Credit Risk Chronicles

CDS compression amounts have fallen (TriOptima Press Release)

2011-01-10T06:10:00.000-08:00

TriOptima announced that its triReduce portfolio compression service had eliminated $45.8 trillion in interest rate swap notionals in a record 53 cycles and $8.5 trillion in credit default swap notionals in a record 95 compression cycles during 2010.

Terminations in interest rate swaps increased significantly in 2010 with 53 triReduce Rates cycles in 23 currencies around the globe eliminating $45.8 trillion in notional outstanding, up from $26.7 trillion in 2009. This included nine cycles run in conjunction with LCH.Clearnet Swapclear. “2010 was another successful year in triReduce rates,” said Raf Pritchard, CEO of TriOptima North America. “We expanded the range of interest rate swap currencies we cover to Israeli Shekel (ILS) and Thai Baht (THB). Terminations in currencies like these with higher capital requirements can free up capital for redeployment and reduce counterparty credit risk. Furthermore, with strong cycles in JPY and eight other Asian currencies, our activities in Asia continue to gain traction.”

Compression results in credit default swaps have decreased since their peak in 2008 when triReduce Credit cycles eliminated $30.2 trillion in notional outstanding. “The success of our compression efforts in previous years as well as the increased industry efforts and prioritization accorded to clearing contributed to lower compression levels for CDS index trades in 2010,” said Raf Pritchard. “However, we have seen a doubling in the termination of single name trades since 2008 due to the introduction of coupon standardization in ISDA’s Small Bang.”

Since the introduction of its innovative triReduce service in 2003, TriOptima has terminated $108 trillion in IRS notional outstandings and $68.2 trillion in CDS notional outstandings. Full compression statistics are available on TriOptima’s website at: http://www.trioptima.com/resource-center/statistics/triReduce.html.

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

2010-12-12T19:21:00.000-08:00

by Nicholas Vause

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

Download here: www.bis.org/publ/qtrpdf/r_qt1012g.htm

The Inefficiency of Clearing Mandates (Craig Pirrong)

2010-12-07T04:23:00.000-08:00

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

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

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1710802

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

2010-12-02T05:52:00.000-08:00

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

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

Download here: www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1271.pdf

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

2010-12-02T05:30:00.000-08:00

by Ilhyock Shim and Haibin Zhu
BIS Working Papers No 332

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

Download here: www.bis.org/publ/work332.htm

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

2010-11-23T04:32:00.000-08:00

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

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

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1706623

The Effect of Market Structure on Counterparty Risk (SSRN)

2010-11-22T04:29:00.000-08:00

By Dale W. R. Rosenthal

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

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1571552

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

2010-11-19T07:41:00.000-08:00

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

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

2010-11-17T04:22:00.000-08:00

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

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

For the graphics and tables, get the report here: www.bis.org/publ/otc_hy1011.pdf

Market structure developments in the clearing industry (CPSS)

2010-11-10T12:32:00.000-08:00

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

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

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

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

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

Download here: www.bis.org/publ/cpss92.htm

The European Commission consults on rating agency policy

2010-11-05T08:48:00.000-07:00

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

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

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

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

Questions asked include:

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

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

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

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

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

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

More information:

http://ec.europa.eu/internal_market/securities/agencies/index_en.htm

Concentration of OTC Derivatives among Major Dealers (ISDA)

2010-11-05T04:16:00.000-07:00

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

The full report: www.isda.org/researchnotes/pdf/ConcentrationRN_4-10.pdf

Credit Risk Transfers and the Macroeconomy (ECB)

2010-11-01T05:11:00.000-07:00

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

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1685771

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

2010-10-29T09:31:00.001-07:00

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.

FSB issues principles to reduce reliance on CRA credit ratings

2010-10-28T04:36:00.000-07:00

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.

FSB publishes report on improving OTC derivatives markets

2010-10-25T20:17:00.001-07:00

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: www.financialstabilityboard.org/publications/r_101025.pdf

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

2010-10-20T04:19:00.000-07:00

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.

Download here: econpapers.repec.org/paper/venwpaper/2010_5f13.htm

Robust Linkages between CDs and Credit Spreads

2010-10-15T05:34:00.000-07:00

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: papers.ssrn.com/sol3/papers.cfm?abstract_id=1686772

Emergence and Future of Central Counterparties

2010-10-11T07:24:00.000-07:00

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.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1687862

Credit Ratings and Credit Risk

2010-10-11T06:49:00.000-07:00

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: www.defaultrisk.com/pp_other166.htm

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

2010-09-28T04:36:00.000-07:00

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

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

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

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

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

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

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

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

The report is available for immediate download by all TABB Research Alliance Equity clients and pre-qualified media at https://www.tabbgroup.com/Login.aspx. For an executive summary or to purchase the report, please visit http://www.tabbgroup.com, or write to info@tabbgroup.com.

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

2010-09-27T09:57:00.000-07:00

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

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

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

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

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

# # #

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

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

2010-09-24T06:13:00.001-07:00

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

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

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

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

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

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

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

S&P Launches “Understanding Ratings” Web Site

2010-09-24T05:21:00.000-07:00

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

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

UnderstandingRatings focuses on three core elements of credit ratings:

Criteria used to determine ratings and analytics;
Ratings performance; and
People--the 1,300 Standard & Poor's analysts around the globe who rate debt securities.

To explain these areas, Standard & Poor's rating analysts, credit officers, ratings executives and other staff address topics such as:

The ratings process and the processes we have put in place to support the independence of ratings;
The specific methodologies used to analyze various asset classes such as corporate bonds, municipal bonds,structured finance, and sovereign debt;
The ways in which ratings performance can be measured and compared;
An evaluation of the performance of ratings in various asset classes over the past several years;
The role of the analyst and rating committee in arriving at ratings, and
Standard & Poor's credit outlook for various industries, sectors, countries, and regions.

In addition, the site allows users to download Standard & Poor's "Guide to Credit Rating Essentials" and "Guide to Ratings Performance," which explain key concepts of credit ratings in simple, accessible language.

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

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

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

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

2010-09-22T04:24:00.000-07:00

by Chris Kenyon of DEPFA Bank Plc.

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

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

Download here: www.defaultrisk.com/pp_liqty_52.htm

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

2010-09-10T04:20:00.000-07:00

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

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

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1670118

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

2010-09-09T05:10:00.000-07:00

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

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

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

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

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

Conference ID: 98801653

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

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

Agenda for the Joint CFTC-SEC Public Roundtable Discussion

8:45 a.m.	Opening Statements by CFTC and SEC Staff
9:00 a.m.	Panel One – SDR Registration, Functions and Responsibilities Duties of SDRs in addition to those required by the Dodd-Frank The most efficient and effective way for SDRs to execute their statutory duties How to implement the confirmation function under Dodd-Frank—to what extent and under what circumstances will SDRs be expected to do trade confirmations
10:45 a.m.	Break
11:00 a.m.	Panel Two – Mechanics of Data Reporting Type of data reported by SDRs, derivatives clearing organizations (DCOs), designated contract markets (DCMs), swap execution facilities (SEFs), swap dealers and major swap participants (MSPs) Parties responsible for reporting of swap and security-based swap data Means by which mandatory reporting may be made Reporting of swap and security-based swap transactions executed or cleared on an electronic platform The time by which swap and security-based swap transactions must be reported Handling of data corrections Reporting of life cycle events Reporting of past transactions
12:45 p.m.	Lunch Break
1:45 p.m.	Panel Three – Models for Real-Time Transparency and Public Reporting Benefits of real time reporting of swaps and security-based swaps transactions Entities responsible for reporting Data elements Ensuring anonymity of market participants The meaning of “real-time” Appropriate media for real-time reporting of swap and security-based swap transaction data Feasibility/desirability of a consolidated tape or ticker for swaps and security-based swaps
3:30 p.m.	Break
3:45 p.m.	Panel Four – Effect of Transparency on Liquidity: Block Trade Exception Defining block trades and large transaction sizes for swaps and security based swaps Determining an appropriate delay for reporting block trades and large transactions Effects of transparency on post-trade liquidity Responsibility for determining minimum block sizes and large transaction sizes for reporting purposes
5:30 p.m.	Roundtable concludes

Alternatives to the Use of Credit Ratings in OCC Regulations

2010-09-08T13:27:00.000-07:00

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

Use of Credit Ratings in Regulatory Capital Standards

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

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

Use of Credit Ratings in Other OCC Regulations

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

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

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

Further Information

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

/signed/
Timothy W. Long
Senior Deputy Comptroller for Bank Supervision Policy
and Chief National Bank Examiner

Attachments:	Joint Capital ANPR www.occ.treas.gov/fr/fedregister/75fr49423.pdf
	OCC Investments and Other Regulations ANPR www.occ.treas.gov/fr/fedregister/75fr52283.pdf

DBRS Requests Comments on Proposed Unified Interest Rate Model Methodology

2010-09-01T13:35:00.000-07:00

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

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

Unified Interest Rate Model

Risky Funding: A unified framework for counterparty and liquidity charges

2010-09-01T06:02:00.000-07:00

By Massimo Morini and Andrea Prampolini of Banca IMI

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

Download here: www.defaultrisk.com/pp_liqty_50.htm

ISDA Streamlines Credit Derivative Novation Process

2010-08-26T06:32:00.000-07:00

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.

Ratings Arbitrage and Structured Products

2010-08-25T07:44:00.000-07:00

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: www.defaultrisk.com/pp_other194.htm

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

2010-08-25T07:41:00.000-07:00

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.

Download here: www.defaultrisk.com/pp_other193.htm

S&P Applies Identifier To Structured Finance Ratings

2010-08-24T05:09:00.000-07:00

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

To read the full report: app.info.standardandpoors.com/e/er.aspx?s=795&lid=45351&elq=d84c603a49c04e1ba81830c4a5cbbd5e

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

2010-08-24T04:39:00.000-07:00

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.

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

2010-08-15T19:37:00.001-07:00

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
Noon	Roundtable concludes

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

2010-08-12T19:12:00.000-07:00

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.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1650802

Rating Performance and Agency Incentives of Structured Finance Transactions

2010-08-10T09:15:00.000-07:00

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.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1646906

Credit Derivatives and the Default Risk of Large Complex Financial Institutions

2010-08-10T09:13:00.000-07:00

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.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1645798

The Economics of Credit Default Swaps (CDS)

2010-08-10T09:11:00.000-07:00

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.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1646373

DTCC Launches Equity Derivatives Reporting Repository

2010-08-05T09:15:00.000-07:00

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.

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

2010-08-02T04:31:00.000-07:00

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.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1639261

Realpoint advocates point-in-time ratings

2010-07-28T05:51:00.000-07:00

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

From the Realpoint website:

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

Goldman Sachs Announces Clearing Services for OTC Derivatives

2010-07-27T09:32:00.000-07:00

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

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

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

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

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

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

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

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

Adverse Selection in Mortgage Securization

2010-07-26T04:45:00.000-07:00

By Sumit Agarwal, Yan Chang and Abdullah Yavas

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

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1635749

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

2010-07-22T05:45:00.000-07:00

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

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

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

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

Unfettered access to global regulators

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

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

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

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

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

About the Warehouse

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

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

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

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

Davis-Polk Guidance on Use of Credit Ratings in Securities Offerings Following Dodd-Frank

2010-07-21T18:49:00.000-07:00

Among the many provisions contained in The Dodd-Frank Wall Street Reform and Consumer Protection Act (signed into law by the President today), is a provision which nullifies Rule 436(g) under the Securities Act beginning tomorrow . Under Rule 436, if information is included in a registration statement that is prepared or certified by an expert, that expert’s consent must be obtained. Rule 436(g) had provided an exemption for credit ratings provided by nationally recognized statistical rating organizations (or “NRSROs”) such that consent was not required even if a rating was included in the registration statement.

Many corporate issuers refer to the ratings of their outstanding debt and preferred securities in the prospectus and prospectus supplements for those securities as well as in their Annual Reports on Form 10-K and Quarterly Reports on Form 10-Q that are incorporated into their registration statements. The repeal of Rule 436(g) therefore raises certain questions regarding the continued use of ratings information given that certain rating agencies have already indicated that they are currently unwilling to consent and others are expected to take a similar position.

Please click here for a White Paper, prepared by Davis Polk along with several other law firms, after consultation with staff members of the SEC Division of Corporation Finance, which sets forth approaches that we believe are appropriate with respect to the use of NRSRO ratings in offerings of securities.[1]

[1] This white paper does not address asset-backed securities offerings governed by Regulation AB, as Regulation AB requires inclusion of ratings information.

CESR Consultation on Transaction Reporting on OTC Derivatives

2010-07-21T04:48:00.000-07:00

This consultation paper sets out CESR’s proposal for the possible organisation of transaction reporting on OTC derivatives as well as for the extension of the scope of transaction reporting obligations.

CESR’s proposal on transaction reporting on OTC derivatives is based on the assumption that all persons not exempted from European Market Infrastructure Legislation (including MiFID-authorised firms) would have to report their OTC derivatives transactions to trade repositories (TRs) after these will have been established and registered under EMIL.

However, CESR proposes that investment firms would retain the possibility of complying with their transaction reporting obligations with respect to OTC derivatives under MiFID provisions. Investment firms reporting their transactions to a TR, supporting MiFID standards, would be exempted from direct reporting when they communicate to the competent authority their decision to report their transactions through a TR. The MiFID regime would therefore apply to reporting obligations but these could be dealt with by TRs for the account of investment firms in order to avoid duplication. In other words, TRs would be recognised as a valid third-party reporting mechanism under Article 25(5) of MiFID.

As long as EMIL has not been finalised and implemented, OTC derivatives transactions would be reported under MiFID rules, where applicable.

Furthermore, CESR is considering to propose to the European Commission to extend, through a change in Article 25 of MiFID, the scope of transaction reporting obligations to financial instruments that are admitted to trading only on MTFs and to OTC derivatives.

Download the paper here: http://www.cesr.eu/popup2.php?id=6986

CESR Consultation on Standardisation and exchange trading of OTC derivatives

2010-07-21T04:44:00.000-07:00

Following the financial market turmoil which began in 2007, a number of regulatory initiatives have been launched to address the problems identified in Europe and the United States in relation to the derivatives traded over-the-counter (OTC). In this regard, the Commission’s communication “Ensuring efficient, safe and sound derivatives markets: Future policy actions” [COM (2009) 332 final] states – among others - that consideration should be given to ensuring that trades eligible for exchange trading take place on organised trading venues as defined by MiFID.

In the U.S., legislative initiatives have been launched in the House of Representatives and the Senate following the Administration’s initiative to strengthen OTC derivative markets through improving risk management and increasing transparency. In this paper CESR explores the need for taking regulatory actions in relation to further standardisation for credit, equity, interest rate, commodity and foreign exchange derivatives both as a means in itself and also in relation to the promotion of trading of these derivatives on organised markets.

This paper does not analyse issues related to post-trading and in particular eligibility for clearing. In relation to standardisation, CESR is of the opinion that firms should be able to retain the flexibility to customise aspects such as standard valuation, payment structures and payment dates given the role that OTC derivatives, and in particular bespoke products, play in meeting hedging needs.

Nevertheless, CESR is of the view that greater standardisation of OTC derivatives contracts can deliver efficiency benefits to the market. In particular, CESR has identified the use of electronic confirmation systems as one measure which could potentially deliver benefits to the market. To date, much of this work has been industry-driven but the question now faced by regulators is whether current progress is sufficient, how best to build on current industry initiatives, and whether regulatory intervention is needed.

As a consequence, CESR is eager to explore with the industry what measures could be taken to foster a higher degree of standardisation. As the degree of standardisation differs by asset class, CESR is keen to solicit views on whether regulators should prioritise their focus on a) a certain element of standardisation and/or b) a particular asset class. CESR particularly invites market participants to provide information on the potential costs of introducing a mandatory electronic trade confirmation requirement for European trading of OTC derivatives so that CESR can take an informed decision when making its final recommendations to the European Commission.

In relation to ‘exchange trading’ of derivatives currently traded OTC, CESR believes that trading on organised markets could deliver a number of benefits like providing a higher level of transparency, enhancing liquidity, ensuring efficiency and risk reduction and providing an easy access for market participants. There are however also a number of limitations or pre-requisites to exchange trading of derivatives that may explain why the OTC segment of the market remains very large: the need for the contracts to be standardised, the inability to customise contracts according to individual customers’ needs and the limited possibility for products innovation.

As a preliminary opinion, CESR is in favour of incentivising the use of organised trading venues but continues to consider whether mandatory usage is desirable, taking into account the discussions currently taking place on this issue in other jurisdictions and international fora. Therefore, CESR would like to further explore with market participants which kind of incentives could effectively promote exchange trading.

CESR invites responses to this consultation paper by 16 August 2010. All contributions should be submitted online via CESR’s website under the heading ‘Consultations’. All contributions received will be published following the close of the consultation, unless the respondent requests its submission to be confidential.

Download the paper: http://www.cesr.eu/popup2.php?id=6987

Record OTC IRS volumes for LCH.Clearnet's SwapClear (Press Release)

2010-07-19T13:41:00.000-07:00

A record number of over-the-counter (OTC) interest rate swap (IRS) trades were cleared in Q2 2010 by LCH.Clearnet Limited’s (LCH.Clearnet) market leading IRS clearing service, SwapClear. The total number of trades for the quarter reached 191,694 trade sides, a 30% increase on Q2 2009, driven by record volumes in May of 73,440 trade sides. The increased figures bring the total outstanding amount of IRS transactions to USD224.6 trillion.

Established over ten years ago, SwapClear’s membership has increased significantly to 32 direct members and the product scope has grown to cover the world’s 14 largest currencies with tenors up to 50 years in USD, EUR and GBP. The only truly global clearing service for IRS, SwapClear now clears over 40% of the market.

Joe Reilly, director, SwapClear said: "SwapClear was developed to provide a global solution for the IRS market. For ten years now it has delivered a secure, reliable and efficient environment for processing trades. The growing demand for the service and these impressive volumes demonstrate just how effective the SwapClear clearing model is.”

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 Lehman Brothers’ margin held and with no recourse to the default fund.

LCH.Clearnet is both a Financial Services Authority (FSA) Recognised Clearing House and a Commodity Futures Trading Commission (CFTC) registered Derivatives Clearing Organization (DCO).

Mutual Fund Fee-Backed Securitization Under Regulatory Fire

2010-07-09T04:29:00.000-07:00

NEW YORK (Standard & Poor's) July 6, 2010--Standard & Poor's Ratings Services
is monitoring regulatory discussions surrounding the guidelines that govern
how mutual funds charge 12b-1 fees to investors. 12b-1 fees are deferred fees
charged by mutual funds to cover certain administrative, marketing, and sales
expenses. The SEC has stepped up its discussions on the topic lately, and
possible reforms could have an impact on the ratings Standard & Poor's assigns
to securitized 12b-1 fee trusts.

Tranches in 12b-1 fee trusts generally cannot achieve ratings at the 'AAA'
level under Standard & Poor's current criteria due to the risks we believe are
posed by potential changes in the regulatory framework for mutual funds.
Periodic regulatory discussions over the past several years have reinforced
these considerations. Most recently, SEC chairman Mary Shapiro commented "We
need to critically rethink how 12b-1 fees are used and whether they remain
appropriate," as reported in the July 6, 2010, issue of The Wall Street
Journal.

It's currently uncertain whether regulatory change will occur and in what
form. Therefore, the potential effect of any such regulatory change on the
outstanding ratings is unknown.

The outstanding rated 12b-1 fee trusts are backed by fees on static pools of
mutual fund shares. The performance of the trusts does not depend on the
issuance of new shares under the 12b-1 regulation. Therefore, unless
regulation alters fees paid by outstanding shares, it's unlikely that the
transactions, or their current ratings, would be affected solely as a result
of the regulation. Additionally, these transactions typically mature after
eight years, as that is the maximum period mutual funds can collect 12b-1
fees. Depending on the timing of any possible new regulations, the outstanding
transactions may have time to repay their notes before regulatory changes take
effect.

Standard & Poor's will continue to monitor developments in this area. As more
information about regulatory changes becomes known, we will take appropriate
rating actions as they are warranted. We will also continue to monitor the
performance of this asset class and provide market updates as needed.

Related Criteria And Research:

"Mutual Fund Fee Securitizations And Underlying Fund Net Asset Values."

"Rating Mutual Fund Fee-Backed Securities"

DTCC to Establish European-Based Trade Reporting Repository

2010-07-01T04:51:00.001-07:00

London, 1 July 2010 – The Depository Trust & Clearing Corporation (DTCC) announced today plans to establish a new subsidiary called DTCC Derivatives Repository Ltd., which will maintain global credit default swap data identical to that maintained in its New York based Trade Information Warehouse.

This move is 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 has always envisaged a ‘global solution’ for repository services supporting each OTC asset class,” said Stewart Macbeth, Managing Director and General Manager, Trade Information Warehouse. “It is very common for counterparties to be located on different continents and to trade on underlying securities issued across borders. This means that repositories for any asset class need to maintain global information to be useful. It also means that steps need 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.”

DTCC Derivatives Repository Ltd will be headquartered in London under a regulatory application filed with the Financial Services Authority (FSA) in the UK.

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

This European-based repository will support a wide variety of critical functions, including operational, customer, technical, and most importantly, CDS trade reporting needed to ensure greater public transparency and to support the information needs of regulators and supervisory authorities.

DTCC’s current customer base in the credit derivatives market includes all major derivatives dealers and more than 1,700 buy-side firms and other market participants located in more than 50 countries and supporting reference entities in 90 countries. The total gross notional value of the approximately 2.3 million CDS contracts held by DTCC is $25.1 trillion.

ISDA Publishes Best Practices for the OTC Derivatives Collateral Process

2010-07-01T04:48:00.000-07:00

NEW YORK, Wednesday, June 30, 2010 – The International Swaps and Derivatives Association, Inc. (ISDA) today published Best Practices for the OTC Derivatives Collateral Process ("Best Practices"). The Best Practices are the result of the collaborative efforts of a working group of buy-side and sell-side market participants, under the auspices of the ISDA Collateral Steering Committee. The detailed document, which will be updated by the Collateral Steering Committee on a periodic basis, provides guidance on current best practices for the collateral management process.

“ISDA continues to harmonize practices between market participants in an effort to mitigate risks, set expectations and establish further market standards,” said Julian Day, Head of Trading Infrastructure, ISDA. “The Best Practices for Collateral are the latest in a series of industry efforts by collateral professionals to enhance the collateral management practice.”

The Best Practices focuses on OTC derivative trades collateralized on a bi-lateral basis under the ISDA English and New York law Credit Support Annexes (CSAs) and English Law Credit Support Deed (CSD) agreed between two parties.

The pro-active focus on industry improvement is based on continuing industry engagement and collaboration to establish a set of best of breed practices. Since the publication of the first Guidelines for Collateral Practitioners by ISDA’s Collateral Committee in 1998, professionals have sought to improve the collateral process. Recent contributions by the industry, which are referenced in the Best Practices, include the 2009 Recommended Practices for Collateralized Portfolio Reconciliation, Standards for the Electronic Exchange of OTC Derivative Margin Calls, the 2010 Market Review of Bilateral Collateralization Practices and the Independent Amount Whitepaper.

Download the paper here: www.isda.org/c_and_a/pdf/ISDA-Best-Practices-for-the-OTC-Derivatives-Collateral-Process.pdf

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

2010-06-25T11:47:00.000-07:00

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
affect.

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.

Last-minute derivative amendment will restrict competition

2010-06-24T14:20:00.000-07:00

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."

OTC Derivatives Regulators' Forum website is now live

2010-06-23T07:12:00.000-07:00

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

2010-06-23T04:58:00.000-07:00

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.”

Bank of Canada on Agency Conflicts in the Process of Securitization

2010-06-22T04:53:00.000-07:00

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: www.bankofcanada.ca/en/review/rev_autumn2009.html

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

2010-06-22T04:42:00.000-07:00

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: www.bankofcanada.ca/en/fsr/2010/index_0610.html

Credit Default Swaps and the Empty Creditor Problem

2010-06-22T04:39:00.000-07:00

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: papers.ssrn.com/sol3/papers.cfm?abstract_id=1612594

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

2010-06-19T06:22:00.000-07:00

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.

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

2010-06-18T07:07:00.000-07:00

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, www.bis.org/publ/cpss89.htm; and "Considerations for trade repositories in OTC derivatives markets: Consultative report", CPSS Publications, no 90, www.bis.org/publ/cpss90.htm.

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.

⁸ www.cmegroup.com/trading/weather/.

Ratings Arbitrage and Structured Products

2010-06-16T20:29:00.000-07:00

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: www.defaultrisk.com/pp_other194.htm

The future of Canadian ABS: public or private?

2010-06-16T10:40:00.000-07:00

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.

EC Publishes Recommendations on Derivatives and Market Infrastructure

2010-06-14T04:24:00.000-07:00

The purpose of the document (which can be downloaded here: http://ec.europa.eu/internal_market/consultations/2010/derivatives_en.htm) 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

2010-06-14T04:10:00.000-07:00

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: papers.ssrn.com/sol3/papers.cfm?abstract_id=1604375

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

2010-06-11T04:41:00.000-07:00

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: www.christian-fries.de/finmath/discounting/Discounting.pdf

MPAA, myriad interest groups lobby on financial regulation bill

2010-06-10T04:14:00.000-07:00

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

Equivalence between US and EU CRA regulatory regimes

2010-06-09T07:38:00.000-07:00

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: www.cesr.eu/popup2.php?id=6642

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

2010-06-05T05:45:00.000-07:00

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

2010-06-05T05:40:00.000-07:00

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.

Pay the rating agencies according to results

2010-06-04T07:57:00.000-07:00

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.

ICE Reports $9 Trillion in CDS Cleared Globally to Date

2010-06-03T05:19:00.000-07:00

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.

CESR advises on US/EU CRA regimes

2010-06-02T06:16:00.000-07:00

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: www.cesr.eu/popup2.php?id=6642 )

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

2010-06-02T06:00:00.001-07:00

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

2010-06-02T05:22:00.000-07:00

June 2, 2010- The Depository Trust & Clearing Corporation (DTCC) announced today that it will post this evening on its website, www.dtcc.com, 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 www.dtcc.com/products/derivserv/data/index.php. This information is posted Tuesday evenings after 5:00 p.m.

No One Said Re-Creating Securitization Standards Would Be Easy

2010-05-28T12:20:00.000-07:00

Originally published on the Housing Wire:

The recently released Mortgage Banker’s Association report, “Anatomy of Risk Management Practices in the Mortgage Industry,” is the latest sign that the industry is connecting some of the dots between what has been done already and what still needs to be done for a sustainable investor base to return in earnest.
(Download here: www.housingamerica.org/RIHA/RIHA/Publications/72939_9946_Research_RIHA_Rossi_Report.pdf

Until now the most prevalent stories in the press have rightly highlighted the important work being done to bring underwriting and issuance standards onto a more level playing field. Attention now though is shifting to the challenges investors face in making use of increasingly commoditized information as disclosure in all its new ‘standard’ forms becomes the norm.

The report highlights much of what we know already about risk taking in the mortgage industry of old and in the structuring and ongoing analysis of the risks in mortgage backed securities. It mentions how, “data and analytical limitations and blind spots led risk managers to grossly underestimate credit losses.”

Nothing new there.

And it calls for a more comprehensive focus on the development of industry-wide data and techniques for measuring risk in mortgage backed securities. Well, we can see that there has been an overwhelming commitment to do that from industry bodies and working groups over the last 18 months.

Achieving a one-size-fits securitization standard is a big thing to ask for but with continued international coordination, a solid platform for a prudent securitization industry can be established. Governments are committed to adopting standards in spirit but the secret to success in the long term will be how the industry translates more openly available data, into more standardized and useful forms that genuinely add value to investors.

More information is one thing, but a sound footing requires a level playing field. Industry bodies such as the ASF and AFME/ESF are doing much to provide a foundation for the most prominent asset classes. The European Central Bank, Bank of England and SEC have all stated the need for standard data points for loan level, pool level descriptors and information in deal documentation, with variations for each asset class.

But they have not yet come to a consensus as to what those should be.

The extension of these efforts into other aspects of disclosure will be critical if investors are able to truly capitalize on the work done so far.

The SEC’s proposals that issuers must provide and publicly disclose a computer program of the securitization’s waterfall could help bridge the gap between loan level data and an investor’s actual investment. Standardizing the way cashflow waterfalls are defined and scripted and trying to implement a common language when non-standardization is the prevailing characteristic, may be nigh on impossible though. There is an opportunity to create a basis from which models’ input assumptions and output cashflow calculations can be standardized across issuers and asset classes. Finding this happy medium, without oversimplifying the modeling that must be provided to investors, will be a sizeable but important barrier to overcome.

Take international accounting standards and securities law as examples of standardization in action. They provide a framework for comparability. In securitization, the equivalent was never going to be created easily such are the inherent complexities of the business. The MBA report describes how consolidation in the industry leading up to the crisis significantly challenged organizations’ IT systems.

It identifies failures in managing complex data in all its various forms and in being able to merge asset performance data with other data across the company so it can be aggregated and reported on in a consistent manner. It’s up to each region to come to a level of agreement on the implementation of standards and to compel issuers and investors to adopt best practices. Once data is disclosed, market participants can find the tools, models and mechanisms to understand it. But if a lack of comparability remains part of the equation then we lose the whole point of having all this readily available information and many of the same challenges will remain.

In the future, turning more commoditized, voluminous data into a value add for investors has to be the desired end game. Investors should be able to focus on their core business rather than spending a disproportionate amount of time collecting data or reverse engineering loan level information and waterfall structures (although more independent analysis is a given in the new environment). Wider adoption of standards by issuers and investors alike can deliver the ammunition to understand investment performance and the fundamental differences between transactions.

Alongside investors building the operational capabilities to merge and analyze all the necessary data, the commoditization and transparency of information will truly be able to play its part in steadying securitization’s footing. Then organizations will be locked and loaded to move from relying on quantitative methods of assessing performance attributes such as delinquency and default risk, and embrace more qualitative assessments of deal, tranche and collateral performance.

Covered Bonds May Play Role In Mortgage-Financing Fix

2010-05-27T10:20:00.000-07:00

Update posted on the CNBC website:

A little-noticed bill introduced in the House last March may be the first step in connecting financial reform efforts with the eventual attempt to restructure the nation's housing financial system and the deeply troubled Fannie Mae and Freddie Mac.
The U.S. Covered Bonds Act, introduced by Scott Garrett (R-NJ) and co-sponsored by Spencer Bachus (R-Ala.) and Paul Kanjorski (D-Pa.) and others, would add liquidity to the still sluggish credit markets and offer a private-market mortgage lending alternative to the government loans and guarantees of the two firms, which were taken over by the Treasury in September 2008 as the financial crisis was about to explode.
Garrett failed to get the measure included in the either the House or Senate versions of the financial reform bill, but there's some speculation it could wind up in the compromise bill that will will be crafted in the coming weeks by a House-Senate conference committee, of which Garrett could be a member.
"We're certainly going to certainly push it," Garrett told CNBC.com in an interview Tuesday. "We always saw it as a slice of the reform process. It's one of the few pieces that will do what the markets' need--provide certainty. It's not a total solution, but a piece of the puzzle."
The proposal is also likely to come up when the House subcommittee on capital markets—whose senior members are Kanjorski and Garrett—takes up the issue of the government-supported housing market with Edward J. DeMarco, acting director of the Federal Housing Finance Agency, at a hearing Wednesday.
The proposal hopes to free up mortgage lending through the use of so-called covered bonds—debt securities that are backed by the cash flow of a loan such as a mortgage. The loan is secured—or covered—by a pool of assets that investors can claim rights to if the issuer, or originator, becomes insolvent.
Though covered bonds are common in European countries, they are relatively rare in the U.S. Bank of Americaand the old Washington Mutual, now a unit of JPMorgan Chase, have issued them and firms like BlackRock and Pimco invested in them. But proponents in the US argue that covered bonds need a solid legal framework with clear rights of onwership to create and drive a healthy, dynamic marketplace.
The push for covered bonds is not new, but the timing is probably better.
In mid 2008, with Fannie and Freddie clearly in trouble, Treasury Secretary Henry Paulson lined up four large US banks to kick-start a covered-bond market, largely as an alternative to mortgage-backed securities. The mortgage market meltdown and broader financial crisis snuffed out the effort.
Today, it's exactly that MBS alternative that's makes covered bonds so relevant, especially since the Obama administraion and Congress opted to keep any overhaul of the two mortgage giants and the mortgage finance system out of the regulatory reform bill. Legislation won't happen until 2011 at the earliest.
"There's not a lot of certaintly about how the GSE debate will evolve and play out," says one market player, referring to Fannie and Freddie's special status as government sponsored enterprises. "The securitization business is obviously still struggling. You need more tools, It's better you have the options."
Proponents point to the dark early days of the financial criss when the government's plan to buy toxic assets from a market with little or transparency was dropped.
"It's a very feasible financing option," said Alex Pollock, a former CEO of the Federal Home Loan Bank of Chicago and now a resident fellow at the American Enterprise Institure. "The loan stays on the balance sheet. You get skin in the game with the retention of credit risk. The bank issuing the bond mantains 100 percent of the credit risk."
Covered bonds do not have the complex and sometimes vague ownership structure of the securitization market that made dealing with mortgage-backed securities a legal and logistic nightmare.
"There's no 127 holders and knowing what they want to do," said Lawrence White, a former regular and White House economist now with NYU's Strern School of Business. "Those poblems go away."
Just how much of an impact covered bonds would have is a matter of some debate.
Some proponents go so far as to say that the MBS market could eventually be replaced entirely by covered bonds, assuming the right transition leading up to the eventual dissolution of Fannie and Freddie.
"I see no reason why you need to have a government securitizer," says independent bank analyst Bert Ely, who argues that the current model emphasizes an originate-to-sell rather than the originate-to-hold biz model. "If you have covered bonds by mortgage originators I'm not sure you need Fannie or Freddie."
Others don't see that kind of impact. "It's a tiny first step," says White. "I don't think we are going to see $5 trillion of this stuff replace the $5 trillion Fannie and Freddie either own or have securitized."
Certainly not any time soon, but the time may be right just the same.
"It's been a long haul over the past two years to keep it alive, but the market is still interested in covered bonds" says Sean Davy, a covered bonds expert and managing director at the Securities Industry and Financial Markets Association.

Inching closer to the derivatives end-game?

2010-05-27T05:39:00.001-07:00

Posted by Richard Raeburn on his EACT Blog:

There’s an enormous amount happening on all economic and financial fronts as I write – with the equity and other markets in freefall and the USD soaring – so I am almost reluctant to blog again about OTC derivatives. In addition I am about to go to Prague for the latest (six monthly) EACT meeting. But I do think we are approaching the beginning of a very extended end-game on derivatives regulation, so here briefly are some not totally random thoughts.

We are about to be faced with a further consultation by the European Commission on its regulatory proposals (now branded as ‘EMIL’). Depending a little on whom you talk to, you may believe that the fact there is this further consultation reflects an acceptance by the Commission that the views of non-financial end users need a further airing. I suspect that the consultation is part of a long-planned process, at the end of which the Commission staff will be more than happy to hand over the topic to ESMA and other interested parties for the real implementation.

There is increasing transparency (to coin a phrase) on what will be involved going forward. The main elements that I have gathered are as follows.

The consultation is almost certain to propose that corporates are out-of-scope of the regulatory initiative – so no central clearing, cash collateral etc etc – unless a local regulator considers that hedging activities breach an investigation threshold. If that happens there will be a friendly conversation with the regulator, at which the corporate should focus on explaining the rationale for its activity; if I have been right in a lot of what I have been saying (when given the chance) the conversation will be almost entirely about risk mitigation.

If activity breaches a second and higher level then there will be a more searching – but retrospective – examination of the transactions around the legitimacy of the hedging. Systemic risk will be strongly on the minds of the regulator and I assume that if the examination fails to convince the authorities, there will be some sanction in the form of obligatory central clearing.

The devil is of course in the detail and that’s where it seems to me that ESMA and the national regulators will have a huge challenge. The particular elephant in the regulatory room is the notion of systemic risk and how that can relate to the higher of the two thresholds. The overall approach is based around the concept that that the Commission team has been talking about publicly, which is that the lower threshold is ‘qualitative’ and the higher is ‘quantitative’.

So….we need to get through what we expect to be a short consultation period with the Commission; then – whilst the rest of the Brussels governance structure turns it wheels on the Commission’s output – focus even more on what is happening on CRD IV and the BIS work to produce Basel III. The core concern here remains: what we may be in the process of winning with the OTC regulatory discussions we may promptly lose, with the application of what officials in Brussels have in the past happily described to me as ‘punitive’ capital requirements to sweep away the remaining OTC market.

In brief that is where we seem to be. The EACT meeting will be discussing the topic amongst many others over the next two days in Prague. We are also planning to mobilise additional resources, in common with some larger individual corporates, to ensure that the concerns of end users are probably articulated and communicated in Brussels and elsewhere.

Are We Building the Foundations for the Next Crisis Already? The case of central clearing

2010-05-25T05:21:00.000-07:00

by Jon Gregory

Abstract: Counterparty risk has been at the heart of the recent crisis driven by the toxicity of over-the-counter (OTC) derivatives and failure of high profile financial institutions. This has led policymakers to propose laws that would require most standard OTC derivatives to be centrally cleared. Central clearing involves a central counterparty (CCP) intermediating a transaction and acting as an insurer of counterparty risk. This has advantages, potentially leading to enhanced transparency and liquidity in markets and smoothing major systemic problems. The idea is also popular since it represents a single and intuitively simple solution to the severe problem of counterparty risk. However, whilst CCPs may have a role to play in reducing counterparty risk, they can also be counterproductive to the stability of financial markets. In this paper, we argue that the introduction of CCPs should be carefully considered and that, far from reducing counterparty risk, they may actually allow it to breed and contribute to the next crisis.

Download the paper here: www.defaultrisk.com/pp_other192.htm

Collateral Posting and Choice of Collateral Currency: Implications for derivative pricing and risk management

2010-05-19T04:21:00.000-07:00

by Masaaki Fujii, Yasufumi Shimada, and Akihiko Takahashi

Abstract: In recent years, we have observed the dramatic increase of the use of collateral as an important credit risk mitigation tool. It has become even rare to make a contract without collateral agreement among the major financial institutions. In addition to the significant reduction of the counterparty exposure, collateralization has important implications for the pricing of derivatives through the change of effective funding cost. This paper has demonstrated the impact of collateralization on the derivative pricing by constructing the term structure of swap rates based on the actual market data. It has also shown the importance of the "choice" of collateral currency. Especially, when the contract allows multiple currencies as eligible collateral and free replacement among them, the paper has found that the embedded "cheapest-to-deliver" option can be quite valuable and significantly change the fair value of a trade. The implications of these findings for market risk management have been also discussed.

Download paper here: www.defaultrisk.com/pp_other191.htm

KPMG and PwC eye rating move

2010-05-17T08:16:00.000-07:00

From the Financial Times:

KPMG and PwC, two of the world's largest accounting firms, have considered entering the credit rating business, in a move that would pitch them against the current top three - and heavily criticised - agencies Moody's, Standard & Poor's and Fitch.
John Griffith Jones, chairman of KPMG in the UK and co-chair in Europe, told the Financial Times it had discussed the move as - being one of the four biggest accounting firms in the world - it had the skills, knowledge and people to provide credit ratings.
However, Mr Griffith Jones said KPMG was "passively considering it", not actively debating it.
"It is something that we talk about as a plausible thing to do. It is effectively something we would be proficient at doing . . . But it's not on the agenda at the moment," Mr Griffith Jones said...
Other accountancy firms said they had also seen credit ratings as a potential opportunity for auditors.
Richard Sexton, UK head of assurance at PwC, said it continually looked for areas to grow its business from its "core skills that include assurance, opinions and underpinning public trust".
Mr Griffith Jones said conflicts of interest would be a stumbling block for an auditor to offer credit ratings as they are also paid by the clients they audit.

How to implement the Franken & LeMieux NRSRO Amendments?

2010-05-15T08:46:00.001-07:00

Interesting post on the Baseline Scenario on how to implement the Franken and LeMieux credit rating agency-related amendments to the Senate financial sector reform bill:

The two (perhaps contradictory) amendments each try to implement a proposed solution that runs into some of the critiques. The Franken amendment has rating agencies assigned to debt issues by a neutral arbiter; critics maintain that lack of competition may reduce the quality of analysis. The LeMieux amendment removes legal mandates to obtain a NRSRO rating and the preferential treatment those issues currently receive. However, it leaves out details about whose advice agencies and public trusts should seek out instead.
This is not such a difficult problem. We already have an example of a successful private rating agency, whose imprimatur is desired or in some cases required by law, that is paid for by fees on the seller, and has been operating since 1894: Underwriters Laboratory. The UL publishes safety standards for almost 20,000 different types of products, many of which are adopted by other standard-setting organizations like ANSI (American National Standards Institute) and Canada’s IRC (Institute for Research In Construction). Although generally not actually required by federal law, the sale of many types of products in the US would be difficult without UL listing. Also, many local jurisdictions responsible for building and fire codes mandate the use of UL approved products. In all cases, the manufacturer must submit samples and pay fees to UL in order to win approval.

The comparison to NRSROs is apt. In both cases, a third party sets standards based on theory, models, and best practices. In both cases, the issue is the assessment of risk by experts in that type of risk. In both cases, approval is desired by the market or required by local ordinance or rules. And in both cases, the seller pays the fees; so the third party might be led to relax their standards in order to capture some extra fee income. Yet in the case of fire safety the model has been functioning well for over 100 years, but in financial safety there has been a rash of fires as one rated product after another has blown up. Why?

There are a few key differences. Until 2007, UL was completely non-profit, so as long as user fees covered their costs there was little incentive to chase extra revenue by relaxing standards. There is no real competition in the US market for UL (although Europe has its own standard-setting body that manages the ), so manufacturers have little leverage to push for easier standards. The LeMieux amendment could allow for the creation of a not-for-profit entity to take the place of NRSROs, while the Franken amendment would reduce competition, limiting it to delivering a better, more reliable rating rather than adjusting standards to capture fees.
Critics of the amendments, including those who support a buyer-pays model, need to address the question of why the UL model for risk assessment has worked well, and why it can’t be applied to debt rating. Is the model broken? If so, I expect a rash of building fires any day. Is rating of financial safety fundamentally different than, say, electrical safety?

Some of the comments are kind of interesting too:

The analogy between UL and the NRSROs doesn’t take one very far. The products that the organizations rate are just too different, and the chief difference is simply that UL-rated products are tangible. As a result, it doesn’t generally pay for manufacturers to game the approval process by adding complexity that hides fundamental safety deficiencies. In the world of tangible products, increased complexity almost always equals increased manufacturing costs and lower expected profit. By contrast, in the securities world, increased complexity has a negligible impact on the cost of “manufacturing” the security and can result in a higher expected profit to the issuer and underwriter by hiding features that accrue to their benefit....

When a fire happens, it can generally be traced to a single root cause, or maybe two (e.g., somebody was smoking in bed + the sprinkler system failed).

Put another way, the conditions that cause physical failures do not change from year to year, because the laws of physics do not change.

As a result, if UL failed to do their job properly, it would be pretty easy to tell. It would not even take an expert.

In the financial sector, the top experts always disagree about what is safe and what is dangerous. That is the nature of the sector.

The financial sector is different because its “laws” change daily. The cause of the crisis was not ratings agency failure. The cause was a universal desire to get something for nothing combined with low interest rates. Had the ratings agencies tried to be careful, they would simply have been ignored, because nobody wants to hear about risks when they see their neighbors are getting rich doing nothing year after year after year.

What drives bank securitisation? The Spanish experience

2010-05-15T08:16:00.000-07:00

Published in the Journal of Banking & Finance (Clara Cardone-Riportellaa, Reyes Samaniego-Medinab and Antonio Trujillo-Ponce):

Abstract: This paper analyses the reasons why Spanish banks securitised in the period 2000-2007 on such a large scale that Spain has become the European country with the second-largest issuance volume after the U.K. The results obtained by applying a logistic regression model to a sample of 408 observations indicate that liquidity and the search for improved performance are the decisive factors in securitisation. We find no evidence to support hypotheses regarding credit risk transfer and regulatory capital arbitrage. Our study also presents a more detailed analysis that differentiates between asset and liability securitisation programmes.

Download the paper here ($$).

Ooops Again! S&P Cuts to Junk Re-Remics It Rated AAA in 2009

2010-05-14T19:31:00.001-07:00

From the Bloomberg story:

Standard & Poor’s cut to junk the ratings on certain securities, backed by U.S. mortgage bonds, that it granted AAA grades when they were created last year by Credit Suisse Group, Jefferies Group Inc. and Royal Bank of Scotland Group Plc.

The reductions were among downgrades to 308 classes of so- called re-remics, or re-securitizations, created from 2005 through 2009, the New York-based ratings company said today in a statement. About $150 million of the debt issued last year, as recently as July, with top rankings were lowered below investment grades, according to data compiled by Bloomberg.

Such re-securitizations, used by Wall Street after the credit crisis began to help create more valuable debt to sell or to restructure investors’ holdings, last year expanded from home-loan bonds to commercial-mortgage securities and collateralized loan obligations backed by company loans.

Residential re-remics exceeded $40 billion last year, according to newsletter Asset-Backed Alert. The notes differ in several ways, such as by including fewer underlying bonds, from the so-called collateralized debt obligations created during the credit boom that in some cases had AAA rated classes that defaulted and returned nothing to investors in less than a year.

Remics, or real estate mortgage investment conduits, are the formal name of certain mortgage bonds. Some of the new securities created in re-remic deals offer investors an additional layer of protection from losses and downgrades, which boost the capital needs of banks and insurers and can force some investors to sell debt.

For more on Re-Remics see Box 2.3 in the October 2009 IMF Global Financial Stability Report here.

One Provision Overlooked in Senate version of reform leglislation

2010-05-14T04:54:00.000-07:00

Shahien Nasiripour in the Financial Fix:

In passing a measure that attempts to end their oligopoly, the Senate purposely did not include a provision in the House bill that forces major credit rating agencies to be accountable to investors by scrapping a Securities and Exchange Commission rule that has shielded them from civil lawsuits for nearly 30 years.

The provision, known as Rule 436(g), insulates the 10 credit rating agencies recognized by the government as "Nationally Recognized Statistical Rating Organizations" from liability if they knowingly make false or misleading statements in connection with securities registration statements to dupe investors. Other experts -- like the rating agencies not part of the group of 10 -- are legally liable for their statements "to assure that disclosure regarding securities is accurate," according to a 2009 SEC document supporting the removal of the exemption.

In short, if a Standard & Poor's or Moody's Investors Service knowingly tries to deceive an investor, under current law that investor can't sue.

Here's what was in the House version:

Rule 436(g), promulgated by the Securities and Exchange Commission under the Securities Act of 1933, shall have no force or effect.

Shahien Nasiripour continues:

But the Senate bill, like the House bill, does provide investors with an improved ability to sue credit raters for faulty ratings. A spokesman for LeMieux pointed to these provisions when asked why his amendment did not include the House language on the 436(g) rule.

The agencies have enjoyed a near-perfect legal record by claiming that their ratings fall under the protection of the First Amendment -- free speech, they've successfully argued. The House and Senate bills attempt to address this by strengthening investors' hand when it comes to suing the rating agencies, but the First Amendment defense may be hard to overcome, as ultimately the courts decide -- not Congress.

Still, according to experts like Barbara Roper, director of investor protection at the Consumer Federation of America, the bills are a big improvement over the status quo. Many consumer groups say the provisions approved Thursday strengthened the Senate bill.

Elsewhere in those amendments were measures that remove various references in federal law to credit ratings, which had compelled their use and guaranteed the majors' oligopoly, and a government mechanism that would inject government officials into deciding which agency rates which securities.

Regarding the removal of the references, federal regulators will largely be forced to define creditworthiness, rather than regulations that currently rely on the credit rating agencies for that.

However, there are open questions about the LeMieux-Cantwell provision. The House bill, largely authored by Rep. Paul Kanjorski (D-Pa.), directs the various federal agencies that would need to modify their rules, like the Office of the Comptroller of the Currency, the SEC and the Federal Deposit Insurance Corporation, to harmonize their standards of creditworthiness "to the extent feasible." The Senate provision includes no such language.

Also, the House bill compels federal agencies to look for other such references to credit ratings in their rules and regulations, and modify them so they instead refer to government-defined standards. The Senate amendment doesn't include this, either.

The measures in the LeMieux-Cantwell amendment won't take effect until two years after the bill is enacted into law; the House provisions take effect within six months.

Corporate CDS: A Market That's Not a Market?

2010-05-13T14:14:00.000-07:00

Donald van Deventer reports that, based on recent DTCC data, only 2 corporate reference names have daily average non-dealer CDS volume over 40 trades, only 72 have more than 5 trades (see http://twitpic.com/1ni22r). For more go to: http://kamakuraco.com/Company/ExecutiveProfiles/DonaldRvanDeventerPhD/KamakuraBlog/tabid/231/EntryId/195/Corporate-Credit-Default-Swaps-and-Non-Dealer-Trading-Volume.aspx

Senate Votes to Exempt Qualified Mortgages from Risk Retention

2010-05-13T09:25:00.000-07:00

Original posted on the Housing Wire by Diana Golobay:

The US Senate consented unanimously to the Sen. Mary Landrieu (D-LA) amendment on S 3217, the Restoring American Financial Stability Act sponsored by Sen. Chris Dodd (D-CT), that will exempt certain qualifying mortgages from credit risk retention requirements.

The provision is already being praised by industry professionals who say that ensuring the underlying quality of mortgages eliminates the need for risk retention by lenders and securitizers. Risk retention requirements, also called ’skin in the game,’ required financial institutions to hold a reserve fund worth 5% of arranged deals, set aside to compensate for any poor performance.

“This amendment will prevent reckless competition based on loose underwriting standards by focusing risk retention on the truly risky loan products and underwriting practices that created the mortgage market turmoil in the first place,” said Glen Corso, managing director of the Community Mortgage Banking Project (CMBP), in a statement.

Corso added: “Creating a ‘qualified mortgage’ exemption ensures that responsible borrowers using traditionally underwritten mortgages will not be forced to pay higher interest rates in order to discourage the risky behavior of others.”

Edward Yingling, CEO of the American Bankers Association said passing such a provision would have been at the fiscal expense of the nation. “An across-the-board five percent risk retention requirement would have reduced credit availability by an estimated $125bn per year, hampering economic recovery and job growth.”

Senators also approved an amendment by Sen. Mike Crapo (R-ID) that modifies the Landrieu amendment on credit risk requirements, to consider commercial real estate and other asset classes.

“What the amendment does is take the exclusive focus off of just one form of risk retention and allows the regulator to evaluate the best approach to address risk retention by asset class,” Crapo said from the Senate floor yesterday. “This still includes a percent retention, if necessary, as well as underwriting standards that actually get at the heart of loans and even strong and uniform representations and warranties which are important to the investors, such as pension funds, mutual funds and endowments who fuel the lending and securitized credit markets.”

He added: “The amendment simply gives important direction to the regulators on structuring reforms by asset class.”

Senators shot down an amendment on derivatives sponsored by Sen. Saxby Chambliss (R-GA). It would have implemented regulatory oversight of the swap markets and improved regulator’s access to information about all swaps, according to a statement. The amendment also aimed to encourage clearing while preventing concentration of inadequately hedged risks in central clearinghouses and ensuring that corporate end users can continue to hedge their unique business risks.

“This amendment would remove the underlying bill’s mandatory exchange trading requirement and removes the mandatory clearing provisions. This is just not acceptable,” said Sen. Blanche Lincoln (D-AR) from the Senate floor. “We understand and know from our experience with the futures market what the clearing does and the stability that it brings to the marketplace.”

Lincoln added: “It is absolutely essential. This amendment removes real price transparency to the public”

She noted the Dodd-Lincoln amendment — which still awaits a Senate vote — provides realtime price transparency to the public and to the regulators while reforming the over-the-counter derivatives market.

S&P on Proposed U.S. Covered Bond Legislation

2010-05-13T08:33:00.000-07:00

NEW YORK (Standard & Poor's) May 7, 2010--If the United States Covered Bond
Act of 2010 (H.R. 4884) is enacted in its current form, it would create a
legal framework for the issuance of covered bonds in the U.S. The bill,
introduced in the House of Representatives by Representative Scott Garrett
(R-N.J.) on March 18, seeks to develop a covered bond market in the U.S. and
create specific provisions aimed at protecting covered bondholders from the
effects of an issuer's bankruptcy.

Covered bonds are essentially bank-issued securities that are typically
collateralized by mortgage loans or public sector assets. Unlike traditional
securitizations, investors have dual recourse to both the issuing bank and to
the assets backing the covered bonds. Because of this dual recourse, covered
bonds offer investors exposure to the mortgage market, yet are seen to have a
stronger credit profile than traditional residential-mortgage backed
securities (RMBS). At year-end 2009, 24 European countries had enacted
legislation governing the issuance of covered bonds.

Based on observations in other jurisdictions, Standard & Poor's believes the
proposed legislation might aid the further development of the covered bond
market in the U.S. However, additional clarification and analysis is required
for us to determine any potential impact that the legislation could have on
our ratings on covered bonds issued by financial institutions domiciled in the
U.S.

Covered bonds have been a long-standing part of the European capital markets.
They provide investors with access to a greater variety of mortgage-backed and
public sector-backed securities, and they provide issuers with access to
liquid pools of capital that have financed various types of real estate and
public sector lending in many European countries. Outstanding European covered
bond totaled approximately €2.5 trillion (approximately USD3.4 trillion) at
year-end 2009, and very strong issuance continued through the first quarter of
2010.

Rep. Garrett's bill addresses, among other matters, covered bondholder rights
and protections in the event of a default of the covered bond or the
insolvency of the issuer or sponsor of the covered bond program, which is an
important aspect of Standard & Poor's analysis of covered bond legislation
(see "Expanding European Covered Bond Universe Puts Spotlight on Key Analytics,
" published July 16, 2004). We believe that greater certainty over the process
and timing to gain access to the covered asset pool would be beneficial for
investors. And, in our opinion, the proposed legislation could mitigate the
effect of collateral liquidation in a very short period, which could otherwise
adversely affect market values of the collateral.

On Dec. 16, 2009, we published our updated methodology and assumptions for
assessing asset-liability mismatch risk in covered bonds (see "Revised
Methodology And Assumptions For Assessing Asset-Liability Mismatch Risk In
Covered Bonds"). In the criteria we introduced a link between the rating on
the covered bond and the rating on the issuing bank. The linkage, which
provides a maximum uplift of seven notches on covered bond ratings, is
intended to communicate the potential risks to assets and cash flows when, in
our view, the program is exposed to asset-liability mismatches. If the
asset-liability mismatch risk is not structurally addressed, based on our
criteria, the amount of the potential rating uplift will be limited based on
our assessment of two factors: 1) the degree of the asset-liability mismatch
that a covered bond program is exposed to, and 2) the program categorization
that encompasses our view of the ability to obtain third-party liquidity or
sell assets to fund any mismatch. The program categorization is dependent on
our assessment of the range of funding options available to the program and
the likelihood of the program sponsor's ability to access these options, which
is largely based on our view of the systemic importance of covered bonds to a
particular jurisdiction's financial system.

Given the relative infancy of the covered bond market in the U.S., it's
difficult to assess how, if at all, the proposed bill would alter the systemic
importance of the U.S. covered bond market in the short term. However,
notwithstanding the exact impact, if any, on our criteria for rating U.S.
covered bonds, we believe that through the introduction of specific investor
protection provisions and clarity on their timing, the proposed United States
Covered Bond Act of 2010 could be a catalyst for the further development of
the U.S. covered bond market as an additional source of private capital to
finance U.S. homeowners.

S&P FAQ On The Implementation Of SEC Rule 17g-5

2010-05-13T08:30:00.000-07:00

NEW YORK (Standard & Poor's) May 7, 2010--The compliance date for the
Securities and Exchange Commission's (SEC's) amended Rule 17g-5 for structured
finance transactions (the Rule) is June 2, 2010. Standard & Poor's Ratings
Services supports the goal of the Rule to provide market participants,
particularly investors, with as many credit rating opinions as possible. In
addition to providing greater transparency, the Rule can help mitigate
"ratings shopping" by encouraging nationally recognized statistical rating
organizations (NRSROs) to compete on the quality of their ratings.

Standard & Poor's has been working to create a password-protected Web site
(the Web site) to identify structured finance transactions covered by the
Rule. In the meantime, we continue to work with market participants to assist
in the effective implementation of the Rule. To further clarify important
implementation issues, we provide our current understanding of the Rule in the
following frequently asked questions (FAQs).

Please note that these FAQs address complicated interpretive issues that are
not free from doubt, and these FAQs are therefore based on our current good
faith understanding of the Rule. These FAQs are not intended to be, and may
not be relied upon as, legal advice. We may revise these FAQs in light of any
formal or informal guidance provided by the SEC or its staff after the date of
this publication.

FREQUENTLY ASKED QUESTIONS

Q: What is Standard & Poor's standard for posting information on the Web site
for complying with the Rule?

A: For securities under review by Standard & Poor's before June 2:

*

Standard & Poor's will not post any information on the Web site about
securities for which we have sufficient information to begin the ratings
process.

*

If Standard & Poor's currently has insufficient information to begin the
rating process, but receives sufficient information prior to June 2, we
will inform the appropriate participants if a transaction will be posted.

When Standard & Poor's starts the process of determining an initial credit
rating on or after June 2, we will post information about securities on the
Web site when:

*

Standard & Poor's has received a signed engagement letter, and

*

Standard & Poor's has received sufficient information.

Q: Does the Rule apply globally, including securitizations backed by non-U.S.
originated assets or sold in local currency to local investors?

A: For transactions rated based on our global ratings scale, we will treat the
Rule as one that applies globally. However, absent further SEC guidance, we
will treat transactions rated solely on a national scale and relating to
securities issued outside the U.S. (e.g., brAAA in Brazil) as not covered by
the Rule.

For additional information concerning market participant's disclosure
requirements, please refer to the SEC's adopting release, which is available
at www.sec.gov/rules/final/2009/34-61050.pdf.

Q: Does the Rule apply to ratings that are not available to the public?

A: Standard & Poor's will treat published ratings issued on or after June 2 on
publicly offered or privately-placed transactions (e.g., 144A offerings) as
covered by the Rule. We will treat ratings that are kept strictly confidential
by the issuer and sponsor as not covered by the Rule.

Q: What asset classes are covered by the Rule?

A: Standard & Poor's will apply the Rule to traditional structured finance
products, such as residential mortgage-backed securities (RMBS), commercial
mortgage-backed securities (CMBS), collateralized loan obligations (CLOs),
collateralized debt obligations (CDOs), and asset-backed securities (ABS)
(including in each case synthetic, hybrid, consumer, and commercial
transactions, as applicable). Given the uncertainty surrounding parts of the
Rule, we expect that we will make coverage determinations on a case-by-case
basis. We are reviewing the treatment under the Rule of existing ratings and
surveillance on ratings assigned before June 2, such as asset-backed
commercial paper (ABCP) programs. We will update the market as soon as we have
more information on this issue.

Standard & Poor's will continue to update the market with developments on
implementation and interpretation of the Rule as information becomes
available. Market participants should feel free to contact us with comments or
questions.

Odd trends in CDS liquidity

2010-05-12T14:06:00.000-07:00

Original posted on FT Alphaville by Joseph Cotterill:

CDS liquidity is suddenly on the rise somewhere in developed markets, Fitch said on Wednesday, using its, er, unique liquidity scoring.

(The lower Fitch’s score, the more liquid contracts on a given reference entity are, which, according to Fitch, indicates greater uncertainty over credit risk.)

However, Fitch’s findings are perhaps not what you think, if you’ve been following Europe’s sovereign debt crisis.

Sovereign CDS remains significantly liquid in developed markets, as you can see from the red line hugging the bottom of Fitch’s chart below — but it has recently become rather less runny (click to enlarge):

Uncertainty in the run up to the weekend’s European rescue package is still to be factored in, no doubt, but it’s still a bit odd. A whiff of regulatory risk is closing positions, perhaps? We can’t be sure.

Even so, take a look at this sector-level CDS liquidity chart (click to enlarge):

Financials pop out of the picture. As for explanation, here’s Fitch, emphasis FT Alphaville’s:

The Sector Liquidity chart shows the average CDS liquidity for the 25 most‐liquid reference entities within each sector. Remembering that the lower the liquidity score, the more liquid the contract, CDS on financial institutions and sovereigns appear to be trading with the most liquidity. Digging deeper, it is apparent that of the 25 most liquid financials, 23 are domiciled in North America with the remaining two in Europe. The Security and Exchange Commission’s lawsuit against Goldman Sachs & Co. in addition to ongoing debates in the Senate over the proposed financial regulations bill, have contributed to renewed uncertainty…

Well, there are a fair few complicated legal risks facing Goldman. Banks have had a rally in CDS tightening over the past few days, on the other hand. For example, Markit’s Senior Financials Index dropped -15bps, to 123bps, on Wednesday. (Goldman is still elevated at 184bps).

Still, who are Fitch’s most CDS-liquid European banks? As the agency says:

CDS written on Banco Santander continue to trade with more liquidity than any other bank in the region, followed by Lloyds TSB Bank plc of the UK and Bank VTB (JSC) of Russia.

Santander CDS has also tightened like lightning since the weekend’s eurozone bailout, reaching 127 bps on Wednesday from 157bps the day before, Markit said.

Very odd bedfellows, though.

Electronic Swaps Trading Surges as Pressure for Increased Oversight of OTC Derivatives Trading Grows

2010-05-12T10:35:00.001-07:00

May 12, 2010 (Jersey City, NJ); Tradeweb, a leading global provider of regulated electronic markets, today announced that institutional trading of interest rate swaps on its multi-dealer-to-client marketplace increased by more than 71% in the first four months of the year, compared to the same period in 2009. Average daily trading volume for interest rate swaps now exceeds $4 billion. The continued surge in electronic trading on Tradeweb coincides with ongoing demands from global legislators for trading of OTC derivatives on regulated execution venues and/or Swap Execution Facilities (SEFs), as noted in the proposed U.S. legislation.

"The industry has crossed the threshold and there is now a clear and unambiguous shift towards the electronic trading of OTC derivatives. Electronic trading is here today and is providing the benefits and safeguards that are being sought by global regulators," said Lee Olesky, CEO of Tradeweb. "Legislative reform will undoubtedly accelerate this trend towards greater efficiency and transparency, but the initial vote for change is coming from the market."

Tradeweb provides a competitive multi-dealer-to-client electronic swaps marketplace, which enables institutional investors to receive simultaneous quotes from multiple dealers. The benefits that this "request-for-quote" model provides are aligned with the core principles of a SEF. These benefits include pre- and post-trade price transparency; efficient trade execution and processing; digital records of all trades and trade inquiries; and a permanent audit trail. The core principles for becoming a regulated SEF are set out in pending U.S. legislation. If passed, Tradeweb‘s U.S. swaps marketplace plans to register as a SEF.

More than 55,000 interest rate swap trades, with an aggregate notional in excess of $5 trillion, have now been executed on Tradeweb's platform since the original launch. Over 1,600 trades took place in April 2010 alone, an increase of 189% over April 2009, and 38% up on March 2010. In total, more than 280 swap dealers and major swap participants have executed interest rate swap trades electronically on Tradeweb since launch.

Total global interest rate swaps volume on Tradeweb since the introduction of the platform in 2005 has grown at a compound annual growth rate of 55%.

In addition to leading the move towards electronic trading of OTC derivatives, Tradeweb recently announced the first electronic interest rate swap trade on a multi-dealer platform to be centrally cleared by an institutional client. This follows the completion of electronic links from Tradeweb to the major derivatives clearing houses. Institutional clients are now able to fully automate their workflow on Tradeweb - from trade execution through clearing, enabling institutions to better manage operational, systemic and market risk.

These links support the legislative focus on central clearing for all standardized swap contracts, and the push for the trading of all cleared swap transactions on regulated execution venues.

FDIC Board Approves NPR Regarding Safe Harbor Protection for Securitizations

2010-05-11T13:54:00.000-07:00

The Board of Directors of the Federal Deposit Insurance Corporation (FDIC) today approved a Notice of Proposed Rulemaking (NPR) to clarify the safe harbor protection in a conservatorship or receivership for financial assets transferred by an insured depository institution (IDI) in connection with a securitization or participation. This action was necessitated by the changes adopted by the Financial Accounting Standards Board in June 2009 to the accounting standards on which the FDIC's prior rule, 12 C.F.R. Part 360.6, was based.

In March, the FDIC Board extended a transitional safe harbor that permanently grandfathered securitization or participations in process through September 30, 2010. Earlier this year, the FDIC Board approved for public comment an ANPR regarding what standards should be applied to securitizations seeking safe harbor treatment for transactions created after September 30th. Conditions for safe harbor treatment focused on greater clarity in the securitization capital structure, enhanced disclosure requirements, and risk retention and origination requirements.

The FDIC received comments on the ANPR from a wide variety of interested parties. In response, the FDIC has proposed some changes to the standards in the NPR, but has retained a clear focus on improved transparency and a better alignment of incentives for strong underwriting in the securitization process. Among the key proposed changes from the sample regulatory text included with the ANPR, the FDIC is proposing 1) a 5% reserve fund for RMBS in order to cover potential put backs during the first year of the securitization, rather than the prior 12 month seasoning requirement; 2) required disclosure of any competing ownership interests held by the servicer, or its affiliates, in other loans secured by the same property; and 3) requiring deferred compensation only for rating agencies, rather than all service providers. The NPR also includes clarifications of the prior text to simplify compliance. Significantly, the FDIC's proposed disclosure and risk retention requirements are aligned with those proposed in April by the Securities and Exchange Commission. Upon final adoption by the SEC of the disclosure requirements in the new Regulation AB, the FDIC anticipates that compliance with those requirements will satisfy the disclosure requirements in the FDIC's proposed rule. The FDIC will continue to work closely with the SEC on these issues.

FDIC Chairman Bair said, "The market is clearly trying to find a new securitization model, with investors placing a premium on transparency throughout the process. With the system awash in cash, investor appetite is coming back. Now is the time to act to put prudent controls in place before the significant issues we saw during the crisis return."

"We must acknowledge the role that the "originate to distribute" model played during the crisis. Insured institutions and our economy have lost many billions because our mortgage finance system broke down."

"The proposed rule compliments other regulatory and legislative efforts to correct the weaknesses in securitization that contributed to the crisis. The proposed NPR will help support stronger, sustainable securitizations – that are consistent with securitization's role as a source of funding and risk management tool for insured banks."

The NPR will be open to public comment for 45 days following publication in the Federal Register.

Download the complete document here: www.fdic.gov/news/news/press/2010/pr10112a.pdf

Darrell Duffie on Banning Naked CDS Transactions

2010-05-11T12:43:00.000-07:00

Posted on Grasping Reality With Both Hands:

Among other things, [the amendment to the Senate financial reform bill that would ban naked CDS transactions] means a big limitation on the entire securitization market, since in many cases the loan default risk is transferred into the structured credit product through a CDS. (This is not to be confused with a synthetic CDO, which is much different, and not such a big loss in my view.) So, lots of loans to ordinary individual Americans (their credit card loans, home equity loans, mortgages, and so on) and American operating companies will get somewhat more expensive. (This effect is not huge. Credit card or home equity interest rates will not go up 4%, say, but they would be higher because of this, other things equal.) [Disclosure: I am a director of Moody's Corporation since late 2008. Moody's makes money rating these products. There would be fewer of them to rate if this passes.]

There seems to be a presumption that buying CDS protection is fine as long as you have lent money to the borrower. That's a bad presumption. Example: I lend you money. There are covenants on the loan that protect me by requiring you to run your business prudently, and to not borrow too much. Then I ask a CDS protection seller, X, to sell me protection on you. Now I don't care if you default or not, so I won't worry about monitoring or enforcing those covenants, because X will pay me if you go under. Bad news. Even worse, where it might be efficient to help you avoid default, so that I can eventually get my money back, I will pull the rug from under you by calling in the loan. You won't be able to pay me back, but I am covered by X. Bad news. CDS can be misused more easily by those buying protection when having lent to the borrower ("legitimate CDS" in this amendment), than by those who have not lent, and have no ability to affect the borrower.

Lost ability of Americans to reduce their risk. Another Example: This one was part of testimony to the House Financial Services last week, on the panel on which I sat. A congressman (Rep. Manzullo, I think) asked how John Deere, a tractor manufacturer in his district, could use derivatives in its business. I gave an example in which John Deere sells 1000 tractors to a Greek company. Another panelist, Bob Pickel, explained that the Greek buyer of tractors would probably not be available as a referenced name in the CDS market, but that John Deere could get a reasonable hedge against the default risk of Greek firms by buying CDS protection referencing Greek sovereign bonds. That is true. But, this amendment would rule that out. John Deere would be unable to hedge the default risk on the receivables of its tractor sales. This is just one of many examples in which CDS protection buyers who reference a proxy name to get a hedge would no longer be able to hedge. Also, the definition of a "valid credit instrument" will probably be too narrow to allow people to hedge against losses when a borrower defaults that are not losses on a valid credit instrument. For example, if Company X defaults, I will lose the opportunity to collect money owed to me on the foreign exchange derivatives I have with X. If Country Y defaults, the market value of my factories in Country Y would decline precipitously. I could no longer hedge that. Why would anyone want to prevent an American company from protecting itself from losses this way?

The reporting requirement is redundant. All CDS and all other OTC derivatives in the SEC's regulatory domain will be required to be reported to the SEC already under the "data repositories" provision of the bill.

The restriction of a maximum of 60 days for a dealer to be "short" without owning a credit instrument is not very elegant, to say the least.

If it passes, it will not be the end of the world, but it is a step backward. The cost-benefit analysis: Cost: moderate. Benefit: none that I can see...

Bank Regulations Miss the Point on Skin in the Game

2010-05-11T12:29:00.000-07:00

Posted on the Mortgage Bankers Association website by Rob Story Jr.:

Modernizing the regulation of our financial institutions will play a critical role in restoring confidence in our financial system and facilitating the recovery of our national economy. For almost two years, the financial services industry has been working with legislators and regulators to improve oversight and protect consumers without restricting consumers' access to affordable financial products.

An often overlooked concept found in both House and Senate reform bills seeks to ensure that loan originators have an additional financial interest in the long-term success of the loan by requiring lenders to retain a portion of a loan's risk on their books if they sell the loan to the secondary market. Though well-intentioned, this approach to risk retention has the potential to have unintended consequences stifling the recovery of both the residential and commercial real estate markets. More important, it would be duplicative of the current risk-retention requirements and require lenders to put aside large amounts of capital, limiting the credit available to consumers.

As it pertains to real estate financing, the principle, known as "skin in the game" or "risk retention," is built on the fallacious notion that residential and commercial mortgage lenders can make reckless loans with no regard for the long-term performance of those loans because once a loan is sold to the secondary market, the lender is free of any responsibility for how the loan was underwritten.

This couldn't be further from the truth. When I sell a loan, whether it is secured by a residential or commercial property, to a secondary market investor, I make representations and warranties to the buyer with respect to the borrower, the underwriting of the loan, the documentation and the property securing the loan.If the loan fails - that is, if it goes into foreclosure - because of an error or oversight on my part, I am required to buy back the loan or reimburse the buyer. Investors, now more than ever, enforce those warranties to hold me accountable for the loans I have made.

Enacting broad risk retention, requiring lenders to keep a portion of the original loan on their books, has the potential to eliminate a sizable percentage of the mortgage-lending capacity in this country. There is an entire segment of the residential mortgage-lending industry that only does mortgages and does not take deposits from customers. Those lenders make loans to borrowers, sell the loans into the secondary market (with representations and warranties) and then use the money they receive from the sales of the loans to make the next mortgage to another borrower.

Requiring these independent mortgage lenders--many of which are small businesses--to retain a portion of every mortgage they sell would render their business model unsustainable. Elimination of this critical segment of the market - often smaller lenders that serve underrepresented areas and borrowers -would limit capacity and choice for consumers, driving up borrowing costs or limiting access to mortgages altogether, which is the last thing we need in a real estate market that is just beginning to see signs of recovery.

Additionally, elimination of these businesses ultimately would mean job losses, which, again, would not be helpful in the current economic environment. Mortgage banking companies that would be forced out of business by this provision employ between 45,000 and 55,000 people.

In order to avoid this, legislators should provide explicit exemptions from additional risk-retention requirements for qualified residential loans that have particular features and meet certain underwriting guidelines. For example, a fully documented, fully amortized mortgage with a 30-year fixed rate has well-understood risk characteristics.

The market for residential real estate already contains mechanisms that serve to ensure that risk is appropriately accounted for.Consumers are best served by a marketplace that gives them choices and competition. Driving competition and liquidity from the residential mortgage market with broad, one-size-fits-all risk-retention requirements is not the means to bringing back confidence and stability to our markets.

CPSS and IOSCO consult on policy guidance for central counterparties and trade repositories in the OTC derivatives market

2010-05-11T12:24:00.001-07:00

The Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO) have today issued two consultative reports containing proposals aimed at strengthening the OTC derivatives market.

The first report, Guidance on the application of the 2004 CPSS-IOSCO Recommendations for Central Counterparties (RCCP) to OTC derivatives CCPs, presents guidance for central counterparties (CCPs) that clear over-the-counter (OTC) derivatives products.

The second report, Considerations for trade repositories in OTC derivatives markets, presents a set of considerations for trade repositories (TRs) in OTC derivatives markets and for relevant authorities over TRs.

"These two complementary sets of high-level guidance constitute an important response of the CPSS and IOSCO to the recent financial crisis. They also reflect the G20's recommendations for the strengthening of the OTC derivatives market," said William C Dudley, CPSS Chairman, and Kathleen Casey, Chairman of the Technical Committee of IOSCO.

Guidance on the application of the 2004 CPSS-IOSCO Recommendations for Central Counterparties to OTC derivatives CCPs

In response to the recent financial crisis, authorities in many jurisdictions have set out important policy initiatives encouraging greater use of CCPs for OTC derivatives markets. Recently, several CCPs have begun to provide clearing and settlement services for OTC credit default swaps. A CCP interposes itself between counterparties to financial transactions, acting as the buyer to every seller and the seller to every buyer.

Mr Dudley and Ms Casey said: "This is a positive development because a well designed CCP can reduce the risks and uncertainties faced by market participants and contribute to financial stability. As the greater use of CCPs for OTC derivatives will increase their systemic importance, it is critical that their risk management should be robust and comprehensive. Moreover, because of the complex risk characteristics and market design of OTC derivatives products, clearing them safely and efficiently through a CCP raises more complex issues than the clearing of exchange-traded or cash products does."

These issues were not fully discussed in the 2004 report of the existing RCCP. Consequently, the CPSS and the Technical Committee of IOSCO have identified such issues and developed international guidance tailored to the unique characteristics of OTC derivatives products and markets. The aim is to promote consistent interpretation, understanding and implementation of the RCCP across CCPs that handle OTC derivatives.

Considerations for trade repositories in OTC derivatives markets

The financial crisis highlighted a severe lack of market transparency in OTC derivatives markets. As an important step in addressing this issue, OTC derivatives market participants, with the support of the regulatory community, are committed to establishing and making use of trade repositories. A TR in OTC derivatives markets is a centralised registry that maintains an electronic database of open OTC derivative transaction records.

Mr Dudley and Ms Casey said: "The CPSS and the Technical Committee of IOSCO welcome various ongoing industry initiatives and associated close regulatory cooperation in this relatively new area of the financial market infrastructure, which will play a key role in identifying signs of systemic risk and threats to market integrity in the future financial system".

Recognising the growing importance of TRs in enhancing market transparency and supporting clearing and settlement arrangements for OTC derivatives transactions, the CPSS and the Technical Committee of IOSCO have developed a set of factors that should be considered by TRs in designing and operating their services and by relevant authorities in regulating and overseeing TRs.

Consultation process

The two reports are being issued as consultation documents. Comments are invited from any interested parties by 25 June 2010 (for contact details, see Note 1). There will be an outreach event with the industry as part of the consultation process.

The CPSS and the Technical Committee of IOSCO do not plan to issue finalised reports after the consultation period. Instead, the guidance presented in the reports, as well as the feedback received in the consultation process, will be incorporated in the general review of the international standards for financial market infrastructures that was launched by the CPSS and the Technical Committee of IOSCO in February this year.

Notes

Comments on Guidance on the application of 2004 CPSS-IOSCO Recommendations for Central Counterparties to OTC derivatives CCPs should be sent to both the CPSS Secretariat (cpss@bis.org) and the IOSCO secretariat (CCP-OTC-Recommendations@iosco.org).
Comments on Considerations for trade repositories in OTC derivatives markets should be sent to both the CPSS Secretariat (cpss@bis.org) and the IOSCO secretariat (OTC-Trade-Repositories@iosco.org).
The comments will be published on the websites of the Bank for International Settlements and IOSCO unless commentators have requested otherwise.
The start of the general review of the international standards for financial market infrastructures was announced by the CPSS and the Technical Committee of IOSCO in their press release of 2 February 2010 (available on the websites of the BIS and IOSCO).
The reports have been prepared for the CPSS and the Technical Committee of IOSCO by a joint CPSS-IOSCO working group co-chaired by Daniela Russo at the European Central Bank and Jeffrey Mooney at the US Securities and Exchange Commission.
The Committee on Payment and Settlement Systems (CPSS) serves as a forum for central banks to monitor and analyse developments in payment and settlement arrangements as well as in cross-border and multicurrency settlement schemes. The chairman of the CPSS is William C Dudley, President of the Federal Reserve Bank of New York. The CPSS secretariat is hosted by the BIS. More information about the CPSS and all its publications can be found on the BIS website at www.bis.org/cpss.
IOSCO is recognised as the leading international policy forum for securities regulators. The organisation's membership regulates more than 95% of the world's securities markets in over 100 jurisdictions, and its membership is steadily growing.
The Technical Committee, a specialised working group established by IOSCO's Executive Committee, is made up of 18 agencies that regulate some of the world's larger, more developed and internationalised markets. Its objective is to review major regulatory issues related to international securities and futures transactions and to coordinate practical responses to these concerns. Ms Kathleen Casey, a Commissioner of the US Securities and Exchange Commission, is the Chairman of the Technical Committee. The members of the Technical Committee are Australia, Brazil, China, France, Germany, Hong Kong SAR, India, Italy, Japan, Mexico, the Netherlands, Ontario, Quebec, Spain, Switzerland, the United Kingdom and the United States.

Al Franken's plan to end the credit rating conflicts

2010-05-11T04:43:00.000-07:00

Posted in the Washington Post by Senator Al Franken:

I was heartened to read the May 5 editorial "A standard and poor remedy," highlighting the disturbing conflicts of interest in Wall Street's credit rating system. For the past two weeks, I've been working with Professor Matthew Richardson of New York University's Stern School of Business, mentioned in the editorial, to craft an amendment that would fundamentally change the incentives driving the rating industry.

As the editorial pointed out, the market is plagued by conflicts of interest and doesn't reward ratings for their accuracy: The current system allows investment banks to shop around to get the most favorable bond rating.

My amendment would create an independent board to assign a rating agency to each newly issued bond, taking into consideration the capacity and expertise of each agency. It would monitor their performance over time and reward the best actors with more assignments. This would eliminate conflicts of interest and make the system more accurate, fair and transparent. It would increase competition by giving smaller rating agencies an opportunity to compete against the largest three agencies, which have abused the current model.

We must take action that would change the way the system works by putting accuracy ahead of profits.

And here's a Q&A from Ezra Klein's blog on the Washington Post:

Why did you decide to focus on the rating agencies?

The agencies were an enormous part of the problem. They were giving AAA ratings to products that didn't deserve them. There's this inherent conflict of interest where the issuers of these financial products were shopping for raters. It's become very clear that what's going on was they had an incentive to inflate the ratings to get more business. In some cases the agencies were just stupid, but there was also a reason to be stupid. They had motive.

How does your amendment fix the problem?

Instead of the issuer shopping for ratings, we'd form a board under the SEC that would decide which rating agency rates each instrument. I don't mandate how they do it. But it wouldn't have to be totally random. The board would be comprised mainly of investors and people who manage pensions and university endowments. One of the advantages of this is that it'd inject more competitions into the business. Right now, we have Moody's and Standard & Poor's and Fitch doing 94 percent of the ratings. This board could give business to smaller agencies. You'd be rewarded on accuracy and so the incentive would be to be more accurate.

And that, you hope, takes care of the problem wherein the rating agencies actually do a worse job because they're now guaranteed to get business?

Right. Depending on the nature of the product, you'd be able to judge the accuracy over some period of time. Developing a track record of accuracy would be in your interest as opposed to rewarding the exact thing we don't want, which is inflating ratings on behalf of the banks.

Another criticism people have raised about this approach is that giving the government more power over the agencies will leave them more beholden to the government. Right now, the agencies have been criticized for downgrading Greece, and in the future, with our deficit, you could imagine them downgrading America. But not if they rely on the federal government for work.

Well, maybe there'd be part of this where they're not rating government securities. I'm not sure how that would work. But this is about the securities that got us into trouble. So it might not be how we'd do a Treasury bond.

Rather than bringing them further into the government's embrace, why not just kick the rating agencies out altogether? Right now, the government credentials them, uses their "AAA" rating in certain laws and generally makes sure they're central to the system. Why not let them rise or fall on their own?

I think that would be a problem. You could say let's just not have any rating agencies. But we'd have a problem if we didn't have rating agencies at all. I think what you want are rating agencies that do a good job.

To press you on that, though, you'd still have rating agencies. It just wouldn't be the government saying you have to listen to them. And that seems like a good thing to me. Even if you get rid of the conflict-of-interest problem, it still seems to me that these players exist to tell Wall Street that it doesn't really need to know what it's doing. You can be an English literature major who's only been on Wall Street for five months and as long as you know it's "AAA" or "BBB," you're good to go.

I think the government sanction in this amendment would incentivize accuracy and mean that these agencies would do their due diligence and compete and be a bit smarter than the ones in Michael Lewis's book, who seemed particularly easy to fool.

It has occasionally seemed to me that the best reform would be to tax the banks and use the money to make the people at the rating agencies the highest-paid folks on Wall Street.

Well, there might be something to that. I don't prescribe how much they'll get paid but if you are rewarded by your track record, people who do a better job will be paid more.

Do you know if your amendment will get a vote?

I'm not certain. But probably next week sometime. We've been talking to the banking committee staff and I hope that it does come up next week, either as is or in some form. We're very prescriptive in this for how the board will look and there are other ways to skin this cat.

OTC Derivatives Market in India

2010-05-11T04:26:00.000-07:00

By Dayanand Arora and Francis Xavier Rathinam:

Abstract: The OTC derivative market in India, though in its infancy, is an interesting case, because it came out unscathed in the present global crisis. The paper seeks to prove the point that this is because of India’s cautious regulatory framework and support institutions such as a centralised counter party (CCP). This case study about the Indian OTC derivativesmarkets can serve as a model for other developing countries.

The paper analyses the regulatory structure of the Indian OTC derivatives market, particularly the role of OTC-traded versus exchange-traded derivatives, the role of reporting platforms and the role of a centralized counterparty (CCP) for the transparent functioning of the market. It further explores some of the open issues, such as competition in reporting platforms and counterparty services and supervision of the off-balance sheet business of financial institutions, to ensure stable growth of OTC derivatives markets.

Read the Vox column here, and download the whole paper here: www.esocialsciences.com/data/articles/Document1352010140.3762781.pdf

BIS announces modest increase in OTC derivatives

2010-05-10T14:12:00.001-07:00

From the BIS website... Key developments in the second half of 2009:

Notional amounts of all types of OTC derivatives contracts outstanding increased by 2% during the second half of 2009, rising to $615 trillion at the year-end. Interest rate and foreign exchange derivatives accounted for most of this increase. By contrast, overall gross market values decreased by 15%, following a contraction of 22% in the previous six-month period. Gross credit exposures fell by 6%, following an 18% decline in the previous period.
Notional amounts outstanding of CDS contracts continued to decline (-9%), albeit at a slower pace than in the first half of 2009 (-14%), while positions on commodities also receded, by 21%. CDS gross market values shrank by 40%, a similar rate of decline to that seen in the first half of the year (-42%). This brought the market value of the CDS contracts down to 35% of its end-2008 peak.

Download full report here: www.bis.org/publ/otc_hy1005.pdf

Experian Provides New Level of Transparency for Non-Agency MBSs

2010-05-10T09:21:00.000-07:00

NEW YORK, May 10 /PRNewswire/ -- Experian®, the global information services company, today announced the launch of CreditHorizons(SM) for Securities, a data-feed product that provides the missing link to understanding the true creditworthiness of the underlying borrowers in each mortgage deal. CreditHorizons for Securities consists of anonymized U.S. consumer credit profiles that have been matched to the private-label securitized mortgage deals in the industry-leading loan-level database from First American CoreLogic/Loan Performance.

Investors who currently utilize only traditional loan-level data will find that CreditHorizons for Securities affords them a new set of influencers in delinquency and loss forecasting, helping to optimize pricing strategies, improve risk management and hedging strategies and increase confidence in residential mortgage–backed securities buy and sell decisions.

"Monthly trustee and servicer data sets provide a limited foundation for predicting payment patterns," said Ethan Klemperer, general manager of Experian Capital Markets. "To compete profitably in today's market, investors need upgraded valuation methods with increased transparency and predictive power. We're delighted to work with First American CoreLogic to launch CreditHorizons for Securities, providing the critical behavioral data needed to determine the true value and future payment trend of clients' securities."

"We're pleased to join Experian in bringing CreditHorizons for Securities to the marketplace," said George Livermore, president, data and analytics segment for The First American Corporation. "By augmenting existing modeling with consumer credit information, investors obtain a holistic view of the underlying collateral and can better predict delinquency and default probabilities for their residential mortgage–backed securities portfolios."

Experian's CreditHorizons for Securities offers a predefined set of more than 50 anonymized consumer credit data variables that have been carefully evaluated and selected for their predictive ability by Experian's team of credit experts. Maintaining a relatively small number of variables ensures that the product is user-friendly and easy to implement.