Value at risk Shock

On october 15th, There was a turmoil in the US treasury security market. The yield on the benchmark 10 year US government bond dropped by 33 basis point to 1.86% before settling to 2.13%. This does not look much move but market participant confirmed that this was seven standard deviation move from the intraday average. Such event can occurs only once in 1.5bn years.

After this huge market volatility analyst tried to figure out the reason and even trader and regulators also wanted a understanding.
One of the explanation is provided as VaR shock. After the financial crisis, major dealer banks have curbed the capital allocation to the market making activity and VaR limits have imposed to trader or desk. If VaR limit gets breached than trader or desk has to sell off these positions. With the shockwaves of late 2008 now gradually receding, and a period of low market volatility taking its place, these VaR models have been indicating that the risk of investors sustaining large losses is very low.That means investors may be subject to a so-called “VaR shock” in the event that volatility returns to markets.

This is what happened in the market as yields dropped in the market and computer algorithms used by market making systems start buying more treasuries in order to stem their losses.

Lower risk appetite at the big dealer banks have created the effect of reducing liquidity in trading security. Market liquidity get worse in selloff periods and dealers positions, long or short, declines in the sell off periods. Dealers reduction in net positions is associated with the reduction in dealer's risk,VaR. 

“VaR-based analysis leads to self-reinforcing loops,” a group of banks warned in a presentation to the US Treasury weeks before October 15. “An unexpected increase in volatility might come from broad-based selling of assets wanting to de-risk in front of a turn of policy.”

Libor Reforms

ICE Benchmark Administration (IBA), the new administrator of Libor has published a position paper on the future evolution of Libor. Following major reforms were proposed by the FSB on July 2014 for the major interest rate benchmark.

• Strengthening the existing IBORs and other potential reference rates based on unsecured bank funding costs by underpinning them to the greatest extent possible with transactions data (“IBOR+”)  
• Developing alternative, nearly risk-free reference rates (RFR) since FSB Members believe that certain financial transactions, including many derivatives transactions, are better suited to reference rates that are closer to risk-free.

Another concern was raised that reference rate should be based exclusively in actual transactions. But this can be applicable only  for the currencies or markets that have enough liquidity and actual transactions. When conditions in the local market do not allow pure transaction rates (ones derived mechanically from transacted data without use of expert judgement), authorities should work with and guide the private sector to promote rates which are derived on a waterfall of different data types: underlying market transactions first, then transactions in related markets, then committed quotes, and then indicative quotes.

IBA has proposed many reforms and it is expects the market participant's view by Dec 2014.Focus is on making the whole process including Libor definition , calculation methodologies used by individual banks, submitting Libor rates and selecting the final Libor rates, more objective and completely transparent.

I agree with Prof Jayanth that submitter should not do the interpolation for the missing points in the Libor calculation as this can be more efficiently done by the administrator.

Another important proposed change is to change the trimming of the top and bottom quartiles allows for the exclusion of outliers from the final calculation. This trimming methodology was benefited to counter manipulations. From this perspective, ‘topping and tailing’ may be less relevant in that it would adjust a rate that had already been calculated formulaically from observable and testable evidence. As mentioned in the position paper currently several alternatives of this approach are being evaluated. If this smoothing of submitted Libor rates gets hanged than it can have large impact on rate and on it's volatility.

Battle lines are drawn, among CCPs, who will win rates

A good read on this.

ISDA Stay protocol

The world’s biggest banks have agreed to rewrite  the rule book on derivatives contracts to make it easier to resolve a future failing institution like Lehman Brothers. ISDA announced that eighteen major global banks or G-18 have agreed to sign the ISDA stay protocol. The Resolution Stay Protocol is a major component of a regulatory and industry initiative to  address the too-big-to-fail issue by improving the effectiveness of cross-border resolution actions against a big bank – therefore ensuring taxpayer money is never again needed to prop up a failing institution. 

“This is a major industry initiative to address the too-big-to-fail issue and reduce systemic risk, while also incorporating important creditor safeguards. The ISDA Resolution Stay Protocol has been developed in close coordination with regulators to facilitate cross-border resolution efforts and reduce the risk of a disorderly unwind of derivatives portfolios,” said Scott O’Malia, ISDA Chief Executive.

Credit support annex of ISDA contracts governs the ~$700 trillion OTC derivatives market. In these type of ISDA contracts banks or firms have the right of termination of trade and seize the collateral when the counterparty fails. Banks or firms exercise this option to minimise the counterparty risk. According to report  from GAO office,Eighty percent of Lehman's derivative counterparties closed their deals with the bank with in five weeks of bankruptcy filing.  

Regulators had expressed concern that the simultaneous close-out of derivatives 
transactions during the resolution of a large, cross-border bank could hamper resolution efforts and destabilise markets.This is being addressed in certain countries through the development of statutory resolution regimes – for instance, Title II of the Dodd-Frank Act and the EU Ban Recovery and Resolution Directive – which impose a stay on termination rights in the event a bank is subject to resolution action in its jurisdiction. But regulators have realised that this can't be effective for cross border trades. 

The orderly liquidation authority (OLA) contained in the Dodd-Frank Act in the US, and the EU's Bank Recovery and Resolution Directive (BRRD) are two examples of so-called special resolution regimes, which allow authorities to take control of a stricken institution, restructure and recapitalise it, in the space of a day or two. These regimes include mandatory stays, but would only apply to a trade if both counterparties were subject to the law. In cross-border trades, that is unlikely to be the case. Hence becomes important that banks themselves give up  their rights to close the deals in case of counterparty fails. 

Some of the issues are still not clear as whether other market participants like asset management firms will follow the suite.Buy side firms can't voluntarily give up their rights because of fiduciary responsibilities to their clients. This further adds complications, major global banks will adhere to the stay protocol from Jan 2015 while other market participant will not adhere to it. Some market participants such as buy side firms will continue have the rights of terminating deals while banks no more can do it. This can create unbalanced scenario for the dealers or major banks.

Another more awkward issue is capital issue. Opinions are split on whether this will impacts the margin period of risk (MOPR) or not.The MPOR represents the length of time regulators believe it would take a bank to exit a portfolio of trades with a defaulting counterparty - the longer the MPOR, the longer the surviving dealer's exposure can grow.

How fruitful this protocol will be in future can be known in future. However working group members believe the document they ultimately produce will make the global financial system more resilient.

Growth of shadow banking

A good read on Growth of shadow banking from IMF blog.

ISDA survey: OTC derivative are important but fragmentation is concern

ISDA conducted end user survey to get more insight into the derivative uses by end users.Biggest highlight is OTC derivatives are not going away and almost eighty seven percent of respondents thinks that OTC derivative are very important or important. Almost eighty percent of respondents thinks that either their uses of OTC derivative are going to be same or will increase in future. Important to know that for what purpose end users uses the OTC derivatives.

1. Sixty five percent of respondents uses OTC derivatives for managing exposures (to currencies, commodities, credit, etc.) so that firm can maintain and improve pricing, operating expenses and returns. 
2. Forty seven  percent of respondents use these for reducing financing costs and managing the cost of capital that  firm borrows to invest in our business
3. Forty five percent of respondents use these derivatives for hedging exposures in international markets to maintain and enhance their competitiveness.
4. Thirty percent of respondents uses derivatives to hedging risks of new activities and investments so my firm can effectively invest for growth

It is clear that firms uses derivatives to manage or reduce uncertainty and these derivatives are getting used as important risk management tool. “It is clear that end-users around the globe see OTC derivatives as vital risk management tools and expect to continue using them to hedge their risk,” said Scott O’Malia, ISDA Chief Executive Officer. “End-users realize the benefits of the regulatory reforms that are currently being put in place, but they’re worried about the effects of market fragmentation on liquidity and cost.”

The survey also highlights that the top three concerns for end-users regarding their ability to use derivatives include: increased costs of hedging (60%), the scope of cross-border derivatives regulations (44%) and uncertainty about regulations in their firm’s principal business regions (38%).
Total 125 firms responding to the survey, 28% were non-financial corporates and 55% were financial institutions.

Could be a Minsky Moment, Ultra low volatility

"Stability is destabilising" is the idea given by the Hyman Minsky,American economist who died in 1996, grew up during the Great Depression, an event which shaped his views and set him on a crusade to explain how it happened. 

Idea of Minsky, which was largely ignored till 2008 credit crisis, is very simple and it challenges the external shock theory, only external shock can disturb economic equilibrium. 

Minsky who long ago wrote – paraphrased – that if and when markets are perceived as being stable, it’s that very perception will make them unstable, because stability, i.e. low volatility, will drive investors into riskier asset purchases. The Fed’s manipulation-induced ultra-low rates have achieved just that, and now they’re surprised? Now fed ants uncertainty and for this rates needs to be increased.

Market is all about people and there has to be certain uncertainty, if you take uncertainty from their life than how are they going to react to  it definitely taking more and more risk as they believe nothing can't happen to them.Free market now looks like distant past as we are now living in controlled economy.

Minsky discussed more ideas such as Minsky Moment, when the whole house of cards falls down, Three stages of debts and preferring words to math and models. 

US interest rate: Potential Shock

A good read by IMF on potential shock for the global market, depends on how and when US will exit from it's unconventional monetary policy.

If US exits bumpy the result could lead to a faster rise in US long-term treasury rates that impacts other bond markets.This could have implications not only for emerging markets, as widely discussed, but, also for other advanced economies.

Full circle of money flow to emerging countries in one year from Aug 2013 to Sep 2014

In August 2013, India faced the worst currency crisis in the wake of US taper tantrum. Indian currency had lost 20.1 percent from beginning 2013 and rupee slumped 3.9 percent to an unprecedented 68.8 per dollar the biggest drop since 1993. The market was in panic mood and RBI and Indian government were trying every thing to stop this mayhem. Some measure like capital control taken by Indian authorities fired back as foreign funds sens that India can freeze their funds or investments. Indian Bond yields was raising and and benchmark government 5Y bond touched the highest yields since 2001.

India has come to long way from August 2013 to August 2014. Rupee is stable and everyone is talking about the Indian growth story in next 5 to 10 years. Mood has completely changed and with corrective measures RBI governor Rajan is well prepared for the further tapering of Fed. Recently ICICI has raised $500m through 5.5 yead bonds, pricing tighter than at it's own funding curve. Money has started flowing back into India and this is the case with almost all emerging countries.

Credit spreads on U.S. dollar-denominated emerging market bonds are back to pre-tantrum levels from early 2013.Bond yields of emerging countries has been tighten and prices are touching all time high. Money is flowing to emerging countries at alarming rate and this is  because of easy monetary policies across the world. There will be a reversal of this money sooner or later but looks like investors are not thinking about that and if this happen suddenly than there could be knee jerk situation again. Indian central bank chief has mentioned his worry on this and he said that we can not reliance on foreign capital, this  money will exit for better use in home countries. Most of the market participants think that this reversal could happen when US do the first rate increase. 

However it is expected that India will be less impacted due to reasons like crude oil is cheaper, high foreign exchange reserve and most importantly India currently has pro business and stable government. 

Flow Trading and is it different from Prop trading ?

Flow trading business is one of the main revenue source for the big investment banks. Theoretically in flow trading  trader trade financial instruments such as bonds, CDS with client's fund and he should be act in interest of client. In financial markets numerous variant of trading are happening. Basic ones are Agency Trading or Proprietary (Prop) trading and all other trading forms overlap between these.

Agency Trading: You simply execute orders for the client – you’re merely an “agent” doing what he/she wants and do not have (much) freedom.

Prop Trading: You are the principal and can make whatever trades you want, using your own money – within your trading mandate and risk limits.

Flow trading where there’s some element of agency trading but also some prop trading involved. In flow trading banks (desk) act as market maker for the clients (mostly hedge funds). Often banks uses Flow trading as  generic term for all activities done to provide and manage the desired exposure for the clients. It may involve the  market making , hedging , risk/p&l review and marking/pricing. Normally all major banks have flow trading business in Investment Grade (IG) ,High Yield (HY),Distressed Products,Loan trading  and Index segments and different trading desk has been setup for these business.

Normally Flow trader takes positions in his books based on the market sense or buying recommendation and later when client places order to buy then he decides based on resting orders and do one of the followings

1. He off load his positions to clients obviously with making profit on that
2. Trader buys for both for his prop books and for his client as well, obviously he continue believe in it
3. He just act as market-maker and back-to-back it with another counterparty cheaper.

In this whole process trader tries to maximize the profit for the firm. In flow trading or market making there is lot of prop trading involved. Volcker rule has proposed to ban  prop trading so there is lot of debate whether Flow trading or market making will be permitted or not. 

Differentiating between Prop trading and Market making can be very complex. Market making is important for the clients and it is not always possible for these clients to find an market participant with opposite trade offer. As suggested by George differentiation can be done as below. 
You simply need to ask each trader how they get paid and you will know whether the firm is doing proprietary trading or market-making.This is a simple, two-step process:

1. The sell-side will need to classify personnel as back office and front office. Then, they need to categorize all compensation paid to the front-office personnel as either commission based or P&L based.
2. If the amount of money that is paid based on P&L is greater than the amount of money paid based on customer flow (commissions), then you are looking at a proprietary trading operation, and the firm should be held in violation of the Volcker Rule.

Cross Margin across OTC and ETD derivatives

Since the financial crisis, regulators are forcing banks and other market participants, through different methods such as less capital charge for OTC trades that are cleared with central counter parties (CCP), to move towards the central clearing model. In 2009 ,in light of credit crisis, G20 countries have stated their ambition of moving from a bilaterally OTC market to a centrally cleared model.This kicked off a new wave of regulations related to centrally cleared OTC market.

In mid of these developments exchange or CCPs realized that, with more and more OTC derivative trades cleared through them, they can provide the clients more benefits,less margin requirements, with cross margin across different products, standard exchange traded products and OTC trades. Now Eurex, Frackfurt based exchange and clearing house is challenging another London based clearing house ,LCH.Clearnet's Swapclear with already released cross margining platform.

One head of rates trading at US bank in London mentioned that this is going to be a clash of titans."SwapClear is the dominant incumbent, Eurex the upstart with a service that has value-add. It's going to be a huge fight."

Oliver Wyman study claims that a global dealer would save up to 75% more by using Eurex Clearing than at what it coyly terms a baseline CCP, relative to the costs of trading OTC derivatives bilaterally. Regional banks could save up to 100% more, while savings for a fixed-income mutual fund could be up to 70% higher. In total, the incremental savings available at Eurex could be up to €5 billion for buy- and sell-side firms combined, the study claims.

Benefits come from allowing participants to cross-margin their euro swaps exposures with other products they are clearing at Eurex, which include repo and securities lending transactions, as well as the exchange's crown jewel – its huge pool of Bund, Bobl and Schatz interest rate futures. This could generate savings of 3–8 basis points over those available at a CCP with no ability to cross-margin. 

The second benefit is the integrated default fund at Eurex. In practice, this means all clearing members contribute to a single pot of money, allowing offsets to be applied. The total size of the default fund is calculated by estimating the amount of cash needed to contain the losses resulting from the collapse of the two clearing members to which the CCP has most exposure. In theory, offsets across cleared products mean individual members will present less net risk, translating into a smaller default fund and lower capital requirements for members' contributions to the fund. This contrasts with LCH.Clearnet's approach, where the CCP's six product lines are backed by separate default funds.LCH is also going to launch it's cross margining platform. 

There are some more factors such as operation burden while switching from one clearing house to another clearing house, BCBS has revised the calculation framework for CCP exposures and experts have said that this has weekend the Eurex position. 

ISDA is going to include new CDS terms from September 2014

International Swaps and Derivatives Association Inc. (ISDA) is updating derivatives credit definition to include the new government bail-in Credit Event trigger for CDS contacts on financial reference entities in non U.S. jurisdiction. ISDA also modify the typical terms of sovereign CDS contracts in wake of recent Greek debt crisis by allowing a buyer of protection to deliver upon settlement the assets into which the Reference Obligation has converted even if such assets are not otherwise deliverable. Further they have more changes and creating a concept called SRO , Standard Reference Obligation.It is proposed that ISDA will publish a list, known as the “SRO List”, of Reference Entities that are frequently traded on the CDS market, and the SRO List will specify a Standard Reference Obligation (and seniority tier) for each of these Reference Entities.This should increase the fungibility of CDS transactions with the same Reference Entity. More details on these changes are here. 

New credit definitions will supersede the ISDA 2003 credit definitions. In 2003 credit definition ISDA had defined six credit events. Historically out of these six, restructuring credit event has been toughest contingency to contract for in a CDS. Contractual conditions affects the pricing of CDS. So there can be spread in 2014 ISDA CDS trade and already traded same CDS on 2003 ISDA definitions. 
It is anticipated that market participants will begin to use the 2014 Definitions with the September 2014 credit default index swap roll date (i.e., September 22, 2014). The 2014 Definitions will apply to new trades only if so elected by the parties (e.g., by incorporating their terms into a trade confirm). Additionally, ISDA has released a draft protocol that parties can use to elect to have the 2014 Definitions apply to existing trades, although certain existing transactions such as sovereign CDS and CDS on European financial entities are expected to be excluded from the protocol given the substantial impact the changes could have on such trades’ terms and value.
As mentioned by Abel in report, "This credit definition change is Creating a challenge for firms to implement the necessary operational and infrastructure changes."
A CDS portfolio will be consisted of ISDA 2014 credit definition trades, ISDA  2013 credit definition trades and mix of both,as explained below by one of the clearing house at OTC space.

List of recent Risk Management Failures

Risk Management Failures

RBI buying dollars & more dollars

Since last couple of months RBI buying dollar in both cash & future market. In June RBI bought $11.3 bn in future market. This forward exposure may have taken in view of FCNR dollar exposure of RBI. Normally RBI act as stabilizer for INR but recently RBI buying dollar even when INR was depreciating. In June RBI bought $11.8 bn dollar while INR depreciated to 59 from 60. Read the complete story here.
This increased dollar buying could be related to RBI's efforts to build sufficient foreign exchange reserve to face capital account crisis that could arise when US increase the tapering. India faced the crisis in 2013 when INR depreciated to 69 in very short time and volatility of INR was very high. IMF also said  India should prepare a plan to respond to volatility in global currency markets that may come as the U.S. Federal Reserve reduces monetary stimulus, the International Monetary Fund staff said in a report."

Securities Market Risk Survey by IOSCO

Research department of IOSCO published a working paper, “A Survey of Securities Markets Risk Trends 2014: Methodology and Detailed Results,” which provides a detailed analysis of responses to IOSCO’s annual survey on market trends and emerging risks.

According to IOSCO,  "The main purpose of the survey is to gather views on emerging risks to/within securities markets and help identify/highlight pockets of risk that may not be captured by normal statistical analysis or desk research."

Six questions was sent to all potential participant and main question is to " “identify from the 

list, five areas that you see as most important to explore for your jurisdiction when it comes to 

maintaining financial stability"

The main points-

• concerns about “micro-prudential” risks clustered around the areas of corporate governance, financial risk disclosure, shadow-banking activities and regulatory uncertainty;
• concerns about issues considered “macro-prudential,” especially in the areas of banking vulnerabilities and capital flows;
• Responses differ by organisational type; regulators see risk emanating from illegal conduct, corporate governance, financial risk disclosure and benchmarking issues, while market participants are more concerned with risk in the areas of search of yield, resolution and resolvability plans, CCPs and market fragmentation.
• the impact of cross-border flows, financial risk disclosure and CCPs generally has drawn more attention between 2013 and 2014 than previously;
• Three risks have been consistently and frequently mentioned during these three years:
  regulatory uncertainty; banking vulnerabilities; and capital flows.
• Over time some risk areas have gained attention while others have lost attention. The speed of change can be very fast. Sovereign debt and the global economic slowdown were prominent two years ago, but not now. 

Cash Reserve and Liquidity Ratios: A Primer

Cash Reserve and Liquidity Ratios: A Primer

RBI policy review

RBI holds rates, cuts SLR and HTM. Here’s is the complete article on this. Statutory liquidity ratio (SLR) has been cut to 22% from 22.5%. This is a kind of back door easing to banks as now they can lend more. Though some analyst sees SLR as a barrier in financial market development. 

CCP Margin Models | Comparing Historic VaR and SPAN

The SPAN model used in futures clearing can survive in the face of widespread adoption of VaR models in OTC derivatives clearing. Here is the complete article.

The difference between the Value at Risk (VaR) and Standard Portfolio Analysis of Risk (SPAN) market-risk measurement methods has been discussed here.

Collateral reporting requirement for BHCs

During the Financial crisis of 2007-09, it has been observed that financial institutions were far more interconnected and dependent on each other than it was assumed by regulators. Institutions were connected through repo market, for funding need, OTC derivatives and other asset markets. Institutions posted collateral to counterparties  to mitigate the credit risk of transactions in these markets. However During the crisis, rapidly falling asset values, corresponding collateral calls, and stricter collateral requirements led to large losses and subsequent funding needs among financial firms. The degree of interconnection between firms caused these effects to spread more broadly and rapidly than expected. The whole system was more fragile.

Now learning lesson from the crisis, FED required bank holding companies (BHCs) with more than $10 billion to start reporting their collateral arrangements in much greater detail.These data provide insight into counterparties and collateral arrangements in these markets.

“Although BHCs have large exposure to banks, most of the collateral involved maintains minimal credit risk and is highly liquid. Conversely, contracts with corporations tend to use more diverse types of collateral, but the volume of these contracts is only one-quarter that of contracts with other banks,” write Marius Rodriguez and Hamed Faquiryan of the Economic Research Department of the San Francisco Fed. “Moreover, the exposure to hedge fund counterparties is minimal and is collateralized by safe, liquid instruments.” 

In the FED report it also has been observed that collateral posed by hedge funds not only managed actively but also posted collateral is more than total exposure. This type of information can play a important role in understanding the linkage of financial institutions and can be very helpful to keep a check on whole system.

GS shredding less profitable hedge fund clients

Goldman Sachs cutting some Less-Profitable Clients as new capital rules takes their roll.
Also it is  increasing some fees on others as it adapts to new banking rules, people familiar with the matter said.

The bank has told hedge-fund clients that the regulations have forced it to set aside more capital, crimping profits at its prime-brokerage business, which executes and finances the funds’ trades.

Recently GS has achieved 4.5% leverage ratio but this needs to be go up to 5% by 2018  as per new regulatory requirements.

Goldman to offer bond using the TRS

Goldman Sachs is planning €10B in sales of a controversial new type of bond that utilizes total return swaps, at the same time the derivatives are gaining popularity in the market due to the historic lows of credit investments.
TRS, Total return swap, is type of credit derivative that allows investors to get the exposure to portfolio of bonds, loans etc. without actually owning these assets. Investors pay the fees to the return payer to get the total rate of return on desired portfolio, without owning it. The investor, receiver of the TRS, must pay any decline in price to the TRS payer. If there is no decline in price than investor does not need to make a payment. If price gets appreciate than investor gets the appreciated amount from the return payer. It is like investors does not own the referenced portfolio laegally but return profile will be same as like investor owns the asset.
TRS is not new product and it has been around at least since 1987 when Salomon Brothers offered the first mortgage swap agreement (“MSA”). 

“They can be used as a mechanism to get short or get long – you can go long something that you can’t necessarily buy in the marketplace or go short something that’s difficult to short.”

TRS are off balance sheet transactions and investors,normally hedge funds, use it for leverage.
TRS are used as a mechanism to get the benefit of funding arbitrage. Low cost borrowers with large global balance sheets are naturally advantaged as payers in TRS. Synthetic assets are created in the process. Higher cost borrowers, such as hedge funds, enjoy the financing and leverage of the total return transaction. The total return payer pays the total return of a reference security and receives a form of payment from the receiver of the total rate of return. Often payment is a floating rate payment, a spread to LIBOR.

The Goldman deal, which the bank is calling a “covered obligation,” uses a TRS provided by a joint venture between the bank and Mitsui Sumitomo Insurance on a changeable portfolio of fixed income assets. Investors also have recourse to Goldman and Sumitomo in a feature typically found in covered bonds. S&P already gave the bond knows as FIGSCO(Fixed Income Global Structured Covered Obligation)  a AAA rating, but Fitch warns that the deal’s "structural protections and collateralization levels are too low to enjoy such a designation.
With this new Bond offering Goldman is trying solve the inventory financing problem.The deal effectively allows Goldman to source financing for a whole slew of assets all at once, rather than strike individual bilateral deals.

Argentina defaults

Argentina defaults again after 13 years.

Central bank liquidity swaps

These swap lines was initiated by the FED, with the foreign central banks,  in response of  US dollar supply freeze in foreign markets. Fed has Dollar Liquidity Swap Lines and Foreign-Currency Liquidity Swap Lines.
First one to provide the US dollar liquidity to foreign central banks in time of US dollar shortage and second one to get the foreign currency from foreign central banks so that FED can provide the foreign liquidity to domestic banks.
Initially these swap lines were temporary and these came into effect with predefined expiry date but now these swap line have been converted to standing facility. Fed has justified the conversion as below.

The dollar liquidity swap lines were designed to improve liquidity conditions in dollar funding markets here and abroad by providing foreign central banks with the capacity to deliver U.S. dollar funding to institutions in their jurisdictions during times of market stress. These swap line arrangements have materially reduced funding pressures in the United States and abroad and thereby proven their capacity to provide an effective backstop and to support financial stability. The foreign currency swap lines provide the Federal Reserve with the capacity to offer liquidity in foreign currencies to U.S. financial institutions should the Federal Reserve judge that such actions are appropriate.

The conversion of these liquidity lines with pre-set expiration dates to standing lines further supports financial stability by reducing uncertainties among market participants as to whether and when these arrangements would be renewed. This action results from the ongoing cooperation among these central banks to help maintain financial stability and confidence in global funding markets.

FED has used the dollar liquidity swap lines multiple times with different central banks since 2008 crisis. It has also releases the FAQ on these swap lines. These swap lines have been used extensively by Federal Reserve as one of the primary responses for 2009 crisis.The FX liquidity lines  went from practically zero to a peak of $582 billion on December 10, 2008. As described in BIS study report Fed bailed out the whole world using these FX liquidity lines.

VaR computation through square root method and assumptions behind it

If historical data (daily returns) have the stationary property of time series, below conditions, then the total variance will rise linearly with time. It means that longer the time period you select more you expect the drift from where you started.

• Constant µ (mean) for all t.
• Constant σ (variance) for all t.
• The autocovariance function between Xt1 and Xt2 only depends on the interval t1 and t2. zero auto correlation.

For stationary process, square root of time rule can be used to calculate the variance of longer or shorter period with given variance. VaR  inherits the property of standard deviation or variance so square root of time rule can be used to convert the VaR from one holding period to another holding period. 

Lot of banks use this property to calculate the var for different holding period. They calculate the var for 1 day and then convert this to different holding periods as required.

But basic assumption that historical returns are stationary are rarely meet in practice. Hence there can be material difference in VaR when directly calculated for a particular holding period and calculated using square root of time rule. 

This was the one of the main reason for the difference in mRWA of different banks for same hypothetical portfolio. The difference in VaR depends upon how co-related series is.
I observed the difference of ~ $12653 in 99 percentile ,10 day VaR for 1 million USD-INR Fx exposure when I calculated it with different methods.

Barclays dark pool story

Attorney General Eric Schneiderman alleging that Barclays defrauded the customers of its LX dark pool.

Streetwise Blog on Barclays Dark Pool

CCIL (India's clearing house) zero curve construction

CCIL (India's clearing house) zero curve construction

Blue Brain Project- Building Virtual Brian in supercomputer

It's so astounding to got to know that scientist are building virtual brain. 

Brief description from website 

Reconstructing the brain piece by piece and building a virtual brain in a supercomputer—these are some of the goals of the Blue Brain Project.  The virtual brain will be an exceptional tool giving neuroscientists a new understanding of the brain and a better understanding of neurological diseases.


The Blue Brain project began in 2005 with an agreement between the EPFL and IBM, which supplied the BlueGene/L supercomputer acquired by EPFL to build the virtual brain.

The computing power needed is considerable. Each simulated neuron requires the equivalent of a laptop computer. A model of the whole brain would have billions. Supercomputing technology is rapidly approaching a level where simulating the whole brain becomes a concrete possibility.

Contingent convertible capital instruments (CoCos)

CoCo, Contingent convertible capital instruments are the hybrid debt instruments that absorb the losses of the issuing bank when the capital of the bank falls below certain level. These instruments have come into existence since 2009, after the financial crisis.

Though banks have issues closed to $70 bn worth of CoCos, still a lot less than issued subordinate or senior unsecured debt in same time period.

The main features of CoCo instruments are how they absorb losses and what are the triggers for them.CoCo absorb losses either by getting converted into equity or by write downs. Triggers can be based on mechanical rules or these can be supervisors’ discretion. In the former case, the loss absorption mechanism is activated when the capital of the CoCo-issuing bank falls below a pre-specified fraction of its risk-weighted assets. The capital measure, in turn, can be based on book values or market values.

Discretionary triggers, or point of non-viability (PONV) triggers, are activated based on supervisors’ judgment about the issuing bank’s solvency prospects. In particular, supervisors can activate the loss absorption mechanism if they believe that such action is necessary to prevent the issuing bank’s insolvency.
As per BCBS guidelines, CoCo can be part of the tier 1 capital if minimum trigger level for the instrument is 5.125%. Lower triggered CoCos can be part of the tier 2 capital.

As discussed in FT, CoCo instruments are highly complex and they can behave as death spiral risk (losses accelerates as things gets worse). In normal markets these instruments behave as HY bond but in distress markets they expose investors to equity like risk and volatility. Currently Both banks and regulators are smiling at the success of bail-in bonds. For regulators, cocos help to plug the capital gap of European banks. For bankers preparing for the upcoming European Central Bank stress tests, cocos are a cheap way to boost capital: they cost roughly half the return on equity demanded by shareholders, and interest is tax-deductible. It seems like a win-win.

The yields on CoCos are consistent with their place in the bank’s capital structure. CoCos are subordinated to other debt instruments as they incur losses first. Accordingly, the average CoCo yield to maturity (YTM) at issuance tends to be greater than that of other debt instruments (eg other subordinated debt and senior unsecured debt). The YTM of newly issued CoCos is on average 2.8% higher than that of non-CoCo subordinated debt and 4.7% higher than that of senior unsecured debt of the same issuer.

The capital adequacy of banks - today's issues and what we have learned from the past

A good read on Capital adequacy of Banks by Andrew Bailey.

There are a number of reasons, which cover both the numerator and denominator of the capital ratio. In brief: the definition of capital set in Basel I included instruments that did not properly absorb losses; capital requirements were too low in relation to the underlying riskiness of assets, particularly for the trading book; and banks were able to move risk assets increasingly into the trading book. The finger is often pointed at Basel II for enabling all of this to happen, but the timeline suggests that the problems built up under the combined Basel I and Market Risk Amendment regime

Basel I allowed hybrid debt instruments to count as Tier 1 capital even though they had no principal loss absorbency mechanism on a going concern basis. They only absorbed losses after reserves (equity) were exhausted or in insolvency. It was possible to operate with no more than two per cent of risk-weighted assets in the form of equity. The fundamental problem with this arrangement was that these hybrid debt instruments often only absorbed losses when the bank entered either a formal resolution or insolvency process. It was more often the latter in many countries, including the UK, since there was no special resolution regime for banks (unlike today). But the insolvency procedure could not in fact be used because the essence of too big or important to fail was that large banks could not enter insolvency as the consequences were too damaging for customers, financial systems and economies more broadly.

The big lesson from this history is that a going concern capital instrument must unambiguously be able to absorb losses when the bank is a going concern.

On the form and use of capital instruments, the Basel I Accord also allowed hybrid debt capital instruments to support the required deductions from the capital calculation, such as goodwill, expected losses (introduced later under Basel II with the internal models regime for credit risk) and investments in other banks' capital instruments. However, as a matter of fact, rather than reporting, any losses arising from these items hit common equity because it will absorb losses first in the going concern state, according to the hierarchy of the capital structure. As a result applying these deductions at the level of total capital, or Tier 1 capital, has the effect of overstating the core equity capital ratio.

The Market Risk Amendment and Basel II dramatically increased the complexity of the capital framework, and whilst it intended to increase the scope of risk capture in the regulatory capital measure it ended up creating new opportunities for "optimising" regulatory capital. Even more difficult, the potential benefits - better differentiation and rank ordering of risk - were undermined by the problems of calibrating overall capital standards, and poor implementation in the rush to achieve compliance. Under Basel I and II, capital ratios were too low to sustain confidence in banks, and thus the system as a whole, through a severe stress, as the crisis sadly demonstrated. The minimum Tier I ratio was 4% of Risk Weighted Assets. And, crucially as the Tier I ratio included capital instruments with the flaws I described earlier, the core (equity) ratio could be as low as 2%. In the trading book, under the Market Risk Amendment, capital requirements could be less than 1% of trading book assets

What is remote booking and why banks are now going away from it

When trader hired by one legal entity is taking positions or managing risk in different legal entity  registered in different jurisdiction, this practice is called remote booking. It is trader hired by Singapore legal entity is booking trades in UK entity and both legal entities are under umbrella of one big investment bank.

Investment banks typically book most of their Asian trading in their London subsidiaries,which offers several benefits relating to capital efficiency, staffing and operations. 

Under the UK’s capital rules, banks are able to achieve significant savings through hedging and netting, identifying and cancelling out trades that offset one another, such as a short and a long position in the same stock. This process, which is more effective when a large number of trades are held in the same place, reduces the overall risk profile of the book and therefore the capital that must be held against it.

Typically, US banks book all non-US trades in London, while European banks book all European and Asian trades there. Some Asian banks, including Japan’s Nomura, also have big London booking centres. By funnelling trade flow back to London, global banks have also been able to minimise the amount of capital they have had to allocate to their Asian legal entities. Keith Pogson, managing partner, Asia Pacific financial services, at Ernst & Young in Hong Kong, said: “In Asia, many international banks have historically made vehicles capital-light – as they act as agents.”

Regulators are now not happy with this practice as they can't effectively control someone sitting in other jurisdiction and taking risk in entities registered in their jurisdiction. It becomes more important when portfolio size of these foreign banks are comparable to local investment banks.
The most immediate regulatory pressure, however, is from the UK’s Financial Conduct Authority, which is growing increasingly concerned by the volume of foreign-originated trades held in its jurisdiction. UK regulators have asked foreign banks to setup UK CRO if not already. 

Several banks are believed to be building new booking hubs in Asia which is understood to be undertaking a huge project to restructure its legal entities and booking hubs. These projects, which would involve legally transferring trades booked in London to new Asian entities, are hugely complex and the banks are understood to be doing intensive scenario analysis. It depends on lot of factors such as for which products you have licence to trade in that region, what are the region's guide line for calculating and reporting risk. 

With these developments booking practice is changing from hub to local.

Explaining the basis: Cash Vs Default swap

I was trying to figure out all different factors for the difference between CDS and bond basis. I got Lehman Brothers research paper on this. In the paper the aim is to explore the differences between the cash and default swap markets for a given credit and develop a frame-work for looking at these differences. Ultimately, the goal is to enable the reader to identify and understand the many reasons for the divergence between the two markets and to give the reader the tools to evaluate it.
Broadly reasons for this spread can be divided into Fundamental factors and Market driven factors.  Fundamental factors are fundamental difference between the CDS and it's replication using the Bond and asset swap spread products. 
Market factors refers to the nature of the market in which the cash and defaults swaps gets traded and so include the demand , supply and liquidity.

Bilateral and tri-party repo haircut differences duering the Financial Crisis

The Odd Behavior of Repo Haircuts during the Financial Crisis & Blog on bilateral and tri-party repo haircut differences: they can’t explain it.

Tri-Party Repo Market

Good reads on Tri party repo market,
Crisis Chronicles: The Commercial Credit Crisis of 1763 and Today’s Tri-Party Repo Market.

Fire sales are one of the three systemic risk concerns highlighted in a May 2010 whitepaper by the Federal Reserve Bank of New York on tri-party repo infrastructure reform These three risks are 1) the market’s excessive reliance on clearing-bank provision of intraday credit to complete settlement, 2) poor liquidity and credit risk management practices on the part of various classes of tri-party repo market participants, and 3) the absence of any mechanism to mitigate the risk of fire sales of collateral in the aftermath of a large-dealer default.

The first two these are being addressed or have been addressed but management of fire sale of collateral of defaulted dealer is still challenge, The Risk of Fire Sales in the Tri-Party Repo Market.

Credit Default Swap - Market Risk sensitivities

CDS risk profile is majorly driven by credit spreads of the reference entity. Means that change in value, MTM , of an CDS trade can be explained by the change in spreads. Interest rate movement has very limited impact on CDS valuation and it become lesser when spread widens. A seller of protection has similar economic exposure to a bondholder (they are both “long” credit) as parties are adversely affected by spread widening. The opposite is true for the protection buyer. 

CS01-  It is the impact of a 1 basis-point increase in credit spreads on the value of the transaction. CS01 will be negative for the protection seller as seller will be long on credit risk. CS01 will be positive for the the protection buyer as buyer will be short on credit risk.

For example , if CS01 for protection seller is −$10 K. In other words, the protection seller would lose $10 K if reference entity's credit spread widened from 100 to 101 bps. However there will be some “convexity” associated with the credit-spread risk. 

If the CDS spread widens from 100 to 200 bps, this 100 bps widening will result in a <10mm decrease in the transaction’s market value for protection seller, which is somewhat less than 100 times the CS01.

CS01 can be calculated by bumping the credit spread curve of the reference entity. 

Parallel CS01-
This is calculated by pricing the CDS using its quoted spread then bumping the quoted spread by 1bps and recalculating the price; the difference is the (parallel) CS01. This number is reported by Markit, Bloomberg etc. 

Bucketed CS01 -
There is no universally accepted definition of bucketed CS01. Below is one of the method to calculate the bucketed CS01.

• For a target CDS, choose a set of maturities (pillars) that you want to measure sensitivity to (these could be the standard liquid points of 6M, 1Y, 3Y, 5Y, 7Y and 10Y).
• Set the spreads at these points equal to the quoted spread of the target CDS.
• Build a credit curve from the pillar CDSs assuming the spreads are par spreads. Price the target CDS from this curve.
• Bump each spread in turn by 1bps, build a credit curve and price the target CDS from this new curve.
• The differences from the original price are the bucketed CS01s.

Yield Curve Sensitivities- Yield curve or discount curve is used to discount the cash flows of the CDS transactions thats why changes in yield curve affects the CDS MTM. Normally yield curve build by using the swap, futures and money market instruments so change in these rates affects the CDS trades. 
Traditionally, these numbers, like other sensitivities in the credit world, have been calculated
by forward finite difference: Each market rate is bumped in turn by one basis point; a new yield
curve is bootstrapped; and finally the CDS is repriced from the new yield curve (the credit curve
remains unchanged). The difference in price is the bucketed IR01. If the rates are bumped in
parallel this is the parallel IR01.

Calculation methodology has been explained in The Pricing and Risk Management of Credit

Default Swaps, with a Focus on the ISDA Model paper.

The Changing Landscape for Derivatives

OTC derivative market has changed and continue changing after the 2008 banking crisis. Big banks are facing heat from regulators and they are forcing banks to standardize the OTC derivatives. A good read on this , The Changing Landscape for Derivatives.

Credit Support Annex, CSA

A Credit Support Annex, or CSA, is a legal document which regulates credit support (collateral) for derivative transactions. It is one of the four parts that make up an ISDA Master Agreement but is not mandatory. It is possible to have an ISDA agreement without a CSA. A CSA defines the terms or rules under which collateral is posted or transferred between swap counterparties to mitigate the credit risk arising from "in the money" derivative positions.

Since the financial crisis, banks are charging customers credit charges if the customer did not conclude a Credit Support Annex (CSA) with the bank. 

A CSA mitigates the credit risk arising from in-the-money positions by defining the terms and conditions under which collateral is posted/transferred between the counterparties of the swap transaction. These terms and conditions mainly specify parameters like:

1. Threshold Amount: This amount is the reference value of the mark-to-market of the swap above which collateral has to be posted. For example, if the Threshold Amount is €5.0 mln for a party, this party is required to post collateral only when the negative mark-to-market of the swap is above €5.0 mln.
2. Frequency: Both parties need to agree on the frequency of collateral postings. Often applied frequencies are daily, weekly, and bi-weekly, meaning collateral transfers can only take place every day, weekly, or bi-weekly respectively.
3. Eligible Collateral: The assets that classify as eligible collateral need to be negotiated. Cash and government bonds are the most common eligible instruments. If securities are to be used, it is necessary to define a set of eligible instruments along with the associated haircuts.
4. Minimum Transfer Amount: If the difference between the mark-to-market and the value of the collateral position is in excess of the Minimum Transfer Amount (MTA), extra collateral needs to be posted. The MTA provides operational efficiency as it prevents from small amounts to be paid/received.

CSA changes the mark to market profile of a swap and it also reduces the credit exposures , CSA and OTC pricing,

IRDA relax interest rate derivative limits for insurers

Indian insurers can now use interest rate derivatives of over one year to hedge exposures but CSAs will be required to transact, according to updated guidelines from the regulator. 

IRDA informs to insurers that after careful examinations of the comments received, the Authority now withdraws the earlier guidelines and issues fresh guidelines. Insurers are allowed to deal as user with following types of Rupee Interest Rate Derivatives to the extent permitted, and in accordance with these guidelines.

i)                    Forward Rate Agreements (FRAs);

ii)                  Interest Rate Swaps (IRS); and

iii)                Exchange Traded Interest Rate Futures (IRF).

Participants can undertake different types of plain vanilla FRAs/IRS. IRS having explicit/implicit option features are prohibited. It is to be noted that FRAs and IRS are Over-the-counter (OTC) contracts.

CSA will be required to transact these interest rate derivatives so it will require time to be operationally ready to transact CSA. "It takes time to set up a CSA programme and it is not just about negotiating a document. From an operational standpoint you also need to be able to manage the collateral process, including the posting and the reconciliation of collateral. these guidelines are a significant step forward but it will take some time before activity picks up as the players will take time to set up processes,"

"It may take two to three years for insurers to fully utilise interest rate derivatives but we do expect the industry to respond positively to the guidelines and we expect the bigger players in the market, especially those who have joint ventures with international insurers, to be the first to the market,"

Repo and how it related to sub prime crisis

The financial crisis was not caused by homeowners borrowing too much money. It was caused by giant financial institutions borrowing too much money, much of it from each other on the repurchase (repo) market. This matters, because we can't prevent the next crisis by fixing mortgages. We have to fix repos. 
Citi Group's analyst  Matt got this correct in his research report, are the brokers Broken.

"Much of the focus on financials during the credit crunch has been upon writedowns. First on subprime and CDOs of ABS, then on ABCP, ARS and a string of other products, and now on more normal loan portfolios. Investors have been almost obsessive about finding the next ‘shoe to drop’.  Yet from a credit perspective, the major question facing all financials going forward is not one of writedowns but one of funding and leverage. After all, it was the catastrophic loss of funding caused by a sudden evaporation of confidence which led to the demise of both Bear Stearns and Northern Rock, not anything to do with writedowns. The common strand linking those two institutions was their dependence on wholesale markets for funding. And yet their models were not so different from those of many other financial institutions today. The other US broker-dealers, in particular, are funded heavily through short-term repo and secured lending markets, and do not have the diversification implied by a large deposit base. Does this mean that they too are similarly vulnerable?" 

Repos are still not fixed and this market still connects banks , shadow banking entities and still have the power to convert entity or product specific crisis into systematic crisis. some of the latest comments in the news

"Regulators and policymakers currently have no reliable, ongoing information on bilateral repo market activity." -- Financial Stability Oversight Council, May 7, 2014.

"The banks remain dangerously interconnected and vulnerable to sudden runs because of their dependence on short-term, often overnight borrowing through the multitrillion-dollar repurchase agreement, or repo, market. -- Jennifer Taub, associate professor, Vermont Law School, April 4, 2014.
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A detailed explanation about repo and how it was main driver behind the 2008 crisis, About Repo.