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.