major participants in the derivatives market have agreed to what amounts to a significant overhaul of the OTC universe.

TO BE NOTED: From Alphaville:

"Wall Street makes significant concessions on OTC derivatives Posted by Stacy-Marie Ishmael on Jun 02 19:26.

Apoplectic regulators like CFTC chairman Gary Gensler - on the job for all of a week and already condemning the evils of credit default swaps - ought to welcome the news that major participants in the derivatives market have agreed to what amounts to a significant overhaul of the OTC universe.

Wall Street banks have committed to the following, according to a statement from the New York Fed issued on Tuesday (emphasis FT Alphaville’s):
* Recording all OTC derivatives transactions in trade repositories: Registering the complete universe of OTC derivatives trades in either central counterparties or trade repositories will improve the ability of regulators to monitor the OTC derivatives market and will increase transparency to the public. The signatories have committed to record all of their credit derivatives trades by mid-July and to establish centralized reporting infrastructures for interest rate and equity derivatives.

* Expanding CDS central clearing to customers by mid-December 2009: A key regulatory priority is to extend the risk reduction benefits of CDS Central Counterparties (CCPs) to all market participants. Dealer clearinghouse participants have committed to provide their clients* with access to any viable CDS CCP solution no later than December 15, 2009.

(*By “clients” read “hedge funds”)
* Expanding central clearing to a wider range of OTC derivative products: Market participants have set near-term targets to expand central clearing support for credit and interest rate derivative products. Expanding central clearing support for standardized OTC derivatives instruments will maximize the credit risk reduction and operational efficiency benefits provided through use of prudently managed, financially strong and regulated CCPs.

* Strengthening counterparty risk management: Major dealers have committed to implement daily reconciliation of portfolios, a requisite practice for robust counterparty credit risk management, by June 30, 2009. In addition, by September 30, 2009, market participants will publish a standard mechanism for timely and fair resolution of valuation disputes.

* Establishing broad-based and transparent industry governance: The industry commits to enhance its newly-established governance structure to ensure that a broad range of market participants will be included in open, transparent decision-making processes that fairly balance the interests of dealers and their customers.

* Continuing to drive operational performance improvements: Market participants have committed to improve operations in four key areas: matching trades on trade date, increased automation, increased standardization and continued reduction of trade confirmation backlogs.

Of course, not all of these are new - dealers have been promised to reduce trade confirmation backlogs for the better part of a decade - but they are notably more specific. Crucially, this is the first time industry participants have set dates and timelines for achieving their various “operational efficiencies.”

Wall Street’s letter to the Fed laying out its commitments is here; a summary (in handy table format) is here.

Related links:
BlueMountain set to earn $817m on CDS - Bloomberg
Central counterparties and CDS risk, a contrarian argument - FT Alphaville
US calls for OTC derivatives regulation - FT

This entry was posted by Stacy-Marie Ishmael on Tuesday, June 2nd, 2009 at 19:26 and is filed under Capital markets. Tagged with CDS, derivatives, Regulation."

Me:

Don the libertarian Democrat Jun 2 23:02

I'd like to know how this would help in a panic. The reason that CDSs and CDOs froze was because they were sitting right on the bottom of the Flight to Safety totem pole. In other words, in a Flight to Safety, they lost a good part of their worth, especially as compared to other assets. That left the owners of them in a quandary. Whether to sell or hold onto them. The crisis was a huge disparity between bid and ask. That will happen next time as well, if we have a Flight to Safety. The reason is simple: Safe is relative to other assets and the financial context. You cannot stop this reordering and revaluation of assets in a panic. You can only hope to smooth it out. This might help marginally, but, unless the assets are immediately callable, I don't see how.

according to sharia principles, and used for hedging risk rather than speculation.

TO BE NOTED: From the FT:

"Derivatives forecast to make gradual return

By Robin Wigglesworth in Abu Dhabi

Published: May 20 2009 16:36 | Last updated: May 20 2009 16:36

Derivatives have become a bit of a bugbear for some regulators. They blame certain unregulated, over-the-counter instruments for exacerbating the financial crisis but sometimes lump them together with more common, listed derivatives.

The Gulf is no exception. As regulators across the world study the entrails of the financial crisis for lessons, there will be a natural slowdown in their introduction in the Gulf as well, bankers say. But most expect it only to be a matter of time before their use is more widely sanctioned.

Even in the relatively unsophisticated Gulf, many banks dabble in derivatives, but occasionally to disastrous effect.

Several Bahraini banks, and Abu Dhabi Commercial Bank in the United Arab Emirates, have lost significant amounts on credit derivatives such as asset-backed securities and collateralised debt obligations.

Most dramatically, Gulf Bank, one of Kuwait’s oldest and largest lenders, suffered a rare bank run and had to be rescued by the government after a large currency derivatives trade on behalf of a client went awry.

This has hardened attitudes among regional regulators towards such instruments, bankers admit.

Youssef Kamal, the Qatari finance minister, told the Financial Times last year that Gulf Bank’s predicament could never happen in Qatar because its institutions are prohibited from using derivatives.

But regional bankers insist a blanket ban is a mistake. “Derivatives are like a chainsaw,” observes one expert. “If you don’t know how to use one you can cause serious damage, but if you use them correctly and are well protected you will be fine.”

While the market for complex credit derivatives is unlikely to be resuscitated soon, bankers argue that simple, listed equity derivatives would be a boon for regional stock markets.

“There are some very opaque and complex derivatives, but many – such as futures, options and swaps – are very useful and important instruments for risk management and the proper functioning of capital markets,” says Jamal Al Kishi, head of Deutsche Securities Saudi Arabia.

Indeed, while Nasdaq Dubai is at present the only bourse that offers listed equity derivatives – it rolled out futures contracts on 21 UAE shares and a Nasdaq Dubai index last November – most exchanges in the region are keen to introduce full derivatives platforms to boost trading volumes.

NYSE Euronext has signed deals with the Qatar and Abu Dhabi stock exchanges to help provide technical support and expertise for derivatives, and the recently launched Bahrain Financial Exchange has targeted the instruments as a way to muscle in on the Middle East exchange market.

Though often thought of as un-Islamic, Muslim scholars say derivatives are permissible as long as they are structured according to sharia principles, and used for hedging risk rather than speculation.

Even Saudi Arabia has introduced them – albeit indirectly. Last year it introduced swap structures to allow foreigners to acquire the “economic rights” of individual Saudi stocks."

not being able to hedge currency risk through the use of a derivative can leave a company exposed to fluctuations in currency markets

TO BE NOTED: From the WSJ:

"By RENé M. STULZ

The dictionary defines a derivative in the field of chemistry as "a substance that can be made from another substance." Derivatives in finance work on the same principle. But if you read the headlines these days, you might think derivatives were made from arsenic by Wall Street institutions bent on causing financial destruction.

There are two sides to derivatives -- one positive and beneficial, one exploitive and negative. Of the latter, the most visible example today comes to us courtesy of the American International Group (AIG) and reveals what happens when a lightly regulated but highly interconnected financial institution ends up positioned in a way that it cannot survive a housing crash and then such a crash occurs.

The other side of derivatives, however, involves the less-publicized but widespread use of these financial instruments in ways that benefit companies. Derivatives have been immensely valuable tools and will be instrumental in providing the liquidity needed to jump-start the economy. Derivatives are used by a vast number of U.S. companies, both small and large, to manage various risks that arise in connection with their businesses.

From the perspective of Main Street companies, derivatives are not just about high finance, quants and politics, but about investing in America's core industries, jobs and economic recovery. Companies find that over-the-counter derivatives are essential to their day-to-day operations. Derivatives help insulate them from risk, which allows them to borrow capital at better prices than they would otherwise. And derivatives are more useful than ever in these days of unusual volatility in financial markets.

For example, not being able to hedge currency risk through the use of a derivative can leave a company exposed to fluctuations in currency markets. Without derivatives companies could see movements in exchange rates turn a profitable export contract into a money-losing agreement.

In its current annual report, Caterpillar Inc. makes the case for why it relies on derivatives: "Our risk management policy . . . allows for the use of derivative financial instruments to prudently manage foreign currency exchange rate, interest rate, commodity price and Caterpillar stock price exposures."

For those unfamiliar with market jargon, credit default swaps, which are most often in the news, are simply financial contracts between two parties. If, for example, you own bonds in a company and are worried that the company will default, you can manage your risk and protect your holdings with a credit default swap. Under it, you would make regular payments to maintain the contract. If the company does not default, you're out-of-pocket the payments. But if the company does default, the swap serves as a form of insurance by giving you the right to exchange the questionable bonds for the principal amount, or to be reimbursed in other ways. There's nothing exotic or complex about these contracts. They can be highly valuable for Main Street firms, because they enable them to protect themselves against the failure of large customers.

However, Main Street firms cannot afford derivatives unless there is a competitive market for them with participants willing to take the opposite position. Restricting access to derivative markets, which is being proposed by some in Congress as well as by some regulators, would make the costs of derivatives prohibitively expensive and eliminate liquidity.

That derivatives benefit our financial system and our national economy is well established. Twenty-nine of the 30 companies that make up the Dow Jones Industrial Average use derivatives. According to data from Greenwich Associates, two-thirds of large companies (those that have sales of more than $2 billion) use over-the-counter derivatives and more than half of all mid-size companies (those that have sales between $500 million and $2 billion) are very active in derivatives markets. Derivatives are necessary and helpful tools for companies seeking to manage financial risk.

The most important benefit of derivatives is that they allow businesses to hedge risks that otherwise could not be hedged. This does a number of positive things. It transfers risk, allowing firms to guard against being forced into financial distress. It also frees lenders to offer credit on better terms, giving companies access to funds that they can use to keep their doors open, lights on and, even, invest in new technologies, build new plants, or hire new employees.

It's important for regulators not to overreact by pushing for counterproductive new rules. The regulators, after all, were no better at foreseeing the current crisis than the private sector, proving that regulation has obvious limits and cannot replace efforts by financial institutions to devise risk-management approaches that enable them to cope with crises in the financial markets of the 21st century.

At the same time, some sensible regulations are in order. With the interconnectedness of markets today and the systemic problems facing the world's economies, there is a lot that can be done to limit systemic risks. One beneficial step would be for Congress to adopt some version of a systemic-risk regulator that would place every participant in the financial markets that poses a systemic risk, including derivatives traders, under federal regulatory oversight.

Unbelievably, the arm of AIG that dealt with derivative products was not subject to serious scrutiny by a federal agency with relevant experience. A systemic-risk regulator, or markets-stability regulator, should oversee every kind of financial institution that is found to be systemically important, including banks, broker-dealers, insurance companies, hedge funds, private equity funds and others. That regulator should have the authority to ensure that such financial institutions have sufficient capital to reduce the risks they pose to the financial system, to examine parent companies and subsidiaries, and to bring enforcement actions.

Additionally, a clearinghouse for standardized credit default swaps was launched in March, and other competitor clearinghouses are under construction. Clearinghouses clear and settle trades and limit the risk to the larger financial system if any one dealer, like AIG, fails to meet its obligations. A clearinghouse also allows regulators to monitor the exposure firms have to these products, while simultaneously ensuring that each firm posts the necessary collateral to cover its obligations under its trades.

However, clearinghouses should be reserved for established and standardized derivatives, leaving participants in capital markets free to engage in bilateral contracts for derivatives that fulfill specific needs as well as for new products. Further, use of a clearinghouse should not be compulsory, but capital-requirement regulations should recognize that derivatives positions that are not put through a clearinghouse may pose greater systemic risks than those that are.

The subprime mess triggered one of the most destructive financial crises in decades. It's not surprising, then, that the hunt is on for culprits. But derivatives are not the culprit. They had little to do with the rise and collapse of housing prices. Wider availability of housing derivatives would have actually reduced the impact of the collapse of housing prices if homeowners had been able to hedge against possible decreases in home values.

Our businesses need derivatives. Most of us choose to drive cars even though they sometimes crash. But we also insist that cars are made as safe as it makes economic sense for them to be, and that speed limits and other rules of the road are enforced. The same logic should apply to derivatives.

Mr. Stulz is a professor of finance at the Fisher College of The Ohio State University."

the value of derivatives and other financial market contracts are based principally on their fluctuating market value

From The Economics Of Contempt:

"Special treatment of derivatives in bankruptcy

I'm puzzled by all the recent hyperventilating over the 2005 bankruptcy bill and the special treatment of derivatives in bankruptcy proceedings. Derivatives and certain other financial contracts are exempt from the automatic stay in bankruptcy, which essentially gives derivatives counterparties priority over all other claimants. (For an explanation of why it's important to give derivatives special treatment in bankruptcy, see the excerpt at the end of this post.)

Josh Marshall kicked off the outrage a few days ago, when he highlighted the exemption for derivatives in a post titled, "How the Rules Were Rigged":

But separate from the immediate financial implications related to AIG, it does point us toward the larger political economy point: the self-reinforcing cycle in which financialization leads to vast sums of money concentrated in the hands of paper-jobbers, who then mobilize that money in Washington to rewrite the laws to privilege them for even greater profits.

Arianna Huffington, among others, quickly agreed with Marshall's interpretation:

It's worth noting that, thanks to the industry-written 2005 Bankruptcy Bill, derivatives claims are not stayed in bankruptcy -- so the financial institutions that gambled and lost would nevertheless be the first ones paid off. Isn't gaming the system fun?

The problem with this story is that the 2005 bankruptcy bill didn't create the derivatives exemption (called a "carve-out") — the exemption for derivatives was originally enacted in 1982, and was really solidified when the statutory language was clarified in 1990. The 2005 bankruptcy bill just clarified the definitions of the various exempt contracts. For example, the pre-2005 definition of an exempt "swap agreement" included the catch-all phrase "or any other similar agreement," which almost certainly covered credit default swaps. But just to be sure—to provide that all-important legal certainty—the 2005 bankruptcy bill amended the definition of "swap agreement" to explicitly include credit default swaps. There was no substantive change, just a clarification—a process otherwise known as "modernizing" the financial regulations in order to keep up with financial innovations. Given how rarely our financial regulations have been modernized over the past 25 years, it's a bit strange that one of the few successful efforts to actually modernize financial regulations is attracting so much criticism.

Moreover, the special treatment of derivatives and other financial contract isn't unique to bankruptcy proceedings. In old-fashioned FDIC receiverships (which everyone seems to love right now), "qualified financial contracts" (QFCs) — e.g., derivatives and securities contracts — have long been exempt from the FDIC's avoidance powers, in order to permit the orderly netting of derivatives contracts. Since major bank holding companies (e.g., Lehman, Citigroup) aren't covered by the FDIC resolution process, it's only natural for the FDIC's QFC exemption to be extended to the Bankruptcy Code. Essentially, exempting derivatives from the automatic stay in bankruptcy is a way to harmonize insolvency procedures.

------------------------------

This FDIC article provides a nice explanation of why it's important that derivatives and other financial contracts be exempt from the automatic stay. It's all about close-out netting:

As with other financial instruments, including bonds and equity securities, derivatives pose credit, market, liquidity, operating, legal, settlement, and interconnection risks. One of the primary ways to reduce the risks to individual parties in derivative or other financial contracts is the ability to settle the transactions by payment of a single net amount. Netting is simply taking what I owe you and what you owe me and subtracting to yield a single amount that should be paid by one of us. Netting can be a valuable credit risk management tool in all multiple transaction relationships by reducing the credit and liquidity exposures by eliminating large funds transfers for each transaction in favor of a smaller net payment.

Close-out netting, or the ability to terminate financial market contracts, determine a net amount due, and liquidate any pledged collateral, is a valuable tool to protect against credit and market risks in cases of default. This is particularly important in the financial markets because, unlike loans or many other financial contracts, the value of derivatives and other financial market contracts are based principally on their fluctuating market value. If one of the parties to a derivative or other financial market contract is placed into bankruptcy or receivership, the normal stays on termination of contracts and liquidation of collateral could create escalating losses due to changes in market prices. As a result, the ability to terminate the contract and net exposures quickly can be crucial to limit the losses to the non-defaulting party because such contracts can change in value rapidly due to market fluctuations.

Posted by Economics of Contempt at 12:35 AM"

Me:

Don said...

"This is particularly important in the financial markets because, unlike loans or many other financial contracts, the value of derivatives and other financial market contracts are based principally on their fluctuating market value"

This makes it sound like it is simply a procedure to put these investments on an equal footing with fixed investments, since, theoretically, when the assets were dispersed, the fluctuating claims could be worthless.

Don the libertarian Democrat

March 10, 2009 5:48 PM

Slate Does Some Explaining

Jacob Leifenluft on Slate asks:

"How can the derivatives market be larger than the entire world's financial wealth?"

It can't:

"Gross market value of all outstanding derivatives was $14.5 trillion at the end of 2007, less than one-fortieth of the $596 trillion estimate. (That number shrinks to about $3.3 trillion once you take into account contracts that directly offset one another.)"