Friday, October 29, 2010

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

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

The recommendations cover five areas of reform, as follows:

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

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

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

Thursday, October 28, 2010

FSB issues principles to reduce reliance on CRA credit ratings

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

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

Monday, October 25, 2010

FSB publishes report on improving OTC derivatives markets

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

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

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

It can be downloaded here:

Wednesday, October 20, 2010

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

By Alessandro Fontana

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

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Friday, October 15, 2010

Robust Linkages between CDs and Credit Spreads

By Rajna Gibson and Silika Prohl

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

Download here:

Monday, October 11, 2010

Emergence and Future of Central Counterparties

By Thorsten V. Koeppl and Cyril Monnet

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

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Credit Ratings and Credit Risk

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

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

Download here: