A question of values …
Derivative contracts are valued on a mark-to-market (“MtM”) basis. This requires valuation of the contracts based on the current market price.
OTC derivatives trade privately. Market prices for specific transactions are not directly available. This means current valuations rely on pricing models.
In current accounting argot, most derivatives are Level 2 assets (Mark-to-Model). In practice, this means that they cannot be priced based on quoted trade prices (Level 1) but are valued using observable inputs; for example, comparable assets or instruments or using interest rates, volatility, correlation, credit spreads etc that can be put through an accepted model to establish values.
There are significant differences in the complexity of the models and the ability to verify and calibrate inputs. More complex products used sophisticated financial models, often derived from science or statistical methodology. There are frequently differences in choice, exact factorisation and even numerical implementation of the models. Different dealers may use different models.
Some required inputs for the models are available from markets sources. The nature of the OTC market and the limited trading in certain instruments mean that key input parameters must frequently be “estimated” or “bootstrapped” from available data. In certain products, the limited number of active dealers means that “market” prices are sometimes no more than the dealer’s own quote being fed back after being collated and “scrubbed” by an external data provider. This is referred to prosaically as “mark-to-myself”.
Model variations and small differences in input can frequently result in large changes in values for some products.
The models make numerous assumptions including the ability to borrow at market rates for (theoretically) infinite amounts, unrestricted ability to enter into transactions and abundant trading liquidity. These assumptions are difficult to satisfy in practice.
For example, a key assumption of derivative valuation is that a transaction can be hedged with a counterparty or through other means at all times. In late 2008, in the aftermath of the collapse of Lehman Brothers and problems at AIG, market liquidity dried up and made it impossible to source market prices or transact in many instruments.
Model based valuations drive pricing of transactions and dealer hedging. They also are used to calculate the risk of the transactions and ultimately to derive the capital required to be held for regulatory and internal purposes.
The model-based valuations are also used to determine earnings and ultimately bonus payments for dealer staff. In Warren Buffet’s inimitable words this allows the dealer to see “… where the arrow of performance lands and then [paint] the bull’s eye around it”.
Non-professional dealers rarely have the required sophisticated pricing and valuation systems. They are dependent upon valuation date (predominantly) supplied by dealers or (less frequently) rely on pay-as-you-go pricing services.
Investors use the model-based prices to generate values for their fund units. Investors transact at these model-based prices when they invest or redeem investments
The accuracy and tractability of derivative valuation, especially for complex products, is questionable.
MtM prices may be also prone to manipulation. Recent disclosures about events leading up the government bailout of AIG highlight potential problems.
There is limited internal or external (auditors and regulators) oversight of the models. This reflects, in part, the complexity of the models and the scarcity of experienced professionals capable of undertaking such reviews.
Widespread reliance on models and MtM methodology is perhaps surprisingly an unquestioned article of faith in financial markets. It allows immediate recognition of gains and losses that will accrue over many years immediately. After his purchase of Gen Re and discovery of the problems surrounding its derivatives operations, Buffett remarked: “I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably they have favoured the trader who was eyeing a multi-million dollar bonus … Only much later did shareholders learn that the reported earning were a sham.”
Interestingly, MtM accounting is generally not available outside of financial instruments. An often neglected element of the Enron scandal was the company’s ability to convince its auditors and the U.S. Securities and Exchange Commission (“SEC’) to allow MtM accounting to be used in the natural gas industry. This allowed the company to record current earnings based on the future value of long term contracts.
Current regulatory proposals do not attempt to deal with the pricing, valuation and model issues. As Daniel C. Gelman observed: “Where secrecy reigns, carelessness and ignorance delight to hide.”
Stand by Me …
In derivative contracts, each party takes the credit risk of the other side in terms of performing their obligations. This is known as counterparty risk. The failure of Lehman Brothers and a number of banks during the Global Financial Crisis (“GFC”) highlighted the problems of counterparty risk in derivatives.
Counterparty risk in derivatives is different from credit risk generally. In a loan, the lender is exposed to the risk of the borrower failing to pay interest or repay the known face value of the loan. In contrast, in most derivative contracts (other than options), the risk is mutual with both parties being exposed to the risk of non-payment by the other.
Counterparty risk is complex because the payment obligations between the parties are contingent. The quantum and the direction of payments depend on market price movements. The potential counterparty risk is not known in advance and is apparent only when actual price movements occur. In practice, this requires parties to estimate the potential exposure using mathematical models based on the expected evolution of the relevant market prices.
In the 1980s when derivative markets developed, counterparties were generally of high credit quality. This had the effect of reducing, although not eliminating, counterparty risk.
Over the last two decades, the derivatives market has becoming more democratic. Entities with lower credit ratings have become active users of derivatives. This includes highly leveraged investors, such as hedge funds and private equity funds. Participation of these riskier entities has entailed reliance on credit enhancement techniques.
The primary form of credit enhancement is the use of bilateral collateral. This entails counterparties posting collateral in the form of cash or high quality securities to secure the current value of the contract. The collateral acts as surety against non-performance under the contract. Collateral arrangements are highly customised. For example, AIG’s collateral arrangements required the firm to post collateral only where the exposure under the contracts increased above an agreed level or AIG’s credit rating was reduced below a specified quality.
Other credit enhancement techniques used include a right to break that allows either party to terminate the contract under certain credit-related circumstances. Any such termination is at market values triggering an obligation of one party to pay the other party the current value of the contract.
Counterparty risk and credit enhancement techniques are predicated on the same models used for pricing and valuation. Use of bilateral collateral relies on the accuracy of valuations and risk models. It also relies on certain and enforceable legal rights in respect of collateral and proper management of the cash and security lodged.
The GFC, especially the bankruptcy filing of Lehman Brothers, provided a test of counterparty risk in derivatives. The quantification and management of such risk proved problematic. The quantum of credit risk from derivatives was higher than model based estimates as market volatility increased and correlations between risk factors moved erratically. Legal enforceability, control and management of collateral also experienced problems.
Current regulatory proposals focus heavily on counterparty risk issues. The central legislative reform proposed is a central clearinghouse – the central counterparty (“CCP”). The BIS also proposed changes in capital requirements against counterparty risk in the light of recent experience.
Under the CCP arrangements, “standardised” derivative transactions must be transferred to an entity that will guarantee performance. In a curious circularity, standardised means anything that is eligible for and can be “cleared”. Interesting inclusions and exclusions – both in terms of products and parties that must trade through the CCP – are to be found. The arrangement centralises contracts in a single entity, the ultimate case of “too big to fail”.
The CCP implements risk management systems to manage its exposure under derivative contracts.
The CCP will be reliant on risk models and the ability to value contracts. As noted above, there are significant issues in pricing and valuing contracts and, for some products, reliance on complex models.
The CCP proposal relies heavily on “self-confidence”, which as Samuel Johnson observed is “the first requisite to great undertakings.” In relation to the CCP, legislators and regulators are basing their approach on Lillian Hellman’s helpful advise: “It is best to act with confidence, no matter how little right you have to it.”
One (Not Very Nice) World…
The GFC, in line with previous derivative crises including the collapse of Long Term Capital Management (“LTCM”), revealed deep fault lines in financial markets.
Derivative markets entail complex chains of risk that link market participants. This is similar to the re-insurance chains that proved problematic in the case of Lloyd’s Insurance market problems. In both markets, the risks are both potentially significant and “long tail”, that is, they do not emerge immediately and may take some time to be fully quantified.
As in the re-insurance market, the long chain of derivative contracts can create unknown concentration risks. This is exacerbated by the highly concentrated structure of derivative trading. It is likely that for each product or asset class a few dealers (less than 10-12 and sometimes as few as 4-6) account for the bulk of trading. Five entities account for more than 95% of American financial firms’ derivative holdings. This means that financial problems or uncertainty about any major dealer could cause the financial system to become gridlocked as uncertainty about counterparty risks restricts normal trading.
Current regulatory proposals have not focused on the issue on inter-connected trading and concentration risk other than as a by-product of the CCP proposal. It is widely believed that the CCP will improve the market structure.
In reality, the CCP becomes a node of concentration. The CCP may also increase concentration risk. The heavy investment required to establish the infrastructure to clear contracts through the CCP will mean that a few large derivative dealers will quickly dominate the business. Other dealers will inevitably be forced to clear and settle trades through these dealers creating counterparty credit risk and perversely increasing systemic risk. This corresponds to the experience in exchange traded futures and options markets. In addition, to the extent that products are not routed or counterparties are not obligated to trade through the CCP, the problems remain and may increase.
A central problem of the current derivative markets is potential liquidity (cash or funding) risks. Ironically, the problems derive, in substantial part, from the desire to reduce counterparty risk through credit enhancement procedures, such as bilateral collateral.
Where derivative contracts are marked-to-market daily and any gain or loss covered by collateral to minimise performance risk, movements in market rates can trigger large cash requirements. These requirements may be unanticipated. If there is a failure to meet a margin call then the position must be closed out and the collateral applied against the loss. This may leave the parties unhedged against underlying risks or on offsetting positions creating the risk of additional losses.
For example, ACA Financial Guaranty sold protection totalling US$69 billion while having capital resources of around US$425 million. When ACA was downgraded below “A” credit rating, it was required to post collateral of around US$ 1.7 billion. ACA was unable to meet this requirement.
AIG’s CDS contracts were subject to the provision that if the firm was downgraded below AA- then the firm would have to post collateral. In October 2008, when AIG was downgraded below the nominated threshold, this triggered a collateral call rumoured to be around US$14 billion. AIG did not have the cash to meet this call and ultimately required government support. The problems at ACA and AIG are not unique.
Current regulatory proposals do not address liquidity risks in derivative markets. Interestingly, the CCP may inadvertently increase liquidity risk as more participants may be subject to margining and unexpected demands on cash resources. The BIS has proposed an extensive regime of liquidity risk management controls that would, in part, cover some liquidity risks.
Failed Plumbing…
The GFC has exposed long standing and significant problems with the infrastructure of derivatives markets.
In 2006, Alan Greenspan expressed shock and horror at the state of settlements in the credit derivative market. He expressed surprise that banks trading CDS seemed to document trades on scraps of paper. The ex-Chairman, perhaps unfamiliar with the reality of financial markets, had difficulty reconciling a technologically advanced business with this “appalling” operational environment.
Derivative systems and trade processing are generally inadequate, with infrastructure lagging well behind innovation. Delays in documenting contracts forced regulators to step in requiring banks to confirm trades more promptly. The accuracy of the mark-to-market values of contracts, particularly of less liquid and infrequently traded reference entities, is not unimpeachable. Where collateral is used, as noted above, monitoring and management of collateral poses significant risks.
Current regulatory proposals seek welcome improvements processes and systems for derivative trading.
Derivative contracts are documented under the International Swap and Derivatives Association (“ISDA”) Master Agreement. The ISDA Agreement has been remarkably successful in standardising documentation of trading.
The contract has not been tested under stressful conditions such as those of the GFC. A number of issues have emerged.
The bankruptcy of Lehman Brothers and resulting unwinding of complex derivative arrangements has exposed problems of derivative and bankruptcy law, especially in cross-border, multi-jurisdictional transactions. The GFC also exposed issues relating to the documentation of specific derivative contracts, such as CDS contracts, and the impact on bankruptcy and resolution of financial distressed firms.
Current regulatory proposals do not address any of these documentary issues.
Bank regulatory capital has long distinguished between banking (loans or hold-to-maturity assets) and trading books (trading or available-for-sale assets). Differing capital rules between the banking and trading books encouraged regulatory arbitrage, generally using derivative structures to reduce the required level of capital. The BIS has addressed some regulatory anomalies, increasing the capital required against derivative positions.
Regulatory initiatives continue to emphasise improved disclosure of derivative contract. There is already significant disclosure, although much of it is incomprehensible and lacks utility. Additional disclosure will not significantly reduce systemic risks of derivatives.
On 25 September 2002, speaking at the U.K. Society of Business Economist while in London to collect an honorary knighthood for contribution to economic stability, Alan Greenspan outlined the case for less transparency:
…paradoxically, the full disclosure of what some participants know can undermine incentives to take risk, a precondition to economic growth….to require disclosure of the innovative product either before or after its introduction would eliminate the quasi-monopoly return and discourage future endeavours to innovate….market imperfections would remain unaddressed and the allocation of capital to its most productive uses would be thwarted.
Greenspan argued that even “disclosure on a confidential basis solely to regulatory authorities may well inhibit…risk taking.” Dealers will undoubtedly resist meaningful disclosure prejudicial to their economic interests.
Regulatory initiatives do little to address the quality of regulators and the acuity of oversight. The absence of suitably expert and experienced regulators will undermine regulatory and legislative initiatives. Given the shortage of talent in derivatives generally and the pay grades of regulators, it will be difficult for regulatory agencies to properly supervise dealers and derivative activity. In terms of an old Spanish proverb “Laws, like the spider’s web, catch the fly and let the hawk go free.”
Regulatory Tango…
Debate over regulation of financial services has taken on a frenzied tone. Voluminous, overlapping and (sometimes) contradictory proposals have been enacted or are under consideration. Activity and achievement are confused.
Regulatory agencies are jockeying for position, sometimes forming unlikely coalitions to preserve or expand territory. The Commodity Futures Trading Commission (CFTC), under Chairman Gary Gensler, has been a staunch champion of regulation, including the CCP. The CFTC, which would share oversight of derivatives trading with the SEC, will require 119 new employees and a $45 million budget increase to $261 million. Interestingly, its hiring focus is on rule-making attorneys with a minimum five years’ legal experience for “drafting especially lengthy and difficult rules and regulations implementing new legislation.” With a starting salary of $145,000, it will be interesting to see if the CFTC attracts candidates with the requisite skills. More interestingly, the CFTC clearly feels that what regulation needs is more lawyers and more rules.
Consultation with industry participants is unlikely to result in progress. As Wolfgang Schäuble, the German finance minister, told the Financial Times: “If you want to drain a swamp, you don’t ask the frogs for an objective assessment of the situation.”
Banks and their lobbyists do not believe that there is a case for regulation. In William Davenant’s words: “Had laws not been, we never had been blam’d; For not to know we sinn’d is innocence.”Banks argue that the complex nature of derivative trading dictates that self-regulation is the only feasible approach. If that fails, then banks seek to minimise scrutiny of major issues, such as the size of the market, speculative activity, pricing issues, complexity and mis-selling of derivatives to unsuitable clients. They argue that existing regulations already adequately cover some issues. Proposed regulations will be masterfully narrowed to minimise impediments to profitable activities.
There will be a familiar threat. Lack of international agreement and regulatory uniformity makes compliance impractical. Banks and derivative activity will relocate with losses of jobs and taxes to the host country. Familiar arguments will be heard regarding the loss of competitive advantage, diminished financial innovation, slower capital formation and higher cost of capital. Each is a well-known step in the familiar “regulatory tango”.The complexity of the issues means that ultimately no laws may be truly effective. As one famous law maker, Adlai Stevenson, observed “Laws are never as effective as habits.”Groucho Marx observed that “[government] is the art of looking for trouble, finding it, misdiagnosing it and then misapplying the wrong remedies.” Legislators and regulators are likely to discover the truth of that proposition in their attempts to regulate the derivative market.
© 2011 Satyajit Das All Rights reserved.
Satyajit Das is the author of Extreme Money: The Masters of the Universe and the Cult of Risk (fortcoming) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2010).