Sunday, June 7, 2009

Derivatives, the WRONG war

Sober Look received numerous e-mails (often hostile) referencing our posting on CFTC’s new proposal for derivatives regulation. The public out there is angry, they want derivatives regulation, and many believe derivatives caused this financial crisis. Of course politicians and career hungry bureaucrats had much to do with this perception. In addition, futures exchanges would love nothing more than to destroy the OTC derivatives market, believing it will increase their volumes (actively lobbying for restrictive OTC derivatives regulation). Sober Look would like to challenge that view.

Many bring up AIG as an example of derivatives out of control. The issue with AIG was simply that they did not capitalize themselves accordingly. People point to having a derivatives clearing house as a solution that would have forced AIG to post margin. That’s not the case. Just like much of their insurance product, AIG’s credit default swaps were too customized to be cleared on an exchange. For example, putting corporate insurance policies onto a clearing platform just doesn’t work. A company needs fire and flood insurance for their warehouse facility in Florida – you wouldn't want to standardize it and put it on an exchange. OTC derivatives face the same issues. Also it should be nobody’s business what type of insurance a company has and how much they paid for it.

But insurance policies pose significant risk to insurance firms - does that mean they should be standardized, restricted, and moved to an exchange? The way this risk is mitigated in the insurance business is with proper capitalization. Insurance regulation focuses on capitalization, not standardization. So should derivatives regulation.

When AIG wrote insurance contracts, they had to set aside capital, but when they wrote credit default swaps (credit insurance), they didn’t. What gives? Well the State of NY insurance regulator, the State of Connecticut insurance regulator, the US Office of Thrift Supervision, and the UK FSA (all of whom were responsible for regulating AIG) simply did not provide sufficient oversight to enforce capital requirement rules and did not involve the Fed until it was too late. And now they all blame derivatives. Similarly some at the SEC blamed derivatives for failures at Lehman and Bear Stearns. Much easier of a target for the SEC than let's say the massive securities repo market.

Note the resemblance to 9/11, when the various agencies had pieces of intelligence but did not work together enough to take preventive action. Then the administration focused in Iraq as the culprit. Political careers are not made by getting at the truth, but by finding an easy target and getting the mass media engaged. Sounds familiar?

Some point to public disclosure as the solution. For example Citibank did not fully disclose their exposure they say. But what nearly brought down Citi had little to do with derivatives. It was their use of off-balance-sheet conduit entities financed with commercial paper. As the commercial paper market dried up, Citi had to take deteriorating assets onto their balance sheet. And they clearly were not sufficiently capitalized to take losses on such assets. Sober Look will revisit this story in another discussion.

Part of the issue is that the public, the politicians, the mass media, and regulators simply don’t understand how OTC derivatives are used. And futures exchanges want to keep it this way. The key to OTC product is customization. When a company buys an insurance policy, they don’t want a canned exchange traded solution that is publicly disclosed. A company wants a policy that is customized for their needs and is confidential (because it may give them a competitive advantage). Just as insurance firms compete to provide the best product at the lowest cost, so should the dealers compete on derivatives services. And just as writing an insurance contract requires proper capitalization, so should the writing of derivatives contracts. Putting everything on an exchange is not the solution.

To clear some of this confusion, we want to provide a brief listing of derivatives uses that one rarely sees in the mass media. We also discuss cases where and why a clearing platform concept maybe helpful.

Here is a rough breakdown of the notionals outstanding in the various types of derivatives contracts.

Let's start with the largest market and work our way down.

Interest Rate Derivatives

* Common contracts: interest rate swaps, caps, floors, swaptions, overnight index swaps

* Exchange-traded equivalent: actively traded interest rate futures and options

* Need for clearing house: limited. Only the standardized interest rate swaps could benefit from a clearing house. Overnight index swaps are also good candidates for a clearing platform as they can be easily standardized. LCH.Clearnet (London Clearing House) for example already clears some fraction of interest rate swaps. This is helpful for those who actively trade swaps and need to net out their long and short contracts without getting ripped off by the dealer in an unwind.

* Example of customization:
ABC Company took out a loan that pays LIBOR plus a spread (most common type of corporate loan). The loan is amortizing and can be prepaid at the time of the company’s choosing (also extremely common). ABC is concerned about interest rates going up and decides to put on an amortizing interest rate swap that is cancellable (has a built in swaption). This allows ABC to reduce their risk. A standardized product is just not going to work here (or be way to difficult to implement operationally) and the last thing the company needs is to pay more for the customized product (or having no access to it at all) because the government imposed restrictions (because someone at CFTC is gunning for a political career).

Currency Derivatives

* Typical products: currency forwards, currency options, currency swaps

* Exchange traded equivalent: currency futures and options – far less liquid than the OTC product

* Need for clearing house: none. FX derivatives have been successfully transacted in the OTC markets for 25+ years. The FX settlement is cleared via institutions like the NY Clearing House.

* Example of customization:
ABC Company borrowed dollars but needs to finance an acquisition in the UK. It buys GBP and locks in the exchange rate to buy back USD (to repay the loan) in 5 years via a currency swap. But ABC may want to repay their loan early, so may need dollars before the 5-year maturity. So it makes the currency swap cancellable once a year. ABC also wants to keep this transaction confidential (for obvious reasons). This helps ABC reduce their risk. No standardization can easily replace this commonly used product.

Credit Derivatives

* Typical products: single name credit default swaps (CDS) - high yield and investment grade, index credit default swaps, index tranches

* Exchange traded equivalent: none.

* Need for clearing house: high. Given that no liquid exchange traded product exists, this market needs a clearing house (such as the one set up by ICE). This will allow those who actively trade this product to offset their buys and sells without being taken for a ride by a dealer.  But even without the help of a CDS clearing house, GM bankruptcy was settled quite smoothly.  DTCC, an organization that  provides electronic settlement of CDS pointed out that the $35.3 billion of outstanding GM CDS notional netted down to payments between market participants of roughly $2.2 billion.

* Example of customization:
Fund ABC wants to invest in bonds of fifty companies they selected. They want to make this investment for a year and do not wish to buy and sell these bonds. In addition they want their risk to be equivalent to a BBB rating – thus a junior tranche of this basket. ABC sells 1-year protection to a dealer on this customized (bespoke) basket tranche. Although this seems exotic, it’s actually a common transaction that can’t be easily standardized. As long as ABC posts appropriate amount of margin (both initial and variation) on protection sold, this transaction presents no significant credit risk to the dealer (the dealer will hedge off most market risk).

Equity derivatives

* Typical products: equity options, equity basket swaps, volatility products

* Exchange traded equivalent: stock options, ETFs, index and stock futures and options

* Need for a clearing house: none. The OTC offerings complement exchange traded products available.

* Example of customization:
Mutual fund company ABC has issued a number of exchange traded funds that have leverage (for example Rydex 2x S&P Select Sector Financial ETF, NYSE:RFL). ABC needs to adjust it’s exposure to a specific sector daily to always stay at 2x the NAV. The ETF enters into a total return swap with a dealer on the specific sector basket of stocks. To replicate such a product on an exchange or a clearing house would be an extraordinary difficult undertaking operationally, particularly for customized baskets of stocks. The dealer gets paid some spread to provide this customization service to ABC. This is a common product that needs to stay customized.

Commodity Derivatives

* Typical products: Energy: crude oil, natural gas, products swaps, caps, and floors, basis swaps; Metals: swaps; Precious metals: forwards, options, and leases

* Exchange traded equivalent: liquid futures, options markets, and forwards (on LME)

* Need for clearing house: none. OTC products complement exchange trade products

* Example of customization:
ABC utility buys natural gas in a specific location. It generally hedges with natural gas futures, but is concerned about price basis risk between Henry Hub delivery (NYMEX futures) and ABC's specific purchase location (prices can vary significantly). Instead of using futures they enter into a swap with a dealer in which ABC pays a fixed price monthly and receive variable price of gas for their location. The swap has a seasonally adjusted notional to address ABC’s varying purchasing patterns. This helps ABC reduce their risk.

There are hundreds of other examples of commonly used customized derivatives products. Clearly we had misuses and abuses of the various OTC products in the last 20 years (just as firms and individuals time and time again got decimated by trading exchange listed derivatives). Clearly dealers made massive amounts of money on OTC derivatives sometimes ripping off clients (similar to the way insurance firms profited from writing insurance). The knee-jerk reaction regulation is however not the answer. Clearing platform solutions, standardization, and disclosure to regulators are sometimes helpful but represent only a fraction of the answer. The key is sound margining procedures (such as the ones used by exchanges) and proper bank capitalization. Most banks already have such procedures in place and the Fed (as well as the OCC) should review and push for strengthening of these practices. The industry is already moving in this direction (see story on the letter from the dealers to the Fed and SEC). Destroying or restricting various risk management tools provided by dealers is unsound, even if it makes for great press coverage.

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