How
will banks compensate for the billions in revenues that could evaporate when the
derivatives playing field is re-landscaped?
The
stories have been told often over the
years how derivatives markets have surged and soared, how derivatives
have become a market of trillions (measured by the "notional" or face
value of the derivatives traded globally).
The
credit-default-swaps market is said to be over $25 trillion. (That
would be "notional" face value, not actual market value or market
outstandings.)
The
story is also told often about how derivatives markets are opaque, sometimes
illiquid, often misunderstood or too complex and how markets are dominated by banking behemoths
that dictate pricing spreads, trading procedures, collateral requirements and
who gets to join the inner circle of dealers.
WHAT REALLY IS A "DERIVATIVE"?
"Derivatives"
is a financial term that today encompasses a wide range of financial
activity. The term was rarely used before the mid-1980s, although some forms of
derivatives have existed for as long as there have been viable trading markets. In current times, a derivative might include
almost any financial instrument that is influenced by market risks and credit
risks, but is not a director investment into a corporate entity. In other words, it encompasses all that is
not an equity investment, a plain-vanilla bond, or a loan.
Derivatives,
by convention, include options of all kinds (puts, calls and collars),
convertible bonds (and other "hybrid" instruments), interest-rate swaps,
credit-default swaps, equity-linked swaps, commodity swaps, index trading and index swaps,
and currency swaps. They include futures
trading--those traded on
exchanges
and those traded "over the counter."
Frequently,
derivatives will include forward foreign-exchange transactions. For most in finance, the term will include
mortgage-backed securities, CDOs, CLOs, IOs, POs, CDOs squared, synthetic CDOs, and synthetic CLOs, And
if we dare get fancy, they include swaptions, "knock-out" swaps, and CAT (catastrophe) bonds.
Derivatives
creators adore acronyms, complexity, quantitative analytics and the lure of
something new and different. Derivatives
managers enjoy the open-round gush of profits.
Financial theorists and financial engineers embrace whiteboards of equations and
calculus that try to define the behavior of these instruments.
Derivatives,
the term, captures just about any complicated instrument that doesn't
sound like a stock, bond or loan. The
finance media define derivatives
as financial instruments "the value of which are based on other securities
and instruments"--a catch-all phrase that often doesn't explain exactly
what they are or how they perform in live markets.
THE APPROACH OF BIG BANKS AND DEALERS
Here
is how large banks and hedge funds that have dominated prominent segments
of the market define and approach derivatives--at least until now, while the
global business model for trading derivatives is under threat:
1. The first institution to conceive, create, build a
model, sell, and trade a new derivative gets to determine and mark the playing field or the "rules of the game."
2. The first few firms, usually large
banks, that leap into the arena
of a new derivative product determine the profit dynamics--how profit
margins and spreads are determined, how positions are valued, and how prices
are reported. Therefore, they become the core of large dealers that dominate the
new market at the outset. They will
behave in ways to ensure they maintain control of the market--especially
the lucrative pricing spreads.
3. The large dealers who control the market
decide when and how to open it up to new clients and counter-parties. This permits the new market to grow, boosts
liquidity, and spawns a large number of "end-users," who often use
the derivative for risk-management or hedging purposes.
4. The large dealers and their inner circle will
design the marketplace such that
the growing number of "end-users" (corporations, manufacturers, small funds,
and individuals) must arrange trades by going to one of the large dealers.
5. Large dealers, banks and hedge funds are able
to maintain control of markets (and profits) because of advantages in capital
resources, systems and technology,
and information. They can survey, see,
comprehend and act upon all the activity that occurs around them.
6. Large dealers, because they control pricing,
spreads, and profits, have little
incentive to change the status quo, except to increase activity and liquidity
and reduce counter-party risk (the risk of clients and counter-parties defaulting on trades).
7. Once they understand the new product and
market behavior, speculators abound and will pounce on any opportunity to take
advantage of market abnormalities or inefficiencies. They will likely be
specialized hedge funds and funds that house "quant-jocks," but they
may also (at least in the past) be the proprietary trading units of large banks
and dealers.
8. Large dealers, because they control the
market, can determine the price reported
among themselves, prices reported to other interested end-users, and prices
reported to the public.
9.
Large dealers determine, as they see fit or with guidance from regulators,
how the transactions are "cleared" (settled, paid for, or consummated
formally) and how they protect themselves from "default
risk" by
setting rules for how end-users participate (for example, by pledging collateral
or requiring they meet certain capital standards).
Large
banks and dealers claim they haven't managed these markets ruthlessly. They
argue there has been sufficient self-policing and adequate oversight from regulators
and industry-related organizations.
(ISDA, for example, is an industry association that continues to set
common standards for trading, documentation,
reporting, and collateral-pledging. Markit is an independent company that offers pricing services.)
Then
came the financial crisis.
Then
came the public's charges that improper selling and trading of derivatives explains
why the crisis unfurled and infected much of the global economy.
Then
came Dodd-Frank legislation and regulation.
Dodd-Frank was a comforting anecdote
to the crisis. It had the right themes and provided outlines to make markets
safe. But Dodd-Frank didn't stipulate tough deadlines.
Armed with Dodd-Frank powers, regulators have a blueprint and a vision for how
derivatives markets should be overhauled.
They have been tardy, however, in writing the thousands of rules, line
by line, that will redesign markets from front to end. Because derivatives are amorphous financial instruments
and don't fall easily into categories, regulators fuss among themselves about
which body should have the most oversight. The debates among the SEC, the CFTC, the
securities and derivatives exchanges (NYSE, ICE, NASDAQ, CME, etc.) are part of
the reason for delays. The Federal
Reserve, FDIC, FHFA, and OCC have opinions, too. An alphabet smorgasbord of sometimes conflicting
input.
In spirit, regulators seek to require most
commonly traded derivatives
be bought, sold, traded and reported on a major exchange with pricing and
dealer transparency rules. Commonly traded derivatives must be cleared and settled (all post-trade
operations) via an approved, recognized arrangement, usually funnelled through large
well-capitalized banks and overseen by established clearinghouses.
Regulators
knew, too, large dealers and banks weren't going to sit still and
let millions/billions in profits wither away. Until banks figured out a way to
re-engineer their business models to generate profits while strapped by new rules,
they would stall the implementation of regulation and continue to
squeak out profits. Or they would retreat to their finance labs to craft other
ways of making money from derivatives dealing.
WHAT'S ON THE HORIZON?
Where
are we now? Where do we go from here? Will reforms do what they are intended
to do--reduce risks in the system, reduce the likelihood that trading won't
implode into market nightmares, and prepare institutions for the next crisis?
1. Banks are rebuilding their
derivatives-trading desks, reorienting them toward
customer activity and customer flow and allocating proper amounts of capital
to support them, as required by Basel III regulation. Some banks are downsizing their desks, not able to make economic or regulatory sense from the wave of regulation.
2. But big banks won't go away sheepishly. Revenues from derivatives soared until the
late 2000s. They will continue to eke out profits until the economics and capital
requirements dictate that old models make no sense. The biggest and best dealers (including
Goldman Sachs and JPMorgan) will develop new, different business models to
generate profits.
3.
Massive regulation, oversight and public concern will discourage banks and
hedge funds from creating new derivative products--at least not as rapidly as
the 1990s and early 2000s, when new products flew off the shelves. Not long ago, large banks seemed to roll out
a fancy new acronym for a new product every other quarter, always a moment of
pride for them and for the quantitative experts they had hired to think them
up.
4. Regulators, in an effort to come to a
conclusion soon, will unveil new rules (thousands of them), but will probably soften some of them, compromising with banks and hedge funds, yielding
to some of their unrelenting lobbying efforts.
5. "Pain vanilla" activity (basic
swaps, basic forwards, will thrive, even with
thinner profit margins. The big banks will compensate with volume and take advantage
of other banks exit derivatives activities.
It
will have been a long haul, and it won't be over soon. Derivatives markets are
huge, impactful, and complex. This story
still has many chapters remaining.
Tracy Williams
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