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.

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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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