On the varieties of capital arbitrage June 19, 2012 at 7:10 am

There are only a few basic types of capital arbitrage trade. My first attempt at a taxonomy is:

  • The leveller. Here risk within the same category is treated unfairly, with some risk cheap or equitable, and some risk expensive. The leveller turns expensive risk into something cheaper.

    A typical example is the collateral swap. Say a counterparty has collateral which is good, but which doesn’t count for regulatory purposes. For a fee, that is swapped for something which does count. If the capital saving is sufficient, then the fee is worth paying even if the risk has not changed (or even has got worse).

  • The tranformer. Here something can be looked at in two different ways, with two different capital treatments. You turn the expensive one into the cheap one.

    A good example is doing a swap structured as a loan to avoid CVA capital.

  • The deconstructor. Here the parts of something are cheaper than the thing. Buy the thing and split it into parts. (The inverse trade, the constructor, is sometimes seen too.)

    CDO tranches fall into this category. The capital on the underlying assets in the CDO is often much smaller than that of all the tranches. If you own enough of the tranches, it can make sense to buy the rest and split the CDO apart.

  • The natural home. This is an arb between rules, where one set is expensive and the other is cheap (or non-existent).

    Most trades between banks and insurers fall into this category, as do banks offloading expensive risk, like CVA, onto hedge funds.

  • The label. Trades with a certain label are cheaper, so get the label.

    Ratings are the obvious example here: a ‘AAA’ rating might have been relatively easy to get, and it meant a lot in capital terms.

  • The offloader. The capital the market would want an off balance sheet entity holding the same risk to have is much less than the capital regulators require. Set up an SPV, deconsolidate it somehow, and move the risk into it.

    ABCP conduits were a good example of this trade.

This leads to DEM’s checklist of questions for capital optimizations groups. Suppose you have a position that you like, but that uses too much capital. What do you do?

  • Can we buy cheap protection that reduces capital dramatically?
  • Can we rebook the risk as a different, cheaper trade?
  • Can we split the trade into cheaper pieces, perhaps by buying or selling other parts of the structure?
  • Can we pay someone else to take the expensive risk?
  • Can we get a rating or some other indicator of quality that will improve capital?
  • Can we move the risk into an off balance sheet vehicle or otherwise retain most of the risks and rewards while getting it off the regulatory balance sheet?

Your thoughts and comments, especially any additions to the basic types, would as always be welcome.

3 Responses to “On the varieties of capital arbitrage”

  1. I suggest “The World Tour” – trades which are booked far away from where they were actually put together. This may be to exploit differences in the way that regulators interpret and enforce the supposedly harmonised rules. Rather than exploit differences between rulesets, they are exploiting differences between umpires.

    By the way: I think the name “transformer” is quite commonly used in the insurance world to denote an offshore SPV used to transfer insurance risk into capital markets risk (cat bonds) or derivatives risk (credit insurance -> CDS), so you might want to consider rearranging some of your terminology.

  2. CDS certainly seems like it has been exploited as insurance without the insurance regulation.

  3. Thanks JH – I like the world tour.

    I was aware of transformers. Indeed for my sins I even arranged a few of them. They do a similar thing though – transform CDS (trading book capital/fair value) into insurance (insurance capital and accounting). That was often both an accounting and a reg arb.