Thursday, December 30, 2010

What We Don't Know We Don't Know (Gregory J. Gordon, SSRN)

Abstract: Do you read everything in your field today? Do you even know what everything means any more? Readers of scholarly research are faced with an overabundance of information due to interdisciplinary subject areas, access to research at earlier and multiple stages, and simply more research from more scholars. My simple definition of innovation is the ability to create new things by being exposed to a broader and deeper set of existing things, but broader and deeper have their limits. There is no substitute for reading and truly comprehending a specific article, but there aren’t enough hours in the day to read everything. We need better tools to know what research we need to read. We need to know what we don’t know.

Download here:

Saturday, December 25, 2010

The dark side of financial innovation (SSRN)

By Brian J. Henderson and Neil D. Pearson

Abstract: The offering prices of 64 issues of a popular retail structured equity product were, on average, almost 8% greater than estimates of the products’ fair market values obtained using option pricing methods. Under reasonable assumptions about the underlying stocks’ expected returns, the mean expected return estimate on the structured products is slightly below zero. The products do not provide tax, liquidity, or other benefits, and it is difficult to rationalize their purchase by informed rational investors. Our findings are, however, consistent with the recent hypothesis that issuing firms might shroud some aspects of innovative securities or introduce complexity to exploit uninformed investors.

Published in the Journal of Financial Economics ($$) but the working paper version is available here:

Sunday, December 12, 2010

Derivatives in emerging markets (BIS)

by Dubravko Mihaljek and Frank Packer

Abstract: Turnover of derivatives has grown more rapidly in emerging markets than in developed countries. Foreign exchange derivatives are the most commonly traded of all risk categories, with increasingly frequent turnover in emerging market currencies and a growing share of cross-border transactions. As the global reach of the financial centres in emerging Asia has expanded, the offshore trading of many emerging market currency derivatives has risen as well. Growth in derivatives turnover is positively related to trade, financial activity and per capita income.

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User's guide to the Triennial Central Bank Survey of FX market activity (BIS)

by Michael R King and Carlos Mallo

Abstract: This article provides an overview of the foreign exchange components of the Triennial Central Bank Survey. It highlights key dimensions of this dataset and methodological issues that are important to interpret it correctly. It also compares the methodology of the Triennial Survey to that of more frequent surveys from regional foreign exchange committees.

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Tuesday, November 23, 2010

Emanuel Derman on Metaphors, Models & Theories

Abstract: Theories deal with the world on its own terms, absolutely. Models are metaphors, relative descriptions of the object of their attention that compare it to something similar already better understood via theories. Models are reductions in dimensionality that always simplify and sweep dirt under the rug. Theories tell you what something is. Models tell you merely what something is partially like.

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Monday, October 25, 2010

FSB publishes report on improving OTC derivatives markets

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

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

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

It can be downloaded here:

Thursday, October 21, 2010

Joint Forum Report on Developments in Modelling Risk Aggregation

The report suggests improvements to the current modelling techniques used by complex firms to aggregate risks. It also examines supervisory approaches to firms' use of risk aggregation models, particularly in light of the global financial crisis.

Mr Tony D'Aloisio, Chairman of the Joint Forum and Chairman of the Australian Securities and Investments Commission, said "This report is essential reading for firms considering ways to make more effective use of risk aggregation methods, and for supervisors wanting to understand firms' use of risk aggregation models to help identify shortcomings in a firm's approach."

Key Findings

  • Despite recent advances, models currently in use have not adapted to support all the functions and decisions for which they are now used. Firms using these models may not fully understand the risks they face, including tail events.
  • While some firms are addressing these issues - particularly the treatment of tail events - others are not.
  • Firms face a range of practical challenges when modelling risk aggregation. These include managing the volume and quality of data and communicating results in a meaningful way. Despite these challenges, the Joint Forum found that firms have little or no appetite for fundamentally reassessing or reviewing how risk aggregation processes are managed.
  • In carrying out their responsibilities, supervisors generally do not rely on aggregation models currently used by firms as they are generally considered a "work in progress" with best practices yet to be established. Substantial improvements and refinements in methods - particularly in aggregating across risk classes - are needed before supervisors are likely to be comfortable in placing reliance on these models for supervisory purposes.

Key Recommendations

  • Firms should improve their risk aggregation techniques, for example by reassessing and reorienting models according to their purpose and function. Such improvements will assist firms to better comprehend the risks they face.
  • Firms using models for risk identification and monitoring purposes should ensure they are sufficiently sensitive, granular, flexible and clear. Models used for capital adequacy and solvency purposes should be improved to better reflect tail events.
  • Supervisors should recognise the risks posed by continued use of current aggregation processes and methods. Supervisors are urged to communicate their concerns to firms while highlighting the benefits of appropriately calibrated and well-functioning aggregation models for improved decision making and risk management. Supervisors should work with firms to implement these improvements.
Full publication (PDF 113 pages, 572 kb)

Wednesday, October 20, 2010

Macroprudential policy, tools and systems for the future

In its newest report on Macroprudential Policy, the Group of Thirty calls for urgent action to strengthen system-wide financial regulation and supervision.

The report calls on public officials to empower systemic financial regulators with new tools to enhance economic stability and potentially lessen the severity of future economic crises. These tools would address leverage, liquidity, credit and supervision. The report underscores the fact that while policy action may be difficult and controversial, robust action is necessary.

For more information on the release of the report, visit the publication's press page.

You may also download the executive summary of the report, or purchase the publication in its entirety. It is also available for free here.

A survey of current regulatory trends - report of the IBA Task Force on the Financial Crisis

The International Bar Association’s Task Force on the Financial Crisis has released a new report:
A Survey of Current Regulatory Trends, dated October 2010. This report features an overview of the work of the Task Force from its Chair, Hendrik Haag, as well as updates on regulation from diverse jurisdictions: the US, the UK, Germany, Switzerland, France, Spain, Japan and Russia.

Download here:

Thursday, September 30, 2010

Satyajit Das on the European Financial Stability Facility (”EFSF”)

In a guest post on Naked Capitalism, Satyajit Das critiques the European Financial Stability Facility (”EFSF”):

In order to finance member countries as needed, the EFSF will need to issue debt. The major rating agencies have awarded the fund the highest possible credit rating AAA.

The EFSF structure echoes the ill-fated Collateralised Debt Obligations (”CDOs”) and Structured Investment Vehicles (”SIV”). The Moody’s rating approach explicitly draws the analogy and uses CDO rating methodology in arriving at the rating.

The Euro 440 billion ($520 billion) rescue package establishes a special purpose vehicle (”SPV”), backed by individual guarantees provided by all 19-member countries. Significantly, the guarantees are not joint and several, reflecting the political necessity, especially for Germany, of avoiding joint liability. The risk that an individual guarantor fails to supply its share of funds is covered by a surplus “cushion”, requiring countries to guarantee an extra 20% beyond their shares. A cash reserve will provide additional support.

Given the well-publicised and deep financial problems of some Euro-zone members, the effectiveness of the cushion is crucial. The arrangement is similar to the over-collateralisation used in CDO’s to protect investors in higher quality AAA rated senior securities. Investors in subordinated securities, ranking below the senior investors, absorb the first losses up to a specified point (the attachment point). Losses are considered statistically unlikely to reach this attachment point, allowing the senior securities to be rated AAA. The same logic is utilised in rating EFSF bonds.

If 16.7% of guarantors (20% divided by 120%) are unable to fund the EFSF, lenders to the structure will be exposed to losses. Coincidentally, Greece, Portugal, Spain and Ireland happen to represent around this proportion of the guaranteed amount. Greece whilst an Eurozone member will not participate in EFSF’s lending programs as a provider of guarantees for the obvious reason that nobody would seriously place much value on any such guarantee.

Unfortunately, the Global Financial Crisis illustrated that modelling techniques for rating such structures are imperfect. The adequacy of the cushion is unknown. If one peripheral Euro-zone members has a problem then others will have similar problems. If one country requires financing, guarantors of the EFSF will face demands at the exact time that they themselves will be financially vulnerable.

Rubbery Numbers

The rating analysis published by the Agencies highlights subtle but extremely significant features in the structure designed to ensure the desired AAA rating.

Where an Eurozone member draws on the facility, the amount of funds on lent by EFSF will be adjusted by the following deductions:

  • A 50 basis point service fee
    A percentage equal to the net present value of EFSF’s on-lending margin. For example, the Greek financing package had a margin of 300 basis points. This would translate into a deduction of around 13-14% (depending on the discount rate applied).
    [1 and 2 constitute a fungible general cash reserve ("the Reserve") which will support all EFSF debt.]
  • An additional reserve specific to each loan made by EFSF (”the Buffer”) will be created. The exact methodology of determining this buffer has not been disclosed but will determined by several factors. The first factor will be the borrower and it credit condition. The second will be the position EFSF itself and the level of credit support available for its existing obligations.

The Reserve and Buffer are to be invested in liquid AAA rated government, supranational, or agency securities to be available as credit support for the EFSF’s obligations.

The requirement for the Reserve and Buffer significantly reduces the amount of funds available from the EFSF. Standard & Poor’s (”S&P”) estimated that after adjusting for the guarantee overcollateralization and the exclusion of Greece from EFSF’s program, the EFSF can raise up to Euro 350 billion (20% lower than the announced amount). After adjustment for the fact that borrowing governments cannot guarantee EFSF bonds and deduction of the Reserve and Buffer the potential available EFSF lending is further reduced.

Assuming a Reserve of say 13.5% and a Buffer of 10%, this would reduce the amount available to around Euro 270 billion (39% lower than the announced amount). Assuming an equivalent reduction in the IMF component of the package, the total amount available is around Euro 460 billion. The EFSF’s ability to lend compares to the forecast budget financing need of Greece, Ireland, Portugal and Spain of over Euro 500 billion in the period 2009 to 2013.

The structure outlined also increases the cost of the funding for borrowers drawing on the EFSF facility. This additional cost is generated by the fact that the Reserve and Buffer has to be invested in securities that may earn less than the interest paid by EFSF on any issue.

In order to attain the coveted AAA rating, the EFSF structure has been “tweaked” subtly. For example, Moody’s states that “the Buffer is to be sized so that the remaining portion of the debt issue that is not fully backed by cash will be fully covered by contributions from Aaa-rated member states.” In essence this appears to confirm that the EFSF’s rating relies heavily on the support of the guarantees of AAA countries – currently Germany, France, The Netherlands, Austria, Finland, and Luxembourg. In reality this means that significant reliance is being placed on the larger parties such as Germany, France and the Netherlands.

If the EFSF is drawn upon and increasing reliance is placed on cornerstone guarantors such as Germany and France, it is not clear whether politically it will be possible for these countries to continue the facility beyond its original 3-year maturity. Interestingly, S&P state that: “… we consider it likely that its mandate would be extended if market conditions remained unsettled.”

For investors, there is a risk of rating migration, that is, a downgrade of the AAA rating. If the cushion is reduced by problems of an Euro-zone member, then there is a risk that the EFSF securities may be downgraded. Any such ratings downgrade would result in losses to investors. Recent downgrades to the credit rating of Portugal and Ireland highlight this risk.

Given the precarious position of some guarantors and their negative rating outlook, at a minimum, the risk of ratings volatility is significant. The rating agencies indicated that if a larger Euro-zone member encountered financial problems, then the rating and viability of the EFSF might be in jeopardy.

Investors may be cautious about investing in EFSF bonds and, at a minimum, may seek a significant yield premium. The ability of the EFSF to raise funds at the assumed low cost is not assured.

Ironically, the actual structure of credit enhancement encourages troubled countries to access the facility early to ensure its availability. The structure embodies an accelerating “negative feedback loop”.

As market conditions deteriorate, market access becomes limited and countries draw on the EFSF facility (eliminating them from the guaranty pool), increased financial pressure will be exerted on the AAA rated Eurozone countries. The need to maintain adequate coverage to preserve the EFSF’s AAA rating on existing debt will mean that the Buffer will increase and the capacity of the EFSF to lend may become impaired. Moody’s rating analysis indicates that in the event that a large number of countries simultaneously lose market access and draw on the facility, the current lending capacity of the EFSF would likely be overwhelmed. Moody’s believes that it would be unlikely that the EFSF would start issuing under those circumstances.

At this stage, the EFSF have indicated that they don’t plan to issue any debt, as they do not anticipate the facility being used. The facility also has a very short maturity, three years till 2013. The importance of these factors in the grant of the preliminary rating is unknown.

S&P correctly inferred that the “EFSF has been designed to bolster investor confidence and thus contain financing costs for Eurozone member states.” The agency indicated that if its establishment achieved this aim then the EFSF would not to need to issue bonds. However, if as pressures mount and market access becomes problematic for some Eurozone members, then the EFSF and it structure will be tested.

The EFSF’s structure raises significant doubts about its credit worthiness and funding arrangements. In turn, this creates uncertainty about the support for financially challenged Euro-zone members with significant implications for markets.

Tuesday, September 28, 2010

Financial Stability Board meets on the financial reform agenda

The Financial Stability Board (FSB) met in Paris on 27 September. It reviewed risks and vulnerabilities affecting the global financial system and progress on the regulatory reform agenda under coordination by the FSB.

Vulnerabilities in the financial system

While considerable progress has been made in strengthening the resilience of the financial system worldwide, financial systems in advanced economies remain vulnerable to risks of fiscal strains in national and local governments, of renewed fragilities in bank funding markets and of weakening economic conditions. The potential for adverse feedback loops between weak economies, fragile banking systems, and fiscal strains remains significant. Further financial stability challenges arise from the continued reliance of some banks on support mechanisms, and from potential market pressures and risks of disorderly unwinding of large capital inflows to faster growing emerging markets.

The FSB emphasised the need to accelerate financial system repair by identifying and resolving weak banks in an orderly way, noting there are large benefits to a clear and systematic process which avoids forbearance. Intensified supervisory scrutiny in targeted areas is needed as well to stem undesirable side-effects of low interest rates and low market incentives for banks to adjust. Finally, authorities should continue to foster transparency through targeted consistent disclosures by financial institutions of risk factors that are most relevant to the market conditions at the time (e.g. sovereign risk during times of fiscal strains).

Progress on regulatory reforms

Basel III. FSB members welcomed the agreement reached by the Basel Committee’s governing body on the new bank capital and liquidity standards. The new standards will markedly increase the resilience of the banking system, by reducing the likelihood and severity of future financial crises and creating a less procyclical banking system that is better able to support long-term economic growth.

The FSB, with the Basel Committee, have assessed the macroeconomic impact of the transition to the stronger capital and liquidity standards. The final report of the Macroeconomic Assessment Group, taking into account the calibration and phase-in arrangements agreed in September, will be published later this year.

Addressing systemically important financial institutions. The FSB reviewed the development of policy approaches for addressing the “too big to fail” problems associated with systemically important financial institutions (SIFIs). It will make recommendations to G20 Leaders at the November Summit in Seoul covering the need for global SIFIs to have a higher loss absorption capacity; enabling the resolution of SIFIs without taxpayer solvency support; strengthening the intensity of SIFI supervision; and a peer review process to promote consistent national policies in this area.

Implementing central clearing and trade reporting of OTC derivatives. The FSB reviewed recommendations developed by an FSB Working Group to achieve the G20’s objectives to improve transparency, mitigate systemic risk and protect against market abuse in the over-the-counter (OTC) derivatives market. The draft recommendations promote consistent implementation across jurisdictions of measures to increase standardisation, central clearing and, where appropriate, exchange or electronic platform trading, and to have all OTC derivatives contracts reported to trade repositories. The report will be published at the time of the November G20 Summit in Seoul.

Reducing reliance on CRA ratings. The FSB reviewed principles being developed to reduce authorities’ and financial institutions’ reliance on credit rating agency (CRA) ratings. The goal of the principles is to reduce the cliff effects from CRA ratings that can amplify procyclicality and cause systemic disruption. The principles will call on authorities to reduce reliance on CRA ratings in rules and regulations, in order to reduce mechanistic market reliance on those ratings. The principles will be presented to G20 Finance Ministers and Central Bank Governors in October.

Sunday, September 12, 2010

Regulating Systemic Risk

By Steven L. Schwarcz and Iman Anabtawi

Abstract: Systemic risk management is at the forefront of financial regulatory agendas worldwide. The global financial crisis was a powerful demonstration of the inability and unwillingness of financial market participants to carry out the task of safeguarding the stability of the financial system. It also highlighted the enormous direct and indirect costs of addressing systemic crises after they have occurred, as opposed to attempting to prevent them from arising. Governments and international organizations are responding with measures intended to make the financial system more resilient to economic shocks, many of which will be implemented by regulatory bodies over time. These measures suffer, however, from the lack of a theoretical account of how systemic risk propagates within the financial system and why regulatory intervention is needed to disrupt it. In this Article, we address this deficiency by examining how systemic risk is transmitted. We then proceed to explain why, in the absence of regulation, market participants are poorly situated to disrupt the transmission of systemic risk. Finally, we advance a regulatory framework for correcting that market failure.

Download here:

Thursday, September 9, 2010

The payment system - payments, securities and derivatives, and the role of the Eurosystem

The European Central Bank (ECB) has published a book entitled "The payment system - payments, securities and derivatives, and the role of the Eurosystem". It provides comprehensive insight into the handling of financial transactions and the functioning of the related financial market infrastructure - a core component of the financial system. It also explains the role and policies of the Eurosystem - which comprises the ECB and the 16 national central banks of the euro area - in this field. The book is in three parts.

The first provides insight into the market infrastructure of modern economies with a view to examining key concepts which have general validity and are thus applicable around the world. Emphasis is placed on the principles governing the functioning of the relevant systems and processes and the presentation of the underlying economic, business, legal, institutional, organisational and policy issues.

The second concentrates on issues concerning the market infrastructure for the handling of euro-denominated payments, securities and derivatives, as well as the most important EU legislation.

The third explains the operational, oversight and catalyst roles of the Eurosystem and the policies established by the Governing Council of the ECB in this field. It also considers the legal basis for the Eurosystem’s involvement and describes the transparent and cooperative approach adopted by the Eurosystem with a view to pursuing its public policy objectives while acting within a modern market economy environment.

Download the book here:

Wednesday, September 8, 2010

Tail VaR approach to measuring and managing systemic risk

By Joseph H.T. Kim and Phelim P. Boyle, University of Waterloo

Abstract: This paper proposes a framework for measuring and managing systemic risk. Current approaches to solvency regulation have been criticized for their focus on individual firms rather than the system as a whole. Our procedure shows how an insurance program can be designed to deal with systemic risk through a risk charge on participating institutions. We use the Conditional Tail Expectation (Tail VaR) to compute the risk exposure and the premiums. One of the frequent criticisms of the current regulations is that the capital requirements have a pro-cyclical impact since they require extra capital in periods of extreme stress thus exacerbating a crisis. We show how to implement an insurance program that is counter-cyclical and we illustrate the procedure using a numerical example.

Download here:

Tuesday, August 31, 2010

Explaining the Housing Bubble

By Adam J. Levitin and Susan M. Wachter

Abstract: There is little consensus as to the cause of the housing bubble that precipitated the financial crisis of 2008. Numerous explanations exist: misguided monetary policy; government policies encouraging affordable homeownership; irrational consumer expectations of rising housing prices; inelastic housing supply. None of these explanations, however, is capable of fully explaining the housing bubble, much less the parallel commercial real estate bubble.

This Article posits a new explanation for the housing bubble. It demonstrates that the bubble was a supply-side phenomenon, attributable to an excess of mispriced mortgage finance: mortgage finance spreads declined and volume increased, even as risk increased, a confluence attributable only to an oversupply of mortgage finance.

The mortgage finance supply glut occurred because markets failed to price risk correctly due to the complexity and heterogeneity of the private-label mortgage-backed securities (MBS) that began to dominate the market in 2004. The rise of private-label MBS exacerbated informational asymmetries between the financial institutions that intermediate mortgage finance and MBS investors. The result was overinvestment in MBS that boosted the financial intermediaries’ profits and enabled borrowers to bid up housing prices.

Despite mortgage securitization’s inherent informational asymmetries, it is critical for the continued availability of the long-term fixed-rate mortgage, which has been the bedrock of American homeownership since the Depression. The benefits of securitization, therefore, must be reconciled with the need for economic stability. The Article proposes the standardization of MBS to reduce complexity and heterogeneity in order to rebuild a sustainable, stable housing finance market based around the long-term fixed-rate mortgage.

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Monday, August 30, 2010

Canada’s Very Own Mortgage Mess: The Laws and Programs Behind a National Dilemma

By Nathan Hume, University of Toronto - Faculty of Law

Abstract: Canadian house prices require explanation. Despite a deep global recession and persistent credit crisis, they remain near record highs while prices elsewhere have plummeted. This article offers an institutional account of that anomaly. The insurance and securitization programs of the Canada Mortgage and Housing Corporation have insulated the Canadian mortgage and housing markets from recent turbulence. These large, unfamiliar programs also distort and may ultimately destabilize the Canadian economy. Arguments about asset bubbles are unproductive. This article explains these programs, their effects and their legal framework so that we can better discuss what to do with them.

Download here:

Friday, August 27, 2010

FSA outlines a fundamental review of trading activity regulation

The Financial Services Authority (FSA) has today published a discussion paper (DP) that considers fundamental changes to the regulation of trading activities – one of the key recommendations of the Turner Review following material trading losses incurred during the crisis.

Since the Turner Review was published, the Basel Committee on Banking Supervision (BCBS) has proposed several reforms to the prudential regime for banks and in addition has mandated a fundamental review of trading activities called for in the Turner Review.

The FSA believes that the delivery of a new, robust, long-term, approach to prudential requirements for trading activities is one of the key areas of regulatory reform that must be delivered to build a stronger financial system. The outcome of the BCBS’s fundamental review is central to achieving this objective internationally.

The DP describes the FSA’s current views and ideas in relation to major areas of reform that need to be considered to address areas of structural weakness that exacerbated the build up of risk before the financial crisis.

Paul Sharma, FSA director of prudential policy, said:

"There are clear benefits of participants in traded financial markets taking risks to facilitate a more efficient allocation of resources across the economy – where these gains in efficiency are real and the risks posed are adequately captured or controlled we are not seeking to undermine these activities.

"However, the financial crisis has highlighted that, for trading activities in particular, an over-reliance on the principles of efficient financial markets can lead to severe consequences when risks are misunderstood at a system-wide level. The balance needs to be redressed to ensure that risks posed to the system as a whole are more adequately reflected in the structure of prudential regulation."

The DP sets out a number of recommendations which are grouped into three key areas:

  1. Valuation: We recommend an increased regulatory focus on the valuation of traded positions and think there is a need for a specific assessment of valuation uncertainty.
  2. Coverage, coherence and the capital framework: We recommend changing the structure of the capital framework to bring greater coherence and reduce the opportunities for structural arbitrage within the banking sector and the wider financial system.
  3. Risk management and modelling: We recommend specific measures aimed at improving firms’ risk management and modelling standards, and ensuring that these are aligned with regulatory objectives.

The closing date for responses is 26 November 2010. The FSA will issue a feedback statement in the first half of 2011.


  1. The Discussion Paper can be found on the FSA website.
  2. The Turner Review can be found on the FSA website.
  3. The FSA regulates the financial services industry and has five objectives under the Financial Services and Markets Act 2000: maintaining market confidence; promoting public understanding of the financial system; securing the appropriate degree of protection for consumers; fighting financial crime; and contributing to the protection and enhancement of the stability of the UK financial system.
  4. See also FT Alphaville's summaries; Part 1, Part 2 and Part 3.

FHFA Releases First Conservator’s Report on the Enterprises’ Financial Condition

Washington, DC - August 26, 2010 - The Federal Housing Finance Agency (FHFA) today released its first Conservator’s Report on the Enterprises’ Financial Condition. The Conservator’s Report provides an overview of key aspects of the financial condition of Fannie Mae and Freddie Mac (the Enterprises) during conservatorship. The report will be released on a quarterly basis following the filing of the Enterprises’ financial results with the Securities and Exchange Commission (SEC).

“FHFA initiated the Conservator’s Report to enhance public understanding of Fannie Mae’s and Freddie Mac’s financial performance and condition leading up to and during conservatorship,” said FHFA Acting Director Edward J. DeMarco.

The report includes information on Enterprise presence in the mortgage market; credit quality of Enterprise mortgage purchases; sources of Enterprise losses and capital reductions; and Enterprise loss mitigation activity. Information presented in the report includes:

• The key driver in the decline of the Enterprises’ capital from the end of 2007 through the second quarter of 2010 was the Single-Family Credit Guarantee business segment, which accounted for 73 percent of the capital reduction over that period. The bulk of this capital reduction was associated with losses from mortgages originated in 2006 and 2007.
• The Investments and Capital Markets business segment (which includes the retained portfolio and credit losses associated with private-label mortgage-backed securities) accounted for 9 percent of the capital reduction over the same period.
• Since the establishment of the conservatorships, the credit quality of the Enterprises’ new mortgage acquisitions has improved substantially. Single-family mortgages acquired by the Enterprises during conservatorship have, on average, higher credit scores and lower loanto- value ratios, resulting in lower early cumulative default rates.

Download the full report here:

Wednesday, August 25, 2010

Structured Finance Influence on Financial Market Stability: Evaluation of current regulatory developments

by Sebastian A. Schuetz of the University of L√ľneburg

Abstract: In 2007 the world faced one of the biggest financial crises ever. It was the third important financial crisis in the last 12 years. Spillovers to the real economy and moral hazard behaviour of carpetbaggers resulted in enormous pressure on worldwide political institutions to approve a more rigorous regulation on financial institutions and predict financial crises via early warning systems. We analyzed the performance of structured finance ratings and structured finance issuance/outstanding to detect the main shortcomings of the subprime crisis. Afterwards we explain the behaviour of market participants with theoretical models and a survey of institutions involved in securitization. With the conclusions of this analysis we evaluate the EU regulation on credit rating agencies and current Basel II enhancements. Finally we can determine that most regulatory enhancements are in accordance with our analyzed shortcomings. Some approaches like the introduction of a leverage ratio are counterproductive and a danger for worldwide economic growth.

Download here:

Thursday, August 12, 2010

Oliver Wyman: Risk Management Practices Still Inadequate

The second Oliver Wyman / Financial Times Global Emerging Risks Survey of 650 senior executives at global companies with revenues of more than $1 billion finds that most executives consider their firms' risk management practices to be inadequate. Despite significant investments in improving their risk management capabilities since the financial crisis first started, over 60% of senior managers still believe their firms are "ineffective" or only "moderately effective" at incorporating emerging risks into their decision making.

"I'm surprised at how little progress has been made. So many companies have worked to improve their risk management practices since the financial crisis started," says Oliver Wyman partner Alex Wittenberg. "Yet many of the current approaches to managing emerging risks are not providing companies with the business information they need, leaving many vulnerable to a wide range of potential sudden shocks."

The results clearly show that even with their renewed focus on managing risk, most companies still fail to take information about emerging risks into account. Emerging risks are defined as both new risks, such as this year's eruption of volcanic ash in Iceland, and familiar risks in unfamiliar conditions, as when volatile commodity prices suddenly become some of the largest costs for businesses such as airlines and consumer products manufacturers. That general lack of progress is especially troubling given that 71% of respondents view global recession as the greatest risk to their business.

This report makes recommendations for how risk management programs should address not only traditional risks but also new risks that threaten to change the rules of the game.

Reasons for the serious disconnect between companies' approaches to assessing risks and effectively using the information to make better decisions highlighted in the report include:

Many boards of directors receive emerging risk information only infrequently.

Many executives rely on basic, "static" risk analytics and tools rather than multidimensional approaches that take advantage of a wide range of outside data.

Immediate and pressing financial events have pushed risks not directly related to their business, such as climate change or pandemics, off most executives' radar screens.

Only half of executives surveyed integrate emerging risk information into their strategic planning process.

For more information about this report, please visit

Monday, August 2, 2010

Into the Abyss: What If Nothing is Risk Free? (SSRN)

By Aswath Damodaran, New York University - Stern School of Business

Abstract: In corporate finance and investment analysis, we assume that there is an investment with a guaranteed return that offers both firms and investors a “risk free” choice. This assumption, innocuous though it may seem, is a critical component of both risk and return models and corporate financial theory. But what if there is no risk free investment? During the banking crisis of 2008, this question came to the fore, as investors began questioning the credit worthiness of US treasuries, UK gilts and German bonds. In effect, the fear that governments can default, hitherto restricted to risky, emerging markets, had seeped into developed markets as well. In this paper, we examine why governments may default, even on local currency bonds, and the consequences. We also look at how best to estimate a risk free rate, when no default free entity exists, and the effects on both investors and firms. In particular, we argue that the absence of a risk free investment will make investors collectively more risk averse, thus reducing the prices of all risky assets, and induce firms to borrow less money and pay out lower dividends.

Download here:

Tuesday, July 20, 2010

Funding liquidity risk: definition and measurement (BIS)

by Mathias Drehmann and Kleopatra Nikolaou

Abstract: Funding liquidity risk has played a key role in all historical banking crises. Nevertheless, a measure based on publicly available data remains so far elusive. We address this gap by showing that aggressive bidding at central bank auctions reveals funding liquidity risk. We can extract an insurance premium from banks' bids which we propose as measure of funding liquidity risk. Using a unique data set consisting of all bids in the main refinancing operation auctions conducted at the ECB between June 2005 and October 2008 we find that funding liquidity risk is typically stable and low, with occasional spikes, especially around key events during the recent crisis. We also document downward spirals between funding liquidity risk and market liquidity. As measurement without clear definitions is impossible, we initially provide definitions of funding liquidity and funding liquidity risk.

Download here:

Wednesday, July 14, 2010

European Repo Market White Paper Emphasises Importance Of Repo And Urges Reform Of Market Infrastructure

(Press Release) ICMA’s European Repo Council (ERC) has today published a White Paper on the European repo market, including the role of short-selling, the problem of settlement failures and the need for reform of the market infrastructure. It emphasises the importance of the repo market for the efficiency and stability of the financial system.

The White Paper was commissioned by ICMA’s ERC in response to current regulatory considerations which will impact the repo market. There is concern that regulatory initiatives should not constrain the capacity of the repo market in Europe at a time when increasing demands are being made on it, both by the regulators themselves in terms of proposals for enhanced collateral management to reduce risk and by governments in terms of increased debt issuance.

Proposals relating to the restriction of short-selling would have unintended consequences for the securities market, which will increase costs and risks for issuers and investors.

There is also an urgent need for action to remove the barriers to the efficient cross-border transfer of securities posed by the settlement infrastructure. The paper highlights infrastructure problems which have caused fails in the system in recent difficult market conditions and suggests solutions.

The White Paper was written by Richard Comotto of the ICMA Centre drawing on extensive interviews with market participants, regulators and clearing systems.

Godfried De Vidts, Chairman of the ERC commented: “The White Paper will make an important contribution to the debate that is needed amongst policy makers, assisting them to make informed decisions. The support from the market, in the form of the ERC Committee and the ERC Operations Committee, allowed the author to produce this comprehensive document in a comparatively short time, demonstrating the commitment of the repo community of the ERC to continue working on a meaningful debate to solve repo related issues. We welcome more in-depth, constructive discussions with all concerned and trust they will lead to a well-functioning secured funding market that will continue to be an important brick in the building of a more robust financial market environment.”

The main issues which the ERC White Paper addresses are:

Role and functioning of the repo market: The White Paper emphasises the important role played by the repo market in providing secure and efficient cash funding, and as a means of borrowing securities, which underpins bond market liquidity. Repo is also a key tool for central bank operations. At a time when governments are depending on markets to distribute large quantities of debt, regulation which affects the repo market could have serious consequences for sovereign debt issuance. It also explains how some of the more arcane features of that market (ie negative repo rates) form a normal part of market operation.

Short selling: In response to the Greek crisis regulators are discussing how to control short-selling and in particular naked short-selling. The repo market provides the borrowing facilities that support short-selling. The paper describes the essential role of short-selling, and outlines the likely costs and risks of regulatory restrictions. The argument is made that short-selling is not a problem but a necessary and desirable market activity for a well-functioning and liquid securities market, and that “abusive” short-selling is rare and should be tackled through existing market abuse regulations. The paper supports reporting of short positions to regulators to assist them in monitoring short-selling and identifying potential abusive behaviour. The cost of suppressing a normal market activity would be serious unintended consequences for market efficiency and liquidity at a time when governments are seeking to use those markets to issue large amounts of debt. The damage to the repo market would also derail the regulators’ proposals to encourage increased collateral management as a means of containing credit risk.

Clearing and settlement: The White Paper proposes that official action is needed by regulators to remove barriers to clearing and settlement in Europe, which may have contributed to problems experienced during recent market turbulence; and suggests reforms. It details interconnectivity barriers between national Clearing and Settlement Depositories in various Eurozone countries and the International Clearing and Settlement Depositories (ICSDs) used by international investors.

The European repo market White Paper is available from ICMA’s website

Thursday, July 8, 2010

NY Fed Working Paper on the Shadow Banking System

By Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky

Abstract: The rapid growth of the market-based financial system since the mid-1980s changed the nature of financial intermediation in the United States profoundly. Within the market-based financial system, “shadow banks” are particularly important institutions. Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector credit guarantees. Examples of shadow banks include finance companies, asset-backed commercial paper (ABCP) conduits, limited-purpose finance companies, structured investment vehicles, credit hedge funds, money market mutual funds, securities lenders, and government-sponsored enterprises.

Shadow banks are interconnected along a vertically integrated, long intermediation chain, which intermediates credit through a wide range of securitization and secured funding techniques such as ABCP, asset-backed securities, collateralized debt obligations, and repo. This intermediation chain binds shadow banks into a network, which is the shadow banking system. The shadow banking system rivals the traditional banking system in the intermediation of credit to households and businesses. Over the past decade, the shadow banking system provided sources of inexpensive funding for credit by converting opaque, risky, long-term assets into money-like and seemingly riskless short-term liabilities. Maturity and credit transformation in the shadow banking system thus contributed significantly to asset bubbles in residential and commercial real estate markets prior to the financial crisis.

We document that the shadow banking system became severely strained during the financial crisis because, like traditional banks, shadow banks conduct credit, maturity, and liquidity transformation, but unlike traditional financial intermediaries, they lack access to public sources of liquidity, such as the Federal Reserve’s discount window, or public sources of insurance, such as federal deposit insurance. The liquidity facilities of the Federal Reserve and other government agencies’ guarantee schemes were a direct response to the liquidity and capital shortfalls of shadow banks and, effectively, provided either a backstop to credit intermediation by the shadow banking system or to traditional banks for the exposure to shadow banks. Our paper documents the institutional features of shadow banks, discusses their economic roles, and analyzes their relation to the traditional banking system.

Download here:

Tuesday, June 29, 2010

S&P places Moody's on CreditWatch

June 29 (Bloomberg) -- Moody’s Corp.’s short-term debt ranking of A-1 was placed on CreditWatch with negative implications by rival credit rating company Standard & Poor’s.

“We believe there may be added risk to U.S.-based credit rating agency Moody’s business profile following recent U.S. legislation that may lower margins and increase litigation related costs for credit rating agencies,” S&P, a unit of McGraw-Hill Cos., said in a today statement.

Moody’s and S&P, both based in New York, along with Fitch Ratings, owned by Paris-based Financiere Marc de Lacharriere SA, have drawn criticism from officials, including Financial Crisis Inquiry Chairman Phil Angelides, and from investors after assigning top ratings to securities that collapsed in value.

Thursday, June 24, 2010

Collapsed debt market poses dilemma for G20

Some pithy commentary from Gillian Tett:

At the height of the credit bubble in June 2007, European bankers working in the world of complex credit were so optimistic about the future that they held their annual meeting in swanky Barcelona and threw parties flowing with champagne.

No longer: last week the European Securitisation Forum – the body that represents bankers slicing and dicing debt – held its annual meeting in Edgware Road, a scruffy quarter of London. As attendees sipped their coffee, the group creating a buzz were not hedge funds but government officials, particularly those from the European Central Bank...

Unsurprisingly, all western central banks are deeply uncomfortable about the fact that they, in effect, have replaced, or become, the securitisation sphere. They are thus looking for exit strategies and urging the banking industry to restart the securitisation machine...

While such reforms are laudable, unfortunately they are unlikely to be enough. In 2007, when bankers were guzzling champagne, a large source of the demand for securitised bonds came from quasi “invented” buyers – that is, banks and bank-funded vehicles that were developing investment strategies to take advantage of regulatory and rating agency loopholes, fuelled by artificially cheap loans.

Cheap funding has since vanished and governments are determined to close all those loopholes. As a result, those invented buyers have disappeared.

That need not spell the end of securitisation, per se. After all, there are still real money investors out there, such as pension funds, which could buy securitised bonds. But if these real investors reappear, they will demand much better returns. That means the market will be smaller in future, and funding costs will rise.

Wednesday, June 23, 2010

Swaps Push-Out to Have Major Impact on U.S. Dealers

According to a Moody's report published on June 21:
If enacted into law, the “swaps push-out” will make it impossible for major U.S. dealers to conduct market-making of OTC derivatives -- a major franchise and a large earnings contributor -- within their U.S. bank subsidiaries. Housing OTC derivatives within the lead bank offers dealers funding and capital efficiencies, and makes them more desirable counterparties from a credit risk standpoint. Losing these advantages and moving positions to a different subsidiary can have material franchise, operational and, possibly, capital implications for U.S. dealers…

Wednesday, June 16, 2010

Deriviatives and the New Financial Legislation

SEC's Rick Bookstaber on the OTC derivatives portion of the Senate bill, S. 3217 and "the potential for that legislation to allow regulatory arbitrage and reduce transparency to the regulators."

The bill divides the regulation of OTC derivatives between the SEC and the CFTC, assigning the SEC regulatory authority over some – but not all – securities-related derivatives and the CFTC authority for others, such as indexes of those securities. In a world where financial engineering can create an asset in any number of ways, this is an approach that is just asking to be gamed.

Let me illustrate this with a simple example. When I ran a long-short equity hedge fund a few years ago, I traded in the U.K. equity market. However, I never bought or sold a U.K. stock. I only traded total return swaps on U.K. equities. The reason I took this circuitous route is that by using a total return swap, I avoided the tax that the U.K. puts on stock transactions. My broker bought the stock I wanted and kept it on its books (apparently the transaction tax did not apply to the broker) and then the broker executed a swap with me. The swap gave me a payment equal to the return from the stock in exchange for a payment from me to the broker. Of course, this payment to my broker was identical to the cost of funding the stock.

As far as I was concerned, I owned the stock: I treated the swap transaction in my trading and risk management systems as if I held the stock, and my portfolio return was the same as if I held the stock.

If regulation allows equity index swaps to be under the CFTC’s regime and the stocks to be under the SEC regime, there will be the same potential for regulatory arbitrage. I can already envision a thriving new market developing for what might be called Index Spread Total Return Swaps. A fund that wants to hold a long equity position in IBM and P&G, but wants to do it under the CFTC regime, will have a broker give them a total return swap that pays the difference between a position in an index that holds the S&P 500 and another index that holds all the stocks in the S&P 500 except for IBM and P&G. This is a swap on indexes, and so will be under the aegis of the CFTC. Whatever equity positions the fund wants to hold, a swap can be created to fulfill its needs. With the push of a button, voila, the fund is effectively trading stocks – securities – under the CFTC rather than SEC umbrella.

This is a simple example of a broader point: a financial engineer could just as easily construct a position drawn from the equity market that behaves like a commodity, or create a currency swap that looks like a bond. In other words, under the proposed OTC derivatives regime, traders will be permitted to choose their regulators. In my view, these provisions should seek to eliminate regulatory arbitrage, not create it.

Another weakness of the bill is what it affords regulators in terms of transparency. As I stated in my 2007 testimony before your subcommittee, I believe that regulators should know the positions, leverage and web of counterparty connections across firms. I do not think regulators can fulfill their mission of protecting investors, the market or the economy at large without this information. The bill enhances the transparency of OTC derivatives both by improving price discovery and by pushing for greater simplicity and standardization, a critical step. However, the division of OTC derivatives oversight between the SEC and the CFTC moves us away from this objective. There is no ready mechanism envisioned within the bill to allow unfettered sharing of these data. This not only will create routes to hide abuse, but also, because what is essentially the same asset will end up in different buckets based on how it is constructed, neither agency will be able to readily amass this position and exposure information.

One last thought, based on my experience in risk management. Risk managers have the unfortunate tendency of fighting last year’s war, of developing tools and reports to prevent the crises that just occurred from happening again. Of course, the next crisis almost always comes from a different direction. To some extent, the financial legislation has a similar tendency. For example, much thought has been given to credit default swaps. It is likely, however, that the next major issue will spring from a new financial innovation. The nature of the markets is to exploit weaknesses and to find ways to work around regulation and other constraints. Because legislation can only address what has happened in the past and what is currently expected to occur in the future, the legislation must give the regulators the flexibility to address the unanticipated.

Tuesday, June 15, 2010

CVA desks and sovereign CDS spreads

The Bank of England's most recent Quarterly Bulletin has a nice little box on the impact of dealer CVA (counterparty valuation adjustment) desks influence the spreads on sovereign credit default swaps (CDSs):
Increased use of derivatives by financial institutions during the past couple of decades, together with a general consolidation of the international banking system has led to a structural reorganisation in the way large banks manage counterparty risk. Specifically, many banks have set up specialist trading units to measure and hedge counterparty credit risk, known as counterparty valuation adjustment (CVA) desks. This box explains the activities of CVA desks and how they may influence financial markets; particularly the market for credit default swaps (CDS).

A commercial bank’s CVA desk centralises the institution’s control of counterparty risks by managing counterparty exposures incurred by other parts of the bank. For example, a CVA desk typically manages the counterparty risk resulting from a derivative transaction with another financial institution (such as entering an interest rate swap agreement).

CVA desks’ hedging of derivatives exposures In a derivative transaction, a bank may incur a loss if its counterparty defaults. Specifically, if the bank’s derivative position has a positive marked-to-market (MTM) value (calculated for the remaining life of the trade) when the counterparty defaults this is the bank’s ‘expected positive exposure’. These potential losses are asymmetric. If the value of a bank’s derivative position increases (ie the bank is likely to be owed money by its counterparty), the potential loss in the event of default of the counterparty will rise. In contrast, if the value of the bank’s derivative position falls such that it is more likely to owe its counterparty when the contract matures then the potential loss on the transaction is zero.

Having aggregated the risks, CVA desks often buy CDS contracts to gain protection against counterparty default. If liquid CDS contracts are not available for a particular counterparty, the desk may enter into an approximate hedge by purchasing credit protection via a CDS index and increase the fee charged to the trading desk to reflect the imperfect nature of the hedge. On occasion, when CDS contracts do not exist, CVA desks may try to short sell securities issued by the counterparty (ie borrow and then sell the securities) but this is rare.

Another way to mitigate counterparty risk is for parties to a derivative trade to exchange collateral when there are changes in the MTM value of the derivative contract. The terms of the collateral agreements between the counterparties (detailed in the credit support annex in the derivative documentation) include details such as frequency of remargining. Since MTM exposure for the bank is greatest if counterparties do not post collateral, CVA desks have reportedly been influential in promoting better risk management via tighter collateral agreements in order to reduce the CVA charge.

CVA activity and the sovereign CDS market

Against the background of heightened investor awareness of sovereign risk, the cost to insure against default on government bonds through CDS has risen recently. According to contacts, increased hedging by CVA desks has been an influential factor behind these moves.

Specifically, CVA desks of banks with large uncollateralised foreign exchange and interest rate swap positions with supranational or sovereign counterparties have reportedly been actively hedging those positions in sovereign CDS markets. For example, for dealers that have agreed to pay euros to counterparties and receive dollars, a depreciation in the euro will result in a MTM profit and hence a counterparty exposure that needs to be managed.

Given the relative illiquidity of sovereign CDS markets a sharp increase in demand from active investors can bid up the cost of sovereign CDS protection. CVA desks have come to account for a large proportion of trading in the sovereign CDS market and so their hedging activity has reportedly been a factor pushing prices away from levels solely reflecting the underlying probability of sovereign default.

Monday, June 14, 2010

SIFMA Offers Guidance to Enhance Regulators’ Ability to Protect Against Systemic Risk

New York, NY, June 14, 2010—The Securities Industry and Financial Markets Association (SIFMA) today released the results of a study intended to assist regulators and policymakers in preparing for expanded systemic risk oversight and enhance their ability to respond to potential future systemic risk events. The guidance is aimed at supporting the financial industry's efforts to foster financial stability and accommodate the information needs of a systemic risk regulator. SIFMA believes developing the right information structure for tracking systemic risk can play a major role in the ability of the firms and regulators to identify and address potential problems before they escalate.

“SIFMA strongly supports the creation of a tough, competent systemic risk regulator to oversee systemically important firms so that the activities of one or a few firms will not threaten the stability of the entire financial system,” said Tim Ryan, SIFMA president and CEO. “With this study, we offer important insights into the development of a systemic risk regulation regime, which we hope will be useful to the regulatory community as it works to expand its monitoring of systemic risk and better understand the inter-connected risks between systemically important institutions.”

Produced together with Deloitte & Touche, the Systemic Risk Information Study is based on interviews with 22 organizations, including regulators, commercial and investment banks, insurers, hedge funds, exchanges, and industry utilities. The interviews focused on how the interviewees defined and/or viewed systemic risk, then specifically identified what type of information and data regulators would require from large, interconnected financial institutions to effectively monitor systemic risks. Systemic risks are developments that threaten the stability of the financial system as a whole and consequently the broader economy, not just that of one or two institutions.

Among the study’s major findings:

  • The study highlights eight different potential systemic risk information approaches which a regulator could use in to monitor and understand potential systemic risks.
  • There is not a single ideal approach, and the various approaches may work best in concert, complementing their different strengths and weaknesses. Some are better at understanding certain drivers of systemic risks, while others are easier to aggregate across firms and products.
  • The information approaches vary considerably in their structure and the granularity of information which is provided to the regulator. Some take a top down approach, while others are bottoms up. There were varied opinions as to which would be the most effective. They also vary in the resources necessary, including personnel and technology to provide and analyze data that a regulator would require.
  • Where possible, systemic risk regulation can be more effective by drawing on resources which already exist in the system, either in current regulatory filings or in firms’ own risk and information systems and leveraging infrastructure and repositories of data.
  • Significant concerns were expressed that a focus on granular position level data may cause the systemic risk regulator to be looking at the wrong “altitude” of information, which may hinder the ability of the systemic risk regulator to focus on the relevant build-up of systemic risks.
  • Reporting structures should reflect the difference between normal times when periodic reporting can provide information about latent problems, and periods of market stress when frequent reporting is valuable in understanding an unfolding shock.
  • Systemic risk regulation should recognize the importance of capturing information on macroprudential risks which threaten the stability of the system as a whole; current regulation has a microprudential focus looking mainly at the stability of individual firms.

The study also looks at current reporting metrics and compares what is currently reported with the data firms and regulators thought would be needed to better understand and monitor systemic risks, thus identifying key gaps in current reporting systems. Current reporting metrics focus on the soundness of individual firms and do not effectively capture all of the drivers of broader sources of risk, but they do capture parts of the information needed to monitor systemic risk.

The study reports that systemic risk builds up over time, influenced by drivers which are distinct from factors which create risk in individual firms. Interview subjects discussed the drivers of systemic risk, as understanding these drivers is critical to designing ways to track and monitor risk. Major drivers which were identified include: firm size, interconnectedness, liquidity, concentration, correlation, tight coupling, herding behavior, crowded trades, and leverage.

The full study is available on SIFMA’s website at

EC Publishes Recommendations on Derivatives and Market Infrastructure

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

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

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

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

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

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

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

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

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

  • Mandatory clearing of all "standardised" OTC derivatives;

  • Mandatory reporting of all OTC derivatives to trade repositories;

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

  • More transparency through reporting to trade repositories.

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

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

Reducing counterparty credit risk by mandating CCP-clearing where possible

Increasing transparency by mandatory reporting to trade repositories

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

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

What are the main issues you are consulting on?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Annex – Glossary of key terms

For information purposes … not legally binding:

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

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

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

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

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

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

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

Thursday, June 10, 2010

MPAA, myriad interest groups lobby on financial regulation bill

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

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

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

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

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

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

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

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

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

Wednesday, June 9, 2010

Rick Bookstaber on Common Sense Crisis Risk Management

The catch is that "what protects you in a crisis is also what leaves money on the table pre-crisis... [and] the best trades... in the pre-crisis regime are the ones that cause the greatest losses in the crisis."
All days in a normal market seem the same, but when a crisis occurs, it seems as if we have never seen the likes of it before. But of course, we have seen it before, or at least some aspects of it. The cause might be different, the initial market from which it propagates might take us by surprise. But the path a crisis takes, at least in broad strokes, hardly differs from one case to the other.

We all know the limitations of standard risk management methods in dealing with times of market crisis. And we are starting to get a sense of what is needed beyond these methods in order to see a market crisis coming, things like understanding who is under pressure, what sorts of positions they hold (and thus might be forced to liquidate) and who else is holding those positions (and thus who might get caught up in the propagation of the forced selling).

Common Sense about Market Crisis
Unfortunately, although we can hope that this sort of information will end up with those regulating the markets, it is beyond the realm of anyone in the private sector. But here are a few common sense things we know about the way markets behave during a crisis:
  • Equities drop
  • Volatility goes up
  • Credit spreads widen
  • Correlations rise
  • Areas of low liquidity decline more than similar areas with high liquidity
  • The yield curve flattens
Volatility goes up because everyone is jumpy, so any new piece of information leads to a big reaction, and also because there are fewer people willing to step up as liquidity providers, so prices have to move more to elicit the other side of the trade.

Correlations rise because people don’t care much about the subtle characteristics of one instrument versus another. Everything is either high risk or low risk, high liquidity or low liquidity. I think of the market during a crisis like in high energy physics, where matter melds into a homogeneous plasma when the heat gets turned up.

Because liquidity becomes critical, the less liquid markets – emerging markets, low cap stocks and the like – take it on the chin more than their more liquid cousins.

(Oh, and what about gold? Sometimes it responds, sometimes it doesn't. There is nothing intrinsic about gold that makes it part of the crisis/no-crisis equation. If it is a flavor-of-the-month market, it will respond positively, otherwise, it will simply act like a commodity, responding to economics).

Knowing this, it is not hard to take steps to protect against a crisis. Just move away from equities, avoid being short volatility, stay away from credit-laden debt, focus on the liquid markets, and watch those carry trades. Also, don’t trust diversification, because those low correlations you are depending on will not be there when it matters.

Or, if you want to be more sophisticated about it, create a variance-covariance matrix predicated on these sorts of relationships, and be sure to add a constraint to your portfolio optimization so that you will not breach a specified risk level under this crisis-based matrix. For example, if your usual risk constraint is to keep you portfolio volatiliy below twelve percent, perhaps you also make sure it won’t be higher than thirty percent in the case of crisis. Or, because we know the direction of these market effects, to make life simpler you can add a simple scenario test, and not allow the portfolio to lose more than, say, ten percent in that scenario. Doing this will guard against the tendency to over-rely on diversification, over-lever or put too much exposure into the markets that are particularly sensitive to a crisis.

The problem with this advice is that it is exactly the opposite of what will make sense when the crisis has yet to emerge. More to the point, it is exactly the opposite of what makes money as the market is building into a crisis.

Before a crisis (I won’t say “during a bubble”):
  • Equities are rising
  • Volatility is low
  • Credit spreads are narrow
  • Correlations are low
  • The opportunities are in the hinterland markets of low liquidity
  • The yield curve is steep
Volatility is low because everything is so rosy. Any new piece of information is No Big Deal, and liquidity is swarming around the market, so prices barely have to move to get an order filled.

Correlations are low because, in an attempt to find value in when every portfolio manager, trader and dentist is spending his time combing the hills for value, the slightest difference between otherwise similar instruments is worth mining. And with the languid pace set by the low volatility and money sloshing over the sides, people have the luxury of spending time in fine-tuning.

With so much money flooding into the market (and so much money means so much leverage), people start to scan the landscape for the less known – and less liquid – markets to find value.

Regime-switching models of market crisis
People sometimes look at periods of market crisis in the context of a regime switching model. There are the normal times and then there are the crisis times. But what I am suggesting above is that there are (at least) three regimes. There are the crisis times, the normal times, and the pre-crisis times. The transition generally is not from normal to crisis, but rather from pre-crisis to crisis. And the move from the pre-crisis to the crisis regime is more gut-wrenching because in almost every dimension things are moving from one extreme to another.

The killer is that what protects you in a crisis is also what leaves money on the table pre-crisis. The best trades and market positions in the pre-crisis regime are the ones that cause the greatest losses in the crisis.