Risk management for Whales

Risk management for Whales


LVAR could help kill liquidity risk

LIBOR days are numbered

Libor alternatives it would be either OBFR, Overnight Bank Fund Rate, or GCRR,General Collateral Repo rate.

Orderly liquidation of bankcrupt Banks

FED is proposing new measures  to prevent the chaotic crash of banks and  orderly liquidation of financial institution can be done.

RBI released consultative document for the uncleared margin requirement

The Reserve Bank of India released a discussion paper on margining un-cleared OTC business, in the same framework as others. The RBI intend to mandate the schedule based approach to IM, unless they give approval for a VaR based approach. 

Good series to read on Market Liquidity

Introduction to a Series on Market Liquidity.

Bail In - Total loss-absorbing capital (TLAC)

In November 2014, Financial Stability Board proposed a minimum total loss absorbing capacity requirement ,TLAC,to make sure that world's 30 most systemically important banks (G-Sibs), BCBS defined these banks as Too big to fails, can be stabilised and shut down in orderly way with out taxpayer bailouts. The TLAC rule would require banks to issue ordinary shares, subordinated debt and other potentially loss-absorbing securities equivalent to as much as 15-20% of their assets weights for risks. 

Basel III rules require banks to meet a minimum total capital ratio of 10.5% by 2019 – though in some jurisdictions the minimum ratio is far higher. The proposed minimum TLAC requirements for G-Sibs unveiled at the G20 Brisbane summit in November 2014 is 16% to 20% of a group's consolidated risk-weighted assets. This proposal was under consultation until February 2, 2015, when the requirement was finalised.The TLAC rule is set to take effect in 2019 at the earliest.

This the concept of 'bail in' spearheaded during the Lehman's collapse. Wilson Ervin, now credit suisse's vice chairman, explains how his Lehman experience led to the creation of bail-in, and describes some of the innovations by the Swiss regulators.

Initially FSB excluded all structured notes/securities from the TALT requirement,  now structured notes are being considered to the extent that the repayment of the principal at maturity is unconditional and not contingent on any derivative-linked feature, reported by Bloomberg. 

COCO bonds raised by many banks can be considered as bail-in type securities. Regulators needs to increase the oversight on COCO bonds as risk profile of these bonds are complex as suggested by FT.

Swiss regulators pushed for 5% leverage ratio for TBTF banks

• As per Bloomberg, Swiss regulators will require that country's biggest banks to have capital of 5% of total assets - this will be in line with the rule for U.S. too-big-to-fail lenders, and significantly above the 3% minimum set by Basel.

• UBS and Credit Suisse have argued the Swiss financial system isn't comparable to the U.S. with its far deeper capital markets.

• Leverage ratios have gained favor among regulators as the most effective way to evaluate a bank’s robustness because the method doesn’t involve estimates of risks on their activities.

• Switzerland imposed some the world’s strictest too-big-to-fail requirements in 2011 after the government came to UBS’s rescue during the 2008 financial crisis. UBS and Credit Suisse have assets of 1.83 trillion francs combined, about three times the size of the Swiss gross domestic product, making the two banking behemoths a disproportionately bigger danger to their country’s economy if they fail than their peers elsewhere. Both are compliant with all Swiss capital rules.

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.

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.

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.

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.

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,"