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.