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.