Sunday, December 12, 2010

Counterparty risk and contract volumes in the credit default swap market (BIS)

by Nicholas Vause

Abstract: After more than a decade of rapid growth, the volume of outstanding credit default swaps peaked at almost $60 trillion at the end of 2007. Since then it has nearly halved, while turnover has continued to rise. The decline in volumes outstanding reflects intensified efforts to reduce counterparty risk, which have eliminated more than $65 trillion of offsetting positions.

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Tuesday, December 7, 2010

The Inefficiency of Clearing Mandates (Craig Pirrong)

Abstract: In the aftermath of the financial crisis, attention has turned to reducing systemic risk in the derivatives markets. Much of this attention has focused on counterparty risk in the over-the-counter market, where trades are bilaterally executed between dealers and derivative purchasers. One proposal for addressing such counterparty risk is to mandate the trading of derivatives over a centralized clearinghouse. This paper lays out the advantages and risks to a mandated clearing requirement, showing how, in some instances, such a mandate can actually increase systemic risk and result in more financial bailouts.

This paper also describes the dynamics of counterparty risk in the derivatives market. Discussing the relative importance of both the risk that arises from the price risk of the instrument at issue and the financial condition of the counterparty. The analysis then turns to an evaluation of how bilateral markets and clearinghouses manage these two risks. After demonstrating that resolving and replacing defaulted trades is the primary resolution problem facing both market structures, the paper lays out an auction alternative designed to address this issue.

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Thursday, December 2, 2010

An Analysis of Euro Area Sovereign CDS and their Relation with Government Bonds

by Alessandro Fontana, and Martin Scheicher
ECB Working Paper No. 1271

Abstract: This paper studies the relative pricing of euro area sovereign CDS and the underlying government bonds. Our sample comprises weekly CDS and bond spreads of ten euro area countries for the period from January 2006 to June 2010. We first compare the determinants of CDS spreads and bond spreads and test how the crisis has affected market pricing. Then we analyse the ‘basis’ between CDS spreads and bond spreads and which factors drive pricing differences between the two markets. Our first main finding is that the recent repricing of sovereign credit risk in the CDS market seems mostly due to common factors. Second, since September 2008, CDS spreads have on average exceeded bond spreads, which may have been due to ‘flight to liquidity’ effects and limits to arbitrage. Third, since September 2008, market integration for bonds and CDS varies across countries: In half of the sample countries, price discovery takes place in the CDS market and in the other half, price discovery is observed in the bond market.

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The impact of CDS trading on the bond market: evidence from Asia

by Ilhyock Shim and Haibin Zhu
BIS Working Papers No 332

Abstract: This paper investigates the impact of CDS trading on the development of the bond market in Asia. In general, CDS trading has lowered the cost of issuing bonds and enhanced the liquidity in the bond market. The positive impact is stronger for smaller firms, non-financial firms and those firms with higher liquidity in the CDS market. These empirical findings support the diversification and information hypotheses in the literature. Nevertheless, CDS trading has also introduced a new source of risk. There is strong evidence that, at the peak of the recent global financial crisis, those firms included in CDS indices faced higher bond yield spreads than those not included.

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Tuesday, November 23, 2010

What Reforms for the Credit Rating Industry? A European Perspective (SSRN)

By Karel Lannoo (Centre for European Policy Studies, Brussels)

Abstract: Despite having singled out credit rating agencies (CRAs) early on in the financial crisis as needing more regulation, policy-makers in the EU seem not to be reassured by the measures that have been adopted in the meantime, and want to go further. This paper starts with an overview of the credit rating industry today. The second section analyses the use of credit ratings and shows how the authorities have created a captive or artificial market for CRAs. Section 3 reviews the new EU CRA regulation and its possible impact, and the final section compares proposals for regulatory reform.

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Monday, November 22, 2010

The Effect of Market Structure on Counterparty Risk (SSRN)

By Dale W. R. Rosenthal

Abstract: Two network structures of derivative contracts are studied as representatives of a bilaterally-cleared OTC market and a centrally-cleared market. An initial bankruptcy induces counterparties to trade with price impact. The two market structures yield economically different price impact, volatility and follow-on bankruptcies. A large market-induced bankruptcy yields two destabilizing phenomena in bilateral markets: checkmate and hunting. Checkmate occurs when a counterparty cannot expect to prevent impending bankruptcy. Hunting occurs when counterparties push markets further than necessary, inducing further bankruptcies which may yield profits. The results suggest that bilateral OTC markets have larger externalities (distress volatility) which can be priced relative to centrally-cleared markets. Bilateral OTC markets are also more sub ject to liquidity and funding crises. This has real effects: follow-on bankruptcies, unemployment, a reduction in tax revenue, higher transactions costs, less risk sharing, and thus a reduction in allocative efficiency. Pricing the distress volatility may suggest when and how to encourage markets to transition from bilateral OTC to central clearing. The results also suggest that limiting leverage ratios may reduce distress, that leverage limits may not vary linearly with capital, and that in times of distress coordination by market authorities has value.

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Friday, November 19, 2010

Australian and Japanese Authorities Seek Permanent SEC Rule 17g-5 Exemption

The Australian Securitisation Forum ("AuSF") and Japanese Financial Services Agency (FSA) have submitted letters to the SEC staff in which they have requested that the Commission make permanent the exemption for extraterritorial ratings from requirements of Rule 17g-5. Please click here for the AuSF letter and here for the FSA counterpart.

Wednesday, November 17, 2010

Only 11% of CDS positions were vis-à-vis a CCP (BIS)

The latest BIS seminannual OTC derivative survey introduced additional information on the importance of central counterparties (CCPs) in the CDS market:

At end-June 2010, about 11% of CDS positions were vis-à-vis a CCP. This relatively low share reflects the large amount of non-standard CDS contracts covered in the BIS survey, which are not easily traded with CCPs. In terms of market value, contracts with CCPs account for only 4% of the total value of CDS. The discrepancy between their shares of notional amounts and market values could reflect the fact that CDS indices, which are popular products cleared by CCPs, are often less volatile than other CDS, such as single-name CDS, because of the diversification benefits of the former. Approximately twice as many multi-names as single-name contracts are traded with CCPs.

For the graphics and tables, get the report here:

Wednesday, November 10, 2010

Market structure developments in the clearing industry (CPSS)

During the last decade, the central clearing industry has experienced a large number of changes, which have profoundly affected both its role in the broader financial infrastructure and its own market structure. In June 2009, the Committee on Payment and Settlement Systems (CPSS) therefore commissioned a working group to investigate the developments in the clearing industry's market structure, their drivers and the implications for financial stability. The Working Group was also asked to assess whether different market structures give rise to new risks that may affect the robustness of central counterparties (CCPs) and to outline some practical issues for central banks, regulators and overseers with an interest in the stability of CCPs.

This report first provides a broad overview of the clearing industry in CPSS countries, covering both traditional markets and OTC derivatives markets. In particular, it describes developments in market structure between 2000 and 2010. Second, the report assesses how far these developments have given rise to new risks. It further outlines practical issues that central banks, regulators and overseers may wish to consider, either as part of their oversight role or in the context of their broader financial stability remit. Furthermore, the report examines to what extent changes in market structure or ownership might affect the expansion of central clearing services. Finally, the effect of ownership on CCPs' incentives to manage their counterparty risk is considered.

The report shows that different types of market structure have developed over the last decade. However, there is no evidence that the industry is settling on one particular structure. Specific market structures may create specific risks and amplify interdependencies between systems and markets. These warrant careful consideration by both market participants and the authorities. However, there is no evidence to suggest that one market structure is superior to another, either in terms of CCP risk management or in terms of wider systemic risk. In fact, many risks occur in several types of structures.

Nevertheless, central banks, regulators and overseers may usefully pay attention to specific risks that are more likely to occur in some market structures than in others. These include incentives to weaken the robustness of CCP risk controls that may in turn reduce in the CCP's ability to manage a member default. Although some of the risks considered in the report have yet to materialise, CCPs and their regulators or overseers face significant future challenges, in particular as market structures in many countries continue to evolve. Hence, public authorities will need to continue applying rigorous and consistent oversight.

The clearing industry's structure also has a bearing on how far central clearing will be used in different market segments, and hence on the resilience of the financial system as a whole. In fact, the broader risk-mitigation benefits of central clearing may be diluted if changes in market structure affect access to CCPs, raise the cost of central clearing or hamper the process of creating new CCP services.

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Friday, November 5, 2010

The European Commission consults on rating agency policy

As part of its further work in creating a sounder financial system, the Commission services have launched today a broad consultation on credit rating agencies (CRAs). Whilst credit rating agencies are important actors in the financial markets, recent developments during the euro debt crisis have shown that there may be a need to re-examine certain aspects of the current regulatory framework. There are growing concerns that financial institutions and institutional investors may be relying too much on external ratings and do not carry out sufficient internal credit risk assessments, which may lead to volatile markets and instability of the financial system. The purpose of this consultation is to open a wider debate and get input from all stakeholders in order to calibrate the scope and ambition of any possible future legislative initiative in the field of credit rating agencies. These issues are similar to those raised at a global level in the recent Financial Stability Report. The deadline for replies is 7 January 2011.

Internal Market and Services Commissioner Michel Barnier said: "We need to learn all the lessons of the crisis. We have already Introduced EU-wide rules for better supervision and increased transparency in the credit rating market. This was an important first step. But we need to think about step two: the role of ratings themselves and the impact they can have on markets. Today, we are launching a consultation where we ask all the questions that need to be asked. The feedback we get will help us determine what further action is needed."

On 7 December 2010, a new EU regulatory framework applicable to the credit rating sector will come into force. New rules will require credit rating agencies to comply with rules of conduct in order to minimise potential for conflicts of interest, ensure higher quality ratings and greater transparency of ratings and the rating process. (See IP/09/629).

However, learning lessons from the recent euro debt crisis, some issues related to credit rating agencies still need to be sorted out. The consultation launched today asks a whole series of questions to gather views from all stakeholders on possible initiatives to strengthen the regulatory framework further for credit rating agencies.

Questions asked include:

- Overreliance: the recent euro debt crisis has renewed concerns that financial institutions and institutional investors may be relying too much on external credit ratings. The question should be asked as to whether it is right that European and national legislation refers to credit ratings, thus giving them a very important role, and whether alternatives could exist. The Commission therefore asks which measures could reduce this possible overreliance and increase disclosure by issuers of structured finance instruments in order to allow investors to carry out their own additional due diligence on a well-informed basis;

- Improving sovereign debt rating: sovereign debt ratings play a crucial role for the rated countries, since a downgrading has the immediate effect of making a country's borrowing more expensive. Given the importance of these ratings, it is essential that ratings of this asset class are timely and transparent. While the EU regulatory framework for credit ratings already contains measures on disclosure and transparency that apply to sovereign debt ratings, further measures could be considered to improve transparency, monitoring, methodology and the process of sovereign debt ratings in EU;

- Competition: Only a handful of big firms make up the CRA sector. There are high barriers to entry. Concerns have been expressed that the rating of large multinationals and structured finance products is concentrated in the hands of only a few CRAs. This lack of competition could negatively impact the quality of credit ratings. The Commission asks what options exist to increase diversity in this sector;

- Liability: the rules on whether and under which conditions civil liability claims by investors against credit rating agencies are possible currently vary greatly between Member States. It is possible that these differences could result in CRAs or issuers shopping around, choosing jurisdictions under which civil liability is less likely. The Commission asks whether there is a need to consider introducing a civil liability regime in the EU regulatory framework for CRAs;

- Conflicts of interest: The "issuer-pays" model raises questions of conflict of interest. This model is when issuers solicit and pay for the ratings of their own debt instruments. This model is the prevailing model among CRAs. As rating agencies have a financial interest in generating business from the issuers that seek the rating, this could lead to assigning higher ratings than warranted in order to encourage the issuer to more business with them in future for example. It may also lead to practices of "rating shopping", which is when an issuer chooses a CRA on the basis of its likely rating. The Commission asks what evidence there is for such practices and whether alternative models would be possible.

On the basis of the replies to the consultation, the Commission will decide on the need for any measures in 2011.

More information:

Concentration of OTC Derivatives among Major Dealers (ISDA)

Abstract: U.S.-based derivatives dealers account for 37 percent of the global total notional amount outstanding of derivatives reported by Survey respondents. The largest fourteen derivatives dealers (G14) hold 82 percent of the total notional amount outstanding. Broken out by products, the G14 group holds 82 percent of interest rate derivatives, 90 percent of credit default swaps, and 86 percent of equity derivatives. Evaluated by traditional measures, concentration of notional amounts among major dealers appears to be low.

The full report:

Monday, November 1, 2010

Credit Risk Transfers and the Macroeconomy (ECB)

Abstract: The recent financial crisis has highlighted the limits of the "originate to distribute" model of banking, but its nexus with the macroeconomy and monetary policy remains unexplored. I build a DSGE model with banks (along the lines of Holmström and Tirole [28] and Parlour and Plantin [39]) and examine its properties with and without active secondary markets for credit risk transfer. The possibility of transferring credit reduces the impact of liquidity shocks on bank balance sheets, but also reduces the bank incentive to monitor. As a result, secondary markets allow to release bank capital and exacerbate the effect of productivity and other macroeconomic shocks on output and inflation. By offering a possibility of capital recycling and by reducing bank monitoring, secondary credit markets in general equilibrium allow banks to take on more risk.

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Friday, October 29, 2010

Reform of Over-the-Counter (OTC) Derivatives Markets in Canada

The Canadian OTC Derivatives Working Group published a paper that sets out preliminary recommendations for implementing Canada's G-20 commitments related to OTC derivatives.

The recommendations cover five areas of reform, as follows:

  • capital incentives and standards
  • standardization
  • central counterparties and risk management
  • trade repositories
  • trading venues

See Reform of Over-the-Counter (OTC) Derivatives Markets in Canada.

The OTC Derivatives Working Group is an interagency group chaired by the Bank of Canada, composed of members from the Office of the Superintendent of Financial Institutions (OSFI), the federal Department of Finance, the Ontario Securities Commission, the Autorité des marchés financiers du Québec, the Alberta Securities Commission and the Bank of Canada.

Thursday, October 28, 2010

FSB issues principles to reduce reliance on CRA credit ratings

The FSB published on 27 October Principles for Reducing Reliance on Credit Rating Agency (CRA) ratings. The goal of these principles is to reduce the cliff effects from CRA ratings that can amplify procyclicality and cause systemic disruption. The principles would do so by removing the "hard wiring" of CRA rating thresholds into regulatory regimes, which cause mechanistic market responses to CRA rating changes. Such changes would incentivise banks and other financial institutions to improve their independent credit risk assessment and due diligence capacity.

The FSB is asking standard setters and regulators to consider the next steps to translate the principles into more specific policy actions to reduce reliance on CRA rating over a reasonable timeframe. The FSB will monitor progress.

Monday, October 25, 2010

FSB publishes report on improving OTC derivatives markets

The Financial Stability Board (FSB) published today a report on Implementing OTC Derivatives Market Reforms. The report responds to calls by G20 Leaders at the Pittsburgh and Toronto Summits to improve the functioning, transparency and regulatory oversight of over-the-counter (OTC) derivatives markets..

The report sets out recommendations to implement the G20 commitments concerning standardisation, central clearing, organised platform trading, and reporting to trade repositories. The report represents a first step toward consistent implementation of these commitments. Authorities will need to coordinate closely to minimise the potential for regulatory arbitrage.

The report was developed by a working group comprising international standard setters and authorities with the responsibility for translating the G20 commitments into standards implementing regulations.

It can be downloaded here:

Wednesday, October 20, 2010

The Persistent Negative CDS-Bond Basis during the 2007/08 Financial Crisis

By Alessandro Fontana

Abstract: I study the behaviour of the CDS-bond basis - the difference between the CDS and the bond spread - for a sample of investment-graded US firms. I document that, since the onset of the 2007/08 financial crisis it has become persistently negative, and I investigate the role played by the cost of trading the basis and its underlying risks. To exploit the negative basis an arbitrageur must finance the purchase of the underlying bond and buy protection. The idea is that, during the crisis, because of the funding liquidity shortage and the increased risk in the financial sector, which exposes protection buyers to counter-party risk, the negative basis trade is risky. In fact, I find that basis dynamics is driven by economic variables that are proxies for funding liquidity (cost of capital and hair cuts), credit markets liquidity and risk in the inter-bank lending market such as the Libor-OIS spread, the VIX, bid-asks spreads and the OIS-T-Bill spread. Results support the evidence that during stress times asset prices depart form frictionless ideals due to funding liquidity risk faced by financial intermediaries and investors; hence, deviations from parity do not imply presence of arbitrage opportunities.

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Friday, October 15, 2010

Robust Linkages between CDs and Credit Spreads

By Rajna Gibson and Silika Prohl

Abstract: We propose a new statistical technique, namely the wild bootstrap base method, to study the relationship between the CDS and the bond credit spreads. The finite sample properties of this statistical methodology are studied in several numerical experiments. We next apply this technique to a large sample of US and European firms' CDS data and report robust linkage between the CDS and credit spreads of highly rated companies. Furthermore, we compute the Value-at-Risk associated with CDS holdings and show that sudden jumps in volatility in August 2007 influenced their estimated VaR figures.

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Monday, October 11, 2010

Emergence and Future of Central Counterparties

By Thorsten V. Koeppl and Cyril Monnet

Abstract: The authors explain why central counterparties (CCPs) emerged historically. With standardized contracts, it is optimal to insure counterparty risk by clearing those contracts through a CCP that uses novation and mutualization. As netting is not essential for these services, it does not explain why CCPs exist. In over-the-counter markets, as contracts are customized and not fungible, a CCP cannot fully guarantee contract performance. Still, a CCP can help: As bargaining leads to an inefficient allocation of default risk relative to the gains from customization, a transfer scheme is needed. A CCP can implement it by offering partial insurance for customized contracts.

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Credit Ratings and Credit Risk

by Jens Hilscher of Brandeis University, and Mungo Wilson of Oxford University

Abstract: This paper investigates the information in corporate credit ratings. We examine the extent to which firms' credit ratings measure raw probability of default as opposed to systematic risk of default, a firms tendency to default in bad times. We find that credit ratings are dominated as predictors of corporate failure by a simple model based on publicly available financial information (failure score), indicating that ratings are poor measures of raw default probability. However, ratings are strongly related to a straight-forward measure of systematic default risk: the sensitivity of firm default probability to its common component (failure beta). Furthermore, this systematic risk measure is strongly related to credit default swap risk premia. Our findings can explain otherwise puzzling qualities of ratings.

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Tuesday, September 28, 2010

TABB Says Launch of CFD Clearing Service to Thrive Under New EU Derivatives Regulation; Buy-Side Firms to Benefit

In new research published today, TABB Group explains how a new Contracts-for-Difference (CFD) clearing service set to launch before the end of 2010 by LCH.Clearnet and Chi-X Europe is well timed as European regulators look to move derivatives into a centralized clearing model.

A centrally cleared Contract-For-Difference (ccCFD) is a CFD/equity swap that is initiated as an over-the-counter (OTC) trade and is brought on-exchange and cleared through a central clearing counterparty (CCP) instead of as a bilateral agreement. Clearinghouses and execution facilities are entering the space to benefit from expected growth in CFDs, proposed regulatory changes, and address buy-side concerns surrounding OTC counterparty risk.

According to Will Rhode, a research analyst in TABB’s London office and author of “Centrally Cleared CFDs: A Buy-Side Perspective,” centrally-cleared CFDs (ccCFDs) will add to the size of the overall CFD market, which TABB forecasts at a compound annual growth rate (CAGR) of 23% with notional amounts reaching £1.1 trillion by 2012, with ccCFDs estimated at £110 billion of the overall market.

The new joint initiative, Rhode explains, aims to benefit from expected growth in CFD, the proposed regulatory changes (on September 15, the European Union’s “European Regulation on OTC Derivatives, Central Counterparties and Trade Repositories” ruling proposed mandatory CCP clearing for eligible OTC derivatives) and address buy-side concerns surrounding over the counter (OTC) counterparty risk.

Describing the new service, Rhode points out that while it will not have a formal exchange listing, it will offer a wholesale, standardized CFD product in a central clearing counterparty model with a complete post-trade transparency. Set for a soft launch in the fourth quarter this year at a time when first adopters and allocated clearing members (ACMs) test the waters, he says, the new ccCFD service, which is not expected to ramp up until early in 2011,has the approval of HM Revenue & Customs (HMRC), effectively legitimising tax uncertainty around CFDs.

“The new ccCFD service,” he says, “will appeal to long-only asset managers on the prowl for risk management tools (and currently use single-stock futures), UCITS III funds seeking counterparty credit risk mitigation models, statistical arbitrage hedge funds looking for tax certainty and retail aggregators facing capital adequacy regulation.” In the event that European regulators force CFDs into a central counterparty (CCP) clearing house, he adds, TABB, expecting ccCFDs will ultimately replace the existing OTC CFD market, estimates that the ccCFD market place will grow dramatically, reaching £245 billion in 2011, rising to £440 billion in 2012.

“At TABB,” says Rhode, “we expect that the success of the service will be influenced heavily by the extent of impending regulation. We will see either OTC CFDs forced into a clearing model or, at the very least, make it more capital intensive, in effect more expensive, to provide OTC CFDs.”

The 19-page report with 15 exhibits, based on conversations with long only asset managers, hedge funds, retail aggregators, prime brokers, clearing houses and exchanges, provides a detailed description of the types of firms that may be attracted to a clearing service for CFDs, and their respective motivations for doing so. It also examines key regulatory developments and their potential implications for the new service’s launch.

The report is available for immediate download by all TABB Research Alliance Equity clients and pre-qualified media at For an executive summary or to purchase the report, please visit, or write to

Monday, September 27, 2010

FDIC Board Approves Final Rule Regarding Safe Harbor Protection for Securitizations (FDIC)

The Board of Directors of the Federal Deposit Insurance Corporation (FDIC) today approved a final rule to extend through December 31, 2010, the Safe Harbor Protection for Treatment by the FDIC as Conservator or Receiver of Financial Assets Transferred by an Insured Depository Institution in Connection With a Securitization or Participation. Under this safe harbor, all securitizations or participations in process before the end of 2010 are permanently grandfathered under the existing terms of 12 C.F.R. Part 360.6.

When a safe harbor was initially adopted in 2000 for securitizations and participations, the FDIC provided important protections for securitizations and participations by confirming that in the event of a bank failure, the FDIC would not try to reclaim loans transferred into such transactions so long as an accounting sale had occurred. In June of last year, however, the Financial Accounting Standards Board ("FASB") finalized modifications to the accounting treatment for such transactions through Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets, an Amendment of FASB Statement No. 140 ("FAS 166") and Statement of Financial Accounting Standards No. 167, Amendments to FASB Interpretation No. 46(R) ("FAS 167"). Following the November 15, 2009 effective date of these changes, most securitizations no longer meet the off-balance sheet standards for sale accounting treatment and, as a result, no longer comply with the preconditions for the application of the original FDIC safe harbor.

The FDIC Board had previously extended the protections twice, with the last set to expire on September 30, 2010. The final rule is substantially similar to the March 11, 2010, extension.

"This rule has been in process for nearly a year, and the industry should have no problem adjusting to it by the time the safe harbor expires at the end of the year," said FDIC Chairman Sheila C. Bair. "A fair balance has been struck between protecting the FDIC's Deposit Insurance Fund and allowing participants to adjust to a safer, more transparent securitization market. We want the securitization market to come back, but in a way that is characterized by strong disclosure requirements for investors, good loan quality, accurate documentation, better oversight of servicers, and incentives to assure that assets are managed in a way that maximizes value for investors as a whole. Importantly, the rule is fully consistent with the clear mandate of the Dodd-Frank Act to apply a 5% risk retention requirement unless sufficiently strong underwriting standards are in place to counter incentives for lax lending created by the originate to distribute model. We look forward to working with our colleagues in developing those standards. Once in place, our rule will automatically conform to the interagency regulations."

The FDIC safe harbor regulation fully conforms to the provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act and addresses issues of particular interest to the FDIC in its responsibilities as deposit insurer and receiver for failed insured institutions. In order to ensure that the safe harbor regulation fully conforms with the risk retention regulations required by the Dodd-Frank Act, the FDIC's new safe harbor rule provides that, upon adoption of those interagency regulations, those final regulations shall exclusively govern the risk retention requirement in the safe harbor regulation.

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Attachment: Safe Harbor Extension Final Rule - PDF (PDF Help)

Friday, September 24, 2010

Bank of America Merrill Lynch Announces Formation of Global Futures and Derivatives Clearing Services

NEW YORK, Sep 23, 2010 (BUSINESS WIRE) -- Bank of America Merrill Lynch ("BofA Merrill") is pleased to announce the formation of the Global Futures and Derivatives Clearing Services (GFDCS) group. This global initiative is in anticipation of the substantial growth in OTC derivatives clearing and the tremendous demand for education and related services from the company's institutional investor and corporate clients.

GFDCS builds off the company's highly rated Futures business -- known for its excellence in clearing services and access to more exchanges than any other broker -- to provide agent-clearing services for rates, currencies, credit, equities and commodities derivatives. The GFDCS group will operate as part of BofA Merrill's industry-leading Global Markets Financing and Futures platform (GMF&F), which includes prime brokerage and services.

Bob Burke and Gonzalo Chocano have been named co-heads of the GFDCS group, reporting to Denis Manelski and Syl Chackman, co-heads of GMF&F.

"Establishing an industry-leading derivatives clearing service is a top priority for our Global Markets business. Every client we serve will be impacted by the financial reforms transforming the OTC derivatives market," said Tom Montag, president of Global Banking and Markets. "We are committing considerable resources to all areas of the business to ensure our client clearing services are best-in-class."

The launch of BofA Merrill's GFDCS platform follows a yearlong planning effort, including feedback from more than 3,000 clients who have attended educational seminars and one-on-one briefings.

"Bank of America Merrill Lynch is taking an important leadership role in educating the industry and dealing with issues surrounding OTC derivatives clearing," said Mike Roberge, president of Mass Financial.

"Bank of America Merrill Lynch was one of the first dealers to recognize and prepare for the transformation of the derivatives clearing market. We are grateful that they stepped up to the plate as testing agent on behalf of many market participants," said Martha Tirinnanzi, chairperson of the clearinghouse working group of the Federal Housing Finance Agency, at an industry conference held earlier in the year.

S&P Launches “Understanding Ratings” Web Site

NEW YORK (Standard & Poor's) Sept. 21, 2010--Standard & Poor's Ratings Services, one of the world's leading credit rating agencies, today launched "Understanding Ratings," a new information and education resource for investors that can be found at UnderstandingRatings. The Web site brings together, free of charge, articles, videos, podcasts, and educational guides to provide insights into what credit ratings are (and what they are not), the processes by which Standard & Poor's produces ratings, and how those ratings have performed over time.

"Discussions with investors around the world over the past two years have consistently highlighted their desire for more transparency about how ratings are determined," said Bruce Schachne, Vice President of Market Development at Standard & Poor's. "Credit ratings continue to serve as benchmarks for creditworthiness, and investors continue to utilize credit ratings and research as part of their investment decision making processes. Investors seek a better understanding of how Standard & Poor's arrives at its ratings--what the methodologies are, what role the analysts play in the process, and how ratings perform. UnderstandingRatings was designed to meet the information and ratings transparency needs of the investment community, particularly pension funds and plan sponsors. Moreover, our ratings and research are aimed at helping investors better identify and understand credit risks."

UnderstandingRatings focuses on three core elements of credit ratings:
  • Criteria used to determine ratings and analytics;
  • Ratings performance; and
  • People--the 1,300 Standard & Poor's analysts around the globe who rate debt securities.
To explain these areas, Standard & Poor's rating analysts, credit officers, ratings executives and other staff address topics such as:
  • The ratings process and the processes we have put in place to support the independence of ratings;
  • The specific methodologies used to analyze various asset classes such as corporate bonds, municipal bonds,structured finance, and sovereign debt;
  • The ways in which ratings performance can be measured and compared;
  • An evaluation of the performance of ratings in various asset classes over the past several years;
  • The role of the analyst and rating committee in arriving at ratings, and
  • Standard & Poor's credit outlook for various industries, sectors, countries, and regions.
In addition, the site allows users to download Standard & Poor's "Guide to Credit Rating Essentials" and "Guide to Ratings Performance," which explain key concepts of credit ratings in simple, accessible language.

Ratings performance has been a particular area of heightened investor focus over the past two years.

"In the wake of the financial crisis, there has been much discussion about the performance of credit ratings," said Deven Sharma, President of Standard & Poor's. "Earlier this year, we conducted a comprehensive review of credit ratings, and the review demonstrated that ratings, for nearly all asset classes, performed broadly as expected in the face of the extreme stresses of the past two year, with the exception of ratings on certain U.S. residential mortgage-related securities. Through the 'Guide to Ratings Performance' and other materials on UnderstandingRatings, we address the questions that investors have posed regarding recent ratings performance, deliver facts and data on how ratings have, in fact, performed, and also provide details on the changes that Standard & Poor's has made based on lessons learned from the recent financial crisis."

UnderstandingRatings is the most recent initiative in Standard & Poor's ongoing investor outreach program, which also includes conferences, seminars, live video Web casts, teleconferences, mobile applications (including our successful CreditMatters iPhone app available free of charge through iTunes). Standard & Poor's also conducts countless meetings and calls between Standard & Poor's analysts and investors each year.

Wednesday, September 22, 2010

Completing CVA and Liquidity: Firm-level positions and collateralized trades

by Chris Kenyon of DEPFA Bank Plc.

Abstract: Bilateral CVA as currently implement has the counterintuitive effect of pro ting from one's own widening CDS spreads, i.e. increased risk of default, in practice. The unified picture of CVA and liquidity introduced by Morini & Prampolini 2010 has contributed to understanding this. However, there are two significant omissions for practical implementation that come from the same source, i.e. positions not booked in usual position-keeping systems. The first omission is firm-level positions that change value upon firm default. An example is Goodwill which is a line item on balance sheets and typically written down to zero on default. Another example would be firm Equity. The second omission relates to collateralized positions. When these positions are out of the money in future, which has a positive probability, they will require funding that cannot be secured using the position itself. These contingent future funding positions are usually not booked in any position-keeping system. We show here how to include these two types of positions and thus help to complete the unified picture of CVA and liquidity.

For a particular large complex financial institution that profited $2.5B from spread widening we show that including Goodwill would have resulted in a $4B loss under conservative assumptions. Whilst we cannot make a similar assessment for its collateralized derivative portfolio we calculate both the funding costs and the CVA from own default for a range of swaps and find that CVA was a positive contribution in the examples.

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Friday, September 10, 2010

The 2010 Tahawwut Master Agreement: Paving the Way for Shari'Ah-Compliant Hedging

By Richard Fagerer, Michael E. Pikiel Jr., and Michael J.T. McMillen, Fulbright & Jaworski L.L.P.

Abstract: Modern Islamic finance remains in its infancy, having emerged only in the mid-1990s. Despite exceptional growth rates, Islamic finance is essentially devoid of derivatives products, in part due to doctrinal constraints and due in part to the infancy of the industry. In March of 2010, after years of effort, the International Swaps and Derivatives Association (ISDA) and International Islamic Financial Market (IIFM) released The 2010 Tahawwut Master Agreement for the standardized effectuation of certain swaps and derivative transactions that are compliant with the principles of Islamic Shari`ah. This paper analyzes certain provisions of The 2010 Tahawwut Master Agreement and compares those provisions with ISDA’s 2002 Master Agreement.

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Thursday, September 9, 2010

CFTC, SEC to Host Public Roundtable to Discuss Swap Data, Swap Data Repositories and Real Time Reporting

Staff from the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC) will hold a public roundtable on September 14, 2010, to discuss issues related to swap data repository (SDR) registration, functions and responsibilities, the mechanics of data reporting, models for real time public reporting and the effect of transparency on liquidity of block trades and large transaction sizes.

The roundtable will assist both agencies in the rulemaking process to implement the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The roundtable will be held in the Lobby Level Hearing Room at the CFTC’s Headquarters, Three Lafayette Centre, 1155 21st Street, NW, Washington DC. The discussion will be open to the public with seating on a first-come, first-served basis. Members of the public also may listen by telephone and should be prepared to provide their first name, last name and affiliation.

U.S./Canada Toll-Free: (866) 312-4390 begin_of_the_skype_highlighting (866) 312-4390 end_of_the_skype_highlighting

International Toll: (404) 537-3379 begin_of_the_skype_highlighting (404) 537-3379 end_of_the_skype_highlighting

Conference ID: 98801653

A transcript of the public roundtable discussion will be published on the CFTC’s website. Members of the public wishing to submit their views on the topics addressed at the roundtable may e-mail their submissions to the e-mail addresses provided on the CFTC’s website on the Swap Data Repositories Registration Standards and Core Principle Rulemaking page, Interpretation & Guidance page, Data Recordkeeping & Reporting Requirements page or Real Time Reporting page, or through the comment form or e-mail address for roundtable comments provided on the SEC website.

All submissions provided to either the CFTC or the SEC in any electronic form or on paper will be published on the website of the respective agencies, without review and without removal of personally identifying information.

Agenda for the Joint CFTC-SEC Public Roundtable Discussion

8:45 a.m.

Opening Statements by CFTC and SEC Staff

9:00 a.m.

Panel One – SDR Registration, Functions and Responsibilities

Duties of SDRs in addition to those required by the Dodd-Frank

The most efficient and effective way for SDRs to execute their statutory duties

How to implement the confirmation function under Dodd-Frank—to what extent and under what circumstances will SDRs be expected to do trade confirmations

10:45 a.m.


11:00 a.m.

Panel Two – Mechanics of Data Reporting

Type of data reported by SDRs, derivatives clearing organizations (DCOs), designated contract markets (DCMs), swap execution facilities (SEFs), swap dealers and major swap participants (MSPs)

Parties responsible for reporting of swap and security-based swap data

Means by which mandatory reporting may be made Reporting of swap and security-based swap transactions executed or cleared on an electronic platform

The time by which swap and security-based swap transactions must be reported

Handling of data corrections

Reporting of life cycle events

Reporting of past transactions

12:45 p.m.

Lunch Break

1:45 p.m.

Panel Three – Models for Real-Time Transparency and Public Reporting

Benefits of real time reporting of swaps and security-based swaps transactions

Entities responsible for reporting

Data elements

Ensuring anonymity of market participants

The meaning of “real-time”

Appropriate media for real-time reporting of swap and security-based swap transaction data

Feasibility/desirability of a consolidated tape or ticker for swaps and security-based swaps

3:30 p.m.


3:45 p.m.

Panel Four – Effect of Transparency on Liquidity: Block Trade Exception

Defining block trades and large transaction sizes for swaps and security based swaps

Determining an appropriate delay for reporting block trades and large transactions

Effects of transparency on post-trade liquidity

Responsibility for determining minimum block sizes and large transaction sizes for reporting purposes

5:30 p.m.

Roundtable concludes

Wednesday, September 8, 2010

Alternatives to the Use of Credit Ratings in OCC Regulations

The Office of the Comptroller of the Currency (OCC) is seeking comment on two advance notices of proposed rulemaking regarding alternatives to the use of credit ratings in the OCC’s regulations. These advance notices are issued in response to section 939A of the Dodd–Frank Wall Street Reform and Consumer Protection Act, enacted on July 21, 2010.1 Section 939A requires the OCC and other federal banking agencies to review regulations that (1) require an assessment of the credit-worthiness of a security or money market instrument and (2) contain references to or requirements regarding credit ratings. In addition, the agencies are required to remove such references and requirements and replace them with substitute standards of credit-worthiness. In developing substitute standards of credit-worthiness, each agency is required to take into account the entities it regulates and, to the extent feasible, seek to establish uniform standards.

Use of Credit Ratings in Regulatory Capital Standards

The federal banking agencies (the OCC, Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision) currently use credit ratings issued by nationally recognized statistical rating organizations (NRSROs) in their risk-based capital standards. These standards reference credit ratings in four general areas: (1) the assignment of risk weights to securitization exposures under the general risk-based capital rules and advanced approaches rules; (2) the assignment of risk weights to claims on, or guaranteed by, qualifying securities firms under the general risk-based capital rules; (3) the assignment of certain standardized specific risk add-ons under the agencies’ market risk rule; and (4) the determination of eligibility of certain guarantors and collateral for purposes of the credit risk mitigation framework under the advanced approaches rules. In 2008, the agencies issued a notice of proposed rulemaking that sought comment on implementation in the United States of certain aspects of the standardized approach in the Basel Accord. The Basel standardized approach for credit risk relies extensively on credit ratings to assign risk weights to various exposures.

The agencies have issued a joint advance notice of proposed rulemaking (ANPR) to solicit comment and information as they begin to develop alternatives to the use of credit ratings in their capital rules (Capital ANPR). The Capital ANPR solicits input on alternative standards of credit-worthiness that could be used in lieu of credit ratings in those rules and asks for comments on a range of potential approaches, including basing capital requirements on more granular supervisory risk weights or on market-based metrics. The comment period for the Capital ANPR closes on October 25.

Use of Credit Ratings in Other OCC Regulations

The noncapital regulations of the OCC include various references to and requirements for use of credit ratings. These references include:

  • Investment Securities—The OCC’s investment securities regulations at 12 CFR 1 use credit ratings as a factor for determining the credit quality, liquidity/marketability, and appropriate concentration levels of investment securities purchased and held by national banks. For example, under these rules, an investment security must not be “predominantly speculative in nature.” The OCC rules provide that an obligation is not “predominantly speculative in nature” if it is rated investment grade or, if unrated, is the credit equivalent of investment grade. “Investment grade,” in turn, is defined as a security rated in one of the four highest rating categories by two or more NRSROs (or one NRSRO if the security has been rated by only one NRSRO). Credit ratings are also used to determine marketability in the case of a security that is offered and sold pursuant to Securities and Exchange Commission Rule 144A. In addition, credit ratings are used to determine concentration limits on certain investment securities.
  • Securities Offerings—Securities issued by national banks are not covered by the registration provisions and SEC regulations governing other issuers’ securities under the Securities Act of 1933. However, the OCC has adopted part 16 to require disclosures related to national bank-issued securities. Part 16 includes references to “investment grade” ratings. For example, section 16.6, which provides an optional abbreviated registration system for debt securities that meet certain criteria, requires that a security receive an investment grade rating in order to qualify for the abbreviated registration system.
  • International Banking Activities—Pursuant to section 4(g) of the International Banking Act (IBA), foreign banks with federal branches or agencies must establish and maintain a capital equivalency deposit (CED) with a member bank located in the state where the federal branch or agency is located. The IBA authorizes the OCC to prescribe regulations describing the types and amounts of assets that qualify for inclusion in the CED, “as necessary or desirable for the maintenance of a sound financial condition, the protection of depositors, creditors, and the public interest.” At 12 CFR 28.15, OCC regulations set forth the types of assets eligible for inclusion in a CED. Among these assets are certificates of deposit, payable in the United States, and banker’s acceptances, provided that, in either case, the issuer or the instrument is rated investment grade by an internationally recognized rating organization, and neither the issuer nor the instrument is rated lower than investment grade by any such rating organization that has rated the issuer or the instrument.

The OCC has issued an ANPR soliciting comment on alternative measures of credit-worthiness that may be used instead of credit ratings in the above regulations (Investment Securities and Other Regulations ANPR). The ANPR seeks comments on criteria that the OCC should consider when developing such measures and outlines a range of alternatives for replacing references to credit ratings in part 1. The comment period for the Investments and Other Regulations ANPR closes on October 12.

Further Information

For information or questions on the Capital ANPR, contact Mark Ginsberg, Risk Expert, Capital Policy Division, (202) 874-5070, or Carl Kaminski, Senior Attorney, Legislative and Regulatory Activities Division, (202) 874-5090. For information or questions on the Investment Securities and Other Regulations ANPR, contact Michael Drennan, Senior Advisor, Credit and Market Risk Division, (202) 874-4564, or Carl Kaminski, Senior Attorney, Legislative and Regulatory Activities Division, (202) 874-5090.

Timothy W. Long
Senior Deputy Comptroller for Bank Supervision Policy
and Chief National Bank Examiner
Attachments: Joint Capital ANPR
OCC Investments and Other Regulations ANPR

Wednesday, September 1, 2010

DBRS Requests Comments on Proposed Unified Interest Rate Model Methodology

DBRS Ratings Limited (DBRS) is requesting comments on the proposed rating methodology for its Unified Interest Rate Model. Comments should be received on or before October 29, 2010. Please submit your comments to the following e-mail address: DBRS will publish a final methodology following the review and evaluation of all submissions.

The methodology describes the DBRS’ process for the generation of consistent interest rate stresses across currency markets as well as markets which do not have underlying term structures.

Risky Funding: A unified framework for counterparty and liquidity charges

By Massimo Morini and Andrea Prampolini of Banca IMI

Abstract: Standard techniques for incorporating liquidity costs into the fair value of derivatives produce counter-intuitive results when credit risk of the counterparty (CVA) and of the investor (DVA) are added to the picture. Here, Massimo Morini and Andrea Prampolini show that a consistent framework can only be achieved by giving an explicit representation to the funding strategy, including associated default risks.

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Thursday, August 26, 2010

ISDA Streamlines Credit Derivative Novation Process

NEW YORK, Wednesday, August 25, 2010 – The International Swaps and Derivatives Association, Inc. (ISDA) announced that it will further streamline the process of novating or assigning credit derivative trades by way of its 'Credit Consent Equals Confirmation' project. As a key measure in this initiative, ISDA today published Additional Provisions for Consent to, and Confirmation of, Transfer by Novation of OTC Derivative Transactions. The overall objective of the project is to rationalize the current two-step practice of consent followed by confirmation, with an automated, single-step process for parties to provide their consent and their legal confirmation to a novation simultaneously.

“The credit derivative industry has made a series of improvements to the operational processing of novations over the past several years, including the landmark ISDA Novation Protocol,” said Robert Pickel, Executive Vice Chairman, ISDA. “The result of the Consent Equals Confirmation initiative will be an enhanced automated process that will improve accuracy and facilitate same-day processing, thereby reducing risk and the necessary degree of resourcing. It is the culmination of collaborative industry efforts to further streamline transaction processing and advance operational standards.”

The Additional Provisions, which amend the rules in the ISDA Novation Protocol, allow these operational changes to take effect without requiring parties to re-adhere to the Novation Protocol.

In a series of commitments to international regulators, the industry undertook to significantly improve novations processing such that the action of consent for eligible trades would achieve a valid legal confirmation.

The Credit Consent Equals Confirmation process will go live on September 30, 2010. The Additional Provisions, Business Requirements and Best Practices document will be made available here.

Wednesday, August 25, 2010

Ratings Arbitrage and Structured Products

by John Hull and Alan White of the University of Toronto

Abstract: This paper studies the criteria used by rating agencies when they rate structured products. We assume that some investors assign a value to a product that is monotonic in the credit rating. This leads to a necessary condition for there to be no arbitrage. The criterion used by S&P and Fitch does not satisfy the condition while that used by Moody’s does.

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Discounting Revisited: Valuations under funding costs, counterparty risk and collateralization

by Christian P. Fries of DZ Bank AG

We present two different valuations. The first is a mark-to-market valuation which determines the liquidation value of a product. It does, buy construction, exclude any funding cost. The second is a portfolio valuation which determines the replication value of a product including funding costs.

We will also consider counterparty risk. If funding costs are presents, i.e., if we value a portfolio by a replication strategy then counterparty risk and funding are tied together:
  • In addition to the default risk with respect to our exposure we have to consider the loss of a potential funding benefit, i.e., the impact of default on funding.
  • Buying protection against default has to be funded itself and we account for that.
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Tuesday, August 24, 2010

S&P Applies Identifier To Structured Finance Ratings

The structured finance identifier is required under the new European regulation on Credit Rating Agencies (Regulation (EC) No 1060/2009) (the "Regulation"). The addition of the identifier indicates only that the instrument is deemed to meet the regulatory definition of "structured finance." In no way does it modify the meaning of the rating itself.

To read the full report:

IMA warns about consequences of the EU's OTC derivatives reforms

The Investment Management Association (IMA) welcomes the move towards central clearing for OTC derivatives and supports the G20's Toronto communiqué in this regard.

In its recent responses to the European Commission's consultation on "Derivatives and Market Infrastructures" and to the Commission of European Securities Regulators' (CESR) consultation on "Standardisation and exchange trading of OTC derivatives" IMA supported the legislative work underway in the EU, but cautioned that further work was needed to ensure that costs and operational burdens were not unduly placed on the client side of the market.

Commenting on the Commission's consultation, Jane Lowe, Director of Markets at IMA, said:

IMA members as the buy side of the market supports the move from bilateral to central clearing. However, central clearing could produce perverse results if the impact on the client side of the market is not fully addressed.

The cost of central clearing should be proportionate to the risk. Unless the margin and collateral arrangements established within the central clearing houses (CCPs) are correctly calibrated, the cost of clearing will be borne disproportionately by the very people the legislation seeks to protect - the man in the street, through his pension, insurance endowment policy and savings in funds.

We urge the European Commission to widen the approach to collateral management so that long term savers are not disadvantaged by having to convert their portfolios into unproductive assets purely for collateral use. Retaining collateral within custodian accounts, subject to ring fencing, charge or pledge, should achieve the objectives of greater security, whilst reducing operational risk and cost to clients.

Further, we urge the Commission to introduce mandatory segregation for all client assets and monies, so that this important element of investor protection is not left to purely commercial pressures.
In its comments to CESR the IMA reiterated that regulators needed to do more work to ensure that the client side of the market was not disadvantaged by the work underway. Otherwise, the IMA supported the analysis provided by CESR into standardisation of OTC derivatives for the purposes of central clearing but, did not support regulatory action at this stage to mandate exchange trading, advising instead that this should be left as future possibility.

Commenting on the CESR consultation, Jane Lowe said:
As regards standardisation for exchange trading, the aim should be to ensure that these contracts are truly fungible as this will pave the way for future market development. We believe that the timeframe for introducing product standardisation is tight and consider that the industry has enough on its hands without forcing the issue of exchange trading at this stage.

Sunday, August 15, 2010

SEC, CFTC to Host August 20 Roundtable on Clearing and Listing of Swaps and Security-Based Swaps

Washington, D.C., Aug. 13, 2010 — The Securities and Exchange Commission and Commodity Futures Trading Commission staffs will hold a public roundtable on August 20 to discuss issues related to governance and conflicts of interest in the clearing and listing of swaps and security-based swaps.

The roundtable will assist both agencies in the rulemaking process to implement the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The roundtable will be held at the CFTC hearing room at Three Lafayette Centre, 1155 21st Street NW, Washington, D.C. The discussion will be open to the public with seating on a first-come, first-served basis. Members of the public may also listen by telephone and should be prepared to provide their first name, last name, and affiliation.

  • U.S./Canada Toll-Free: (866) 312-4390 begin_of_the_skype_highlighting (866) 312-4390 end_of_the_skype_highlighting
  • International Toll: (404) 537-3379 begin_of_the_skype_highlighting (404) 537-3379 end_of_the_skype_highlighting

    Conference ID: 94280143

Members of the public wishing to submit their views on the topics addressed at the discussion may do so through the comment form or e-mail address on the SEC website or the governance rulemaking page on the CFTC website.

All submissions provided to either the CFTC or the SEC in any electronic form or on paper will be published on the website of the respective agency, without review and without removal of personally identifying information.

# # #

Agenda for the Joint CFTC-SEC Public Roundtable Discussion

9:00 a.m.

Opening Statements by CFTC and SEC Staff

9:15 a.m.

Panel One — Types of Conflicts

  • Securities Clearing Agencies and Derivatives Clearing Organizations
    • Access to clearing
    • Determination of swaps eligible for clearing
    • Risk management
  • Security-Based Swap Execution Facilities and Swap Execution Facilities
    • Access to trading
    • Determination of swaps eligible for trading
    • Potential for competition with respect to the same swap
  • Designated Contract Markets and National Securities Exchanges
    • Listing of swaps
    • Comparison with conflicts of interest for Swap Execution Facilities and Security-Based Swap Execution Facilities: similarities and differences

10:45 a.m.

Panel Two — Possible Methods for Remediating Conflicts

  • Ownership and voting limits
  • Structural governance arrangements
    • Independent or public director requirements for Board and Board committees
    • Consideration of market participant views: Derivatives Clearing Organizations and Designated Contract Markets
    • Fair representation requirement in the Securities Exchange Act
    • Other governance matters (e.g., transparency)
  • Substantive requirements
    • Membership standards
    • Impartial access requirements
  • Appropriateness of applying the same methods to each type of entity


Roundtable concludes

Thursday, August 12, 2010

Ratings Reform: The Good, The Bad, and The Ugly

By John C. Coffee Jr.

Abstract: Both in Europe and in the United States, major steps have been taken to render credit rating agencies more accountable. But do these steps address the causes of the debacle in the subprime mortgage market that triggered the 2008-2009 crisis? Surveying the latest evidence on how and why credit ratings became inflated, this paper argues that conflicts of interest cannot be purged on a piecemeal basis. The fundamental choice is between (1) implementing a “subscriber pays” model that compels rating agencies to compete for the favor of investors, not issuers, and (2) seeking to deemphasize or eliminate the role of credit ratings to reduce the licensing power of rating agencies. Although it strongly favors the first option over the second, it also recognizes that the “public goods” nature of ratings makes it unlikely that a “subscriber pays” system will develop on its own without regulatory interventions. Thus, it considers how best to encourage the development of a modified system under which the investor would choose and the issuer/deal arranger would pay for the initial rating on structured finance transactions.

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Tuesday, August 10, 2010

Rating Performance and Agency Incentives of Structured Finance Transactions

Daniel Roesch and Harald Scheule

Abstract: The mismatch between credit ratings o fstructured finance transactions and their true risks has been a source of the Global Financial Crisis which manifested in criticism of models and techniques applied by credit rating agencies (CRA). This paper provides an empirical study which assesses the historical performance of credit ratings for structured finance transactions and finds that CRAs do not include all factors explaining securitization impairment risk. In addition, CRA ratings for selected asset categories underestimate risk in origination years when the fee revenue is high.

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Credit Derivatives and the Default Risk of Large Complex Financial Institutions

By Giovanni Calice, Christos Ioannidis and Julian M. Williams

Abstract: This paper addresses the impact of developments in the credit risk transfer market on the viability of a group of systemically important financial institutions. We propose a bank default risk model, in the vein of the classic Merton-type, which utilizes a multi-equation framework to model forward-looking measures of market and credit risk using the credit default swap (CDS) index market as a measure of the global credit environment. In the first step, we establish the existence of significant detrimental volatility spillovers from the CDS market to the banks' equity prices, suggesting a credit shock propagation channel which results in serious deterioration of the valuation of banks' assets. In the second step, we show that substantial capital injections are required to restore the stability of the banking system to an acceptable level after shocks to the CDX and iTraxx indices. Our empirical evidence thus informs the relevant regulatory authorities on the magnitude of banking systemic risk jointly posed by CDS markets.

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The Economics of Credit Default Swaps (CDS)

By Robert A. Jarrow, Cornell University - Samuel Curtis Johnson Graduate School of Management

Abstract: Credit default swaps (CDS) are term insurance contracts written on traded bonds. This paper studies the economics of CDS using the economics of insurance literature as a basis for analysis. It is alleged that trading in CDS caused the 2007 credit crisis, and therefore trading CDS is an "evil" which needs to be eliminated or controlled. In contrast, we argue that the trading of CDS is welfare increasing because it facilitates a more optimal allocation of risks in the economy. To perform this function, however, the risk of CDS seller failure needs to be minimized. In this regard, government regulation imposing stricter collateral requirements and higher equity capital for CDS traders need to be imposed.

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Thursday, August 5, 2010

DTCC Launches Equity Derivatives Reporting Repository

London, 5 August 2010 -- The Depository Trust & Clearing Corporation (DTCC) announced today two significant developments: 1) the launch of its Equity Derivatives Reporting Repository (EDRR) and 2) FSA approval of DTCC Derivatives Repository Ltd subsidiary.

The building of the EDRR repository, follows a competitive request for proposal process (RFP) led by the International Swaps and Derivatives Association (ISDA) last year, and represents the industry's efforts to strengthen its operational infrastructure and improve transparency across all major OTC derivatives asset classes. All of the 14 global market dealers are now live on EDRR.

EDRR’s central registry will hold key position data, including product types, notional value, open trade positions, maturity and currency denomination for participants’ transactions, as well as counterparty type. OTC equity derivatives products the service will initially support include options; equity, dividend, variance and portfolio swaps; CFD (contracts for difference); accumulators and a final category covering other structured products.

By aggregating and maintaining the data, DTCC’s EDRR will generate reports that keep industry participants and regulators up to date on the industry’s outstanding notional and positions as well as other position related information through a single, secure, easy-to-access portal.

"DTCC played an important role in bringing this new service to market over an aggressive timeframe, allowing the OTC derivatives community to meet commitments made to global regulators to have a repository service running for equity derivatives by the end of July," said Patrick Dempsey, managing director and CFO, Global Equity Derivatives Group at J.P. Morgan and chairman of the International Swaps and Derivatives Association's (ISDA’s) Equities Steering Committee, EDRR subgroup.

In addition, DTCC announced that its new European subsidiary, DTCC Derivatives Repository Ltd (“DTCC Derivatives Repository”) has received UK Financial Services Authority (FSA) approval to operate as an FSA regulated Service company. This new subsidiary will jointly house the global equity derivatives repository and will maintain global credit default swap data identical to that maintained in its New York based Trade Information Warehouse. The move is, in part, intended to help ensure that regulators globally have secure and unfettered access to global data on credit default swaps (CDS) by establishing identical CDS data sets on two different continents.

DTCC also operates the global repository for credit default swaps (CDS) through its U.S. regulated subsidiary Warehouse Trust Company LLC. An identical set of this global CDS data will now be maintained in the London-based DTCC Derivatives Repository.

“It is very common for counterparties to be located on different continents and to trade on underlying securities issued across borders,” said Stewart Macbeth, Managing Director and General Manager, Trade Information Warehouse. “We felt that steps needed to be taken to ensure that the data is always available to regulators globally regardless of events and circumstances taking place in one location or another.”

How the Equity Derivatives Reporting Repository Works

Participating firms are responsible for loading all their open third-party positions in the repository. DTCC is responsible for managing the data, and providing reports to regulators and participants. MarkitSERV will provide operational support, including account management, on-boarding and customer service, and other product management services.

Reporting to Regulators

On a monthly basis, DTCC will provide both the designated regulators and participating firms with a series of summary reports on the position data. DTCC will create and make available three different reports:

  • A Participant Report showing a summary of the open positions for each individual organization;
  • An Aggregate Report showing a summary of the aggregate positions for the firms that have the same designated regulatory authority (Regulators Only); and
  • An Industry Report showing a summary of the aggregate positions for all trading parties.

These reports will contain repository data which includes gross notional and number of position by product, counterparty type, local currency and maturity profile.

“We are pleased to be now bringing the transparency and risk mitigation benefits of a central repository for the OTC equity derivatives market,” said Bill Stenning, managing director, DTCC DerivSERV Business Development. “DTCC has been working in the OTC derivatives market for nearly a decade and we have demonstrated our ability to bring automation and trade reporting services, working with the OTC derivatives community and regulators, to establish the global repository and post-trade processing infrastructure for the CDS market.”

“MarkitSERV is committed to helping the industry increase transparency and mitigate risk and we are very pleased to assist the DTCC in providing this valuable service for the OTC equity derivatives market," said Gina S. Ghent, managing director and head of equity derivatives at MarkitSERV. "We look forward to expanding our work with DTCC in this arena to help the industry meet its objectives."

EDRR’s strategic direction and operation was developed and guided by the ISDA Equity Steering Committee in conjunction with DTCC who was selected by the industry along with MarkitSERV, to build this new global service. It is a direct result of the commitments to improve market transparency that 14 major dealers, buy side firms and industry trade associations made to global regulators in June 2009.

Monday, August 2, 2010

CDO and Structured Financial Products: A Modeling Perspective (SSRN)

By Charles S. Tapiero and Daniel Totouom, BNP Paribas

Abstract: This paper is intended as a pedagogical note to explain CDO and structured financial credit products modeling and some approaches to their pricing.

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Wednesday, July 28, 2010

Realpoint advocates point-in-time ratings

Realpoint, a subsidiary of Morningstar, has been in the media recently discussing the use of point-in-time ratings in response to Nationally Registered Statistical Rating Organizations (NRSROs) provisions in the recently passed Dodd-Frank Act. The bill makes NRSROs liable for the quality of their calls when they are used for public sale documents. One strategy that could reduce the firm's liability is the point-in-time ratings model, Realpoint's attorneys and investors said. The agency believes sticking to ratings that refer to a specific point in time, as opposed to grading a share class on how it may do in the future, may limit exposure to liability.

From the Realpoint website:

Realpoint is a nationally recognized credit-rating agency that has earned a reputation for innovation and excellence in the structured finance market. Our goal is to increase market transparency and provide investors with the highest quality ratings and analysis by offering a wide array of securities research, surveillance services, data, and technology solutions. More than 225 institutional investment firms trust Realpoint to help them identify credit risk in structured finance investments.

Tuesday, July 27, 2010

Goldman Sachs Announces Clearing Services for OTC Derivatives

New Derivatives Clearing Services (DCS) business to provide suite of integrated agency clearing services for all listed and OTC derivatives

Goldman Sachs announced today the launch of its Derivatives Clearing Services (DCS) business. DCS provides clients with a comprehensive global OTC clearing service for interest rates, credit, foreign exchange, equities and commodities.

“The DCS offering provides our clients with a host of value-added services and multi-product expertise to successfully navigate this dynamically changing environment.”

Goldman Sachs DCS is an agency business designed to streamline the client derivatives clearing experience across products, asset classes and regions. DCS builds upon the firm’s globally recognized prime brokerage and futures clearing platforms to maximize efficiency and provide an integrated suite of tools and reporting for clients.

“In partnership with our clients, regulators and multiple clearing venues, we are committed to improving market structure for derivatives,” said Michael Dawley, Managing Director and Co-Head of Futures and DCS, Goldman Sachs. “The DCS offering provides our clients with a host of value-added services and multi-product expertise to successfully navigate this dynamically changing environment.”

Goldman Sachs recognizes that clients will be faced with new reporting, connectivity, and regulatory requirements. The firm is committed to investing in innovative solutions to help clients address these changes.

“The move to central clearing for OTC derivatives is a significant turning point in the marketplace," said Jack McCabe, Managing Director and Co-Head of Futures and DCS at Goldman Sachs. “Our strong trading franchise, coupled with our market leading futures and prime brokerage services, enables us to provide our clients with the foundation they need to adapt to these important industry developments."

The Goldman Sachs Group, Inc. is a leading global investment banking, securities and investment management firm that provides a wide range of financial services to a substantial and diversified client base that includes corporations, financial institutions, governments and high-net-worth individuals. Founded in 1869, the firm is headquartered in New York and maintains offices in London, Frankfurt, Tokyo, Hong Kong and other major financial centers around the world.

Monday, July 26, 2010

Adverse Selection in Mortgage Securization

By Sumit Agarwal, Yan Chang and Abdullah Yavas

Abstract: We investigate lenders’ choice of loans to securitize and whether the loans they sell into the secondary mortgage market are riskier than the loans they retain in their portfolios. Using a large dataset of mortgage loans originated between 2004 and 2008, we find that banks sold low-default risk loans into the secondary market while keeping higher-default risk loans in their portfolios. This result holds for both subprime and prime loans. We do find strong support for adverse selection with respect to prepayment risk; securitized loans had higher prepayment risk than portfolio loans. It appears that in return for selling loans with lower default risk, lenders retain loans with lower prepayment risk. Small lenders place more emphasis than large lenders on default risk versus prepayment risk of the loans they retain. Securitization strategies of lenders changed during the sample period as they became less willing to retain higher-default loans after the housing market reached its peak. There are also differences in the performance of loans sold to GSEs and loans sold to private issuers. Loans sold to private issuers have lower prepayment rates in each year while relative default rates vary across the years.

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Thursday, July 22, 2010

DTCC Further Expands Public Release of Credit Default Swap Data Registered in its Global Trade Repository (DTCC Press Release)

The Depository Trust & Clearing Corporation (DTCC) today further expanded its public release of credit default swap (CDS) data, providing more detailed market segmentation information on the largest corporate and sovereign CDS (single named reference entities) registered in its Trade Information Warehouse's (Warehouse) global repository. This extension of the data posted on DTCC's website ( will enable the public to assess key characteristics of these CDS contracts more efficiently and is another step in DTCC's on-going efforts to bring greater transparency into the over-the-counter (OTC) derivatives market.

Starting today, DTCC is including specific additional information to that already shown in tables 6 and 14 for the top 1000 single reference entities posted on its website. This new information will cover the type of market (e.g., corporate, government), sector (e.g., financial services, sovereign) and the ISDA (International Swaps and Derivatives Association) Determinations Committee Region (e.g., Americas, Europe, Japan, Asia Ex-Japan, and Australia NZ) for each single named reference entity.

DTCC will also be posting a new table showing traded activity on a weekly basis initially for the top 1000 single-named reference entities. Being published in a new Section 4, this table is an extension of a report released last June and can be used to understand contract liquidity better. Similar to the data issued in June, the table will show traded activity levels and exclude certain contractual booking events (e.g. rebooking for clearing, and portfolio compression) which are not representative of price-making activity. Further enhancements will continue to be made to enrich the data for asset types, such as indices and tranches.

"We have seen considerable interest among market observers in getting a better view on the types of contracts and sectors that make up the largest portions of the CDS market, and see continued interest in volume levels," said Stewart Macbeth, general manager, DTCC Trade Information Warehouse. "Adding these specific classifications to the gross and net notional values and number of CDS contracts already published for these single reference entities will enhance the ability of the market to assess these contracts as part of a sector group or region. Providing additional traded volume information will build on the one-off report published in June, originally designed to give regulators more liquidity information, as they look at clearing."

Unfettered access to global regulators

Upon request, DTCC also provides global regulators with specific counterparty information needed to fulfill their regulatory mission. DTCC currently provides regular reporting to more than 30 regulators across the globe, including the Federal Reserve Bank, the Securities and Exchange Commission (SEC), the Commodities & Futures Trading Commission (CFTC), the European Central Bank, Banque De France, the U.K. Financial Services Authority (FSA), Bank of Japan and the Hong Kong Securities and Futures Commission.

It is one of DTCC's bedrock principles that all interested regulators should have unfettered access to Warehouse information to help further their respective regulatory missions. DTCC has also called for comparable access to data for regulators interested in specific trading patterns regardless of location. The standards for release of CDS data maintained in the US to non-US regulators would be the same as those for release to US regulators.

Since launching the Warehouse in 2006, DTCC has worked closely with market participants and in consultation with regulators across the globe to build a robust central repository that provides an accurate snapshot of the CDS market from a central vantage point. DTCC has also been collaborating with the OTC Derivatives Regulatory Forum, which is made up of more than 40 international financial regulators, to meet their objective of fostering a global framework for the sharing of data requested by regulators from the Warehouse. The Forum recently provided DTTC with new guidelines on the sharing of CDS data from its global CDS trade repository, helping bring greater clarity and building consensus on the process for responding to regulatory requests.

Earlier this month DTCC announced its plans to establish a new European subsidiary, DTCC Derivatives Repository Ltd., which will maintain global CDS identical to that maintained in its New York-based Trade Information Warehouse. Headquartered in London under a regulatory application filed with the Financial Services Authority (FSA), the new subsidiary is intended to help ensure that regulators globally have secure and unfettered access to global CDS data on (CDS) by establishing identical data sets on two different continents.

DTCC Derivatives Repository Ltd. will jointly house the global equity derivatives repository being built by DTCC as the result of winning the International Swaps and Derivatives Association (ISDA®) global bid for this service. The location of this European subsidiary was made based on the ISDA mandate to have the global equity derivatives repository in London.

About the Warehouse

The Warehouse is the only comprehensive global repository for the OTC credit derivatives market. DTCC uses it to gather and store information on OTC credit derivatives and perform critical post-trade processing functions such as automated calculation, netting and central settlement of payment obligations, as well as settlement of credit events such as bankruptcies. It is operated through DTCC's Warehouse Trust Company LLC subsidiary, which is regulated by the New York State Banking Department and a member of the Federal Reserve System. Its customer base includes all major dealers and more than 1800 buy-side firms and market participants in more than 50 countries.

The Warehouse publishes current and historical data on CDS trades. The data population includes all electronically confirmed contracts for both cleared and uncleared transactions. Currently, there are four active central counterparties (CCPs) utilizing the Warehouse services. While the Warehouse also has basic, non-legal records of highly customized trades ("copper records"), that data is not included in its weekly updates. These "copper" records, comprising more bespoke contract submissions not confirmable on an automated electronic platform, represent less than 6% of total contract volume held in the repository.

The total gross notional value of the nearly 2.3 million legally confirmed CDS contracts held in DTCC's Warehouse as of July 16 was approximately US$24.9 trillion.

DTCC updates its website weekly on Tuesdays, after 5:00 p.m. ET (2200 GMT).