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.
****

A detailed explanation about repo and how it was main driver behind the 2008 crisis, About Repo.

Size of the Fed balance sheet

A good read on Fed balance sheet size and asset buying program. 

Fed balance sheet size. 

Lender of last resorts & dealers of last resorts

Be the "Lender of last resorts" in crisis period is a classical advise given by the Walter Bagehot to central banks. Walter mentioned, in 1873, that in time of crisis central banks must lend freely but at high rate.
But as Bagehot pointed out, by lending liberally, central banks make it less likely that their money will be needed. By demanding good collateral, the central bank can try to distinguish insolvent banks from illiquid ones; and by charging a penalty rate of interest, it ensures that it is truly the lender of last resort.

But in sub prime crisis Fed had to be not only the lender of last resort but also "Dealer of last resort" and later it acted as private capital market. 
Below is the snap shot of how balance sheet of Fed changed during the crisis time. Size of balance sheet increased from almost 1 trillion to 2.5 trillion between Jul 2008 to Jan 2010.




Fed responded to crisis initially with selling  off treasury securities and lent out the proceeds through various extended discount facility. After the collapse of Lehman and AIG, money market was almost frozen both domestically and internationally. Banks were not willing to lend each other. Repo collateral haircuts reached to record high and even banks were not accepting the mortgage securities as collateral. In this scenario Fed did even more and shifted much of the wholesale money market onto its own balance sheet. This is referred as Dealer of last resort. 
Once emergency situation was over than Fed replace the temporary loans of various financial sector with permanent ones like mortgage securities. 

OTC Derivatives Valuation: Adoption of Multiple Pricing Curve

Good read on OTC derivative valuation and how it changed after the 2008 crisis.

OTC Derivative Valuations

Credit Default swap - IV , Risky PV01

Let's discuss how MTM of CDS gets calculated. CDS are traded products and booked into trading books, except some exceptions, so these products needs to be marked to fair value daily. 
At the inception of CDS, both leg of CDS have equal value but this get change as premium level moves for reference entity. These changes in premium reflects changes in credit quality of reference entity and general market dynamics.These changes in premium cause CDS to have either a positive or negative net present value. For a protection buyer, if the market premium moves wider than the contract premium, he will experience a MTM gain because he bought the protection cheaper than currently available in the market. Vice versa if market premiums tighten. Obviously the protection seller experiences the opposite MTM results.

Calculating a CDS MTM is the same as calculating the cost of entering into an offsetting transaction. Suppose an investor bought 5-year protection at 100bp per annum, and 1 year later the protection widened to 120bp. The investor would then have a MTM gain. To calculate this MTM amount, we can assume a hypothetical offsetting trade where the investor sells protection at 120bp for 4 years, thereby hedging his position. Assume also that the offsetting trade matches the original one perfectly in terms of contract terms, including the same payment and maturity dates, except for the contract premium. This will leave a residual cash flow of 20bp per annum (5bp per quarter) for 4 years in favour of the investor, effectively a 4-year annuity. The present value of this annuity is the MTM amount.

However, we need to bear in mind that these cash flows can cease, since the investor will

receive the 5bp per quarter only until the earlier of a credit event and contract maturity. Upon 

the occurrence of a credit event, Credit Event Notices will be served and premium payments will then cease on both transactions, wiping out future annuity payments.

Valuing this annuity payment therefore involves more than just discounting it using risk

free rates. It also involves weighting the annuity with the probabilities of receiving these

quarterly payments, i.e., the probabilities of no credit events occurring before each quarterly payment date. These are the survival probabilities that were introduced in the previous chapter. So, the MTM of a CDS is the present value of an annuity representing the difference between the contract premium and the current market premium, with the annuity cash

flows weighted by the survival probabilities. 

             MTM = (change in spreads)*(number of periods)*(survival probability)*(discount factor)

Risky PV01- Risky PV01 being the sum of the discount factors weighted by their  corresponding survival probabilities, i.e., the sum of the risky discount factors. This risky

PV01 measures the present value of 1bp risky annuity received or paid until the earlier

of a credit event or the maturity of the CDS. The CDS MTM is therefore the annuity multiplied by the PV01.

                                          MTM = Annuity * Risky PV01

Roles and objectives of central banks

A good read by BIS, Roles and objectives of modern central Banks. 

Negative deposit rates..

We live in the central bank's era. The current domination of  central banks is unprecedented. Earlier they managed the same responsibility , price and finance stability, with limited tools such as twisting short term borrowing and lending rate but now central banks have evolved a lot and they have tried lot of other tools to manage the same responsibility and still results are not coming the way these should have been.

ECB has cut the deposit rates to -0.10 per cent and now deposit rates are Negative. 

We are not sure whether this will work and push the banks to lend money to house holds or business. Banks that were reluctant to lend when rate was almost zero will not find any reason now to lend more with negative deposit rate. They can store cash in their vaults rather than depositing it with ECB or they can pass this cost to customer.It is global capital market and now with negative deposit rate investors or euro zone banks can flee outside to earn the better yields. 

The real purpose of this rate cut could be not about bank lending at all. I think it is about German disinflation and the exchange value of the Euro, Currency War.German CPI inflation is currently 0.9%, far below the ECB’s target of “close to” 2%, and trending downwards. It’s unclear exactly why this is, but one possibility is the strong Euro. Because of Germany’s export dependence, a strong Euro puts downwards pressure on German inflation – indeed this is why historically the Bundesbank, ever the inflation hawk, has preferred a strong currency. As Germany is very dominant in the Eurozone, German disinflation feeds through into low Eurozone inflation.

Indian Public sector banks

Top five public sector banks of India make up more than 70 per sent market share of Indian banking. These banks have very high NPAs and are being managed very poorly. There are several issues with these public sector banks. We could start with their rising bad loans. Total stressed assets, a figure that combines both non-performing and restructured loans, jumped to almost 11 per cent of lending in March. 
Leverage ?, In 2012-13 the average leverage ratio (defined as the ratio of total assets of a bank to its equity capital) was about 16.5 per cent for public sector banks as against about 10 per cent for private sector banks.
Capital? Quite a few public sector banks fail their requirements and some more just scrape by, despite the regulatory “forbearance” which the RBI provides on restructured assets. Government needs to provide more than $28 bn as new capital for these state backed banks by 2018 and much more than this to make them Basel 3 compliant.   
Latest report of P J Nayak committee on state backed banks have suggested lot of recommendation for restructuring these banks. 
I believe other problem have grown with time because of poor management and forced political decision on these banks. These issues can be solved with time if we can achieve below two major reforms.

Public sector banks should get the equal treatment in compare to Indian private banks. Currently these are regulated by RBI and Finance Ministry. If these banks have to compete with private banks than they should have same yardstick.

Public sectors banks should be completely professionally managed and government should not be involved in any major decision such as appointing directors , chairman.This can be achieved by making a intermediary investment firm between government and these banks. 

Some of the recommendation that related to above two points.

Recommendation 2.2: There are several external constraints imposed upon public sector banks which are inapplicable to their private sector competitors. These constraints encompass dual regulation (by the Finance Ministry, and by the RBI, which goes substantially beyond the
discharge of a principal shareholder function); the manner of appointment of directors to
boards; the short average tenures of Chairmen and Executive Directors; compensation
constraints; external vigilance enforcement; and applicability of the Right to Information Act.
Each of these constraints disadvantages these banks in their ability to compete with their
private sector competitors
Recommendation 4.2: The Government should set up a Bank Investment Company (BIC) to hold equity stakes in banks which are presently held by the Government. BIC should be incorporated under the Companies Act, necessitating the repeal of statutes under which these banks are constituted, and the transfer of powers from the Government to BIC through a suitable shareholder agreement and relevant memorandum and articles of association.

Recommendation 4.3: While the Bank Investment Company (BIC) would be constituted as a
core investment company under RBI registration and regulation, the character of its business
would make it resemble a passive sovereign wealth fund for the Government's banks. The
Government and BIC should sign a shareholder agreement which assures BIC of its autonomy
and sets its objective in terms of financial returns from the banks it controls. It is also vital that
the CEO of BIC is a professional banker or a private equity investment professional who has
substantial experience of working in financial environments where investment return is the
yardstick of performance, and who is appointed through a search process. While the non-
executive Chairman and CEO of BIC would be nominated by the Government, it is highly
desirable that all other directors be independent and bring in the requisite banking or
investment skills.

Recommendation 4.4: The CEO of the Bank Investment Company (BIC) would be tasked with
putting together the BIC staff team. BIC employees would be incentivised based on the financial returns that the banks deliver. If such incentivisation requires the Government to hold less than 50 per cent of equity in BIC, the Government should consider doing so, as it will be the prime financial beneficiary of BIC's success.

Recommendation 4.5: The Government should cease to issue any regulatory instructions
applicable only to public sector banks, as dual regulation is discriminatory. RBI should be the
sole regulator for banks, with regulations continuing to be uniformly applicable to all
commercial banks.