Review of 2013: Grave new world

Clearing, execution, reporting – three elements of the reforms agreed by the Group of 20 nations in 2009 are now a reality in the US, but if the industry made it look easy to start using central counterparties (CCPs), the long-awaited arrival of swap execution facilities (Sefs) more than made up for it. Platforms were caught out by the now-infamous footnote 88, which radically expanded the scope of the rules, and all participants struggled to work out how and whether clearing could be guaranteed at the point of execution.

In the prudential regulatory space, rules are still taking shape – by the end of the year, regulators hope to finalise the Basel III leverage ratio, for example, and there are a host of other, lesser rules still being drafted.

If non-banks ever wondered why they should care about all of this, they found out in May and June, when fixed-income markets sold off dramatically. In the weeks and months that followed, dealers and buy-side firms claimed this was a preview of a grim new reality – one in which regulatory constraints prevent them warehousing risk, resulting in prices that fall further and faster than expected. As interest rates rise in the coming months or years, and investors attempt to exit huge bond portfolios, that prediction will be tested.

“The market completely dislocated...”

It really shouldn't trade negative - it doesn't make sense

Critics of post-crisis regulation often argue the new regime will come with a hidden price tag – less liquidity, more volatility and higher costs for all participants. Weird, violent moves in three unrelated markets this year may have been the canary in the coalmine. 

It started in equity markets at the end of 2012, when a big roll of Eurostoxx 50 futures sent the implied equity repo rate sharply negative, breaking out of the 10-basis point range it had occupied since 2006. And it kept falling until the third quarter, hitting unprecedented depths amid rumours of huge losses at one dealer – exotics and structured products desks have a natural long repo exposure, and some banks left this unhedged, given its previous stability. 

Explanations for the move differ, but one popular theory is that the market’s self-regulating mechanism has broken – ordinarily, delta-one desks would have brought the rate back into line by selling futures and buying baskets of stocks, but regulation-driven inventory limits prevented it.

Then, in May, three-month Euribor futures started yielding less than corresponding forward-rate agreements (FRAs). It was a marginal and short-lived aberration, but one that should be impossible – FRAs and futures do similar things but have different payouts, which until this year had been reflected in a higher implied yield for the future. Again, there were competing explanations, but one is that central clearing has changed the economics of the FRA market. 

Later in the same month, the chairman of the Federal Reserve Bank gently suggested it might possibly start thinking about not buying quite as much debt each month. The markets went bananas. Yields on 10-year US Treasury bonds rose more than 200 basis points in a matter of weeks, with equally dramatic moves seen in high-yield and emerging market bonds. Some traders saw this as a natural and proportionate reaction to the Fed’s comments. Others said it was a shocking over-reaction. 

One thesis quickly rose to prominence: capital-constrained market-makers had been unable to warehouse client positions in the sizes they used to, so prices moved further and faster than many expected. The topic remains divisive, but its adherents warn the episode was just a taster for what’s to come when the Fed actually hikes rates. With that in mind, the UK’s Financial Conduct Authority (FCA) started quietly asking macro hedge funds about their exposure to rising rates – a story Risk broke in September. 

“It was extreme – the market completely dislocated. I’ve been doing this for more than 10 years and I have never seen moves like this across all the major indexes” 

One head of delta-one trading at a European bank 

(Risk August 2013, pages 22–24). 

“It really shouldn’t trade negative – it doesn’t make sense” 

Hjalte Gloerfelt-Tarp, head of euro swaps trading at Danske Bank 

(Risk July 2013, pages 18–20)

“The only reason I allowed us to carry that position is that, in my mind, you should be able to blow out of it in basically a day,
or even an hour for that kind of size. But the reality was it took
us a month” 

Senior trader at a large US hedge fund

“We’ve just had a 30-second trailer for the full movie” 

Head of rates distribution at one UK bank

“When you start looking at the size of the institutional market and daily turnover as a function of the dealer balance sheet, you get some pretty horrific stats” 

Richard Prager, head of trading and liquidity strategies at BlackRock

“There is no-one to be a governor in terms of any kind of market volatility that’s there. That role we had is no longer our role. We’re increasingly going to see outsized moves on very, very little volume, with no ability to stand in the way” 

Head of fixed income, European bank 

(Risk August 2013, pages 12–17)

“The FCA requested some information from some hedge funds during the summer. As part of that, we asked about their preparedness for changes to interest rates” 

FCA spokesman 

(Risk October 2013, page 8)

Clearing: the end of the beginning

For many US participants in over-the-counter derivatives markets, 2013 was punctuated by a series of big compliance deadlines – with a major one falling on March 11, when mandatory clearing came into force for swap dealers, active funds and major swap participants. 

Despite some last-minute craziness, the first deadline came and went smoothly. Fears turned quickly to the far bigger June 10 clearing deadline, when hundreds, or possibly thousands, of firms would become subject to the regime. That was also a success – although not an unqualified one. Smaller derivatives users, including regional banks, said they were struggling to sign up a futures commission merchant (FCM) and get access to a CCP, but opinions were divided on whether this was the fault of the clients, the FCMs, or the middleware.

By the time the third deadline arrived, the market had seen it all before – attention had already switched to the impending start of trading on Sefs, which proved to be messier than anyone had anticipated.

“A lot of firms won’t be ready, and even if they are ready, they may not be fully tuned in to what they need to actually do. For want of a better expression, I’m afraid it is going to be amateur hour” 

Chief operating officer at one large hedge fund

“When I was in the army, we used to say that hope is not a method. Well, as far as central clearing is concerned – unfortunately – hope is now a method” 

Neil Orechiwsky, managing director of capital markets, Susquehanna Bank 

(Risk June 2013, pages 48–50)

“If firms have been looking for an FCM and haven’t found one, then perhaps they haven’t looked hard enough” 

Steve Scalzo, head of OTC clearing at Nomura

“I wasn’t even in the office. It was a non-event” 

Head of clearing at a US FCM, talking about the third clearing mandate 

(Risk October 2013, pages 36–37)

Active funds and major swap participants

As the clock counted down to the start of mandatory clearing in the US, it was not clear who would be affected – swap dealers identified themselves via a public registration process, but the other two groups to go first were cloaked in mystery. Which firms would be defined as active funds? How many of the impressive-sounding major swap participants (MSPs) would there be? 

Risk shed some light on the first question by publishing a leaked list of 77 active funds – prompting some firms to complain to the curator of the list, Markit. A number of funds, it emerged, had incorrectly classified themselves. The answer to the second question was “two” and both MSPs – monoline insurers that were winding down their derivatives books – turned out to be a lot less major than the name suggests.

“We have received numerous calls from concerned clients about their data not being held confidential. If this concern becomes widespread, it could hinder further adoption of Isda Amend and push clients towards a paper solution, adding to your operational burden” 

Email from Markit 

(Risk March 2013, page 7)

“We registered because our interpretation of the rules is such that we believe we are required to do so given our legacy CDS portfolio. But we haven’t written any new derivatives in over five years and have no intention of doing so going forward” 

MBIA spokesman 

(Risk April 2013, page 7)

Goldman’s OIS gold rush

It’s not every day the pricing orthodoxy for an entire financial market changes, so when dealers started switching to collateral-based discounting in 2008 and 2009, it caused mass confusion. It also unlocked trading opportunities that made some banks a killing, notably Goldman Sachs. Based on interviews with five former Goldman traders, Risk told that story in June – it became our biggest story of the year.

Goldman had started preparing operationally for the switch in 2005, and it gave it a huge advantage during the crisis, when Libor diverged from the overnight indexed swap (OIS) rates that set what one counterparty will pay another on cash collateral. Trades valued using the technically correct OIS rate would have a much higher present value than those valued using Libor – then the industry standard – so Goldman started positioning its books to benefit. The bank also spotted the value of collateral agreements that allowed a counterparty to post a range of different currencies, each implying a different discount rate. It sought to strip this optionality from some agreements to protect itself from having to pay a higher rate, and also managed to step into trades in which it would be posting cheap collateral to one party, while receiving more valuable collateral from another.

Other banks soon caught on, unleashing an industry-wide game of beggar thy neighbour – the result was a theoretically sound approach to pricing, but also a surge in disputes, stand-offs and squabbling. Some of the bad blood remains today. So, how much did Goldman Sachs make? Its rivals reckon as much as $1 billion. Its traders are – still – keeping their cards close to their chest. 

“I wouldn’t want to understate the profitability of this enterprise” 

Former Goldman Sachs swaps trader

“It was a very tense few years, and there was an awful lot of stuff going on. It had a Wild West-type feel, and it was breaking new ground. With hindsight, they were fantastic times. I learned more in those
two years than in the previous 10 years of my career” 

Swaps trader at an international bank

“Once you realised that euro was the cheapest-to-deliver collateral, it became completely obvious that you could optimise collateral posting so as to lock in the funding bases, and start moving your collateral around en masse” 

Satya Pemmaraju, founding partner, Droit Financial Technologies

“We certainly had some issues with Goldman. When we were trying to unwind, we were seeing a much lower value from them, and they told us they were charging for the optionality… To this day, we don’t trade with them” 

Derivatives trader at a US insurer

“We were doing the right thing; we were pricing the trade, to the best of our knowledge, in the correct way” 

Former Goldman Sachs trader

“Every other bank I know wishes they could have done exactly the same. I have the utmost respect for them. And they did us all a favour in the end – you just had to make sure you weren’t lunch” 

Head of fixed income at an international bank in London 

(Risk June 2013, pages 14–19) 

Securitisation: dead again?

It took Europe’s securitisation market a long time to climb out of the post-crisis frying pan. This year, facing new exposure limits, as well as revamped capital requirements – the modified supervisory formula approach (MSFA) – it found itself in the fire. 

Banks blamed the US subprime trauma for the capital rules – which abandon the principle of capital neutrality, potentially meaning the securitised debt would be more expensive to hold than the underlying assets. But the exposure limits, promulgated by the European Banking Authority (EBA), were similarly punishing. 

The big question for 2014 is whether European policy-makers will douse the flames. Officials including the European Central Bank’s Mario Draghi talked this year about using securitisation to underpin credit growth in the region. 

“When the MSFA paper came out, we were working on an absolutely vanilla deal, so I put the formula into my model. It tripled the capital of the unsecuritised pool, and my initial reaction was that something must be wrong with my coding – it didn't occur to me that this would be the intent of the formula” 

Georges Duponcheele, head of private-side banking solutions, BNP Paribas

“It’s an ineffective approach. It’s strange this would come out now, just when so many of us want to grow the market here” 

European regulator close to the working group that drafted the MSFA proposal

“They are blithely and radically moving away from any notion of neutrality” 

William Perraudin, adjunct professor, Imperial College and director of consulting
firm Risk Control 

(Risk June 2013, pages 30–32)

“It’s death by a thousand cuts. If you take this regulation in isolation, then you can understand the intent – even live with it and find ways to accommodate the constraints. But if you include all the other new rules, then you realise the product is likely dead in Europe” 

Fabrice Susini, global head of securitisation, BNP Paribas 

The adjustment bureaus

By the end of the year, they were being called the XVAs – the family of pricing adjustments that have added bewildering complexity to the post-crisis swap markets – and banks were trying to decide how and whether to manage them all from a centralised desk. But whether considered collectively or individually, the XVAs remain a source of controversy and contradictions.

Credit and debit valuation adjustments (CVA and DVA) are the elder statesmen of the group, together representing the counterparty risk of both sides in a bilateral trade. While accountants recognise both adjustments, only CVA exists from a regulatory capital point of view – and for European banks, it only exists in trades with financial counterparties, thanks to an exemption for corporates, sovereigns and pension funds. That creates a rift with the US and other countries, and there are fault lines within Europe, too, where German supervisors told Risk in June they could bypass the exemptions with a new capital overlay.

A more fundamental concern is whether the credit default swap (CDS) market is deep enough to bear the pressure CVA places on it. CDS spreads are the key input to CVA and DVA calculations, but are not available on most counterparties – forcing banks to use proxies – and some banks warned this year that a shrinking CDS market could make both adjustments dangerously fickle.

Funding valuation adjustment (FVA) is a newer addition to the family, and although dealers broadly agree with the concept, there is no standard approach to calculating its two halves – a funding cost for trades that are in-the-money and a benefit for trades that are out-of-the-money. In this vacuum, some observers worry games are being played, and the April cover story on this topic was one of the year’s most popular features.

“We were surprised that regulators made CVA and DVA so dependent on this market because we know it can be illiquid – I think it puts too much pressure on our book, on our business” 

Head of fixed income at one UK bank (Risk March 2013, pages 14–18)

“What legislators have come up with is a set of good rules, and regulators and authorities should not rethink and re-establish them. They should accept the legislation that the council and the parliament in their wisdom have decided upon” 

Markus Ferber, member of the European Parliament 

(Risk July 2013, pages 12–17)

“There’s no convergence on how FVAs should be calculated, and everybody is doing it differently, because at the moment there are no right or wrong answers. Quite frankly, it’s a bit of a mess” 

An auditor, (Risk April 2013, pages 14–18)

“I tend to favour a unified approach… Managing the XVAs needs the skills of quants, not traditional treasurers, and putting it in treasury may generate a clash between them and the front-office guys” 

Massimo Morini, head of interest rate and credit models, Banca IMI

“The derivatives people have to understand: things have changed, and they can’t decide these things. Funding – all of it – ultimately has to be the provision of the treasury function. There can be no risk of loss of control” 

Senior investment banking treasurer 

(Risk September 2013, pages 22–24)

“I’m way outside my risk appetite"

Replacement valuation adjustment (RVA) is a junior member of the XVA family, but it produced one of the year’s most memorable quotes. The add-on covers the risk banks face in trades containing downgrade triggers, which oblige a bank with sliding credit quality to first stump up extra collateral then pay another dealer to step into the trade – a cost that is fiendishly difficult to calculate. In Risk’s September cover story, traders pointed to Royal Bank of Scotland (RBS) to illustrate why this matters – the bank has a big enough share of the inflation swap market with UK pensions funds, they claimed, that it would be impossible for other dealers to absorb the flood of trades that could come to them following an RBS downgrade. 

Later that month, speaking at a Risk conference in London, RBS’s global head of market risk seemed to agree, telling delegates he was “way outside” his risk appetite, and arguing the industry as a whole had not paid enough attention to downgrade triggers.

“[Downgrade triggers] are horrible. We have no idea how to price them or manage the risk associated with them. All I know is that if we get downgraded to a certain point and our counterparties choose to exercise the option, we are going to lose a lot of money” 

Head of rates trading at one large
European bank

“This is a big problem. A large inflation player could easily have £50 million IE01 out to pension schemes. That is massive risk to replace. You’re talking about a couple of years’ worth of market flow and many years of interbank flow” 

A trader at one asset manager (Risk September 2013, pages 16–21)

“I'm way outside my risk appetite now and I'm there because other people in my firm have built up large positions” 

Martyn Brush, chief risk officer for RBS Markets and global head of traded market risk 

(Risk October 2013, page 6)

Clients speak out

For clients, changes in derivatives pricing are a headache. It’s not so much that collateral-based valuation or the various adjustments are hard to understand in isolation – more that dealers approach them differently, making prices difficult to compare.

“We need to be able to sit on this side of the fence, look at a pricing screen and see a similar picture to that which the counterparty is seeing, and know we are getting a fair price” 

Mike Walsh, head of solutions distribution and management, London-based Legal & General Investment Management (Risk March 2013, pages 59–61) 

“No banks price these things the same – they all use the same terms but there is an appalling lack of standardisation among the methodologies” 

Pedro Madeira, London-based assistant treasurer, Heathrow Limited

“The funding component is easy to get to grips with in theory, but the actual implementation is so diverse, that to compare prices across different banks becomes very difficult” 

Lars Eibeholm, treasurer, Nordic Investment Bank 

(Risk September 2013, pages 16–21)

Capital vs P&L

The year opened with two reports on the estimated $6.2 billion trading loss suffered by JP Morgan’s chief investment office (CIO) in 2012 – one from the bank itself and one from a Senate committee. Both found problems began after the unit’s trading strategy became a mushrooming, messy attempt to preserve profits while reducing capital. The moral of the story for some market participants was that banks should manage economic risk, rather than risk-weighted assets (RWAs). 

Deutsche Bank ignored that advice. In its half-year report, the bank revealed it had been able to halve the RWAs generated by Basel III’s CVA charge – from €28 billion to €14 billion – via a hedging programme. But the hedges also produced a loss of €94 million, because the accounting and regulatory measures of CVA differ and Basel III insists potentially loose-fitting index hedges are used in many situations. Despite that, Deutsche’s rivals see the hedges as a sensible policy, with the trading loss a small price to pay for such a big capital saving. 

“People are being pushed in the direction of managing RWAs rather than managing actual risk. So what you get in some cases is RWA decreasing but economic risk massively increasing” 

Senior credit portfolio manager, European bank 

(Risk February 2013, page 7)

“It’s worse than before... there's nothing that can be done, absolutely nothing that can be done, there's no hope... The book continues to grow more and more monstrous” 

Bruno Iksil, head trader, JP Morgan CIO, quoted in Senate report 

(Risk April 2013, page 9)

“You look at it from a regulatory point of view, not an accounting point of view. This time, our efforts to reduce risk-weighted assets have resulted in a loss” 

Deutsche Bank spokesman 

(Risk September 2013, page 6)

“How much volatility is it worth to halve your CVA value-at-risk capital? That’s the million-dollar question” 

Johann Kruger, head of accounting and regulatory advisory, Lloyds Banking Group 

(Risk November 2013, pages 24–26)

Model behaviour

Despite being given the same 26 benchmark portfolios, the banks that took part in the Basel Committee on Banking Supervision’s study of trading book capital modelling returned wildly different results – in one extreme case, the RWA number generated by one bank was 3% of the group’s median, while another institution was at more than 2,500%. 

The results of the year-long study, published in January, concluded that different guidelines from domestic supervisors played a large part in this, but it inflamed the continuing battle between modelling sceptics and supporters within the regulatory community. 

The discipline’s problems are not limited to market risk – huge legal and regulatory settlements have far exceeded the scale of losses predicted by operational risk models, for example. And in Denmark, a probe of credit risk modelling at Danske Bank turned ugly, when the bank decided to fight an order from its supervisor that would have added an estimated Dkr100 billion ($18 billion) to its RWAs. 

“It is enormously difficult for outsiders to understand what is going on in banks. How can I forecast earnings if I don't understand the balance sheet?” 

Bank analyst, large European bank 

(Risk February 2013, page 6)

“How did regulators not notice that these differences were emerging when these models were being approved? The Basel Committee is braced for a backlash over this” 

Industry source 

“In the past three years, we have seen, again and again, massive legal claims against banks that dwarf the sum of all the other operational risk loss events. That’s a major issue, and I don’t think many of the current risk models are reflecting this reality” 

Paul Embrechts, professor of mathematics, ETH Zürich 

(Risk March 2013, pages 25–27) 

“What is the right level of risk weights on corporate exposures? We need estimation methodologies to be based on fair assumptions, but in the end only time will tell whether they’re fair or not” 

Ulrik Nødgaard, director-general, Danish FSA 

(Risk August 2013, pages 38–39)

“When it comes to models, you can run but you can't hide. Any conversations between banks and supervisors are going to have to be framed in terms of models” 

Mark Zelmer, deputy superintendent, Office of the Superintendent of Financial Institutions 

(Risk November 2013, page 8)

The joy of Sefs

The market had been waiting for the Commodity Futures Trading Commission’s (CFTC) final word on Sefs since proposals appeared in January 2011. It ended up being a 28-month wait. The rules were agreed in May – but not before a series of false alarms. The word on the street was that they would arrive before the end of 2012, then in January this year, then on St Valentine’s Day.

As the wait dragged on, Sefs got antsy – while they were being forced to sit on the sidelines, futures exchanges were potentially stealing their dinner with new swap futures products that promised the same benefits as OTC swaps, but at a significant discount in margin terms. Icap group chief executive, Michael Spencer, told Risk that Sefs ought to be allowed to trade futures as well. Bloomberg went a big step further and sued the CFTC in a valiant – and doomed – attempt to even up the margin treatment. Bloomberg’s head of fixed-income trading told Risk in March that if the suit was unsuccessful, the platform could even launch an exchange – a designated  contract market (DCM) in US regulatory jargon.

The drama continued in the weeks before and after the October 2 start date for Sef trading – thanks to three big problems. First, the final rule expanded the scope of the regime to include any and all platforms that met the definition of a Sef – a multilateral venue that traded anything defined as a swap. But because the new requirement was hidden in footnote 88 of the text, it took some time for the industry to get up to speed. Platforms found they had a matter of weeks to rush through the Sef registration process and persuade their users to sign the necessary documentation. Some non-US platforms threatened to bar US participants, and some firms – including BlackRock – went back to trading selected products over the phone. 

Second, Sefs were interpreting the CFTC’s rule 1.73 as a requirement
for all clients to have a pre-trade guarantee that a futures commission merchant (FCM) would accept their business for clearing – and the platforms had written that into their rule books, making FCMs unwilling to sign up. Third, some Sefs were also requiring buy-side firms to negotiate bilateral breakage clauses with their counterparties, spelling out what would happen in the event that a clearing-mandated trade failed to reach a CCP – buy-siders argued this would limit the number of counterparties they could use. CFTC chairman Gary Gensler later waded into this issue, telling a number of platforms that they were not complying with a Dodd-Frank Act requirement to offer impartial access (see page 11).

In the fortnight that followed the start of Sef trading, market confusion was compounded by the fact the US federal government had shut down – the CFTC was staffed by a skeleton crew of a couple of dozen officials, leaving most calls unanswered.

“Nothing says ‘Valentine, I care’ like a Sef final rule-making” 

Scott O’Malia, commissioner, Commodity Futures Trading Commission

“Why is clearing of futures contracts uniquely not open access, as it is for bonds and shares and now also for OTC instruments? There is no logical reason for this” 

Michael Spencer, group chief executive, Icap

“Setting up as a DCM is a hedge position we are looking at if our petition for a change in the margin treatment is unsuccessful” 

George Harrington, global head of fixed-income trading, Bloomberg (Risk April 2013, pages 38–41)

“Some Sefs have already begun to tell US participants that once the registration requirements go into effect, they will not be allowed to trade on the facility” 

Diane Genova, general counsel for global markets, JP Morgan

“The whole thing is a mess. Many Sefs believe the limit checking requirements in regulation 1.73 require FCMs to guarantee clearing. This is plain wrong” 

A dealer

“In the event a trade does not clear, we need to have a fall-back position we can take to deal with any trades that may be rejected from clearing – which counterparty owns the trade in that situation?” 

Lee Olesky, chief executive of Tradeweb (Risk October 2013, pages 48–50)

“There isn’t anyone at the CFTC to pick up the phone today to receive or process enquiries related to Sef compliance dates” 

Tom Zikas, head of e-rates, State Street (Risk November 2013, pages 28–31)

New world disorder

Rules are made to be broken, they say. But they probably weren’t thinking about the Dodd-Frank Act when they said it. Within weeks of Risk reporting that some FCMs were not abiding by a requirement that they accept or reject trades for clearing within 60 seconds, the CFTC had launched a probe, citing the article. 

A second – less clear-cut – breach came to light at a Risk event in New York in early June, when executives at Citadel and Fortress said they had been dismayed to find that some of their non-US dealer counterparties did not consider themselves to be swap dealers, and were therefore not reporting bilateral trades to one of the market’s new data repositories. It’s difficult to know what the CFTC would do about this but one of the agency’s top regulators issued an ominous – if vague – warning at a separate Risk conference in October. 

Elsewhere the combination of new businesses and new practices appeared to be generating wildly different approaches to compliance – while all FCMs are required to hold excess margin to ensure their clients are not under-protected, data revealed the proportion of own funds to client funds ranged from just 4.2% at Morgan Stanley to 44% at Credit Suisse as of the end of October. 

The Swiss bank’s ratio translated into $1.75 billion in capital, shocking its rivals, which said they were under pressure to keep their consumption of financial resources on a much shorter leash.

“There have been some trades that haven’t been cleared in under 60 seconds… But we haven’t rejected any trades so far. That is not what you want to do in this situation” 

The head of clearing at a US bank (Risk April 2013, pages 22–25)

“What we’ve found in some pretty sizeable niche markets is that some dealers are claiming they are exempt from the regulation and they are not doing the reporting” 

Richard Mazzella, chief operating officer for global fixed income and mortgages, Citadel (Risk July 2013, page 8)

“Will a time come when we look around and see that people are not registered even though they have sufficiently impacted US commerce? Congress has said that their activities are subject to Dodd-Frank, so that day will come” 

Gary Barnett, director of the division of swap dealer and intermediary oversight at the CFTC (Risk November 2013, page 8)

“I think it surprised a lot of people – I know I was surprised – to see the Credit Suisse buffer so high … It goes against the grain of everything else that is happening in this business” 

An FCM source

Ice vs SEC

One of the year’s most entertaining tussles between industry and regulator started on March 8, when the Securities and Exchange Commission (SEC) responded to months of criticism and gave participants in the single-name CDS market a way to cross-margin those trades with the index CDSs that were about to fall into the clearing mandate set by the CFTC. 

The SEC’s terms were a shortcut to a drawn-out model approval process – still running today – but meant most buy-side firms would have to hold twice as much margin as that charged by a clearing house to its member banks. Buy-side firms that use index arbitrage strategies were incandescent, so Ice announced it would not offer single-name CDS clearing at all – a position it held until a quiet word from the SEC prompted a u-turn. 

But clients have voted with their feet. Despite a notice from the SEC, allowing firms to portfolio margin their CDSs on roughly the same terms as banks until the provision expires in December, volumes remain light – buy-side traders say they are not willing to start clearing until a permanent regime is in place.

“The 200% level is arbitrary and unexplained. It puts the buy side at a material disadvantage to the sell side” 

Manager at a buy-side firm

“We made a decision, based upon that unexpected development – news of which we received very late in the day on Friday – and based upon input from many clients, that it would be better not to offer single-name clearing under those conditions” 

Peter Barsoom, chief operating officer, Ice Clear Credit (Risk April 2013, page 6)

“The SEC is effectively forcing Ice to launch single-name clearing for clients” 

Clearing executive at a US bank

“If you have a five-year single-name CDS, you would be derelict in your fiduciary duty to put it into clearing at this point because you don’t know what the regime is going to look like in a few
months’ time” 

A senior trader at a large US hedge fund (Risk September 2013, page 10)

Rattled by the Leverage ratio

A year ago, the Basel III leverage ratio would not have featured on most banks’ laundry list of regulatory concerns. It shot to prominence in the middle of this year – first, the Basel Committee proposed a revised version of the ratio that clamped down on the repo market, among other things. 

Then US agencies appeared to up the stakes for their banks considerably, doubling the compliance level for some deposit-taking banks – although US accounting standards will reduce that impact. Finally, Barclays was bumped into a £5.8 billion rights issue at the end of July, after the UK’s Prudential Regulation Authority decided to take a tougher line on implementation.

Suddenly, the leverage ratio was a very big deal. Its critics warned it would cripple clearing businesses and shut down the repo market. Some regulators share those fears – the ratio should only function as a backstop to modelled capital numbers, they argued in Risk’s October cover story.

“For some banks, this would probably mean it no longer makes sense to be a clearing member. We think it is completely intentional, but I’m not sure the regulators have fully assessed the consequences” 

Jouni Aaltonen, director of prudential regulation, Association for Financial Markets in Europe (Risk September 2013, page 8)

“There is data there that you can use to speculate about what is going on, but I have spent some time looking at it, and it just isn’t possible to reverse-engineer” 

European bank source, commenting on leverage ratio disclosures accompanying the Barclays rights issue (Risk September 2013, page 7)

“I would describe market liquidity as a public good. I can see why it’s important to reduce leverage – that’s unarguable – but you don’t want to unnecessarily impact market liquidity” 

Robert Stheeman, chief executive, UK Debt Management Office 

“If you feel internal models are too complex, that banks will always game the system and that the advanced approaches in Basel II were basically a mistake, then we can move to a standardised method… But why take another step back and forget about risk altogether?” 

Lars Frisell, chief economist, Central Bank of Ireland (Risk October 2013, pages 16–21)

As good as cash?

US Treasuries are the closest thing to cash that the capital markets have to offer, and until the CFTC intervened, CCPs in the US had assumed that very-close-to-cash was close enough. Not so, the CFTC ruled in November: government securities will only be counted towards a CCP’s stock of liquid resources if they are supported by some form of committed funding arrangement – contractual certainty that bonds can be turned into cash at the drop of a hat, in other words.

CCPs and FCMs alike were dismayed – the likely outcome is that minimum amounts of cash will have to be posted instead of securities, potentially making clearing more costly and less practical. CME Group felt so strongly about it that it threatened in a comment letter to move business out of the US.

But policy-makers are not in the mood to cut corners. Paul Tucker, then-deputy governor of the Bank of England and chair of a Financial Stability Board working group on resolution, spoke to Risk in May about the need to avoid CCPs becoming too big to fail. The big question is how to achieve that goal, and some of the answers being sketched out by policy-makers – including a forced tear-up of cleared positions – scare market participants.

Banks have a range of other CCP-related fears. Writing in Risk, two Lloyds Banking Group quants compared CCPs to rating agencies – both were given a special role by regulation, but have commercial incentives that conflict with their principal purpose, they argued. 

Others worried about the reliability of the prices coming out of CCP models, which determine margin requirements, feed into bank capital and could also be used by buy-side firms to value their positions – a bad clearing house could become a “toxic node”, warned one prominent academic. 

CCPs dismiss those fears, and one of their big projects this year was to amend existing models to avoid a sudden drop in margin requirements as post-Lehman Brothers volatility was erased from lookback periods.

“How do you articulate your risk appetite to a CCP? What choice do you have? Stop trading?” 

Lesley Jones, group chief credit officer, Royal Bank of Scotland (Risk November 2013, page 10)

“I sometimes worry people get the impression that a CCP resolution will be orderly and neat. It won’t be” 

Paul Tucker, deputy governor, Bank of England

“A tear-up negates the reason for having a CCP… If a CCP is able to back out of its obligations when there is an adverse event in the market, how can that be a good solution for paying customers?” 

Diana Chan, chief executive, EuroCCP (Risk June 2013, page 25–28)

“Ultimately, a badly managed CCP can be worse than no CCP. It can become a toxic node” 

Rama Cont, professor of mathematics, Imperial College (Risk September 2013, pages 34–36)

“Like the agencies before them, CCPs have a commercial incentive to expand the scope of products they cover, and to give up pricing accuracy for the sake of increased business” 

Chris Kenyon, director in the CVA/FVA quantitative research team, Andrew Green, head of the team, Lloyds Banking Group (Risk September 2013, page 33)

“When Lehman leaves the time series, we could see a fairly large drop in initial margin… We don’t want that, which means we need to switch to a longer lookback. For SwapClear, we’ve already decided to do this” 

Dennis McLaughlin, LCH.Clearnet group chief risk officer, (Risk October 2013, pages 28–30)

“If the Aussies, the Singaporeans and the Europeans – with the Bank of England as a specific example in Europe – have been clear about the fact they consider government securities, including US Treasuries, to be liquid collateral, that will provide a competitive advantage” 

Kim Taylor, president, CME Clearing