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Derivative dilemmas
16 Aug 2010
The Edge Financial Daily
Financial Times
N/A
Daily
25,000 / 40,000
Language
Page No
Article Size
Color
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English
18
2
663 cm
Full Color
7,650
22,950
Derivative dilemmas
By July 2011 a new
rulebook will be drawn
up to police the massive
derivatives market
that precipitated the
financial crisis
Aline van Duyn
Ari Bergmann is putting
the finishing touches to
a course he will begin
teaching at New York
University in a few
weeks Yet in spite of
his best efforts much of the curric
ulum cannot yet be written That is
because of a big battle that is about
to explode on Wall Street and in the
deepest bowels of Washington
Bergmann will teach people
ranging from investors to corpo
rate treasurers how to spot financial
risks and how to manage them The
tools used to do this are derivatives
which he first traded in the 1980s
— contracts whose value is
to a financial instrument from the
rate of interest paid on US govern
ment bonds to the price of oil
The derivatives market is one of
the biggest in the world At the end of
last year contracts with a face value
ofUS 636 trillion RM2 quintillion
were swirling around the world s
financial system according to the
Bank of International Settlements
Just 3 4
of the total were traded on
exchanges The rest — US 615
lion equivalent to nearly 10 years
of global economic output —
agreed and traded in private mar
kets under terms struck directly
between the buyers and sellers
Overthenextyear anentiretynew
rulebook is to be drawn up for this
privately traded part of the financial
markets also called over the counter
OTC derivatives President Barack
Obamas signature on the Dodd Frank
Wall Street Reform and Consumer
Protection Act on July 21 started the
countdown The legislation covers
many parts of the financial system
Title seven — the part that deals
derivatives
— is among the
far reaching and controversial sets
ofstatutory changes included in the
newlaws according to lawyers at Cad
walader Wickersham
Taft
But whereas in theory the busi
ness is about to be revolutionised in
reality any changes will be preceded
by bitter haggling over preciselywhat
the rules prescribe — and
Crucially for banks investors and the
infrastructure allowed for misuse of
future health of world economies
recent financial meltdown
just how far reaching the outcome
will be depends in large part on the
confidence in markets before After
these instruments exacerbating the
Regulators have swept in to restore
decisions made by the two Washing
the crash of 1929 the SEC was set
ton regulators who will police a mar
up to police the equity markets and
ket that grew dramatically in recent
decades without direct oversight
create structures thatwould reassure
investors the cards were not stacked
The two the Securities and Ex
change Commission SEC and the
Commodity Futures Trading Com
mission CFTC have increased their
staff numbers in anticipation of the
rule writing and their huge extra
enforcement duties For the most
part the rules have to be written by
July 2011 These are regulators that
usually write just a handful of new
rules every year but thanks to the
new legislation there will be more
than 100 definitions and rules to get
through Many of the key terms in
the derivatives legislation are either
undefined or are left for the regula
tors to fill in says Cadwalader
The root cause ofthe financial cri
sis involved losses on risky US mort
gages The entire global financial sys
tem was exposed to these mortgages
after hundreds ofbfflions ofUS dollars
ofcomplex securities linked to them
were sold to investors from Illinois to
Iceland Derivatives were the building
blocks for those securities
The degree to which derivatives
had created a dangerously intercon
nected financial system became dear
amid the collapse of Bear Steams
Lehman Brothers and AIG in 2008
A default by one bank at the centre
of a tangled web of derivatives con
tracts could paralyse the entire finan
cial system because the derivatives
could become worthless ifthe bank
writing the contract went under
In the wake ofthe recent finan
cial crisis over the counter deriva
tives have been blamed for increasing
systemic risk said Federal Reserve
Bank ofNewYork staffin a paper ear
lier this year OTC derivatives serve
a vital role in financial markets but
deficiencies in the market design and
against them The CFTC with its roots
in commodity markets has done the
same for exchange traded futures
Now the regulators will try to do the
same for derivatives markets
The Wall Street reform bill will
for the first time bring comprehen
sive regulation to the over the coun
ter derivatives marketplace says
Gary Gensler chairman ofthe CFTC
The new rules will lower risk pro
mote transparency and protect the
American public he adds
Under the newregulations the de
rivatives world will be divided in two
On one side will be those products
that are widely used simple in struc
ture and activelytraded standardised
derivatives Those will be pushed on
to clearing houses to make the finan
cial system less vulnerable to the de
fault of a big derivatives dealer
Clearinghouses canreduce coun
terparty and systemicrisks by standing
in the middle oftrades — though
of course remains a risk the clearing
house itself may fail The clearing
house has a pool ofcapital and collects
collateral and margin — upfront
ments against possible losses Ifthese
resources are not enough to cover a
default by a member the others are
supposed to cough up
Cleared derivatives will also have
to be traded on electronic systems
although exactly how those systems
will be denned and how quickly and
frequentlyprice information has to be
made public remains to be resolved
Bergmann who advises investors
on derivatives strategies says public
pricing would reduce the chances
that buyers
— such as
ties or small pension funds
—
overpay Customers who pay banks
too much would soon know if the
Headline
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Derivative dilemmas
16 Aug 2010
The Edge Financial Daily
Financial Times
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value is lower than theythought Ifthe big bank
These questions about the costs
contracts are centrally cleared they also mean mat me risks ofthe clearing
would have to come up with an extra houses and the business model be
margin to pay the clearing house as hind them cannotbe propertyworked
limbo soon as the price fell Mispricing of Out — leaving investors in
When we use a clearing house we
derivatives has often not been discov
ered until it is a disaster says Berg have to be able to make a case as to
mann In theory with widespread why we think they are financially
clearing people will know about it sound says the head oftrading at one
ofthe biggest institutional investors
before it becomes a disaster
We cannot determine this until we
Once regulators determine what
know
what the new rules will be
part ofme OTC derivatives or swaps
There is a lot of play for Accord
markets has to be cleared the re
maining part will also be policed No ing to Tabb Group the biggest de
one knows what proportion will be rivatives dealers generate revenues
uncleared or what the targets are ofUS 40 billion a year from the OTC
Wall
to
although for all derivatives the more
heavily regulated exchange traded
futures market provides the likely
standard Look at the way futures
have traded on exchanges says Vi
ral Acharya professor of finance at
NYU s Stem business school
Simi
lar practices in one way or another
will be applied to OTC derivatives
under new regulations There will be
more capital required less leverage
and less opacity
How regulators decide the clear
ing houses should hold the collateral
against trades and the extent to which
derivatives users can offset positions
against each other will also be key
Banks have built huge internal clear
ing systems in recent decades divi
sions usually called prime broker
age Through these big institutional
investors or hedge funds can buy and
sell all kinds offinancial instruments
derivatives— from bonds to credit
to currency swaps to commodity in
— and onset them
one other If an investor has to pay
usually for each part of the trade —
against vestments
over
called a leg
— having to hand
cash for each piece could add up If
the positions are offset the trade can
be done much more cheaply
We still don t know what kinds
of trades will be profitable orwhich
ofour customers will have to change
their investment strategies says
the head of prime brokerage at one
business
As the rules are rewritten there
will be much behind the scenes
jostling as current derivatives big
shots
— which include all the
English
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2
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about the future shape of the de
rivatives markets now in the hands
of staff and commissioners at the
regulators the CFTC s Gensler says
CFTC and SEC teams have already
met five or six times since the legis
lation was passed A series of public
hearings is expected to be held from
September onwards
The potential for turf wars is of
concern as is the possibility of dis
ruption to investment and trading
activities The enormity ofthe pro
posed changes could result in both
short term pain for users of swaps
and participants in the derivatives
markets generally and long term
unintended and undesirable changes
in the marketplace say lawyers at
Jones Day The extent to which the
rulemaking process will provide the
necessary clarity will depend in part
Street banks
— try to hang on on how well he CFTC and SEC are
market share and newcomers try able to work together in areas ofpo
tentially overlapping jurisdictions
to muscle in This is a big business
Whatever the case the coming
opportunity says LarryTabb chief months will determine what is ul
executive of Tabb Group
timately discussed in Bergmann s
The cast of characters embraces
not only big banks such as Goldman
Sachs JPMorgan Chase Morgan
Stanley Barclays Capital and Deut
sche Bank but exchanges such as
CME Group Nasdaq OMX NYSE
Euronext and Intercontinental Ex
change which want clearing busi
ness It also includes smaller banks
and brokers that do not current
ly trade derivatives for instance
Nomura and Jefferies as well as
inter dealer brokers including leap
and other financial groups thatwant
to get into clearing or trading from
Tradeweb to State Street to tiny start
up brokerage firms
The outcomes will affect inves
tors banks and companies that use
derivatives extensively for hedging
The end result will also depend on
what happens in Europe A lot of
these things won t work well if one
centre applies rules that are not as
strict says Arachya
With the answers to the questions
course about risks and markets Not
for nothing is the biggest section in
his course outline entitled
Deriva
tives weapons of mass destruction
or weapons of mass protection