Do Central Counterparty Clearing Houses (CCPs) have enough capital? A closer look at the CME.

Guest post by Jasper Tamespeke

I was bemused to read the other day a news report that ISDA chair Stephen O’Connor has stated that the major CCPs (LCH and CME) ‘probably’ have enough capital. Bemused because as far as I can see CME Group doesn’t have any real capital at all.

To understand this, we have to do a bit of forensic accounting. Not very exciting, but given the central role the CCPs have been given in clearing OTC derivatives in the future, it is important.

According to CME Group’s 10-K for 2013 the group had stockholders equity of $21.6 billion, which appears to be very healthy. However, when regulators and credit analysts look at a Financial Institution they will critically assess the assets on the balance sheet and deduct from capital any assets that cannot be readily realised in a crisis (which is when we need capital). They particularly focus on intangible assets such as goodwill (what someone pays to buy a company above the tangible value its assets, the franchise value). In CME Group’s case, there are a lot of intangibles: goodwill of $7.6 billion, other intangibles of $2.7 billion and a whopping $17.2 billion relating to Trading Products. In total these amount to $27.5 billion and therefore tangible equity is about $6 billion negative.

The most important number here is the trading products. This is the ‘brand value’ of futures contracts acquired in the mergers with other futures exchanges, particularly CBOT and NYMEX. These have been capitalized on the basis that such products have to be licensed by the CFTC and the license has no expiry date. In theory, it is not difficult to create rivals to CME’s valuable contracts, but anyone who remembers Eurex’s attempts to set up a rival to the Eurodollar Future a decade ago knows that CME’s franchise is implicitly protected. However, there is no guarantee against a less monopolistically inclined regulatory framework being developed in future, and it seems to me that this accounting is really just window dressing: the ‘mergers’ (really takeovers) naturally generated a lot of goodwill, but if it is rebranded ‘Trading Products’ this sounds much better and makes the balance sheet look superficially stronger.

To me, this is a sobering thought for Sober Look readers : possibly the largest CCP in the world (certainly the largest clearer of exchange traded derivatives) has no capital.

But how can this be? CCPs are regulated so surely they must be required to have capital? CME Group Inc. is the holding company of the group and not itself the CCP, and therefore (I presume) not directly subject to the CFTC’s capital requirements. The CCP is a division of its most important operating subsidiary, CME Inc. CME Inc. does have about $1 billion of capital. How is this possible, given that CME Inc. is wholly owned by CME Group? As far as I can see, this is achieved through a bit of alchemy called double leverage. CME Group has about $2.85 billion of long and short term debt and part of this is used to provide equity capital for CME Inc. CME is not regulated under the Basel regime, which has been subject to much criticism, at lot of it justified. However it does at least require that capital requirements are met on a consolidated basis, which would stymie this sort of manoeuvre.

So there appears to be some clever creative accounting going on here. But does this really matter? Anyone who has spent more than 5 minutes studying CCPs knows that capital is not really relevant in protecting them against counterparty credit risk, which is what they are about. The main line of defence is Initial Margin, and to a lesser extent the Default Funds, which are there as a top-up if extreme losses run through the margin deposits. And CME has a veritable wall of money here: nearly $120 billion at end 2013. So $1 billion of capital, whether it is real or not, gets lost in the roundings.

I think it does matter for a number of reasons. The money of members and their clients may be the primary mitigants against a CCP’s credit risk, but what happens if there is an operational failure (e.g. if systems errors lead to a CCP having an unbalanced position, creating losses in a volatile market)? Here the primary loss absorber should be capital. Double leverage makes a group more fragile if there are problems. The holding company’s debt has to be serviced by upstreaming dividends from its subsidiaries, but if they are subject to prudential capital requirements this may not be possible, increasing the risk of default (although at the moment CME does generate prodigious cash flow).

Also it is important that CME’s shareholders have skin in the game. Most of the CCPs these days are public, profit seeking companies and it is important that they operate with the right incentives (not that the banks and brokers can complain too much about this, as they opportunistically sold their seats and relinquished control in the course of the last decade in pursuit of a quick buck).

It matters most of all because we are concentrating so much potentially lethal risk in 3 or 4 critical nodes in the financial system. G-20 politicians made a fateful decision in 2009,moving from the (arguably reasonable) declared aim of requiring credit derivatives to be cleared to the much more ambitious mandate that all standardized OTC derivative are centrally cleared (for reasons which as far as I know are largely unexplained). In my opinion this is just one manifestation of the failure of politicians and the regulatory community who serve them to learn the right lessons from the Financial Crisis: they want to centralise the risk so that it is easy to see and control. However surely the moral of Too Big to Fail was that it is an illusion that we can control everything in human affairs, in this case by confidently assuming that margin at 99.5% with a top up based on stress tests will make us bullet-proof against the unknown unknowns. Instead of concentrating risk in the massive CCPs and the equally massive small number of banks with the economies of scale to afford to be clearing members, in my view it would have been better to diversify risk around the system, to minimise the impact of the things we can’t control. However, it is probably too late to reverse these decisions now, but it is certainly emphasises the need for CCPs to be stable, strong institutions with good governance.


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Credit Value Adjustment (CVA) implementation comes of age

Guest post by Nandita Jhajharia and Lev Borodovsky

In banking, particularly recently, one often hears the term “Credit Value Adjustment” or CVA. Is it a new fashion trend in the world of finance world is it there more to it? Why are traders, quants, and risk officers at large institutions feverishly trying to deal with this topic all of a sudden? It turns out that the increased focus on counterparty risk after the financial crisis as well as the new Basel requirements for bank capitalization (see document) have added urgency to the CVA implementation by international banks, forcing them to focus on the topic.

What is CVA? Those researching CVA for the first time may find it a daunting task simply because a great deal of technical literature has been written on this concept - see this for example. According to Wikipedia, CVA is defined as “the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of counterparty’s default. In other words, CVA is the market value of counterparty credit risk.” This assessment of credit exposure is determined by the bilateral nature of transactions and fluctuations in asset prices. Other factors contributing to CVA valuation include market volatility and correlations across markets as well as legal settings and collateral agreements.

Imagine that you bought two long-dated over-the-counter call options on IBM. One was from JPM and the other from Joe's 1st National Bank - the same amount, strike, maturity, etc. Imagine that both options are in-the-money and your handy Black Scholes calculator says they are each worth $100 (premium value). But the Black Scholes model knows nothing about who you bought these from and what the likelihood is that you will get your money upon exercising the options. So if you try to sell them prior to exercise, the one that will be paid out by Joe's 1st National Bank will sell at a discount to the one from JPM because of the different counterparty risk. That price differential between the "riskless" counterparty and the "risky" one - when applied to a single position or a whole portfolio - is the CVA.

Indeed those who were facing Lehman as a counterparty in 2008 were asking themselves why they weren't differentiating among the dealers when pricing their swap contracts. It was time to start doing so.

The CVA measure is different from the concept of standard Credit Risk because it combines the uncertainty of exposure with the bilateral nature of exposure. It measures the risk that the counterparty to a financial contract will default prior to its expiration and will not make the specified payments. At the same time the amount of those specified payments may have increased due to market movements.

Different types of financial contracts will have different potential future exposure (see definition) profiles (due to different sensitivity to markets). Consider an interest rate swap for example. The longer the swap the more tame rates have to move and the more exposure one has to the counterparty. But as time goes on, the amount of exposure declines as the swap approaches maturity (shorter swap would have lower exposure to the market). That's why the maximum potential future exposure for a swap is about a third of its term.

On the other hand a currency swap that exchanges principal (one currency for another) at maturity will have its potential future exposure grow with time. Unlike a rate swap, the market risk on a currency swap does not diminish with time.

This potential future exposure is then combined with the probability of default of the specific counterparty over time in order to determine the CVA. That process is usually performed via a Monte Carlo simulation, particularly in situations when the counterparty credit quality is correlated with the specific market exposure in a contract. For example if you execute a long-dated gold swap with a mining firm, the potential future exposure of the swap cannot be analyzed separately from the credit quality of the mining firm.

It becomes particularly important to use simulations when a bank has multiple contracts in different markets with a single counterparty. This requires a calculation that simulates multiple markets that are correlated with each other. This makes such analysis quite challenging technically, particularly when one has hundreds of counterparties with contracts across multiple markets. There are 3 components of calculating the distribution of counterparty level credit exposure.

• Scenario Generation – future market scenarios are simulated for a fixed set of simulation dates using evolution models of risk factors
• Instrument valuation (revaluation under varying market conditions) 
• Portfolio aggregation

There are numerous advanced ways to compute CVA and determining which methodology to adopt is often based on an organization`s ability to access appropriate technology, data, and resources. The back of the envelope approach involves:

• calculating the mark to market of the derivative contract (MTM without CVA),
• adjusting the discount rates by incorporating the credit spread (counterparty`s credit spread if the derivative is an asset or processing organization`s credit spread if the derivative is a liability),
• calculating the mark to market applying the new discount rates.
• The difference between the two mark to markets (one that includes the probability of default and one that does not) is the CVA.

The calculation often has to be timely in order to provide a quote to a counterparty on a specific transaction. When a bank quotes a rate swap to a client these days, the CVA is included in the price. This need for speed, combined with increasing regulatory requirements makes the implementation of processes and systems that compute Credit Value Adjustment an urgent and complex issue in the banking sector.

CVA is the premium charged on a specific derivatives contract or a portfolio of contracts that takes into account both the volatility of the contract(s) as well as the probability of the counterparty’s default. Major banks view the implementation of this measurement as one of their top strategic priorities. In the next discussion on CVA we plan to have an overview of the Basel regulation that is adding urgency to CVA implementation at banks as well as special cases that make this implementation particularly challenging.

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Using LIBOR curves to discount cash flows on derivatives contracts is no longer appropriate

Some academically oriented readers may get a bit upset at this statement, but most financial derivatives pricing in practice comes down to this basic formula. The net present value (NPV) of a derivatives contract can be expressed as a sum of expected cash flows (C), weighted by the probabilities of that payout (P), discounted to valuation date using discount factors (D).

For an infinite number of possible payouts, such as an option (for example Cashflow = Max [Spot - Strike, 0]) the sum simply becomes an integral. The basic approach however remains the same.

In the past few decades the approaches to derivatives pricing focused on the cash flows and the probabilities. When it came to the discount factors, in most instances the recipe has not changed. Academic literature prescribes the building of the zero coupon LIBOR curve using BBA's LIBOR settings (at the short end), LIBOR futures, and LIBOR interest rate swaps further out. Using the so-called "bootstrapping" and some sort of interpolation technique (there is a whole science about how to interpolate for gaps in the swap curve), a zero coupon curve is built. The discount factors to be used for derivatives pricing are then derived from that that curve.

But in the past few years practitioners have been asking the question: is LIBOR really relevant for discounting derivatives cash flows? In the age of bilateral master derivatives agreements (Credit Support Annex or "CSA") when each counterparty is expected to post margin, what is the true financing cost of derivatives cash flows? The answer for most cases turns out to be quite simple. Generally the interest on collateral posted by one party to another is Fed Funds or its equivalent in another currency. The cost of funds for a derivatives contract is basically the overnight effective rate. And for most currencies there is an active market to price overnight rates expectations years into the future. It is called the Overnight Index Swap (OIS) market (see this post for more information). The chart below shows the term structure of JPY OIS for example.

Yen OIS curve

Converting this OIS term structure into a zero coupon curve provides a more appropriate set of discount factors that reflect the true cost of cash flow financing. To the extent there is another collateral arrangement, the discounting should be adjusted to reflect the appropriate costs. This is already the standard for discounting interest rates swaps and is becoming common in CDS as well. Using the LIBOR curve simply because it has always been done that way is no longer appropriate, as it does not reflect the actual cost of funds. Most academic derivatives pricing literature is yet to be adjusted to reflect this fact.

JPMorgan: - Differential discounting is the practice of valuing derivative contracts using discount rates that are specific to the terms of governing collateral agreements. Using discount rates that do not reflect the terms of specific collateral agreements can misprice the full economics of derivative transactions.
... 

Typically, the yield on USD cash-collateral in a CSA is based on Fed funds rather than on Libor. This means that derivative subject to collateral agreements should be values using OIS rather than Libor swap rates, which have historically been used for valuing derivative transactions. Over the past few years, the basis between Libor and OIS rates increased significantly and currently stands at 30bp in USD and 29bp in EUR for a 3-month swap. So while valuing a derivative contract using OIS rather than Libor would have had little impact in the past, over the past few years, it has had an increasing impact.

SoberLook.com

CFTC coming under pressure to finalize derivatives regulation

Here is an update on the implementation of the Dodd-Frank derivatives regulation (part of the financial reform and consumer protection law) from JPMorgan (see attached document). For active derivatives end-users the clearing requirement deadline seems to be the end of this year. A good number of them are not even close to being ready and the implementation deadline will likely slip once again.

Source: JPMorgan

Of course this is only for products that can be cleared. What happens to derivatives that are not expected to be cleared, at least initially? The CFTC of course is going to impose certain high margin requirements on those (these margins can't be lower than those applied to cleared products.)

But the "non-cleared" margins can't be applied just to US banks because if margins for non-US swaps dealers are lower, US banks will not be able to compete. It means that these margin requirements have to be fairly uniform across jurisdictions, with other regulators playing in the same sandbox. And that's (one of the many areas) where the CFTC is running into difficulties.

IFR: - ... foreign regulators and banks have joined the chorus of disapproval, focusing on the potentially damaging effect margin requirements for uncleared swaps could have.

The most important response to watch for will not be from any individual country’s banking supervisor or US industry group, but from the European Commission’s lead regulator on Internal Market and Services, Michel Barnier.

“We are particularly concerned with potential CFTC margin requirements for swaps that are not cleared through a central counterparty,” Patrick Raaflaub and Mark Branson, the CEO and head of banking regulation at the Swiss Financial Market Supervisory Authority, wrote in a letter to the CFTC in early July. “If such margin requirements are applied to a Swiss-based entity, this may duplicate the requirements and may possibly conflict with international and domestic capital adequacy rules, thereby producing inefficiencies.”

“Due to [this] concern, we cannot exclude that FINMA may have to deny financial institutions permission to supply certain information or grant direct access to U.S. supervisors,” they warned.

That statement could be perceived as a shot across the CFTC’s bows in what could become a power-struggle between international regulators, said a regulatory lawyer in New York. FINMA is implying that it would deny Swiss banks the right or ability to comply with certain US regulations, even if Gensler mandated it. The effect of such a move by FINMA could mean a regulatory stalemate for Swiss banks looking to engage in swaps with US persons or their affiliates after Dodd-Frank is fully implemented in the US, the lawyer said.

This is not a surprise given that the CFTC has trouble regulating futures brokers in the US - which has been its main job. Now they are trying to dictate global regulation on something the agency has little experience with. Even in the US people are beginning to ask questions.

IFR: - The US Chamber of Commerce submitted a letter this month warning Gensler that foreign regulators may feel the impulse to extend the scope of their derivatives regulations back into the US due to the “extraterritorial application of derivatives regulation”. David Hirschmann, the author of the letter, added that an “overly broad” application could put foreign branches of US firms at a competitive disadvantage – criticism US banks have repeatedly raised.

This process has been fraught with problems from the beginning. Zealous, politically motivated, and an inexperienced group has been at this for years, introducing tremendous uncertainties into the implementation process and incremental risks into the derivatives market as a whole.

Enjoy! J.P. Morgan Regulatory Update Slides July 2012

SoberLook.com

Some facts about OTC derivatives

We've had a number of questions regarding a post from this weekend that discusses OTC clearing for CDS. People quote scary numbers such as hundreds of trillions in CDS contracts that will surely bring down the global financial system. Let's try to alleviate some of those fears.

1. CDS is 4% of the total notional. The OTC derivatives markets are dominated by interest rate and FX swaps. And these days swap participants who use these products for trading post initial and variation margin as they would with futures.

2. The notional outstanding represents swap purchases and sales. If you trade rate swaps for example, you may be flat rate risk but have a large gross notional. The net numbers are actually quite small globally.

Source: Barclays Capital

3. One of the reasons behind a clearinghouse is to allow end users to easily net their swap purchases and sales - to bring down their gross and reduce counterparty risk. Unlike the issues with CDS described in an earlier post, rate swap clearing is progressing well (we plan to have a guest post on the topic soon). In fact over half of OTC rate derivatives are already centrally cleared.

Source: Barclays Capital

So yes, $648 trillion is the gross notional of OTC derivatives. But people need to understand what that number means, which products are represented, and the market changes now taking place.

SoberLook.com

TRS is now the tool of choice to provide leverage

Leverage is back. Banks are once again pitching total return swaps (TRS) to clients. A typical structure involves a bank providing total return on a portfolio of HY corporate loans. An investor can synthetically control a $200 - $300MM portfolio of loans by posting 25%-30% in margin. The investor receives (or pays) total profit/loss on the portfolio and pays LIBOR + spread (spreads are linked to the bank's financing cost and these days vary from 1.25% to 2.5%.) Here is a diagram that illustrates the structure.



Note that a TRS investor doesn't actually own the portfolio, but receives the performance (the economics) of the reference assets. What's powerful about this product is that a TRS investor can change the composition of their portfolio at any time. The bank usually has strict criteria for it's composition and can restrict certain assets from being included.

From the accounting perspective, a TRS and the underlying asset form a precise hedge, receiving "hedge accounting" treatment. That allows an offsetting and consistent mark to market on both the asset and the TRS. The transaction is generally done out of the bank's trading book with the "value at risk" of zero. Thus the only regulatory capital required is based on credit risk - which is mitigated by the margin posted. Therefore the spread charged on the TRS delivers a decent return on capital for a bank.

Banks love this product because they can provide financing without the capital charges associated with loans. A TRS provider is hedged precisely and (unlike a loan) can call for additional margin and liquidate quickly. A bank would guarantee performance on a portfolio, then buy that same portfolio to hedge themselves. To mitigate credit risk they require margin and mark the portfolio daily. If the value of the portfolio drops, the bank calls for additional margin, thus always maintaining sufficient cushion.

From the investor's perspective it's a useful product, but can become a problem if the portfolio is illiquid. As the portfolio drops in value, the investor is forced to post margin. If the price goes up, the extra money the investor put up is returned. At some point in a falling market however, the investor may not have enough capital to post, forcing liquidation into a volatile, illiquid market. Imagine you bought a house with 20% down. Your house gets revalued daily by your mortgage provider, and if it drops in value, you are forced to put more money down. When you run out of money your house is put up for sale. That's precisely the condition that existed for many TRS at the end of 08 with forced liquidations and unwinds. The liquidations exacerbated market deterioration, forcing more liquidations.

For those who think this is an obscure product, think again. Most leveraged ETFs create and adjust their leverage daily using TRS. The ETF doesn't own any stocks - just a TRS. So if you ever traded a leveraged or an inverse ETF, you've been trading TRS.

In fact many equity prime brokerage accounts are set up as one big TRS. The investor has a portfolio of equities (long and short) which she trades actively. But legally the TRS provider owns the portfolio. The investor has one position on - a portfolio TRS, and receives the performance on the leveraged portfolio synthetically. This way the bank doesn't have to take possession of securities in case of prime brokerage client's failure to post margin - the bank can just start liquidating.

One key feature of these transactions is that each TRS transaction is unique. That makes this product nearly impossible to move to an exchange or even a clearing platform. Given the total obliteration of structured product, TRS has become the tool of choice to create customized leverage.

ISDA responds to European Comission

The European Commission just released it's communication on derivatives. It is actually a reasonably well thought out paper, though misguided in a few places:




ISDA immediately responded. Here is a quote from the response that goes to the heart of the matter (that we've discussed numerous times on Sober Look):

ISDA welcomes the Commission’s Communication as the Association has a strong interest in the central clearing of CDS as one part of a strong and healthy market. At the same time, ISDA values recognition by regulators of the continuing need for bilateral customised transactions which by their nature are not suited for clearing.

ISDA believes that those exposed to credit risk should have the option to choose the type of transaction that best suit their business and risk management needs, as works so well for customers in the equity, interest rate, commodity and FX sectors. Removing that flexibility, such as by forcing bilateral participants to trade on an exchange or otherwise limiting the availability of customized risk management solutions, would be a step backwards.

Bloomberg hypes up derivatives revenues, but the headline is misleading

Let's take a sober look at this Bloomberg story - here is headline: "Banks Reap Record $9.8 Billion Trading Derivatives". Wow!

But now let's glance under the hood and check Bloomberg's sources. They site the OCC, and here is the actual OCC Press Release:

U.S. commercial banks reported record trading revenues of $9.8 billion in the first quarter of 2009, compared to losses of $9.2 billion in the fourth quarter of 2008

This is "trading revenue" that includes derivatives and cash securities - all sorts of bonds, loans, stocks, FX, commodities, as well as derivatives. Banks don't have a "derivatives division". Interest rate products may include swaps, caps, floors, swaptions, futures, as well as government bonds and repo. Credit products may include corporate bonds, high yield and distressed bonds, CDOs, mortgage bonds, as well as credit default swaps. Derivatives are tightly integrated with securities.

Here is the banks' revenue by trading business from the OCC. One can't really separate pure derivatives revenue. It's also hard to separate how much is market making (taking the spread) vs. proprietary or strategic position taking or hedging.



Below is the actual report from the OCC. The moral of the story is don't trust the hype of the headlines - even from guys that are usually solid like Bloomberg. Check for yourself.




Update: Note that a reference to "interest rate contracts" doesn't necessarily mean derivatives. Much of it is repo. Asset managers refused to leave cash with prime brokers, lending it to dealers on a secured basis via a reverse repo. The sheer volume of such transactions generated nice revenues for dealers.

The Amherst CDS story - let's all get angry

The WSJ story about Amherst Holdings selling protection to banks and taking them for a ride created quite an uproar. The story is included below for those who haven't seen it. As usual people are reacting with anger without understanding.

Legalities aside, two facts allowed this transaction to work for Amherst:
1. The amount of CDS on the bonds in question was significantly larger ($130 MM) than the bonds outstanding ($29 MM). This is critical because if the amounts were equal, it would cost Amherst more to "fix" the bonds than the amount of premium they collected.
2. Amherst had to "manipulate" the value of the bonds in order for the trade to work. That is they used a portion of the premium from the CDS they sold to pay the servicer who in turn paid par on the outstanding amount. A servicer will sometimes pay the last small portion of a bond off if they collected tons of fees on the rest of the loans securitizing the bond. Given that a huge portion of these loans defaulted, it's unlikely the servicer had collected enough fees to do so. The only way the servicer could cover the remainder of the bond (the last $29 MM of the original $335 MM) is if Amherst paid them.

So the bet the banks made was correct, the $29 MM of bonds outstanding in fact became worthless. Amherst simply injected cash into it to make it worth par.

This is not a new issue. Derivatives are generally based on some index, and in this case the index was the value of these bonds. The risk is always that someone will manipulate the index. There are hundreds of stories of index manipulation in order to profit (or prevent losses on a derivatives trade), ranging from bidding up an emerging market bond to prevent a knock out trigger to manipulating the closing price of natural gas futures that changed the payout of a natural gas swap. In some cases index manipulation is perfectly legal - for example if one has enough capital to trade enough of the "underlying" to move the index. Those who enter into a derivative contract must be aware of such risks. In other cases it may be illegal - we'll see what happens in the case of Amherst (this case is equivalent to selling protection on a company's debt, and then funneling the CDS proceeds to the company to keep it from failing on it's debt.)

The fact that the size of the protection exceeded the size of the bonds is not a new issue in derivatives as well. The index can be the temperature or precipitation in a certain location for a weather derivative. How do you scale that contract relative to the underlying index?

But people are angry that the banks made that bet at all. How dare banks make bets! This is not a casino! Well friends, the biggest bet the banks had made is lending money to all of us on our mortgages. Over the years they made sick amounts of money lending to us and we kept on borrowing. But in the end that bet went awfully wrong. To try to reduce some of the pain from that massive bet gone bad, some made a small bet in the opposite direction on what remained of the mortgages in the Amherst case. In fact banks bought protection on billions of dollars worth of mortgages to try to limit their exposure - Amherst was just a small part.

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