engaging in the OTC business must be a bank, the banks would ensure that their regulation wouldn't change in any way. But their potential competitors in this area, such as energy companies, hedge funds and commodity firms, would effectively be pushed out of the business. That is the little surprise that the Fed and Treasury have for Buy Side funds in the OTC reform legislation.

House Agriculture Committee Chairman Colin Peterson (D-MN) and Senate Banking ranking member Richard Shelby (R-AL), seem to see the Geithner reform plan for OTC derivatives for what it is, namely a proposal by and for the large banks.

But others, such as House Financial Services Committee Chairman Barney Frank (D-MA), appear all too eager to do something, anything, to address this complex issue -- no matter how misguided or anti-competitive it might be. Frank's continuing infatuation with the Fed as the center of the regulatory universe is a subject of quiet wonderment by even some Democrats on the committee, but none are yet willing to challenge the temperamental and volatile Frank.

Even worse, with the US taxpayer now owning substantial stakes in most of the large dealer banks, what incentive does the US Treasury have to eliminate the banks' last truly lucrative monopoly? In a very real sense, without the excess rents earned from the OTC markets, large dealers such as JPM, C and GS might not be viable in their present form. Remember, on a nominal basis, OTC derivatives appear to be the most profitable activity of many large banks. It is only when you assess the OTC derivatives dealing activity of large banks on a risk-adjusted basis does the value destruction become apparent.

One can only hope that reason will prevail, especially the version of reason that now prevails in the Senate, where there is little illusion about the true nature of the relationship between the large OTC dealer banks, the Fed and the Treasury. True reform of the OTC space would force most derivatives on exchange while leaving the banks free to offer customized risk management contracts to their customers, subject to stringent capital requirements.

But JPM and the other OTC dealer banks will fight to their last taxpayer dollar to stop that from happening. The only question now is whether the smaller banks, and the large Buy Side and other non-bank participants in the OTC markets, including some of the largest investment, industrial and energy firms in the world, can deliver the message to Washington that the current reform proposals for OTC derivatives are ill-advised and contrary to the public interest.

Friday, May 15, 2009

Risk monitoring plans marred by turf battles

Posted on Reuters by Huw Jones and Kevin Drawbaugh:

Turf battles and fears of over-concentration of power are delaying the establishment of new financial 'systemic risk' regulators and could lead to the new structure being less effective than intended.

The worst market crisis in decades has highlighted how unrecognized risks from banks can destabilize the broader financial system and even help drag whole economies into recession.

Formal proposals to set up a risk monitoring body in the European Union will be unveiled later this month, and are expected in the United States by June.

Starkly different positions are already emerging, however, among regulators and central banks as they scent possible loss or gain of influence. This will make it harder to find a workable solution with teeth and soon, financial experts said.

"This is hugely political and because of this, there is no question it will take a little bit of time to resolve," said Michael McKee, a lawyer specializing in financial services at DLA Piper in London.

"To some degree, the fact that this issue is coming out in the open as a bit of a bunfight is itself, ironically, a sign that both politicians and supervisors feel to a degree that the worst of the financial crisis is passing," McKee said.

Experts fear ending up with unwieldy solutions.

"We believe the odds favor adoption of systemic risk regulator legislation in 2009. We expect the Federal Reserve to get the job as the FDIC (Federal Deposit Insurance Corp.) is likely to become the receiver for nonbanks and the college of regulators approach does not leave anyone in charge," said Jaret Seiberg, a policy analyst for Concept Capital in Washington,


The EU's executive European Commission is set to make outline proposals on May 27 based on a blueprint from former Bank of France governor, Jacques de Larosiere.

He proposed setting up a European Systemic Risk Council chaired by the European Central Bank, flanked by representatives of national markets, insurance and banks supervisors.

The Commission wants the new council in place in 2010.

The ECB sets interest rates for the euro zone but Britain, which is not part of the single currency, is against the Frankfurt-based institution chairing the new council as it would give it too much power, a view national market, insurance and banking supervisors across the EU share.

Nout Wellink, Dutch Central Bank president and head of the Basel Committee on banking supervision, said on Thursday the De Larosiere proposal was "uneven" as central bankers would outnumber national supervisors on the risk council.

In the United States, the Obama administration is expected to propose legislation calling for the U.S. Federal Reserve to play a central role in regulating systemic risk in the economy, while leaving the door open for others to play a part, as well.

The primacy of the Fed in the administration's plans has divided national regulators and opinion on Capitol Hill, where some key lawmakers blame the U.S. central bank, in part, for the present crisis and question the wisdom of giving it even more power.

During the bubble years before the crisis, "Congress supported and encouraged the Fed even as that agency's policies undermined the safety and soundness of our financial markets," said Christopher Whalen, co-founder of market research group Institutional Risk Analytics in Los Angeles.

The US Comptroller of the Currency John Dugan wants the Fed to oversee systemic risk. The FDIC and the Securities and Exchange Commission have been less definite, tending to favor a council approach involving themselves, the Fed and the Treasury Department among other possible members.

"I have long been concerned about excessive concentration of power -- which really means excessive concentration of point of view -- in a single regulator," SEC Chairman Mary Schapiro said last week.

The administration has said the council approach has value and may be pursued. But financial industry lobbyists have said privately that the White House is determined not to dilute the new systemic risk regulator's clout.

Turf battles among regulators are not new in the United States due to overlapping powers that spark border disputes and creating a risk monitoring body may do little to quell them.

"I can imagine such a council that will be established that clearly won't stop the turf battles," said Benn Steil, director of international economics at the Council on Foreign Relations in New York.

A central "systemic risk" regulator could become too large in size and prove to be ineffective, added Joe Ratterman, chief executive of stock exchange BATS.

"They'll get large and lethargic and not actually be effective, even though you've theoretically gotten rid of the left hand that doesn't know what the right hand is doing with multiple regulators," Ratterman said.

Fears that OTC reforms will affect brokers

Posted in the Financial Times by David Oakley:

The US plan to regulate over-the-counter derivatives could severely undermine the inter-dealer brokers that have fought hard to keep the market private.

Leading inter-dealer brokers, such as Icap and Tullett Prebon, would lose a vast chunk of business if they were forced to move all standardised OTC derivatives onto exchanges.

Derivatives are an important revenue stream for inter-dealer brokers who have battled to keep the market largely private. They can make money from trading the securities or arranging their sale to institutional clients.

The Wholesale Market Brokers Association, the industry body that represents inter-dealer brokers, condemned the US proposals, saying it could drive more standardised OTC derivatives onto exchanges.

The WMBA believes that clearing can be done just as effectively through a central counter party or clearing house, such as LCH.Clearnet. The WMBA says CCPs could clear for both OTC and exchange traded products alike.

David Clark, WMBA chairman, said: “We wish to warn again that forcing OTC products onto exchanges would significantly reduce liquidity in financial markets, resulting in increased costs for end users as their ability to hedge their exposures would be handicapped.”

Analysts say the US policy could have the unintended consequence of hitting profits of banks, which act as brokers, as well as the dealers. This could have a serious impact on the wider economy, as reduced profits could curb bank lending.

Dirk Hoffmann-Becking, senior research analyst at Sanford Bernstein, said: “If OTC derivatives move on to the exchanges, that would hit profits of brokers and banks. Exchange trading narrows spreads, and wide spreads are where they make their money.”

The European Commission is expected to follow the US example and insist on clearing through a CCP or clearing house. Analysts say the European approach could emphasise the advantages of using CCPs.

“The WMBA believes that European initiatives indicate a firmer grasp of the essential role of the clearing house,” Mr Clark said.

Tullett Prebon shares suffered a 12.3 per cent tumble on Thursday.

Analysts said investors may have decided to take profits on their holdings in Tullett after the rise in its share price in recent weeks. In a trading statement on Thursday, the company said it had generated £354m of revenues in the first four months, up 10 per cent from a year ago.

Analysts said Tullett lacks electronic broking and post-trade capabilities, which could hit its business in the push for standardisation.

Icap, by contrast, saw its shares rise 1 per cent. It is part of a consortium bidding for LCH.Clearnet, Europe’s largest independent clearing house. This could provide it with the ability to clear its own trades.

Europe likely to move more slowly on OTCs

Posted in the Financial Times by Nikki Tait:

Proposed reforms to the OTC derivatives market in the US could accelerate similar changes in Europe, but are unlikely to change radically the direction in which the continent was already travelling, industry participants and regulators said on Thursday.

“It wasn’t a surprise – and I think we’ll get to the same place in Europe, but possibly over a longer timeframe and in a more piecemeal fashion,” said one senior industry participant, involved in EU talks over regulatory reform.

The US announcement was given a cautious welcome by the European Commission itself. “We haven’t studied it in detail yet, but it seems to be on the same wavelength,” said a spokesman for EU internal market commissioner Charlie McCreevy.

The EU has already hammered out plans that should see centralised clearing of credit default swaps, one of the biggest classes of OTC derivatives, introduced this year. After weeks of wrangling with regulators, the industry agreed to a system for clearing most EU-based credit default swaps in Europe by end-July.

The idea of broadening the range of OTC instruments that are subject to central counterparty clearing has also been aired, although there are questions over whether there is sufficient standardisation in some other classes of swaps to make this feasible.

Mr McCreevy, however, has said that this is something he would personally welcome, and Brussels is understood to be consulting informally on the issue.

“I am aware of the many reasons why more of these [OTC] derivatives are not exchange-traded. However, I am not convinced that more derivatives could not be standardised. This is one of the issues we need to look at in the time ahead,” the commissioner has said.

Commission officials are due to release a broader report on the market for derivatives and other complex structured products towards the end of June. This will explore “appropriate initiatives to increase transparency and ensure financial stability”.

“Given the size of the derivatives markets, I am looking at whether other measures might be necessary to make sure they are adequately supervised and do not pose unnecessary risks to financial markets,” the commissioner has said.

Industry lobbyists say one possibility is that changes to bolster the capital which banks and others trading in complex products have to hold could be dealt with through further amendments to the existing capital requirements directive.

Other perceived regulatory weaknesses might be handled through a scheduled review of Mifid (the Markets in Financial Instruments Directive) later this year. Some observers contend that Mifid already tackles some of the issues flagged up by Mr Geithner. “In Europe, under Mifid, a lot is already captured,” claimed one industry player.

Industry players suspect that, while Europe’s reforms might not look as elegant as the overhaul of the US’s Commodity Exchange Act, they might arrive at much the same result.