Friday, June 25, 2010

S&P announces which instruments will carry a structured finance qualifier

LONDON (Standard & Poor's) June 25, 2010--Standard & Poor's Ratings Services
has today announced the categories of debt instruments whose ratings will have
a structured finance identifier as required under the new European regulation
on Credit Rating Agencies (Regulation (EC) No 1060/2009) (the "regulation").
We will apply the symbol to all relevant structured finance ratings globally
by early September.

On Feb. 16, 2010, we announced our intention to give all ratings on structured
finance instruments an additional identifier in line with the regulation, and
at that time indicated that we would consider which instruments we believe
will require the identifier (see "S&P To Add Symbol To Global Structured
Finance Ratings," published Feb. 16, 2010).

In making our decision, we considered both the definition of "Structured
Finance Instrument" referred to in the regulation (Capital Requirements
Directive 2006/48/EC, detailed further below) and the principles we believe
the EU intended to establish in the regulation.

We will deem the following types to be structured finance instruments under
the regulation, and will therefore apply an identifier to their ratings:

* All asset-backed securities (ABS);
* All asset-backed commercial paper (ABCP);
* All commercial mortgage-backed securities (CMBS);
* All single and multi-tranched collateralized debt obligations (CDOs) and credit default swaps (CDS), except "single-name CDS";
* All residential mortgage-backed securities (RMBS), including debt backed by mortgages issued by the Japan Housing Finance Agency;
* All insurance securitizations with more than one tranche of debt;
* All project financings with more than one tranche of debt;
* All enhanced equipment trust certificates (EETCs) with more than one tranche of debt;
* All corporate securitizations with more than one tranche of debt; and
* All gas prepay transactions with more than one tranche of debt.

We have come to this decision after consultation with market participants and
an internal review of the instruments that this requirement could potentially

The definition of structured finance instrument, as referenced in the
regulation, is as follows: "(36) 'securitisation' means a transaction or
scheme, whereby the credit risk associated with an exposure or pool of
exposures is tranched, having the following characteristics:
(a) payments in the transaction or scheme are dependent upon the performance
of the exposure or pool of exposures; and
(b) the subordination of tranches determines the distribution of losses during
the ongoing life of the transaction or scheme."

Some instruments to which we will apply the identifier may not correspond to
commonly-held views of structured finance instruments. In addition, we will
not apply the identifier to certain instruments commonly referred to in the
market as structured finance. In the interest of providing transparency, we
will publish shortly a separate report explaining the principles and
assumptions that guided our decision. The following are the key principles and
assumptions we considered:

* We believe that a proper reading of the regulation requires us to place an identifier on all instruments that meet the regulatory definition and only on those instruments.
* We believe the definition of "structured finance" should be an objective definition--for example, only if we believe the instrument falls within the definition set out in the regulation, will we apply the identifier. The definition should not be tied to how our criteria view the instrument's risk, or to commonly-held market perceptions of what does and does not constitute a structured finance instrument.
* We have interpreted "tranche" to refer not just to separate issues of a capital market or loan instrument by the same issuer in respect of the same transaction but to any form of financial or economic interest in a horizontally-sliced credit exposure, however this is derived. This would include for example, the use of deferred purchase prices, attachment points, discount sales, and other "credit-enhancing" devices.
* In our view, the definition in the regulation stating that the "exposure" that is tranched should not be interpreted to refer to the exposure to an issuing corporate entity. Rather, we interpret the regulation to provide that in order to qualify as a structured finance instrument, the transaction must contain two layers of risk, with the rated layer being a means to convey to the investor the credit risk of a second, underlying layer.
* We have included "wrapped" transactions--such as letter of credit, guaranteed, and monoline insurance transactions--in our interpretation of structured finance instruments under the regulation when what is "wrapped" is itself a structured finance transaction according to the regulation. Although in such transactions we usually base our rating on the rating on the insuring party, as stated above, we believe that the use of the identifier should not depend on our criteria. In these transactions, the payment in the transaction is dependent on two credits: the first is the performance of an exposure or pool of exposures, the second is the guaranteeing entity. We believe that if the existence of a guarantee alone were sufficient to remove the requirement for an identifier, in theory a special-purpose entity could be created to serve as a guarantee for a particular transaction, thus removing the requirement for an identifier to be assigned, regardless of the underlying strength of the special-purpose entity. We do not believe this result would be consistent with the intent of the regulation. We have therefore formed the opinion that any transaction that would otherwise require an identifier cannot lose that identifier, merely by reason of being guaranteed.

The symbol that we will use for the ratings on the instruments mentioned above
is "(sf)". We will add this identifier as a suffix to our existing ratings
symbology (see "Standard & Poor's Ratings Definitions," published Feb. 15,
2010). We intend to apply the identifier to all new ratings before the date
that regulated compliance begins under the regulation. We also intend to apply
the identifier to existing transactions in due course.

As we announced in February, we will apply the identifier irrespective of
where the structured finance instrument is issued, or the location of the
issuer, originator, or assets.

We welcome continued dialogue with interested parties on this topic.

Thursday, June 24, 2010

Last-minute derivative amendment will restrict competition

Reuters reports that "a last-minute addition to U.S. legislation designed to reduce risks in the $450 trillion derivatives markets is prompting an outcry over its potential to limit competition."

The proposal, one of 110 put forward by the House of Representatives team negotiating derivatives reforms, would prevent clearinghouses from being forced to accept contracts from other clearinghouses. The proposal was offered "in order to minimize systemic risk..."

CME Group Inc, the futures giant that runs one of the world's biggest clearinghouses, says the language keeps it from having to take on unwanted risk.

But allowing clearinghouses to reject contracts from rivals could crimp competition and make it harder for clients seeking the best prices when trading the contracts, argues the Swaps and Derivatives Market Association, which comprises more than 20 U.S.-based broker-dealers and futures commission merchants...

The provision "could be used by one clearing house, associated with one exchange or swap execution facility, to refuse acceptance of a trade initially executed on a competitor exchange or swap execution facility and cleared by a competitor clearing house," the SDMA said.

"This would have the practical impact of restricting access to the best prices on identical derivatives contracts traded on different exchanges," it added...

"CME Group supports lawmakers' efforts to reduce systemic risk in financial markets," a CME spokesman said on Thursday. "As markets become increasingly interconnected, CME Group believes that central counterparties must carefully manage and not be forced to assume the significant counterparty credit risks of other clearinghouses."

Wednesday, June 23, 2010

OTC Derivatives Regulators' Forum website is now live

The OTC Derivatives Regulators' Forum is comprised of international financial regulators including central banks, banking supervisors, and market regulators, and other governmental authorities that have direct authority over OTC derivatives market infrastructure providers or major OTC derivatives market participants, or consider OTC derivative market matters more broadly. See a list of regulators and authorities currently involved in the Forum.

NASDAQ OMX expands clearing offering to include Interest Rate Swaps

NASDAQ OMX (NASDAQ:NDAQ) announces the launch of a pilot project together with SEB and the Swedish National Debt Office (Riksgälden) through which it will offer central counterparty clearing (CCP) of Interest Rate Swaps (IRS). NASDAQ OMX has also initiated a strategic dialogue with all major swap dealers in Sweden, with the aim to build a full scale clearinghouse for IRS in Swedish kronor (SEK).

Previously, SEK denominated IRS, a market with an average daily turnover of 30 billion SEK, have been collateralized and settled bilaterally. The first transactions were successfully registered for clearing yesterday.

Interest Rate Swaps are typically traded over-the-counter (OTC) with limited pre- and post-trade transparency. As the major derivative instrument traded OTC globally, the aggregated outstanding notional amount was 349 trillion USD at year-end 2009. Interest Rate Swaps have since the financial turmoil in 2008 been subject to proposals by legislators both in the U.S. and Europe to introduce mandatory CCP clearing and to increase pre- and post trade
transparency. Swap dealers may therefore soon be obliged to clear IRS through a CCP, a service that is now available by NASDAQ OMX for SEK-denominated swaps.

“Through the IRS central counterparty clearing offering, NASDAQ OMX is building a Nordic clearing house that covers all Fixed Income instruments,” says Erik Thedéen, Head of Nordic Fixed Income and President NASDAQ OMX Stockholm. “This service will reduce the administrative burden and, more importantly, bring with it a reduction of counterparty risk for market participants and thereby improve financial stability. The ability to net multiple post-trade transactions through a central counterparty also allows our market participants to reduce collateral significantly.”

Tuesday, June 22, 2010

Bank of Canada on Agency Conflicts in the Process of Securitization

Abstract: Recent evidence finds a positive association between the prevalence of loans of inferior quality and the growth in securitized products. Some attribute this development to the lack of incentives for originators to screen and monitor the performance of securitized loans; others stress that certain factors, such as balance-sheet management, also contributed to the problem, making it difficult to pin down the reason for the proliferation of such loans during the period of high securitization growth. The author reviews the conflicts of interest between participants in the securitization process that contributed to the ongoing financial turmoil and highlights the most recent policy measures and potential solutions for ameliorating these agency issues.

Download here:

Bank of Canada on Securitized Products, Disclosure, and the Reduction of Systemic Risk

Abstract: One of the key lessons of the recent crisis is that liquidity depends on information. Market participants may be reluctant to trade in assets if their underlying characteristics are not well known, because their performance may be difficult to assess under changing macrofi nancial conditions. In times of stress, when uncertainty increases, market liquidity can dry up if information is insufficient. Securitized Products, Disclosure, and the Reduction of Systemic Risk, by Scott Hendry, Stéphane Lavoie, and Carolyn Wilkins, discusses issues related to disclosure for asset-backed commercial paper and publicly issued term asset-backed securities in Canada. It argues that disclosure standards that are tailored to the particular features of these markets would provide a more solid basis for restarting them.

Download here:

Credit Default Swaps and the Empty Creditor Problem

By Patrick Bolton and Martin Oehmke

Abstract: Commentators have raised concerns about the empty creditor problem that arises when a debtholder has obtained insurance against default but otherwise retains control rights in and outside bankruptcy. We analyze this problem from an ex-ante and ex-post perspective in a formal model of debt with limited commitment, by comparing contracting outcomes with and without credit default swaps (CDS). We show that CDS, and the empty creditors they give rise to, have important ex-ante commitment benefits: By strengthening creditors' bargaining power they raise the debtor's pledgeable income and help reduce the incidence of strategic default. However, we also show that lenders will over-insure in equilibrium, giving rise to an inefficiently high incidence of costly bankruptcy. We discuss a number of remedies that have been proposed to overcome the inefficiency resulting from excess insurance.

Download here:

Saturday, June 19, 2010

LCH.Clearnet adopts OIS discounting for $218 trillion IRS portfolio

LCH.Clearnet Ltd (LCH.Clearnet), which operates the world’s leading interest rate swap (IRS) clearing service, SwapClear, is to begin using the overnight index swap (OIS) rate curves to discount its $218 trillion IRS portfolio.

Previously, in line with market practice, the portfolio was discounted using LIBOR. However, an increasing proportion of trades are now priced using OIS discounting. After extensive consultation with market participants, LCH.Clearnet has decided to move to OIS to ensure the most accurate valuation of its portfolio for risk management purposes. LCH.Clearnet already uses OIS rates to price the rate of return on cash collateral.

From 29 June 2010, USD, Euro and GBP trades in SwapClear will be revalued using OIS.

Roger Liddell, chief executive, LCH.Clearnet said: “Accurate pricing is essential for prudent risk management. With the market moving increasingly to OIS, it was important for us to consider the implications of this. Our move to OIS discounting demonstrates our commitment to the highest standards of risk management and the sophistication of our SwapClear service.”

SwapClear, the only truly global clearing service for IRS, offers innovative solutions to meet the growing demands of the OTC markets. In December 2009, LCH.Clearnet was the first clearing house to launch interest rate swap clearing for the buy-side clients through SwapClear, offering a unique level of security to clients in the case of a bank default through margin segregation and portability of contracts.

The resilience of SwapClear’s default management process was demonstrated in September 2008 when it successfully handled Lehman Brothers’ USD9 trillion interest rate swap default. The highly effective default management process ensured that over 60,000 trades were hedged and auctioned off to other clearing members in a timely fashion and that the default was managed well within the margin held and with no recourse to the default fund.

To view the press release as a pdf click here.

Friday, June 18, 2010

Making OTC derivatives less OTC (BIS's Stephen Cecchetti)

The Squam Lake report 2 provides recommendations to, among other things, (i) protect against a systemic failure arising from a failure in the credit default swap (CDS) market, (ii) improve transparency in the CDS market and (iii) reduce the risk of runs on prime brokers and dealers. The recommendations focus on the use of central counterparties (CCPs), derivatives trade reporting, stricter regulation of liquidity requirements for dealers, and segregation of customer assets. Additional steps that would help further the goals of the report are: move end user derivatives trades onto CCPs; adopt standardised exchange traded derivatives for all risk types covered by OTC derivatives and higher regulatory capital requirements for non-standardised contracts; and establish safety-related registration of all financial products.

I would like to thank the Squam Lake Group for inviting me to participate in this important and timely conference. It is a pleasure to have the opportunity to discuss ongoing efforts to reform the regulation of the global financial system with all of you.

Let me start with a very short story about Bombardier, a Montreal-based transportation-equipment giant, which, among other things, used to make and sell snowmobiles. 3

In the winter of 1998, Bombardier came up with an innovative way to improve snowmobile sales. It offered buyers a $1,000 rebate should snowfall in 44 cities total less than a pre-set amount. In short, it offered a "snow-guarantee". 4 Sales increased by 38%.

Not wanting to retain the risk in this guarantee, Bombardier bought insurance. It hedged the snow-guarantee with an over-the-counter (OTC) weather derivative - an option based on a snowfall index - under which Bombardier would be paid the same amount as it would have to pay its customers in the event of low snowfall. In the end, it snowed enough that Bombardier did not have to pay their snowmobile customers, and its insurance contract did not have to pay off. Since the increase in sales generated by the snow-guarantee more than covered the cost of the derivative, it looked like a winning strategy all around. The transfer of risk through the derivative was welfare improving.

But, as we know, derivatives are not always so benign in their economic impact. We can find numerous instances in which they contributed to finanical instability. In the recent crisis, credit default swaps (CDS) were vilified - especially those written by the now infamous financial products division of AIG.

With that as a very brief introduction, I will now turn to the Squam Lake Group's report, in particular Chapters 9 and 10, which cover CDS, clearing houses, exchanges, dealers, prime brokers and runs.

I will then turn to some recommendations I would like to have seen in the report - all of which are only a small step beyond the ones that are there.

The recommendations in the Squam Lake report

Chapter 9: Credit default swaps, clearing houses and exchanges

Chapter 9 makes recommendations to strengthen the infrastructure of OTC derivatives markets. The proposals are aimed at two goals.

The first goal is to lower the risk of a systemic failure arising from a counterparty failure in the CDS market. Imagine a circle of people in which everyone sells to the person on the left the same OTC derivative. Each person is perfectly hedged because each has bought and sold the same security. But if just one person goes broke, the circle is broken. Likewise, in an OTC market, the failure of one firm can create a chain of failures ending in a complete collapse of the system.

The report recommends that financial firms be encouraged to use clearing houses, which I shall also refer to here as central counterparties (CCPs). The encouragement would come in part by requiring additional capital for contracts not cleared through a recognised CCP. If, in my example, the trading had been through a central clearing house, netting would have eliminated the systemic risk.

Importantly, the report notes that CCPs concentrate risks and so should be "well designed". That is, they should be required to have strong operational controls, appropriate collateral requirements and sufficient capital.

The second goal is to increase transparency in the CDS market. Doing so would improve the ability of market participants and regulators to identify "potential trouble spots". Transparency here is about information collection and dissemination.

To increase transparency, the group would target the index and single-name CDS contracts that are relatively liquid and standardised. In particular, the group suggests introducing trade-reporting similar to that in the TRACE system, which provides post-trade price transparency for US corporate bonds.

Underlying the transparency recommendation is the well-known fact that information asymmetries are often the fuel for financial panics. During the last quarter of 2008 as well as more recently, we saw contagion due to uncertainty over counterparty exposures - that is, not knowing who will bear losses should they occur. It follows that transparency is critical if we are to avoid panics driven by uncertainty.

Chapter 10: Dealers, prime brokers and runs

Chapter 10 focuses on reducing the risk of runs on prime brokers and dealers. To reduce the risk, the group recommends imposing liquidity requirements on systemically important banks and broker-dealers. And it would exclude from regulatory liquidity any short-term financing based on assets from counterparties or customers. To head-off attempts by prime brokers to avoid the proposed rules on segregation of customer assets, the report recommends that regulation on that point in major financial centres be at least as tight as it is in the United States.

Implementation: how far along are we?

It should be a source of some satisfaction to the Squam Lake Group that a number of its recommendations have already been taken to heart by policymakers, regulators and, to some extent, market participants. 5 That said, complete adoption is still some distance away. Here is a status report on four of the more important items.

First, we now have trade depositories for CDS and interest rate derivatives. These depositories feature electronic databases of open OTC positions and publication of aggregate numbers on volumes and market activity. But very little information on exposures is publicly available. 6 And while there is some pre-trade price transparency, there no post-trade price transparency at all.

Second, when it comes to the actual use of CCPs, the interest rate swap market is the only OTC derivatives market in which market participants and financial institutions rely on central clearing in a systematic way. The London-based CCP called SwapClear covers roughly 45% of the total interest swap market. The use of clearing houses for other OTC derivatives contracts, however, ranges from very limited to non-existent.

Third, under the Basel III process, regulators have proposed more stringent liquidity requirements, but they have yet to be adopted.

Fourth, the need to segregate broker and client assets addresses not only the need to prevent rehypothecation (ie the pledging of securities in customer margin accounts as collateral for a brokerage's loan) but also the need to prevent co-mingling (ie using the same account for) broker and client assets. Regulations to address the co-mingling problem have been in place for some time, and enforcement has recently become more vigilant. 7 Moreover, anecdotal evidence suggests that hedge funds and other clients have started to insist that their assets not be co-mingled with prime broker assets. I should also note that, with respect to rehypothecation, private contracting practices are beginning to rule it out in response to the Lehman Brothers bankruptcy.

Recommendations I would like to have seen in the report

I agree with most of the report's recommendations, but I believe they do not go far enough. Here are three more proposals that I wish had been there.

1. Corporate derivatives users should be required to rely on central clearing houses

If we are to fully reap the benefits of having CCPs, central clearing houses will have to cover large swaths of the derivatives market, both in terms of counterparties and volume.

Current draft legislation in the United States and the European Union requires important financial institutions to trade through CCPs, as is recommended by the group. But end users could be exempt. The argument for the exemption is that, if end users have to use central clearing, they will have to post more collateral, which would drastically increase their cost of using derivatives for risk management. The result would be too little hedging.

There may be something to this. But the argument implicitly assumes that end users (such as Bombardier in the example I gave at the beginning) are not being charged for the credit risks that their counterparty takes on by not asking for collateral.

I find it hard to believe that banks do not charge their clients for the services they provide. Just as retail clients pay banks for their free checking accounts in one way or another, I have no doubt that end users are already paying for the services they receive. In fact, bankers are known to derisively refer to these services as "fee checking accounts" because of the hidden nature of the charges. What is true in checking is surely true for derivatives. That is, banks are surely compensated via prices, higher bid-ask spreads or higher costs for other services provided by the bank. Because of the opacity of the OTC market, it is very difficult for end users to know what they are actually paying.

In my view, end users wrongly perceive central clearing houses as being more expensive than the current solution simply because (i) CCPs allocate costs directly to the services provided and (ii) CCP costs are transparent.

2. Market participants should be encouraged to create standardised exchange traded derivatives for all risk types currently covered by OTC derivatives. Regulated financial institutions should have higher capital requirements for non-standardised contracts.

Current reforms focus on ensuring central clearing for "standardised" contracts. But to define the contracts that they think should be centrally cleared, the financial industry is using the phrase "eligible " instead of "standardised". This subtle rephrasing must not become a loophole that allows them to retain the status quo ante.

The argument typically advanced in favour of non-standardised OTC derivatives is that markets need tailored hedging tools. I would argue, however, that one can design standardised contracts for nearly all risk types and that standardised contracts are very good hedging tools.

The choice between a tailored hedge and a standardised hedge boils down to a choice between:

    1. a perfect hedge with a high bid-ask spread and counterparty risk, or

    2. an imperfect hedge with a low bid-ask spread and basis risk.

Let me give two examples.

First, weather derivatives. As many of you probably know, there are active exchange-based markets for US weather derivatives. The risks covered include hurricanes, snowfall, extreme temperature and frost. 8 Some of the contracts look remarkably like the one used by Bombardier to insure the snow guarantee it gave in 1998 to the buyers of its snowmobiles.

Clearly, standardised, exchange-traded weather derivatives are unlikely to be a perfect hedge. But a decade ago, they were very much an OTC product. In fact, Bombardier was a pioneer. But who sold the snowfall-option that Bombardier bought? Would it surprise you if I told you the seller was Enron? A perfect hedge using a bespoke OTC derivative - but alas, with counterparty risk.

The second example is exchange-traded futures and options. Very large and liquid derivatives markets exist for US and German government bonds. Contracts have been successfully standardised to provide good but not perfect hedges for these two most liquid government bond markets.

A few observations on the futures and options contracts for US and German government bonds:

1. None of them corresponds to an existing outstanding bond. Rather, each is designed as a contract on a non-existent or synthetic bond.

2. The delivery schedule matches the open interest with the deliverable quantity for bonds that do exist. The conversion factors are calculated as a fraction of the synthetic bond, taking into account the relative riskiness of the delivered bond.

I am hard pressed to understand why the same approach cannot be used to standardise interest rate, foreign exchange and credit derivatives. It would be well worth the effort simply to explore whether one could persuade market participants to seriously attempt such standardisation.

3. Consideration should be given to the introduction of product registration for financial contracts.

I can't help wonder if one should consider a scheme for financial contracts akin to drug regulation. The idea is to balance the need for innovation in financial instruments with the need to limit the capacity of any individual security to weaken the whole system.

The solution is some form of product registration that would constrain the use of instruments according to their degree of safety. The safest securities would be available to everyone, much like non-prescription medicines; next would be financial instruments available only to those with a licence, like prescription drugs; then would come securities available only in limited amounts to qualified professionals and institutions, like drugs in experimental trials; and securities at the lowest level of safety would be deemed illegal. An instrument could move to a higher category of safety only after successful tests analogous to clinical trials. Testing would combine real-world issuance in limited quantities with simulations of how the new instrument would behave under stress. Such a certification system creates transparency. As in the case of pharmaceutical manufacturers, so it should be for manufacturers of financial products: there must be a mechanism to hold them accountable for the quality of what they sell. That mechanism will increase the responsibility of financial institutions for assessing the risk of their products.

Concluding remark

I would like to congratulate the Squam Lake Group on an excellent and thoughtful report on how to fix the financial system. I remain hopeful that many if not most of the recommendations in the report will be implemented and that they will help improve the resilience of the financial system.

Thank you for your attention.

1 I thank Jacob Gyntelberg for his contributions to this presentation. The views expressed here are those of the author and do not necessarily reflect those of the BIS.

2 K French, M Baily, J Campbell, J Cochrane, D Diamond, D Duffie, A Kashyap, F Mishkin, R Rajan, D Scharfstein, R Shiller, H S Shin, M Slaughter, J Stein and R Stulz, The Squam Lake Report: Fixing the Financial System, Princeton University Press, 2010.

3 The Bombardier Recreational Products division was sold in 2003 and is today an independent company owned by, among others, members of the Bombardier family, Bain Capital and Caisse de dépôt et placement du Québec.

4 The rebate would be paid if the snowfall was less than half of what it had averaged in the past three years.

5 In May 2010, the Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organisation of Securities Commissions (IOSCO) jointly released two companion reports that provide guidelines for the establishment of CCPs as well as trade repositories for OTC derivatives: "Guidance on the application of the 2004 CPSS-IOSCO Recommendations for Central Counterparties to OTC derivatives CCPs: Consultative report", CPSS Publications, no 89,; and "Considerations for trade repositories in OTC derivatives markets: Consultative report", CPSS Publications, no 90,

6 The Depository Trust & Clearing Corporation operates the trade repository and data warehouse for CDS, while TriOptima operates a trade repository for interest rate derivatives. A trade repository for equity derivatives is expected to become operational in July 2010. In addition, aggregate data based on surveys are published by the International Swaps and Derivatives Association (ISDA); and by the Bank for International Settlements in collaboration with a number of central banks.

7 In early June 2010, the United Kingdom's Financial Services Authority (FSA) fined JPMorgan a record £33 million because they co-mingled accounts. Later, the FSA fined divisions of Astaire Group and Close Brothers also for failing to segregate clients' money from their own.


Wednesday, June 16, 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.

Download here:

The future of Canadian ABS: public or private?

Stikeman Elliott LLP on the future of Canadian securitization markets:

While the broader and more politically-charged aspects of the regulatory response to the debt crisis of 2008-09 remain largely unresolved, securities regulators have already begun the process of mapping out the implications of this crisis for the ABS market. The generalities of the recent recommendations of the International Organization of Securities Commissions (IOSCO) have already given way to the specific and detailed agenda set forth by the SEC in its reform proposals approved for public comment on April 7, 2010. While the main tenets of the reforms – greatly increased transparency, CEO accountability and risk participation by program sponsors – are interesting and merit discussion and debate, the proposed mechanism for mandating reform is intriguing in and of itself, and particularly so in the Canadian market context.

As is the case with all aspects of securities regulation, the proposed reforms of the ABS market do not aspire to relieve all ABS investors of the burden of caveat emptor. The new expectations to be imposed upon issuers and sponsors of ABS are proposed only as conditions upon those who wish to avail themselves of the procedural and market capacity benefits available in the context of short form public issuance. In essence, the new rules say that if you wish to access the debt market in an expedited fashion to be able to capitalize upon windows of opportunity for public issuance, your investors must be given adequate minimum levels of disclosure to assess the risk of the proposed investment, must have some assurance that the CEO of the entity that originated the underlying assets believes that the investor will be paid out by the assets in due course and must be assured that the program sponsor is exposed to a material risk of loss that ranks at least equal to that assumed by the public investor. These new requirements, among others, are entirely restricted to public issues. To the extent that an ABS issuer can find sufficient investor capacity without utilizing the prompt offering system to issue debt securities, the proposals require little more than evidence that private market investors have been expressly offered prospectus level disclosure.

There are obvious merits to these proposals, and there are also costs and complexities for the issuance process raised by them. However, apart from the analysis of the balance between these benefits and costs, it is interesting to consider the effectiveness of the carrot offered to ABS issuers by these proposals. Implicit in the SEC’s regulatory thinking is the assumption that short form offering capability for ABS issues is such an essential component of cost-effective capital market access that this condition of utilization will be a sufficient lever to effect major reform of the ABS market.

In the context of the pre-crisis ABS market, such an assumption appears entirely reasonable. The issuance data reported in the database maintained by trade publication Asset-Backed Alert shows that in the calendar years 2005-2007, issuance of public ABS (excluding MBS and CMBS) in the US was consistently far in excess of private placement (Rule 144A) offering volumes, being over eight times more in 2005, over four times more in 2006 and still just under three times more in 2007. With the advent of the depths of the debt crisis in 2008, public and private ABS issuance reached virtual parity, and 2009 saw 144A issuance outstrip public issuance by 15%. More striking still, for the first quarter of 2010, Asset-Backed Alert has reported over US$21 billion of 144A ABS issuance versus only US$9 billion of US public ABS.

The story in Canada is no different in Canada. DBRS has reported that rated ABS private placements now constitute 4.0% of all outstanding ABS by dollar volume, a remarkable statistic given that rated private placements had not been offered in the Canadian ABS market before 2007. The recent rise of private placements in the Canadian market is even more striking when one considers that the portion of the current Canadian ABS outstandings categorized as public ABS includes C$3.7 billion purchased by the Business Development Bank of Canada as the administering agency for the Canadian Secured Credit Facility, the government program created to assist in rekindling demand for automobile and equipment receivable-backed ABS. CSCF issues were public in form only, utilizing the short form offering system only to meet the requirement for CSCF participation but were otherwise distributed very narrowly, and were in most cases purchased by BDC alone. Outside of this notional CSCF public issuance, the Canadian ABS market has only seen five public issues since 2007, including one retail and one wholesale automobile receivable-backed deal brought by Ford Canada, a retail automobile receivable-backed deal brought by GMAC and recent credit card-backed issues from each of Royal Bank of Canada and CIBC.

The reasons for this change in the balance between public and private market issuance could reflect growing market unease over looming regulatory changes to the rules governing public issuance. The dramatic change in US issuance patterns in the first quarter of 2010, during which the general disclosure recommendations proposed in the IOSCO report would have been available to the market, would seem to support such a conclusion. However, it is also apparent that average transaction size for US private placements increased only marginally from its historic level of roughly US$500 million, so it could also be that the shift away from public issuance merely reflects the economic realities of bringing smaller transactions to market.

In the Canadian market context, the rise of the private placement market may also be a manifestation of an underlying aspect that reflects a more profound refocusing of distribution efforts. Anecdotal reports would suggest that material portions of at least the shorter-dated tranches of some of these private issuances (and companion tranches issued in connection with CSCF issues) have found their way into the hands of US investors. This new source of liquidity for Canadian ABS has arisen almost simultaneously with the January 1, 2008 elimination of the federal withholding tax on interest paid to US-resident investors by Canadian-resident debt issuers, lending significant credibility to those that have long advocated that such a change in Canadian tax policy would be a transformative development for the Canadian ABS market.

Given the emerging trends in the evolution of the ABS market in both Canada and the US, a starting point for the debate about the efficacy of the SEC proposals for the reform of the ABS market might well lie not with the merits of the substance of the proposals but rather with the question of the effectiveness of short term public issuance eligibility as the means of introducing any reforms to that market. In the Canadian context, an even more specific market transformation might need to be addressed, given that it appears that it might be the depth of the US market for the private placement of Canadian-originated asset-backed offerings rather than access to short form issuance of public ABS that will dictate the immediate prospects for market growth. In either case, securities regulators might need to face the more problematic task of imposing reforms upon private market players in an effort to address the substantive market deficiencies that have been identified in the context of the most recent market crisis.

Monday, June 14, 2010

EC Publishes Recommendations on Derivatives and Market Infrastructure

The purpose of the document (which can be downloaded here: is to obtain information from Member States, market participants and other stakeholders on the measures aimed at enhancing the resilience of derivatives markets and market infrastructures.

The European Commission adopted a Communication on "Ensuring efficient, safe and sound derivatives markets – future policy actions", on 20th October 2009 after a full consultation on a previous Communication of July 2009 (COM(2009)332) and accompanying Staff Working Paper and Consultation Paper (see IP/09/1546). In this Communication, the Commission outlined the policy actions it intended to take to address the problems of OTC (over-the-counter) derivatives markets.

Since then, the Internal Market and Services Directorate General of the European Commission has been developing more detailed measures in this respect. Following better regulation principles and considering the significant impact that the announced policy actions are likely to have on the markets, the Internal Market DG would now like to consult all interested stakeholders on these detailed measures. This consultation, which is open until 10 July 2010, is the final step before the Commission proposes legislative proposals in September.

What is the status of this consultation? Is this a legislative blue-print?

This document is a working document of the Internal Market DG for discussion and consultation purposes. It does not purport to represent or pre-judge the formal proposal of the Commission. However, it does give an overview of the Internal Market DG's current thinking on how to practically implement some of the actions outlined in October 2009.

How does the consultation fit with other Commission initiatives in response to the financial crisis?

In its 2009 October Communication, the Commission announced a series of policy actions to respond to the issues raised by OTC derivatives. The aim of these actions is to reduce systemic risk and increase transparency. These initiatives are in line with the agreement signed by the G20 leaders in Pittsburgh on 25th September 2009, which stipulates that "all standardised OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at latest. OTC derivatives contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements".

What is the objective of the measures put out for consultation?

The consultation document outlines the Internal Market DG's current thinking on how to implement four of the policy actions that were announced in October 2009, notably:

  • Mandatory clearing of all "standardised" OTC derivatives;

  • Mandatory reporting of all OTC derivatives to trade repositories;

  • Common rules for Central Counterparties (CCPs) and for trade repositories; and

  • More transparency through reporting to trade repositories.

Other measures are foreseen later in 2010 or beginning of 2011, notably the revision of the Capital Requirements Directive, MiFID (Market in Financial Instruments Directive) and the Market Abuse Directive.

On substance, the Commission's future proposal will focus on four points:

Reducing counterparty credit risk by mandating CCP-clearing where possible

Increasing transparency by mandatory reporting to trade repositories

Ensuring safe and sound CCPs through stringent and harmonised organisational, conduct of business and prudential requirements.

Improving efficiency in the EU post-trading market by removing barriers preventing interoperability between CCPs while preserving the safety of them.

What are the main issues you are consulting on?

Central clearing requirements: All eligible derivate contracts should be cleared through a CCP. A process needs to be developed for the determination of the eligibility of contracts. There are also questions relating to the scope of exemptions for non-financial corporate end-users.

- Requirements on CCPs: the consultation asks what rules are necessary to ensure that CCPs contain risk in the market instead of becoming a potential source of risk concentration themselves.

- Relationship with third countries: the consultation asks how to ensure that CCPs and trade repositories in third countries can continue to provide services in the EU and what is the right approach for a sector, which is by nature, a global one.

- Interoperability: the consultation asks how best to achieve interoperability between CCPs.

- Requirements on trade repositories: the consultation asks amongst other things how to ensure access to data and make sure that trade repositories are adequately organised to receive, process and store that data. And the consultation asks about reporting requirements for market participants to trade repositories..

Why are you considering introducing requirements on interoperability even if those were not announced in the October Communication?

The Commission services have in recent years repeatedly highlighted that Europe's post-trading sector (i.e. clearing and settlement) ) remains fragmented along national lines (see e.g. European Commission (2006) Draft Working Document on post-trading activities and Commission Staff Working Document (2009), The Code of Conduct on clearing and settlement: three years of experience). This undermines the efficiency of each national system and increases the costs of cross-border transactions. Interoperability (please explain in one sentence what interoperability is) was, and still is, considered as one possible way of solving these problems. However, the experience with the Code of Conduct has demonstrated that industry action alone is not sufficient to attain this goal.

Furthermore, the European Council in its December 2008 and 2009 Conclusions stressed the need for further progress on access and interoperability while ensuring the safety of these arrangements and the high prudential standards CCPs need to comply with.

The consultation contains no reference to authorisation and supervision of CCPs. Why? Will this be addressed in forthcoming legislation?

Authorisation to provide CCP services and supervision (ongoing monitoring of CCP activities) are of paramount importance. But these issues are not technical details which the Commission needs stakeholder input on, but a key political choice. To enable the Commission to take an informed decision on those matters, the Commission services are discussing these institutional arrangements in other, more appropriate fora (e.g. working groups with Member States).

If adopted, how would CCPs, trade repositories and users benefit from the technical measures under consideration?

The measures, if adopted, would establish a level playing field between market infrastructures, which would also benefit users . In particular, users would benefit from high prudential standards imposed on CCPs that will help ensure the safety and soundness of the wider system, and thus greater protection for users. CCPs will benefit from fair competition as common requirements will avoid competition on the margins. Trade repositories will be subject to common requirements: this will add clarity to what they should collect as data and how they should maintain the information recorded.

You are considering a comprehensive solution for all derivatives markets. How are you taking into account important differences between asset segments, e.g. in terms of risk?

Various segments of the OTC derivatives market differ in their characteristics, namely in terms of risk, operational arrangements and market participants. Therefore, at first sight, a specific regulatory approach for each market segment could seem warranted. However, the financial crisis has shown that problems such as lack of transparency and excessive counterparty credit risk are common to all segments. That is why a common policy approach is preferable. Such an approach is also justified by the fact that the boundaries between market segments are blurred, as any derivative contract can be partitioned and reconstructed into different but economically equivalent contracts. A segmented policy approach would enable market participants to exploit differences in rules to their advantage. Moreover, the approaches to some of the key obligations under consideration (e.g. mandatory clearing), contains a number of safeguards that, if adopted, would take into account differences between asset segments.

You are considering giving ESMA significant powers, notably as regards the clearing obligation. Isn't that too much for an Authority that does not yet exist?

The European Securities and Markets Authority (ESMA) needs sufficient powers to be effective. These powers will be set out in the supervision package, currently in the final stages of negotiation between the European Parliament and finance Ministers. We are considering entrusting ESMA with determining the contracts subject to the clearing obligation. This is important, as we need a single list of eligible contracts in Europe. A national approach whereby each Member State would decide in isolation could lead to 27 different clearing obligations for market participants. This would not reduce systemic risk and would only create legal uncertainty across the Single Market.

We are also considering endowing ESMA with responsibility for setting the thresholds above which non-financial institutions should be subject to the clearing obligation. Such thresholds need to take into account the technical and evolving characteristics of the market place; therefore, it is appropriate to give regulators a predominant role in setting them. Moreover, the data necessary for setting the thresholds will only be available after the implementation of the future legislation.

You are considering stringent requirements for CCPs. Should you not limit the future legislation to high level principles to leave room for the implementation of internationally agreed standards?

We need to find the right balance. We are responsible for ensuring that European CCPs are safe and sound institutions, and meet robust and harmonised binding prudential requirements that are the same across all 27 EU-Member States. They should not be allowed to compete on risk grounds. This requires stringent requirements for CCPs setting out the key prudential requirements they have to respect.

International consistency is desirable. We therefore strongly support the work done by central banks and financial market regulators working together in CPSS-IOSCO (Committee on Payment and Settlement Systems - International Organisation of Securities Commissions) ) to review the global non-binding recommendations for CCPs. The future legislation under consideration would leave room for technical details to be developed at a later stage. Accordingly, it would be possible to further integrate aspects of the CPSS-IOSCO review potentially not covered by the legislation.

Why are you considering different options for trade repositories? Would it not be preferable to have one global repository per asset class?

Market participants will be required to report their trades to a repository. Trade repositories will maintain this information, which is of key importance to regulators. It is therefore essential that regulators have access to the relevant information stored in those repositories. This needs to be taken into account when considering the trade repository market structure. All options - i.e. requiring location in the EU only if access to information is not guaranteed, requiring location as in the form of a subsidiary as a condition for registration, or requiring a self-standing EU trade repository, under consideration have pros and cons. We therefore believe it is important to seek the views of stakeholders on these different options so as to eventually have a proposal that would represent the best option.

How do the actions under consideration relate to Credit Default Swaps (CDS)?

If adopted in the forthcoming Commission's proposal, the actions under consideration would have two effects on CDS:

First, it would further increase transparency of CDS transactions by requiring all trades to be reported to trade repositories to which regulators would have full access.

Second, two of the requirements under consideration - the obligation to clear most derivatives with CCPs and the requirement to strengthen the risk management of non-cleared OTC derivatives – would, if adopted, increase the cost of engaging in OTC derivatives deals. Therefore, while the primary aim of these actions is to reduce the systemic risk, they would also increase the upfront cost of engaging in speculative derivatives deals.

The Commission is also considering an initiative on short-selling this autumn where measures on CDS are considered.

Annex – Glossary of key terms

For information purposes … not legally binding:

'Derivatives' means financial instruments as defined by Annex I Section C numbers (4) to (10) of Directive 2004/39/EC. In simple terms, a derivative is a financial instrument - a contract between two people or two parties - that has a value determined by the price of something else, the underlying. The "underlying" can be any kind of asset, for example a share, a currency, a commodity. There are many kinds of derivatives, the most notable being swaps, futures, and options. However, since a derivative can be placed on any sort of security, the scope is endless.

'Over the counter (OTC) derivatives' means derivative contracts whose execution does not take place on a Regulated Market as defined by Article 4(14) of Directive 2004/39/EC.

'Central counterparty (CCP)' means an entity that interposes itself between the counterparties to the contracts traded within one or more financial markets, becoming the buyer to every seller and the seller to every buyer and which is responsible for the operation of a clearing system.

'Trade repository' means an entity that centrally collects and maintains the records of OTC derivatives.

'Market infrastructure' means either a CCP or a trade repository.

'Clearing' means the process of establishing settlement positions, including the calculation of net positions, and the process of checking that financial instruments, cash or both are available to secure the exposures arising from a transaction.

'Interoperability' means two or more CCPs entering into an arrangement with one another that involves cross-system execution of transactions.

OTC Derivatives Market in India: Recent Regulatory Initiatives and Open Issues

By Dayanand Arora and Francis Xavier Rathinam

Abstract: The OTC derivatives markets all over the world have shown tremendous growth in recent years. In the wake of the present financial crisis, which is believed to have been exacerbated by OTC derivatives, increasing attention is being paid to analysing the regulatory environment of these markets. In this context, we analyse the regulatory framework of the OTC derivatives market in India. The paper, inter alia, seeks to prove the point that the Indian OTC derivatives markets, unlike many other jurisdictions, are well regulated. Only contracts where one party to the contract is an RBI regulated entity are considered legally valid in India. A good reporting system and a post-trade clearing and settlement system, through a centralised counter party, has ensured good surveillance of the systemic risks in the Indian OTC market. From amongst the various OTC derivatives markets permitted in India, interest rate swaps and foreign currency forwards are the two prominent markets. However, by international standards, the total size of the Indian OTC derivatives markets still remains small because credit default swaps were conspicuously absent in India until now. It appears that Indian OTC derivatives markets will grow fast once again after the present financial crisis is over. This research paper explores those open issues that are important to ensure market stability and development. On the issue of the much discussed competition between exchange-traded and OTC-traded derivatives, we believe that the two markets serve different purposes and would contribute more to risk management and market efficiency, if viewed as complementary. Regarding the introduction of new derivative products for credit risk transfer, the recent announcement by the RBI that it would introduce credit default swaps is a welcome sign. We believe that routing of credit default swaps through a reporting platform and managing its post-trade activities through a centralised counterparty would provide better surveillance of the market. Strengthening the position of the Clearing Corporation of India Ltd. (CCIL) as the only centralised counterparty for Indian OTC derivatives market and better supervision of the off-balance sheet business of financial institutions are two measures that have been proposed to ensure the stability of the market.

Download here:

Friday, June 11, 2010

Discounting revisited: valuations under funding costs, counterparty risk and collateralization

By Christian P. Fries of DZ Bank AG

Abstract: Looking at the valuation of a swap when funding costs and counterparty risk are neglected (i.e., when there is a unique risk free discounting curve), it is natural to ask "What is the discounting curve of a swap in the presence of funding costs, counterparty risk and/or collateralization".

In this note we try to give an answer to this question. The answer depends on who you are and in general it is "There is no such thing as a unique discounting curve (for swaps)." Our approach is somewhat "axiomatic", i.e., we try to make only very few basic assumptions. We shed some light on use of own credit risk in mark-to-market valuations, giving that the mark-to-market value of a portfolio increases when the owner's credibility decreases.

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.
Download here:

Thursday, June 10, 2010

MPAA, myriad interest groups lobby on financial regulation bill

The Washington Post reports on the diverse lobby groups lining up to influence the financial regulation bill moving through Congress:

The Motion Picture Association of America, the trade group for the six big Hollywood studios, has been working to insert a provision banning a futures market for box office returns.

Two financial companies are trying to establish such futures markets, but studios are concerned that the exchanges could create negative publicity for films.

"Box office futures are not a commodity," said Howard Gantman, a spokesman for the association. "Especially if the industry is not allowed to invest in it, this just becomes a form of pure gambling..."

"The bill is so broad and goes into so many segments of the economy, it was bound to touch agriculture somewhere," said Adam Nielsen of the Illinois Farm Bureau. "We're looking at the bill and hoping there aren't any negative consequences. I think that would probably be the sentiment of a lot of people."

Nielsen said the bureau had concerns about whether, under the bill, farmers would be able to manage risk using options and futures, although the measure is not one of its top priorities.

U.S. Telecom, the trade association for broadband companies, is concerned about pieces of the Senate bill that could affect prepaid phone cards and a broad definition of "financial data processing" in the measure, which could regulate Internet companies with customers who bank online.

Several large utility companies, including Southern Co. and Florida Power & Light, have registered to lobby on provisions of the bill banning derivatives sold in private or "over the counter." Those financial instruments help even non-financial companies hedge against market forces changing prices for commodities or interest rates that affect their business, and many companies are seeking an exemption for end-users that depend on them.

The publishing company Argus Media, which provides energy news and business intelligence, also listed derivatives as one of the issues on which it would lobby. A company official declined to comment. Competitor McGraw-Hill also targeted the bill

Wednesday, June 9, 2010

Equivalence between US and EU CRA regulatory regimes

Clifford Chance reports that "CESR has published its technical advice to the European Commission on the equivalence between the US Regulatory and Supervisory Framework and the EU Regulatory Regime for Credit Rating Agencies."

CESR concludes that, overall, the US legal and supervisory framework is broadly equivalent to the EU regulatory regime for credit rating agencies in terms of achieving what CESR considers to be the overall objective of 'assuring that users of ratings in the EU would benefit from equivalent protections in terms of the credit rating agencies' integrity, transparency, good governance and reliability of the credit rating activities'. However, CESR argues that there are a number of differences between the US legal and supervisory framework and the EU regulatory regime, which mainly relate to the issue of disclosure of credit ratings and the quality of credit ratings and credit rating methodologies. CESR recommends that the differences identified in its advice are addressed to allow for further convergence between both regimes, and considers that reducing the difference may be achieved by future regulatory amendments to the SEC's rules.

Download the report here:

Saturday, June 5, 2010

EU-Backed Rating Company Faces ‘Uphill Struggle’ With Investors

According to the Times Online, "the big three credit ratings agencies [are being] threatened ywith fines and the creation of a new state-backed competitor, only weeks after European leaders attacked them for exacerbating Greece’s problems with downgrades..."

The agencies will be subject to a new European supervisory body with the power to hand out fines and suspensions under plans unveiled in Brussels.

Work on a rival centralised European credit agency is also being carried out by the European Commission, José Manuel Barroso, its President, said...

Mr Barroso, launching the plans yesterday, argued that the big three rating agencies — Moody’s, Standard & Poor’s and Fitch Ratings — should have done more to alert investors to the imminent demise of Lehman Brothers in 2008. “Is it normal to have only three relevant actors in such a sensitive issue where there is a great probability of conflict of interest?” he asked. “Is it normal that all of them come from the same country? Is it normal that such important entities are escaping fundamental regulation?”

Rating agencies have also come under fire in recent weeks after their downgrades of Greek and Spanish sovereign debt rocked markets and led the euro to slide against the dollar. Last month, Angela Merkel, the German Chancellor, and President Sarkozy of France demanded a review of their operations. But Mr Barroso insisted that plans for supervision and regulation were hatched long before the latest row.

Bond investors privately have cast doubt on the credibility of any new body rating sovereign debt if it is bankrolled by those same sovereign nations...

The European Commission proposed that an already-planned central European Union regulatory body — the European Security Markets Authority — should take on oversight of the existing rating agencies when it is due to begin work in January 2011.

The new authority would register rating agencies in return for a fee and check that they meet EU rules showing careful research of their rating and no conflict of interest.

The authority will be able to fine individual national offices of rating agencies that cannot or will not justify their methodology, or stop them from issuing ratings temporarily, or even permanently in the worst cases.

The proposal will now go to EU governments and the European Parliament for approval.

Mr Redwood called on the Commission to think again on its plans for supervision and a central European ratings agency. “They are going to find it extremely hard to change the way that credit rating agencies perform ... There is not a foolproof system for saying that certain assets are absolutely guaranteed in all conditions.”

Kay Swinburne, a Conservative MEP, said: “The problems in the eurozone are predominantly as a result of poor fiscal policies of some EU governments, not because of the decisions of ratings agencies to downgrade them.”

Bloomberg adds:

A government-established credit assessor may find it hard to persuade bond-buyers it isn’t shielding euro-region nations such as Spain and Portugal from scrutiny as countries struggle to cut their budget deficits, said investors including Toby Nangle at Baring Investment Services Ltd. Governments have already extended a 750 billion-euro ($913 billion) lifeline for Europe’s most indebted nations.

“A government-owned ratings agency that was rating sovereigns would have an uphill struggle in building credibility in the market,” said Nangle, who helps oversee $46 billion in assets in London...

Euro-region policy makers want to protect members with the largest budget deficits after contagion from the Greek debt crisis threatened to undermine the euro.

There was “absolutely no change” in information available for months before downgrades of countries including Spain and Portugal, showing the decisions could have been made earlier, Noyer said June 1 in Seoul. Untimely ratings actions are an “enormous problem,” he said.

The next day, Noyer told Germany’s Handelsblatt newspaper that credit insurers such as Paris-based Euler-Hermes and Puteaux could become European rating companies...

“The problem is not setting up a European rating agency,” said Laurent Bilke, a former ECB economist who now works for Nomura International Plc in London. “The problem is that it would not be followed by the investment community, particularly if they issued rating for sovereigns. For that you need strict independence from both fiscal and monetary authorities.”

Some euro-area central banks including Germany’s Bundesbank issue ratings on company bonds to use as collateral for the ECB. President Jean-Claude Trichet said May 6 that the ECB has “no position” on a European rating company, though “the more you have competition, perhaps the better.”

While policy makers have criticized markets’ dependence on ratings, ECB rules magnified their importance during the crisis. Under the terms of its money market operations, only bonds above a certain threshold are accepted as collateral. A series of Greek downgrades by two of the three main rating companies then threatened to make the country’s bonds ineligible at the ECB, which would have shaken the foundations of Greece’s entire financial system.

Goldman Sachs Chief European Economist Erik Nielsen last year described the influence indirectly given to rating agencies by ECB rules as “bizarre and ultimately untenable.”

Ratings companies already face greater EU scrutiny. The European Commission on June 2 called for a single supervisor with powers to investigate, issue fines and revoke licenses. That’s “only the first step,” Financial Services Commissioner Michel Barnier said. “We are looking at this market in more detail.”

“It is easy to think the European rating agency was going to be set up to ensure more favorable ratings, which would lead to a lack of credibility for the euro zone,” Commerzbank AG analysts Ulrich Leuchtmann and Lutz Karpowitz said in a June 2 note to investors...

“It’s too easy to blame” ratings companies, said Christoph Kind, head of asset allocation at Frankfurt Trust in Frankfurt, which manages $17 billion. “There is a saying: ‘you can’t blame the mirror for your ugly face.’ The ratings agencies are a kind of mirror of what’s happening. They just collect the facts.”

ABS issuers rush to beat impact of SEC's Rule 17G-5

The SEC's new Rule 17G-5 requires that newly issued structured products data be simultaneously shared with the 10 accredited ratings agencies at once. Anyone wanting a particular deal exempt from the new rules would have to submit their products for rating by a June 2nd deadline.

Hence banks dumped bucketloads of paperwork on Moody's and S&P on June 1st. According to Asset Backed Alert:
Issuers took advantage of the loophole by submitting mountains of documents on June 1, in many cases for transactions that won't hit the market for some time. At least 15 issuers and underwriters were in on the act, including Bank of America, Citigroup and JP Morgan.

Friday, June 4, 2010

Pay the rating agencies according to results

A new idea from Larry Harris (former SEC chief economist) in an article posted in the Financial Times:

The best solution must address the fundamental problem with ratings: we do not know how good ratings are on average until bonds mature or default. The solution thus must depend on future performance.

An effective solution to the ratings problem would make the profits that rating agencies earn depend on how the bonds they rate perform. Credit agency profits should rise if bonds they rate as investment grade perform well and fall if such bonds default more often than expected.

Credit rating agencies could create this contingent compensation scheme by putting a meaningful portion of their fees into escrow. The custodian of these funds eventually would return them to the agencies if their ratings performed well.

To fund their operations, the rating agencies could borrow against these escrowed funds, using their future contingent payments as collateral. The lenders then would rate the raters instead of the government. The SEC could create this system simply by requiring that rating agencies opt in if they want the NRSRO designation. The SEC would then only need to determine whether the deferred contingent compensation schemes used by each credit agency provided meaningful incentives to produce well-researched and unbiased ratings.

Finally, the SEC should require disclosure of these deferred contingent compensation schemes, so that investors can decide for themselves which schemes provide adequate incentives to rate securities well. The proposal outlined here allows the power, creativity and wisdom of the free market to produce the best solution.

Thursday, June 3, 2010

ICE Reports $9 Trillion in CDS Cleared Globally to Date

Through May 28, ICE's CDS clearing houses have cleared $9 trillion in gross notional value on a
cumulative basis on more than 195,000 transactions. ICE currently lists 233 CDS contracts for clearing.
  • ICE Trust U.S. (ICE Trust) has cleared $5.7 trillion of gross notional value since inception, including $213 billion in single-name CDS, resulting in open interest of $405 billion. ICE Trust offers clearing for 35 indexes and 71 single-name instruments. ICE Trust has also cleared $1.2 billion of non-clearing house member, or buy-side, transactions since launch on December 14.
  • ICE Clear Europe has cleared euro 2.4 trillion ($3.3 trillion) of gross notional value since inception, including euro 330 billion in single-name CDS, resulting in euro 343 billion ($422 billion) of open interest. ICE Clear Europe offers clearing for 26 indexes and 101 single-name instruments.

Wednesday, June 2, 2010

CESR advises on US/EU CRA regimes

Original posted on Lexology:

CESR has advised the Commission on equivalence between the US and EU legal and supervisory frameworks for CRAs. It found the frameworks are broadly equivalent but there are some differences. (Download the document here: )

It highlights the differences in credit rating disclosure, and quality of credit ratings and credit rating methodology. CESR thinks more convergence on these issues would be good. CESR considered the two regimes in terms of:

  • scope of framework;
  • corporate governance;
  • conflicts management;
  • organisational requirements;
  • quality of methodologies and ratings;
  • disclosure; and
  • effective supervision and enforcement.

Senate Bill's CRAB Could Revolutionize Assignment of Credit Ratings

Originally posted on Jim Hamilton's World of Securities Regulation:

The financial reform legislation passed by the Senate conducts a frontal attack on the conflict of interest problem by creating a board overseen by the SEC that will assign credit rating agencies to provide initial ratings for asset-backed securities and structured financial products on a rotating basis. This was a provision authored by Senator Al Franken and adopted as an amendment to the Senate bill. Within 180 days of enactment, the SEC must create a Credit Rating Agency Board, a self-regulatory organization, tasked with developing a system in which the Board randomly assigns a credit rating agency to provide a product’s initial rating. There is no comparable provision in the House bill.

Requiring an initial credit rating by an agency not of the issuer’s choosing, but randomly selected by the Board, will put a check on the accuracy of ratings and end forum shopping, in the Senator’s view. The provision does not prohibit an issuer from then seeking a second or third or fourth rating from an agency of their choosing. The provision leaves flexibility to the Board to determine the assignment process. Thus, the new Board gets to design the assignment process it sees fit, which can be random or based on a formula, just as long as the issuer doesn’t get to choose its initial rating agency. This should eliminate the current incentive for a rating agency to give an inflated rating in the hope of getting repeat business. Cong. Record, May 10, 2010, S3465.

Senator Franken has emphasized that the Credit Rating Agency Board will be a self-regulatory organization that will eliminate the current rating shopping process and the conflict of interest inherent in that process. Since the Board can take past performance into account in handing out rating assignments to agencies, the new process will incentivize accuracy in the market. Cong. Record, May 19, 2010, S3955.

The SRO rating system being created will essentially operate as a clearinghouse to assign credit ratings under an SRO, which will set up its own rules and how the assignments wil work.

The Credit Rating Agency Board would be comprised of industry experts: investors, issuers, raters, and, independents. A majority of its members would be investors, including institutional investors who have experience managing pension funds and university endowments. According to Senator Franken, they would have a vested interest in accurate credit ratings because they depend on them when making investments. Cong Record, May 5. 2010, S3155.

Another key element of the new SRO regime is that the Board will regularly evaluate the performance of the credit rating agencies, and they would have to take that performance into account in coming up with an assignment mechanism. In Senator Franken’s view, there is no better way to get accurate ratings than giving more initial rating jobs to the most accurate raters and fewer jobs to those that repeatedly do a sloppy job. The Board will also be able to prevent raters from charging unreasonable, which strikes at the heart of sweetheart deals in which a rater asks for more money for a better rating. Cong Record, May 5. 2010, S3155.

In addition to randomly assigning credit ratings, the Board will also qualify rating agencies to issue ratings for structured products. The term qualified nationally recognized statistical rating organization with respect to a category of structured finance products means a nationally recognized statistical rating organization that the Board determines, using statutory criteria, to be qualified to issue initial credit ratings with respect to such category.

The term category of structured finance products as used in the legislation must include any asset-backed security and any structured product based on an asset-backed security. The SEC can further define and expand on the definition as necessary, but in issuing such regulations the Commission must consider the types of issuers that issue structured finance products and the types of investors who purchase them, as well as the different categories of structured finance products according to capital flow and legal structure, underlying products, terms used in debt securities, the different values of debt securities, and the different numbers of units of debt securities issued together.

The process of the Board qualifying a rating agency is spelled out in the statute. First, the rating agency submits an application to the Board on a form prescribed by the Board to become a qualified nationally recognized statistical rating organization with respect to a category of structured finance products. The application must contain information regarding the institutional and technical capacity of the NRSRO to issue credit ratings, and information on whether the NRSRO has been exempted by the SEC from any requirements under any other provisions, as well as any additional information the Board may require.

The Board may reject an application if the NRSRO has been exempted by the Commission from any requirements under any other provision of this section. The Board must select qualified rating agencies with respect to each category of structured finance products from among nationally recognized statistical rating organizations that submit applications.

An entity selected as a qualified nationally recognized statistical rating organization must retain its status and obligations under the law as an NRSRO and neither the SEC nor the Board is authorized to exempt qualified nationally recognized statistical rating organizations from obligations or requirements otherwise imposed by federal law on nationally recognized statistical rating organizations.

An issuer seeking an initial credit rating for a structured finance product may not request an initial credit rating from a nationally recognized statistical rating organization. Rather, the issuer must submit a request for an initial credit rating to the Board on a form the Board may prescribe.

Issuer requests for ratings will be given to a rating agency selected by the Board under a system determined by the Board based on statutory selection guidelines.

The Board must evaluate a number of selection methods, including a lottery or rotating assignment system, incorporating factors to reduce the conflicts of interest that exist under the issuer-pays model and prescribe and publish a selection method. In evaluating a selection method, the Board must consider the information submitted by the qualified nationally recognized statistical rating organization regarding its institutional and technical capacity to issue credit ratings; evaluations conducted, formal feedback from institutional investors, and information to implement a mechanism which increases or decreases assignments based on past performance. In choosing a selection method, the Board may not use a method that would allow for the solicitation or consideration of the preferred national recognized statistical rating organizations of the issuer.

The Board must also issue rules describing the process by which it can modify the assignment of ratings process. Also, a rating organization must charge an issuer a reasonable fee, as determined by the Commission, for an initial credit rating on a structured financial product. Fees may be determined by the qualified national recognized statistical rating organizations unless the Board determines it is necessary to issue rules on fees. The Board must issue regulations to define the term reasonable fee.

A rating agency selected by the Board to give an initial rating on a structured product can refuse to accept a selection for a particular request by notifying the Board of such refusal; and submitting to the Board a written explanation for the refusal. Upon receipt of the refusal notification, the Board must select another rating agency. The Board must also annually submit any explanations of refusals it received to the SEC and the explanatory submissions must be published in the required annual inspection reports.

Each initial credit rating issued for a structured financial product must include, in writing, the following disclaimer: ‘This initial rating has not been evaluated, approved, or certified by the Government of the United States or by a Federal agency.’’

The Board is directed to adopt rules by which it will evaluate the performance of each qualified nationally recognized statistical rating organization, including rules that require, at a minimum, an annual evaluation of each NRSRO. The Board, in conducting such an evaluation, must consider the results of the annual examination, surveillance of credit ratings conducted by the rating agency after the credit ratings are issued, including how the rated instruments perform, the accuracy of the ratings provided compared to the other rating agencies, and the effectiveness of the methodologies used to arrive at the rating. The Board must make any evaluations it conducts available to Congress. A rating agency may request a reevaluation not less frequently than once a year.

The SEC will select the initial members of the Board for a four-year term and the SEC has discretion to decide how many members will serve on the Board so long as it is an odd number. A majority of the Board must be investor industry representatives who do not represent issuers. One member must be from the issuer community and one must be from the credit rating agency industry. Finally, one member must be independent. The SEC must adopt rules for the nomination and election of future Board members.

A Board member or employee must not accept any loan of money or securities, or anything above nominal value, from any nationally recognized statistical rating organization, issuer, or investor. However, this prohibition does not apply to a loan made in the context of disclosed, routine banking and brokerage agreements, or a loan that is clearly motivated by a personal or family relationship. Board members or employees must not engage in employment negotiations with any rating agency, issuer, or investor, unless they discloses the negotiations immediately upon initiation and recuse themselves from all proceedings concerning the entity involved in the negotiations until termination of negotiations or until termination of their employment by the Board, if an offer of employment is accepted.

A credit analyst of a qualified NRSRO must not accept any loan of money or securities, or anything above nominal value, from any issuer or investor. Except that this prohibition does not apply to a loan made in the context of disclosed, routine banking and brokerage agreements, or a loan that is clearly motivated by a personal or family relationship.

The SEC must adopt a schedule ensuring that the Board begins assigning rating agencies to provide initial ratings within one year of selection of the members. The schedule must set forth when the Board will conduct a study of the securitization and rating process and provide recommendations to the SEC and when the Board will begin accepting applications to select qualified NRSROs and begin assigning initial ratings. The Board is authorized to levy fees on qualified NRSROS to fund its expenses.

Within five years of the date the Board begins assigning initial ratings on structured financial products, the SEC must report recommendations to Congress on the Board’s continuation and any changes in Board procedures.

DTCC to post CDS market activity data

June 2, 2010- The Depository Trust & Clearing Corporation (DTCC) announced today that it will post this evening on its website,, data compiled from CDS trades registered in DTCC's Warehouse Trust Company LLC at the request of market participants who will use it to assess which of the various single reference entities might have sufficient liquidity to be cleared through a central counterparty (CCP). The information includes market activity from June 20, 2009 through March 19, 2010 for all single-named credit default swap (CDS) reference entities.

Market participants requested the data in keeping with the commitments they made (in their March 1, 2010 letter) to global regulators to continue strengthening the operational infrastructure and mitigating risk in OTC derivatives trading. As part of this commitment, the signatories (including representatives of all major dealers, several buy-side firms and industry trade associations) pledged to increase the range of products eligible for CCP clearing The requested data is being posted on DTCC's public website to ensure that other market participants, interested parties and the public have equal access to the information.

While DTCC compiled and provided the basic data requested by industry firms, the analysis of the data and subsequent assessment of which reference entities might be best suited for clearing will be conducted by market participants, including various members of the Credit Derivatives Steering Committee of the International Swaps and Derivatives Association (ISDA), as well as the relevant CCPs.

DTCC's Trade Information Warehouse is the centralized global repository and post-trade processing infrastructure for the worldwide OTC credit derivatives market. Virtually all CDS trades are registered in the Warehouse, which is operated by the Warehouse Trust Company LLC, a DTCC subsidiary regulated by the New York State Banking Department and a member of the Federal Reserve System. Warehouse customers include all major derivatives dealers and more than 1,700 buy-side firms and other market participants located in more than 50 countries. As of May 21, the total gross notional value of the approximately 2.3 million CDS contracts registered in the Warehouse was $25.1 trillion.

DTCC also publicly releases weekly aggregate information on OTC credit derivatives, including open interest and turnover information for the top 1,000 names traded worldwide and CDS indices, which is available on its website at This information is posted Tuesday evenings after 5:00 p.m.