Wednesday, July 31, 2013

Derivatives: Making Sense of Where We Are

The world of derivatives is in a purgatory state--a prolonged holding pattern until regulators finally finish new rules that will govern how they will be sold, traded, valued, cleared and reported. Regulators and financial institutions in the industry have dragged their feet in annoying, painstaking ways. What will eventually happen to how they will be traded?  How will be big banks respond? What will they do? When will the industry decide?

How will banks compensate for the billions in revenues that could evaporate when the derivatives playing field is re-landscaped?

The stories have  been told often over the years how derivatives markets have surged and soared, how derivatives have become a market of trillions (measured by the "notional" or face value of the derivatives traded globally).  The credit-default-swaps market is said to be over $25 trillion. (That would be "notional" face value, not actual market value or market outstandings.)

The story is also told often about how derivatives markets are opaque, sometimes illiquid, often misunderstood or too complex and how markets are dominated by banking behemoths that dictate pricing spreads, trading procedures, collateral requirements and who gets to join the inner circle of dealers.


"Derivatives" is a financial term that today encompasses a wide range of financial activity. The term was rarely used before the mid-1980s, although some forms of derivatives have existed for as long as there have been viable trading markets.  In current times, a derivative might include almost any financial instrument that is influenced by market risks and credit risks, but is not a director investment into a corporate entity.  In other words, it encompasses all that is not an equity investment, a plain-vanilla bond, or a loan. 

Derivatives, by convention, include options of all kinds (puts, calls and collars), convertible bonds (and other "hybrid" instruments), interest-rate swaps, credit-default swaps, equity-linked swaps, commodity swaps, index trading and index swaps, and currency swaps.  They include futures trading--those traded on
exchanges and those traded "over the counter."

Frequently, derivatives will include forward foreign-exchange transactions.  For most in finance, the term will include mortgage-backed securities, CDOs, CLOs, IOs, POs, CDOs squared, synthetic CDOs, and synthetic CLOs, And if we dare get fancy, they include swaptions, "knock-out" swaps, and CAT (catastrophe) bonds.

Derivatives creators adore acronyms, complexity, quantitative analytics and the lure of something new and different.  Derivatives managers enjoy the open-round gush of profits.  Financial theorists and financial engineers embrace whiteboards of equations and calculus that try to define the behavior of these instruments.

Derivatives, the term, captures just about any complicated instrument that doesn't sound like a stock, bond or loan.  The finance media define derivatives as financial instruments "the value of which are based on other securities and instruments"--a catch-all phrase that often doesn't explain exactly what they are or how they perform in live markets.


Here is how large banks and hedge funds that have dominated prominent segments of the market define and approach derivatives--at least until now, while the global business model for trading derivatives is under threat:

1.   The first institution to conceive, create, build a model, sell, and trade a new derivative gets to determine and mark the playing field or the "rules of the game."

2.  The first few firms, usually large banks, that leap into the arena of a new derivative product determine the profit dynamics--how profit margins and spreads are determined, how positions are valued, and how prices are reported. Therefore, they become the core of large dealers that dominate the new market at the outset.  They will behave in ways to ensure they maintain control of the market--especially the lucrative pricing spreads.

3.  The large dealers who control the market decide when and how to open it up to new clients and counter-parties.  This permits the new market to grow, boosts liquidity, and spawns a large number of "end-users," who often use the derivative for risk-management or hedging purposes.

4.  The large dealers and their inner circle will design the marketplace such that the growing number of "end-users" (corporations, manufacturers, small funds, and individuals) must arrange trades by going to one of the large dealers.

5.  Large dealers, banks and hedge funds are able to maintain control of markets (and profits) because of advantages in capital resources, systems and technology, and information.  They can survey, see, comprehend and act upon all the activity that occurs around them.
6.  Large dealers, because they control pricing, spreads, and profits, have little incentive to change the status quo, except to increase activity and liquidity and reduce counter-party risk (the risk of clients and counter-parties defaulting on trades).

7.  Once they understand the new product and market behavior, speculators abound and will pounce on any opportunity to take advantage of market abnormalities or inefficiencies. They will likely be specialized hedge funds and funds that house "quant-jocks," but they may also (at least in the past) be the proprietary trading units of large banks and dealers.

8.  Large dealers, because they control the market, can determine the price reported among themselves, prices reported to other interested end-users, and prices reported to the public.

9. Large dealers determine, as they see fit or with guidance from regulators, how the transactions are "cleared" (settled, paid for, or consummated formally) and how they protect themselves from "default risk" by setting rules for how end-users participate (for example, by pledging collateral or requiring they meet certain capital standards).

Large banks and dealers claim they haven't managed these markets ruthlessly. They argue there has been sufficient self-policing and adequate oversight from regulators and industry-related organizations.  (ISDA, for example, is an industry association that continues to set common standards for trading, documentation, reporting, and collateral-pledging. Markit is an independent company that offers pricing services.)
Then came the financial crisis.

Then came the public's charges that improper selling and trading of derivatives explains why the crisis unfurled and infected much of the global economy. 

Then came Dodd-Frank legislation and regulation.  Dodd-Frank was a comforting anecdote to the crisis. It had the right themes and provided outlines to make markets safe. But Dodd-Frank didn't stipulate tough  deadlines. 

Armed with Dodd-Frank powers, regulators have a blueprint and a vision for how derivatives markets should be overhauled.  They have been tardy, however, in writing the thousands of rules, line by line, that will redesign markets from front to end.  Because derivatives are amorphous financial instruments and don't fall easily into categories, regulators fuss among themselves about which body should have the most oversight.  The debates among the SEC, the CFTC, the securities and derivatives exchanges (NYSE, ICE, NASDAQ, CME, etc.) are part of the reason for delays.  The Federal Reserve, FDIC, FHFA, and OCC have opinions, too.  An alphabet smorgasbord of sometimes conflicting input.

In  spirit, regulators seek to require most commonly traded derivatives be bought, sold, traded and reported on a major exchange with pricing and dealer transparency rules.  Commonly traded derivatives must be cleared and settled (all post-trade operations) via an approved, recognized arrangement, usually funnelled through large well-capitalized banks and overseen by established clearinghouses.

Regulators knew, too, large dealers and banks weren't going to sit still and let millions/billions in profits wither away. Until banks figured out a way to re-engineer their business models to generate profits while strapped by new rules, they would stall the implementation of regulation and continue to squeak out profits. Or they would retreat to their finance labs to craft other ways of making money from derivatives dealing.


Where are we now? Where do we go from here? Will reforms do what they are intended to do--reduce risks in the system, reduce the likelihood that trading won't implode into market nightmares, and prepare institutions for the next crisis?

1.  Banks are rebuilding their derivatives-trading desks, reorienting them toward customer activity and customer flow and allocating proper amounts of capital to support them, as required by Basel III regulation. Some banks are downsizing their desks, not able to make economic or regulatory sense from the wave of regulation.

2.  But big banks won't go away sheepishly.  Revenues from derivatives soared until the late 2000s. They will continue to eke out profits until the economics and capital requirements dictate that old models make no sense.  The biggest and best dealers (including Goldman Sachs and JPMorgan) will develop new, different business models to generate profits. 

3. Massive regulation, oversight and public concern will discourage banks and hedge funds from creating new derivative products--at least not as rapidly as the 1990s and early 2000s, when new products flew off the shelves.  Not long ago, large banks seemed to roll out a fancy new acronym for a new product every other quarter, always a moment of pride for them and for the quantitative experts they had hired to think them up.

4.  Regulators, in an effort to come to a conclusion soon, will unveil new rules (thousands of them), but will probably soften some of them, compromising with banks and hedge funds, yielding to some of their unrelenting lobbying efforts.

5.   "Pain vanilla" activity (basic swaps, basic forwards, will thrive, even with thinner profit margins. The big banks will compensate with volume and take advantage of other banks exit derivatives activities.

It will have been a long haul, and it won't be over soon. Derivatives markets are huge, impactful, and complex.  This story still has many chapters remaining.

Tracy Williams

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