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 http://www.sifma.org/regulatory/pdf/SIFMA_Systemic_Risk_Information_Study_June_2010.pdf

EC Publishes Recommendations on Derivatives and Market Infrastructure

The purpose of the document (which can be downloaded here: http://ec.europa.eu/internal_market/consultations/2010/derivatives_en.htm) is to obtain information from Member States, market participants and other stakeholders on the measures aimed at enhancing the resilience of derivatives markets and market infrastructures.

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

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

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

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

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

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

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

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

  • Mandatory clearing of all "standardised" OTC derivatives;

  • Mandatory reporting of all OTC derivatives to trade repositories;

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

  • More transparency through reporting to trade repositories.

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

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

Reducing counterparty credit risk by mandating CCP-clearing where possible

Increasing transparency by mandatory reporting to trade repositories

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

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

What are the main issues you are consulting on?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Annex – Glossary of key terms

For information purposes … not legally binding:

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

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

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

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

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

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

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

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.

Friday, June 4, 2010

Pay the rating agencies according to results

A new idea from Larry Harris (former SEC chief economist) in an article posted in the Financial Times:

The best solution must address the fundamental problem with ratings: we do not know how good ratings are on average until bonds mature or default. The solution thus must depend on future performance.

An effective solution to the ratings problem would make the profits that rating agencies earn depend on how the bonds they rate perform. Credit agency profits should rise if bonds they rate as investment grade perform well and fall if such bonds default more often than expected.

Credit rating agencies could create this contingent compensation scheme by putting a meaningful portion of their fees into escrow. The custodian of these funds eventually would return them to the agencies if their ratings performed well.

To fund their operations, the rating agencies could borrow against these escrowed funds, using their future contingent payments as collateral. The lenders then would rate the raters instead of the government. The SEC could create this system simply by requiring that rating agencies opt in if they want the NRSRO designation. The SEC would then only need to determine whether the deferred contingent compensation schemes used by each credit agency provided meaningful incentives to produce well-researched and unbiased ratings.

Finally, the SEC should require disclosure of these deferred contingent compensation schemes, so that investors can decide for themselves which schemes provide adequate incentives to rate securities well. The proposal outlined here allows the power, creativity and wisdom of the free market to produce the best solution.

Wednesday, June 2, 2010

Commission proposes improved EU supervision of Credit Rating Agencies

As part of its work on preventing a future financial crisis and strengthening the financial system, the European Commission has today put forward amendments to the EU rules on Credit Rating Agencies (CRAs). Furthermore, in order to advance swiftly in completing the necessary reforms... the Commission has adopted a more general Communication where it commits itself to table the remaining financial reform proposals in the next six to nine months from now. Following discussion and hopefully strong support from all heads of State and government at the forthcoming European Council, the Commission will present all these proposals – together with its recent ideas on bank resolution funds (see IP/10/610) – at the G-20 Summit in Toronto on 26-27 June 2010. On CRAs, the Commission has two main objectives: ensuring efficient and centralised supervision at European level, and increased transparency on the entities requesting the ratings so that all agencies have access to the same information. These changes would improve supervision, increase competition in the CRA market and improve investor protection.

Internal Market and Services Commissioner Michel Barnier said: "The changes to rules on Credit Rating Agencies will mean better supervision and increased transparency in this crucial sector. But they are only a first step. We are looking at this market in more detail."

As rating services are not linked to a particular territory and the ratings issued by a CRA can be used by financial institutions all around Europe, the Commission is proposing a more centralised system for supervision of Credit Rating Agencies at EU level. Heads of State and government had called the Commission to come forward with proposals on this in June 2009.

Under the proposed changes, the new European supervisory authority – the European Securities and Markets Authority (ESMA, see IP/09/1347) – would be entrusted with exclusive supervision powers over CRAs registered in the EU. This would include also the European subsidiaries of well-known CRAs such as Fitch, Moody's and Standard & Poor's.

It would have powers to request information, to launch investigations, and to perform on-site inspections. Issuers of structured finance instruments such as credit institutions, banks and investment firms will also have to provide all other interested CRAs with access to the information they give to their own CRA, in order to enable them to issue unsolicited ratings.

These changes mean that CRAs would operate in a much simpler supervisory environment than the existing varied national environments and would have easier access to the information they need. Users of ratings would also be better protected as a result of centralised EU supervision of all CRAs and increased competition among CRAs.

The Commission's proposal, which amends Regulation 1060/2009, will now pass to the EU Council of Ministers and the European Parliament for consideration. If adopted, the new rules would be expected to come into force during 2011.

Background: CRAs issue opinions on the creditworthiness of companies, governments and sophisticated financial products. They contributed to the financial crisis by underestimating the risk that the issuers of certain more complicated financial instruments might not repay their debts. In response to the need to restore market confidence and increase investor protection, the Commission put forward new EU-wide rules that put in place a common regulatory regime for the issuance of credit ratings. Under these rules, which will become fully applicable in December 2010 (see IP/09/629), all CRAs that would like their credit ratings to be used in the EU now need to apply for registration. Registrations open this month. The risks of conflicts of interest affecting ratings are also addressed (for example, a CRA cannot also offer consultancy services) CRAs will need to be more transparent as they will need to disclose the methodology and internal models and key rating assumptions they use to make their ratings. This should allow investors to perform better their due diligence.