Das: ‘Swap Tango’: A Derivative Regulation Dance

By Satyajit Das, a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives

A question of values…

Derivative contracts are valued on a mark-to-market (“MtM”) basis. This requires valuation of the contracts based on the current market price.

OTC derivatives trade privately. Market prices for specific transactions are not directly available. This means current valuations rely on pricing models.

In current accounting argot, most derivatives are Level 2 assets (Mark-to-Model). In practice, this means that they cannot be priced based on quoted trade prices (Level 1) but are valued using observable inputs; for example, comparable assets or instruments or using interest rates, volatility, correlation, credit spreads etc that can be put through an accepted model to establish values.

There are significant differences in the complexity of the models and the ability to verify and calibrate inputs. More complex products used sophisticated financial models, often derived from science or statistical methodology. There are frequently differences in choice, exact factorisation and even numerical implementation of the models. Different dealers may use different models.

Some required inputs for the models are available from markets sources. The nature of the OTC market and the limited trading in certain instruments mean that key input parameters must frequently be “estimated” or “bootstrapped” from available data. In certain products, the limited number of active dealers means that “market” prices are sometimes no more than the dealer’s own quote being fed back after being collated and “scrubbed” by an external data provider.

Model variations and small differences in input can frequently result in large changes in values for some products.

The models make numerous assumptions including the ability to borrow at market rates for (theoretically) infinite amounts, unrestricted ability to enter into transactions and abundant trading liquidity. These assumptions are difficult to satisfy in practice.

For example, a key assumption of derivative valuation is that a transaction can be hedged with a counterparty or through other means at all times. In late 2008, in the aftermath of the collapse of Lehman Brothers and problems at AIG, market liquidity dried up and made it impossible to source market prices or transact in many instruments.

Model based valuations drive pricing of transactions and dealer hedging. They also are used to calculate the risk of the transactions and ultimately to derive the capital required to be held for regulatory and internal purposes. The model-based valuations are also used to determine earnings and ultimately bonus payments for dealer staff.

Non-professional dealers rarely have the required sophisticated pricing and valuation systems. They are dependent upon valuation date (predominantly) supplied by dealers or (less frequently) rely on pay-as-you-go pricing services.

Investors use the model-based prices to generate values for their fund units. Investors transact at these model-based prices when they invest or redeem investments

The accuracy and tractability of derivative valuation, especially for complex products, is questionable.

MtM prices may be also prone to manipulation. Recent disclosures about events leading up the government bailout of AIG highlight potential problems.

There is limited internal or external (auditors and regulators) oversight of the models. This reflects, in part, the complexity of the models and the scarcity of experienced professionals capable of undertaking such reviews.

Widespread reliance on models and MtM methodology is perhaps surprisingly an unquestioned article of faith in financial markets. It allows immediate recognition of gains and losses that will accrue over many years immediately.

Interestingly, MtM accounting is generally not available outside of financial instruments. An often neglected element of the Enron scandal was the company’s ability to convince its auditors and the U.S. Securities and Exchange Commission (“SEC’) to allow MtM accounting to be used in the natural gas industry. This allowed the company to record current earnings based on the future value of long term contracts.

Current regulatory proposals do not attempt to deal with the pricing, valuation and model issues. As Daniel C. Gelman observed: “Where secrecy reigns, carelessness and ignorance delight to hide.”

Stand by Me …

In derivative contracts, each party takes the credit risk of the other side in terms of performing their obligations. This is known as counterparty risk. The failure of Lehman Brothers and a number of banks during the Global Financial Crisis (“GFC”) highlighted the problems of counterparty risk in derivatives.

Counterparty risk in derivatives is different from credit risk generally. In a loan, the lender is exposed to the risk of the borrower failing to pay interest or repay the known face value of the loan. In contrast, in most derivative contracts (other than options), the risk is mutual with both parties being exposed to the risk of non-payment by the other.

Counterparty risk is complex because the payment obligations as between the parties are contingent. The quantum and the direction of payments depend on market price movements. The potential counterparty risk is not known in advance and is apparent only when actual price movements occur. In practice, this requires parties to estimate the potential exposure using mathematical models based on the expected evolution of the relevant market prices.

In the 1980s when the derivative markets developed, counterparties were generally of high credit quality. This had the effect of reducing, though not eliminating, counterparty risk.

Over the last two decades, the derivatives market has becoming more democratic. Entities with lower credit ratings have become active users of derivatives. This includes highly leveraged investors, such as hedge funds and private equity funds. Participation of these riskier entities has entailed reliance on credit enhancement techniques.

The primary form of credit enhancement was the use of bilateral collateral. This entailed counterparties posting collateral in the form of cash or high quality securities to secure the current value of the contract. The collateral acted as surety against non-performance under the contract. Collateral arrangements were highly customised. For example, AIG’s collateral arrangements required the firm to post collateral only where the exposure under the contracts increased above an agreed level or AIG’s credit rating was reduced below a specified quality.

Other credit enhancement techniques used include a right to break that allows either party to terminate the contract under certain credit-related circumstances. Any such termination would be at market values triggering an obligation of one party to pay the other party the current value of the contract.

Counterparty risk and credit enhancement techniques are predicated on the same models used for pricing and valuation. Use of bilateral collateral relies on the accuracy of valuations and risk models. It also relies on certain and enforceable legal rights in respect of collateral and proper management of the cash and security lodged.

The GFC, especially the bankruptcy filing of Lehman Brothers, provided a test of counterparty risk in derivatives. The quantification and management of such risk proved problematic. The quantum of credit risk from derivatives was higher than model based estimates as market volatility increased and correlations between risk factors moved erratically. Legal enforceability, control and management of collateral also experienced problems.

Current regulatory proposals have focused heavily on counterparty risk issues. The central legislative reform proposed is a central clearinghouse – the central counterparty (“CCP”). The BIS also proposed changes in capital requirements against counterparty risk in the light of recent experience.

Under the CCP arrangements, (so far unspecified) “standardised” derivative transactions must be transferred to an entity that will guarantee performance. In a curious circularity, standardised means anything that is eligible for and can be “cleared”. Interesting inclusions and exclusions – both in terms of products and parties that must trade through the CCP – are to be found. The arrangement centralises contracts in a single entity, the ultimate case of “too big to fail”.

The CCP will implement risk management systems to manage its exposure under derivative contracts.

The CCP will be reliant on risk models and the ability to value contracts. As noted above, there are significant issues in pricing and valuing contracts and, for some products, reliance on complex models.

The CCP proposal relies heavily on “self-confidence”, which as Samuel Johnson observed is “the first requisite to great undertakings.” In relation to the CCP, legislators and regulators are basing their approach on Lillian Hellman’s helpful advise: “It is best to act with confidence, no matter how little right you have to it.”

One (Not Very Nice) World…

The GFC, in line with previous derivative crises including the collapse of Long Term Capital Management (“LTCM”), revealed deep fault lines in financial markets.

Derivative markets entail complex chains of risk that link market participants. This is similar to the re-insurance chains that proved problematic in the case of Lloyd’s Insurance market problems. In both markets, the risks are both potentially significant and “long tail”, that is, they do not emerge immediately and may take some time to be fully quantified.

As in the re-insurance market, the long chain of derivative contracts can create unknown concentration risks. This is exacerbated by the highly concentrated structure of derivatives trading. It is likely that for each product or asset class a few dealers (less than 10-12 and sometimes as few as 4-6) account for the bulk of trading. This means that financial problems or uncertainty about any major dealer could cause the financial system to become gridlocked as uncertainty about counterparty risks restricts normal trading.

Current regulatory proposals have not focused on the issue on inter-connected trading and concentration risk. The CCP proposal affects these issues. It is widely believed that the CCP will improve the market structure. In reality, the CCP becomes a node of concentration. In addition, to the extent that products are not routed or counterparties are not obligated to trade through the CCP, the problems remain and may increase.

A central problem of the current derivative markets is potential liquidity (cash or funding) risks. Ironically, the problems derive, in substantial part, from the desire to reduce counterparty risk through credit enhancement procedures, such as bilateral collateral.

Where derivative contracts are marked-to-market daily and any gain or loss covered by collateral to minimise performance risk, movements in market rates can trigger large cash requirements. These requirements may be unanticipated. If there is a failure to meet a margin call then the position must be closed out and the collateral applied against the loss. This may leave the parties unhedged against underlying risks or on offsetting positions creating the risk of additional losses.

For example, ACA Financial Guaranty sold protection totalling US$69 billion while having capital resources of around US$425 million. When ACA was downgraded below “A” credit rating, it was required to post collateral of around US$ 1.7 billion. ACA was unable to meet this requirement.

AIG’s CDS contracts were subject to the provision that if the firm was downgraded below AA- then the firm would have to post collateral. In October 2008, when AIG was downgraded below the nominated threshold, this triggered a collateral call rumoured to be around US$14 billion. AIG did not have the cash to meet this call and ultimately required government support. The problems at ACA and AIG are not unique.

Current regulatory proposals do not address liquidity risks in derivative markets. Interestingly, the CCP may inadvertently increase liquidity risk as more participants may be subject to margining and unexpected demands on cash resources. The BIS has proposed an extensive regime of liquidity risk management controls that would, in part, cover some liquidity risks.

Failed Plumbing…

The GFC has exposed some long standing and significant problems with the infrastructure of derivatives markets.

In 2006, Alan Greenspan expressed shock and horror at the state of settlements in the credit derivative market. He expressed surprise that banks trading CDS seemed to document trades on scraps of paper. The ex-Chairman, perhaps unfamiliar with the reality of financial markets, had difficulty reconciling a technologically advanced business with this “appalling” operational environment.

Derivative systems and trade processing are generally inadequate, with infrastructure lagging well behind innovation. Delays in documenting contracts forced regulators to step in requiring banks to confirm trades more promptly. The accuracy of the mark-to-market values of contracts, particularly of less liquid and infrequently traded reference entities, is not unimpeachable. Where collateral is used, as noted above, monitoring and management of collateral poses significant risks.

Current regulatory proposals seek welcome improvements processes and systems for derivative trading.

Derivative contracts are documented under the International Swap and Derivatives Association (“ISDA”) Master Agreement. The ISDA Agreement has been remarkably successful in standardising documentation of trading.

The contract has not been tested under stressful conditions such as those of the GFC. A number of issues have emerged. The bankruptcy of Lehman Brothers and resulting unwinding of complex derivative arrangements has exposed problems of derivative and bankruptcy law, especially in cross-border, multi-jurisdictional transactions.

The GFC exposed issues relating to the documentation of specific derivative contracts, such as CDS contracts, and the impact on bankruptcy and resolution of financial distressed firms.

Current regulatory proposals do not address any of these documentary issues.

Bank regulatory capital has long distinguished between banking (loans or hold-to-maturity assets) and trading books (trading or available-for-sale assets). Differing capital rules between the banking and trading books encouraged regulatory arbitrage, generally using derivative structures to reduce the required level of capital. The BIS has addressed some regulatory anomalies, increasing the capital required against derivative positions.

Regulatory initiatives continue to emphasise improved disclosure of derivative contract. There is already significant disclosure, although much of it is incomprehensible and lacks utility. Additional disclosure will not significantly reduce systemic risks of derivatives.

On 25 September 2002, speaking at the U.K. Society of Business Economist while in London to collect an honorary knighthood for contribution to economic stability, Alan Greenspan outlined the case for less transparency: “…paradoxically, the full disclosure of what some participants know can undermine incentives to take risk, a precondition to economic growth….to require disclosure of the innovative product either before or after its introduction would eliminate the quasi-monopoly return and discourage future endeavours to innovate….market imperfections would remain unaddressed and the allocation of capital to its most productive uses would be thwarted.

Greenspan argued that even “disclosure on a confidential basis solely to regulatory authorities may well inhibit…risk taking.” Dealers will undoubtedly resist meaningful disclosure prejudicial to their economic interests.

Regulatory initiatives do little to address the quality of regulators and the acuity of oversight. The absence of suitably expert and experienced regulators will undermine regulatory and legislative initiatives. Given the shortage of talent in derivatives generally and the pay grades of regulators, it will be difficult for regulatory agencies to properly supervise dealers and derivative activity. In terms of an old Spanish proverb “Laws, like the spider’s web, catch the fly and let the hawk go free.”

Regulatory Tango…

Debate over regulation of financial services has taken on a frenzied tone. Regulators and think tanks are producing voluminous, overlapping and (sometimes) contradictory proposals. Regulatory agencies are jockeying for position, sometimes forming unlikely coalitions to preserve or expand territory. In the U.S. Congress, multiple bills and several committees are jostling to make sense and harmonise complex and irreconcilable draft legislation. Activity and achievement are confused.

Banks and their lobbyists do not believe that there is a case for regulation. In William Davenant’s words: “Had laws not been, we never had been blam’d; For not to know we sinn’d is innocence.”Banks argue that the complex nature of derivative trading dictates that self-regulation is the only feasible approach. If that fails, then banks seek to minimise scrutiny of major issues, such as the size of the market, speculative activity, pricing issues, complexity and mis-selling of derivatives to unsuitable clients. They argue that existing regulations already adequately cover some issues. Proposed regulations will be masterfully narrowed to minimise impediments to profitable activities.

There will be a familiar threat. Lack of international agreement and regulatory uniformity makes compliance impractical. Banks and derivative activity will relocate with losses of jobs and taxes to the host country. Familiar arguments will be heard regarding the loss of competitive advantage, diminished financial innovation, slower capital formation and higher cost of capital. Each is a well-known step in the familiar “regulatory tango”.The complexity of the issues means that ultimately no laws may be truly effective. As one famous law maker, Adlai Stevenson, observed “Laws are never as effective as habits.”Groucho Marx observed that “[government] is the art of looking for trouble, finding it, misdiagnosing it and then misapplying the wrong remedies.” Legislators and regulators are likely to discover the truth of that proposition in their attempts to regulate the derivative market.

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  1. Doug

    Excellent summary — both of the current situation and the collective insanity. Adlai Stevenson was right. And, the habits of all the power players are so ingrained now that it’s difficult to even imagine a path way to reform of those habits that doesn’t involve, ultimately, confrontation that arises from folks outside the inner circles. Such confrontation, if one looks at history, is most likely to be violent.

    1. DownSouth


      I agree completely. Great and moderate statesmen like Keynes and FDR managed to save capitalism from its first major crisis, which manifested itself in two world wars with a world-wide depression sandwiched in between. But I am like Luther in that I believe the reigning orthodoxy is beyond being redeemable:

      But thy See, which is called the Roman Curia, and of which neither thou nor any man can deny that it is more corrupt than any Babylon or Sodom ever was, and which is, as far as I can see, characterized by a totally depraved, hopeless, and notorious wickedness—-that See I have truly despised…. The Roman Church has become the most licentious den of thieves, the most shameless of all brothels, the kingdom of sin, death, and hell… They err who ascribe to the right of interpreting Scripture, for under cover of thy name they seek to set up their own wickedness in the Church, and, alas, through them Satan has already made much headway under thy predecessors. In short, believe none who exalt thee, believe those who humble thee.
      –Martin Luther, letter to Pope Leo X

      Reform of the church from within, as envisioned by Erasmus, proved impossible.

      The Reformation, along with the Counter Reformation and Inquisition which came as a response, unleashed untold violence. Both sides hardened their positions, and the religious wars lasted some 150 years. “By conservative estimates, the wars claimed the lives of 10 percent of the population of England, 15 percent in France, 30 percent in Germany and more than 50 percent in Bohemia,” Michael Allen Gillespie writes. “By comparison, European dead in World War II exceeded 10 percent of the population only in Germany and the USSR.”

      So no one should be deceived about the potential for violence as the world transitions away from the capitalist, and more generally the modernist, paradigm.

      1. Doug Terpstra

        Wow, damning words Luther had for the whore of Babylon; no wonder the church threatened him. How fitting that this empire is now mired in Babylon (Iraq), mining “the devil’s excrement” (oil–H. Chavez). Now, to the delight of the Armageddon Lobby (American Churchianity), ‘modern’ Babylon continues to smolder, seemingly toward a Revelation-like apocalypse.

        But I hold out hope that the ‘apocalypse’, if it must come (2012?), is not a violent, fiery holocaust, but a manifestly inevitable passing away of the old system and passage into a new world (Gaia) that many New Age Mayan scholars anticipate.

  2. i on the ball patriot

    Deception is the handmaiden of perception.

    Deception is the strongest political force on the planet.

  3. Bruce Krasting

    When your plan to put standardized stuff on an exchange happens all of the big boys will still be trading on the curb. How in heavens name are you going to stop a willing buyer and a willing seller from doing business? Make it ‘illegal’ in NYC? It would just move offshore.

    You seem to think that this is all being created by the horrible PDs. That is not right. This is demand driven.

    There is something like 100 Trillion of paper around today. Almost all of it is questionable. So holders have to choices, they can hold the paper and buy some downside protection or they can simply dump the paper.

    You get what you want and they will dump the paper. That of course is the end of the road for what we know of the financial system. It that what you want out of this?

    1. LeeAnne

      Somebody better come up with something. It looks to me like only outside intervention offers any hope for reform; perhaps a rival system like that being contemplated in Asia.

      If I were Asia I would be planning for the next Western disaster to come forward with a competing system.

    2. Robespierre

      You said :”is the end of the road for what we know of the financial system. It that what you want out of this?”

      My answer to you is: “Yes that is exactly what I would like happen. It is time for the “financial system as it stands today” to end.

  4. Wild Bill

    Simple solution. Require that the first line of a derivatives contract spell out the formula to be used to calculate the value of the contract, for the life of the contract. Solves a lot of problems, I believe, and nothing needs to be torn up or changed. Please tell me what is wrong with my proposal, as I’m only a layman who reads here every day. Thanks.

  5. pebird

    How can you have an enforceable contract if the model used to price something is obscure and there is no mark to market? In addition, there is no comprehensible regulation that can be used to determine the terms of sale? Law ends up being whoever has the most power in the courtroom. The sale itself is evidence that the parties agreed to all terms that are discovered post facto. Yes, all those 100 trillion of paper needs to be dumped – into a black hole.

  6. Blissex

    «How in heavens name are you going to stop a willing buyer and a willing seller from doing business? Make it ‘illegal’ in NYC?»

    Just unenforceable, so the loser in a deal has no legal obligation to pay. “In honor only” debts of course mean absolutely nothing to debtors in the financial industry.

    One little aspect of the stunning legislation preventing the regulation of derivatives that Gramm and his accomplices passed in 1998 is that it also exempted the derivatives market from gambling laws, even if derivatives are in effect pure bets on chances.

    «This is demand driven. »

    Of course it is demand driven — a derivatives that is legally enforceable is a cheaper substitute (that is, it allows for higher leverage) for actual risk reserves, and is acceptable to accountants because of the (theoretical) legal enforceability. But remove that, as from gambling debts, and the demand will evaporate, as the demand exists only for tools to evade accounting regulations when levering up to meet bonus goals.

  7. Ignim Brites

    “The models make numerous assumptions including the ability to borrow at market rates for (theoretically) infinite amounts, unrestricted ability to enter into transactions and abundant trading liquidity. These assumptions are difficult to satisfy in practice.” It is hard to escape the impression that we have a business, financial and economic community that fundamentally does not understand capital, money and credit. We should hardly be surprised if disaster is the consequence. In the absence of understanding prudence in lending and borrowing would seem to be the order of the day. But how does that square with the requirement to juice the animal spirits. Maybe it cannot. Maybe we just have to wait until the bad animal spirits of pessimism and fear dissipate and the good animal spirits of optimism and lust reassert themselves.

  8. Blissex

    «“The models make numerous assumptions including the ability to borrow at market rates for (theoretically) infinite amounts, unrestricted ability to enter into transactions and abundant trading liquidity. These assumptions are difficult to satisfy in practice.” It is hard to escape the impression that we have a business, financial and economic community that fundamentally does not understand capital, money and credit.»

    Ah perhaps that is pessimistic. I guess that most of them understand those in practice, at least as far as their compensation goes. The models (and the resulting accounting) are instead written to boost reported profits, as those drive capital gains and thus executive compensation.

    CEO’s don’t hire accountants and modelers that work to limit the compensation potential of their boss.

    As that guy said, “It is difficult to get a man to understand something when his salary depends upon his not understanding it”, and never more so than in the financial industry, where being a “team player” in the right way is all important.

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