Brexit, arbitrage and CCPs

The week on Risk.net, June 24–30, 2016

BREXIT decision causes upheaval

ARBITRAGE warning leaves dealers guessing

CCP RESOLUTION crunch time in Europe

 

COMMENTARY: A leap in the dark

Political risk dominated the news last week as the UK voted to leave the European Union. Markets crashed, ratings were cut and uncertainty surrounded every aspect of financial risk management and regulation. The European Banking Authority came under criticism for failing to include a Brexit-type scenario in its stress tests earlier this year – banks were not asked to test capital adequacy against a market shock followed by a long period of slow growth, rendering the results ‘obsolete', some risk managers said.

The immediate market shock of the vote – following a week in which Remain had been leading the polls – triggered a fire sale of call options on emerging market ETFs, with at least one hedge fund suffering massive losses on its exposure to equity indexes and eurozone sovereign debt. Another shock came with the activation of 'Brexit clauses' to halt major property deals and credit valuation adjustment desks took losses as counterparty risk soared.

But while many market participants had their fingers burned, last-minute hedges by major banks may have helped alleviate the pain; some market-makers had  struggled earlier in the week to recycle the risk from client trades.

In the longer term, of course, the implications are anyone's guess. Though he had promised to start the two-year countdown to exit immediately after a Leave vote, UK prime minister David Cameron instead announced he would resign – but not until October – and leave the decision to his successor. EU leaders have been adamant negotiations cannot begin until the countdown has started; in the meantime, the UK, the EU and the financial markets of the rest of the world remain deep in uncertainty.

Passporting arrangements for access to the single market, the potential for an end to free movement of people from the EU to the UK, clearing of euro-denominated swaps, and trade relations between the UK and the rest of the world all remain to be resolved. Political risk and regulatory restructuring will continue to lead the agenda for months or years yet, and doubt has already been cast over the future of the Solvency II capital rules for insurers.

 

STAT OF THE WEEK

The final volume of iShares MSCI emerging market ETF call options traded on the day of the Brexit vote was at 639,846 lots, versus 103,174 lots for puts – compared with a 20-day average of 155,324 lots for calls and 171,831 for puts. The July 15 call at the $35.5 strike, which was changing hands for 46 cents on Thursday, was selling for 6 cents on Friday – an 86.96% loss – with 152,528 lots traded at that price

 

QUOTE OF THE WEEK

"If you walked on our floor at around 7am to 7.30am, it felt a little Lehman-esque in activity, size and shouting" – Frits Vogels, Icap


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