Category / Clearing and Collateral

A summer daydream, part 1 July 31, 2013 at 6:11 am

In a city park, perhaps in Brussels, perhaps in Washington, perhaps elsewhere, it is hot. A regulator named Alice lounges on a park bench on her day off. She feels the heat of the sun, and, exhausted by her labours, she falls asleep…

… when suddenly a White Rabbit with pink eyes ran close by her. There was nothing so very remarkable in that; nor did the regulator think it so very much out of the way to hear the Rabbit say to itself, ‘Oh dear! Oh dear! I shall be implementing late!’ (when she thought it over afterwards, it occurred to her that she ought to have wondered at this, but at the time it all seemed quite natural); but when the Rabbit actually took a draft regulation out of its waistcoat-pocket, and looked at it, and then hurried on, the regulator started to her feet, for it flashed across her mind that she had never before seen a rabbit with either a waistcoat-pocket, or a draft regulation to take out of it, and burning with curiosity, she ran across the field after it, and fortunately was just in time to see it pop down a large office door under the hedge.

In another moment down went Alice after it, never once considering how in the world she was to get out again.

When Alice got inside, it was all dark overhead; before her was a long passage, and the White Rabbit was still in sight, hurrying down it. There was not a moment to be lost: away went Alice like the wind, and was just in time to hear it say, as it turned a corner, ‘Oh my ears and whiskers, how late it’s getting!’

When she came near the Rabbit, she began, in a low, timid voice, ‘If you please, sir—’ The Rabbit started violently, dropped the regulation, and skurried away into the darkness as hard as he could go.

Alice picked up the document. “The Regulation on Central Counterparty Central Counterparties” it was titled. “At the September 2009 summit in Pittsburgh, G20 leaders agreed that all standardised OTC derivative contracts should be cleared through a central counterparty (CCP) by the end of 2012. However, there are now a multiplicity of CCPs, and information concerning them is usually only available to the contracting parties. CCP interoperations threaten to increase counterparty credit risk, interconnection and market fragmentation. Just as CCPs are the solution to these problems in the bilateral OTC derivatives market, so central counterparty central counterparties (CCPCCPs) are the solution to CCP interoperation. This regulation sets standards for CCPCCPs. Moreover, as incentives to promote the use of CCPCCPs have not proven to be sufficient to ensure that intra-CCP exposures are in fact cleared centrally, mandatory CCPCCP clearing requirements for those CCP exposures that can be cleared centrally are therefore necessary.”

Curiouser and curiouser thought Alice.

To be continued…

That baby July 23, 2013 at 8:47 am

Given that the news seems to be wall-to-wall royal baby, can I suggest that we call it ‘Rehypothecation’?

Update… talking of which, Bloomberg reports that One in three financial institutions would accept “low-quality, complex and opaque” collateral to back trades provided that it’s “cheap,” according to a survey from SIX group. Clearly they caught the other two thirds on a good day…

The ECB attempts to revive the European ABS market July 18, 2013 at 12:26 pm

The ECB is reducing the haircut on ABS to 10 percent from 16 percent. At the same time, it is tightening rules for retained covered bonds so the total effect on eligible collateral will be “overall neutral,” it claims. In particular they are targeting SME-backed ABS:

The ECB will continue to investigate how to catalyse recent initiatives by European institutions to improve funding conditions for Small and Medium-sized Enterprises (SMEs), in particular as regards the possible acceptance of SME linked ABS guaranteed mezzanine tranches as Eurosystem collateral in line with established guarantee policies.

This is deeply unfair, but given the quality of the song, I can’t resist ending with:

When too low is not enough July 8, 2013 at 12:06 pm

Unicredit’s Jean-Pierre Mustier, quoted in the FT, says

We’re moving from a set-up where banks were interconnected, because they had transactions between them, to a system where very lowly capitalised entities, the clearing houses, are supposed to protect the banks from a problem.

What to do? Well, the `finance director of a leading global bank’ (who?) suggests:

Current capital levels [at clearing houses] may be insufficient.

(HT Lisa at Alphaville for story.)

Once, twice, three times a columnist July 6, 2013 at 11:08 pm

Three good ones from Matt Levine when I was away:

  1. Why Blackrock wants corporates to reopen bonds rather than issue new ones, and why they probably shouldn’t, here.
  2. Shock, horror, exchanges want people to trade on exchange, here.
  3. That antitrust case, here. Footnote 3 in particular amused me. Yes, I read footnotes in out of date blog posts. So sue me.

Do high haircuts intensify crash risk? June 12, 2013 at 8:11 pm

I heard an interesting idea today. I’m not sure I buy it, but it does have a sheen of plausibility:

High collateral haircuts increase the risk of large price falls if the collateral is sold.

Here’s why: after default, the collateral holder has no incentive to liquidate the asset for less than the loan amount. If the loan amount is low vs. the market value, they can afford to sell at any old price, because they are still protected. Thus a collateral holder with a 5% haircut can sell at 95, while one with only a 2% haircut will try to manage their liquidation to get at least 98. The higher the haircut, the less the holder of the collateral cares about orderly liquidation, in other words, and so the more likely they are to contribute to crushing the collateral price.

SEFbitrage May 26, 2013 at 9:43 am

Single Dealer Platforms asks a good question: Has CFTC given too much power to SEFs?

… swaps that are subject to clearing, will be required to trade on a SEF or DCM, except where no SEF or DCM makes the swap ‘available to trade’… the SEF or DCM can ‘self determine’ that the swap is available to trade on their platform, and submit that determination to the CFTC.

So that’s really cool. I’m a SEF and I want to make money. I make money by forming a market in things. More things, more money. And if I offer more things, market participants have to use me (or someone like me), providing I can justify to the CFTC with a straightish face why there is enough liquidity in the product to justify trading it on my SEF.

The defaulter does not pays without CVA May 14, 2013 at 9:16 am

The slogan ‘defaulter pays’ is often used of collateral and other credit support arrangements. It’s seductive: after all, shouldn’t the defaulter pay for the damage their default might do to another party? Yes they should – but they don’t. Instead, as Mark Roe points out in a new article (although the point is hardly new), it is the unsecured creditors of the defaulter’s estate who pay. Taking collateral from someone removes it from their estate upon bankruptcy (if you have done it right, anyway): you get paid, which means that someone else doesn’t. In this sense, CVA has its attractions, in that by paying for credit cost up front, as part of the trade price, the defaulter really is paying as part of their ongoing business: that cost is charged to shareholders as it is incurred. By posting collateral, the company doesn’t pay now, and hence its revenues are higher. Instead, if it defaults, a smaller pool of funds is available to pay creditors. ‘Defaulter’s unsecured creditors pay’ is a less catchy slogan, but it is closer to the truth of financial collateral.

EMIR for corporates May 8, 2013 at 8:03 pm

Herbert Smith has a nice summary here (HT the OTC space). What I for one had not realized is that from September 2013, EU parties with more than 500 trades, of whatever status, must establish procedures for Portfolio Reconciliation and they must at least semi-annually consider Portfolio Compression and provide valid explanations if they choose not to engage in it.

The missing futures data repository April 19, 2013 at 10:03 am

While we can clearly agree that Bloomberg has a dog in the futures vs. swaps fight, that does not necessarily mean that all of their comments are wrong. Here for instance is an interesting observation by Bloomberg CEO Daniel Doctoroff in the Huffington Post:

Congress mandated that swap transactions be reported to a “Swap Data Repository” that regulators can monitor to conduct real-time market surveillance and that the public can access immediately and for free. Nothing comparable exists in the futures market. There is no “Futures Data Repository,” and no real-time public reporting of futures data, which means that the public will no longer have the access to market data that it was supposed to have under Title VII. This also creates a firewall between the markets and regulators, denying them access to the real-time trading data they need to determine whether speculators are manipulating the energy markets.

Thank you Bloomberg April 17, 2013 at 6:13 pm

In a move that will at very least make life more interesting, Bloomberg has done as it threatened and sued the CFTC. Their bone of contention is the so-called margin period of risk on OTC derivatives vs. futures. As the FT reports:

Bloomberg objects to how the CFTC has set different margin rules, that favour swap futures at the expense of OTC swaps, arguing that they are similar financial products with the same risk profile for investors.

The CFTC has set minimum margin collateral that can cover five days of possible losses for cleared financial swaps, while margin for futures contracts traded on exchanges presently covers the risks of one to two days of losses.

In other words, swap futures are economically (very nearly) identical to swaps, but have roughly half the margin – and that, Bloomberg suggests, is wrong. The FT quotes their lawyer, Eugene Scalia, as saying “It’s a basic legal principle that similar matters should be treated in similar ways.” Watching the CFTC try to defend this one is going to be fascinating.

You don’t have to clear intergroup trades in the US April 2, 2013 at 7:25 pm

So say the CFTC, according to Bloomberg:

Commissioners approved a rule excluding inter-affiliate trades from requirements that swaps be guaranteed at clearinghouses that protect buyers and sellers against defaults, the CFTC said yesterday.. “The rule requires documentation of such exempted swaps, centralized risk management and reporting requirements for such swaps,” CFTC Chairman Gary Gensler said in a statement.

Closing out Kweku March 28, 2013 at 8:03 pm

Reuters, in between telling a interesting story of the impact of Kweku Adoboli’s losses on UBS, gives us some insightful information on the close out of his position:

The call that would eventually spell the end for [UBS boss Oswald] Gruebel came at 4 p.m. on Wednesday, September 14… [Gruebel] ordered a small taskforce — dubbed “Project Bronze” by those involved — to immediately close Adoboli’s open positions…

The Swiss stock exchange had to be informed by 7.30 a.m. With two-thirds of Adoboli’s open positions closed out overnight, the scale of the losses was clear and executives agreed they would have to say something…

Bankers said Adoboli’s positions were completely closed out by Friday lunchtime.

That would be a little less than two days, then, to get out of exchange traded positions (including ETFs).

Credit index futures ahoy March 22, 2013 at 7:11 am

Continuing the OTC derivatives futurisation trend, ICE announced this week that it will introduce credit index futures in May on the CDX IG, CDX HY, iTraxx main and iTraxx cross-over. Anyone care to take a bet on how much volume will be in futurised swaps vs. cleared OTCs this time next year?

Meanwhile in another part of the forest March 13, 2013 at 6:29 am

First, IntercontinentalExchange said it will launch credit-default swap futures in May.

Second (and as an update from an earlier version of this post), Bloomberg threatened to sue the CFTC unless it halts regulations setting higher collateral standards for swaps than comparable futures:

Bloomberg LP, the parent company of Bloomberg News, said the collateral rules are arbitrary and harm its plans to operate a swap-execution facility, according to a news release and letter yesterday from Eugene Scalia, partner at Gibson Dunn & Crutcher LLP.

Swaps that are converted to futures will “automatically be subject to a lower minimum liquidation time, which in turn will result in more favorable margin treatment,” Scalia said in the letter to the Commodity Futures Trading Commission. The different standards will drive business away from Bloomberg’s swap-execution facility, Scalia said.

The CFTC should stay the regulations, which set a five-day liquidation requirement for financial swaps compared with a one- day period for futures, Scalia said. He requested a response from the CFTC by March 19.

And so it begins March 12, 2013 at 9:13 am

The CFTC has announced that mandatory clearing begins today
(well actually yesterday as I am out of town and got to this a day late).

The requirement applies to new and notated swaps which fall within the CFTC’s clearing mandate.

Quick links March 7, 2013 at 11:36 pm

I’m a little busy, so this will be short form:

  • Jon Danielsson has a piece on VoxEU about the desirability of diversity in capital models. I don’t agree – I think we need fewer models used for capital purposes – but the argument is interesting.
  • There’s a (sadly firewalled) opinion piece by De Larosière on about the tradeoff between bank regulation and economic growth. Unsurprising, he comes down on the side of too much regulation (in places) and too little growth.
  • LSE/LCH looks to be nearly done.
  • Scott O’Malia is not happy about the CFTC approving CME’s trade repository.
  • There is an effort to repeal the swaps pushout provision (section 716) of Dodd Frank. It is early days, but this may come to something.
  • And finally… the corporate CVA exemption is apparently still in the near-final text of CRD IV. if you know what that somewhat opaque sentence means, then you will likely cheer: if you don’t, err, sorry, try here.

I will try to get to the RBS breakup news tomorrow.

Bart no like, bad medicine March 5, 2013 at 6:08 am

I’m a little late with this, but it is interesting. Bart Chilton, CFTC Commissioner, on the futurisation of the swaps market:

while I’m interested in hearing the concerns about futurization, I am more concerned about, a silent creeper. That is, the “swapification” of the futures markets. Specifically, I’m concerned that the conversion of certain standardized cleared swaps will be under-regulated–under-regulated–in the futures markets. It may be block rules or something else, but we need to be cautious about converting certain swaps to futures in an attempt to export the deregulated, opaque swaps trading model to these new futures markets. Let’s be cautious about allowing lax oversight of these futures contracts, regardless of how they were treated before they were futurized.

What did Lehman’s Eurosystem collateral turn out to be worth? February 25, 2013 at 10:07 am

From the Bundesbank:

Frankfurt-based Lehman Brothers Bankhaus AG settled its monetary policy transactions with the Eurosystem via the Bundesbank… In September 2008 … liabilities vis-à-vis the Bundesbank stood at €8.5 billion. These liabilities originated exclusively from monetary policy refinancing operations, for which LBB had pledged a total of 33 securities, chiefly highly complex instruments… Since autumn 2008 the Bundesbank has gradually resolved the pledged securities, in some cases having to restructure them. In 2012, Diversity and Excalibur*, the two largest positions in the LBB collateral portfolio, were sold, amongst other assets. The process of winding down the pledged securities is now complete.

The situation after more than four years of resolving collateral is as follows. With proceeds from sales as well as interest and redemption payments totalling €7.4 billion.

In other words, LBB’s collateral turned out to be worth 84 cents on the dollar, after accounting for haircuts; and it took four years to get that much.

*Diversity and Excalibur where European CMBS deals. See here and here for further details.

That Stein speech February 11, 2013 at 9:42 am

The recent speech by Jeremy Stein received a lot of attention for its suggestion that monetary tools might be used in addressing credit market-overheating. That is an interesting argument, but I don’t want to deal with that today. Rather, I want to look at Stein’s comments on collateral transformation:

Collateral transformation is best explained with an example. Imagine an insurance company that wants to engage in a derivatives transaction. To do so, it is required to post collateral with a clearinghouse, and, because the clearinghouse has high standards, the collateral must be “pristine”–that is, it has to be in the form of Treasury securities. However, the insurance company doesn’t have any unencumbered Treasury securities available–all it has in unencumbered form are some junk bonds. Here is where the collateral swap comes in. The insurance company might approach a broker-dealer and engage in what is effectively a two-way repo transaction, whereby it gives the dealer its junk bonds as collateral, borrows the Treasury securities, and agrees to unwind the transaction at some point in the future. Now the insurance company can go ahead and pledge the borrowed Treasury securities as collateral for its derivatives trade.

Of course, the dealer may not have the spare Treasury securities on hand, and so, to obtain them, it may have to engage in the mirror-image transaction with a third party that does–say, a pension fund. Thus, the dealer would, in a second leg, use the junk bonds as collateral to borrow Treasury securities from the pension fund. And why would the pension fund see this transaction as beneficial? Tying back to the theme of reaching for yield, perhaps it is looking to goose its reported returns with the securities-lending income without changing the holdings it reports on its balance sheet.

There are two points worth noting about these transactions. First, they reproduce some of the same unwind risks that would exist had the clearinghouse lowered its own collateral standards in the first place. To see this point, observe that if the junk bonds fall in value, the insurance company will face a margin call on its collateral swap with the dealer. It will therefore have to scale back this swap, which in turn will force it to partially unwind its derivatives trade–just as would happen if it had posted the junk bonds directly to the clearinghouse. Second, the transaction creates additional counterparty exposures–the exposures between the insurance company and the dealer, and between the dealer and the pension fund.

What this makes clear is that high collateral quality thresholds can be deeply unproductive, in that they encourage collateral transformation activities without enhancing safety. Equity markets professionals have long been used to the idea that low quality highly volatile assets often make good collateral providing that the haircut is big enough (and there isn’t substantial jump risk). That is surely right. Low quality assets can be a lot safer than high quality ones in that their haircuts are less procyclical: they are always big. I’d much rather post 200% of the value of my exposure as BBB bonds and know the haircut was highly unlikely to ever be more than 50% than post 105% of AAAs with the risk that my haircut quadruples at the first sign of trouble. (Assuming good segregation and bankruptcy remoteness of the overcollateralisation anyway.)