Friday, June 19, 2009

Costs set to rise amid shake-up in derivatives trading

Posted in the Financial Times by Michael Mackenzie and Aline van Duyn:

The message is clear: it is going to cost more to trade derivatives.

The plans for regulatory reform unveiled by the Obama administration this week are seeking one of two things. Either users of derivatives have to put aside capital themselves if the contracts are traded privately, or margins have to be paid to clearing houses to cover potential losses.

Regulators – particularly the Federal Reserve – are seeking the authority to raise both capital and margins if they think they need to. This will particularly apply for tailored transactions that, by their nature, are less liquid, riskier and harder to value. These have also been exceedingly profitable for banks in recent decades.

“Somewhere in the system, someone is likely to have to pay more to use over-the-counter derivatives,” said Joel Telpner, partner at Mayer Brown.

The debate about the future of financial regulation is heating up as the government seeks Congressional approval and many investors and dealers have already become more conservative on risk.

The biggest shift follows a realisation that risks resided not just with unregulated investors, such as hedge funds, but with big dealers themselves. In the decade after the collapse of Long-Term Capital Management, the highly leveraged hedge fund that collapsed in 1998, the big fear among bankers and regulators was a replay of that episode.

Hence investment banks kept hedge funds on a relatively tight leash during the credit boom. Although hedge funds operated in the unregulated over-the-counter (OTC) derivatives markets with plenty of leverage, banks required that trades were backed by collateral – assets that were held by the banks as a proportion of the positions outstanding.

This tough risk management approach to collateral was not always emulated by investment banks themselves. They also relied heavily on short-term funding through the repurchase (or repo) market. Through it, assets ranging from Treasury bonds to complex mortgage-backed securities, were lent out overnight and the cash helped finance these holdings.

At the peak last year, the Bank of International Settlements estimated the former top US investment banks funded roughly half of their assets using repo markets. That exposed banks to a classic run given their heavy reliance on short-term financing.

“The demise of Bear Stearns and Lehman Brothers has put the notion in question that hedge funds are the riskier party in a privately negotiated derivatives transaction,” say analysts at Celent in a report.

There are many lessons from this. First, the use of high-quality collateral has become widespread across privately traded markets from OTC derivatives to repo to securities lending.

Second, assumptions about pricing have become much more conservative – previously pricing did not reflect the huge discounts required to sell many assets held as collateral in a liquidation situation.

“The purpose of collateral is to protect the lender and it must be priced conservatively so as to protect their interests,” says Kelly Mathieson, managing director, clearance and collateral management at JPMorgan.

Celent said that collateral had become heavily weighted in favour of cash, and this trend would continue. “The coming years will bring tougher collateral agreements with reduced thresholds and more restrictions on eligible collateral, by excluding exotic, less liquid assets,” the report said. “Aside from tightening credit terms, OTC participants are examining the creditworthiness of their counterparties more closely.”

Greenwich Associates summed up the new risk attitudes in a report this week. A survey of 152 corporate and public pension funds, endowments and foundations in the US and Canada found that 47 per cent have cut back on their securities lending programmes – the shares or bonds lent out to banks. A further 19 per cent plan to reduce lending further.

Amid these shifts, there is a strong undercurrent of tension as dealers and investors tussle for control. The move towards greater use of electronic systems for clearing and trading means that banks are already meeting some requirements from regulators to increase transparency and reduce risks.

Lee Olesky, chief executive officer at Tradeweb, an electronic trading platform for fixed income and derivatives products, says: “The proper solution for the OTC derivatives market lies in enabling access for multiple trading systems to central counterparty clearing mechanisms.”

However, faced with lower profits as investors alter their behaviour and regulators impose tougher standards, dealers are willing to improve the derivative infrastructure up to a point. One bone of contention is a clearing house for credit derivatives. Regulators have pushed dealers to commit to including investors, but the details are still being fought over.

“I want equal access to a central clearing house as dealers,” said Michael Kastner, portfolio manager at SterlingStamos, a hedge fund. “We have seen the worst case scenario and it makes sense to put all the market on an equal footing.”

Looming over all this will be the shadow of the Federal Reserve. It wants to have the final word over whether the amounts put aside to cover risks are enough, having lost faith in its ability to rely on “moral suasion”. The government report on regulatory reform says: “Responsibility and authority for ensuring consistent oversight of all systemically important payment, clearing, and settlement systems and activities should be assigned to the Federal Reserve.

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