Category Archives: financial innovation

Risk manager of the Year: Bob “Kid Rock” Ritchie

When Rap-metal-rocker “Kid Rock” launched his album Devil Without a Cause fifteen years ago, he became an instant success, after years of toiling in obscurity.

Now, the man is shooting to superstardom in finance, by tackling the high costs of attending rock concerts. If he succeeds (and I hope he does) he will turn the music industry on its head!

Singers are paid an agreed fee per concert (say $200,000), with the rest going to the organizers of the event. Organizers are the residual claimants and bear all the risks. Sometimes they win, other times they lose. To protect themselves, organizers charge high ticket prices and control a large concentration of the concert venues.

Egg head Kid Rock figured this might not be an optimal arrangement. So he is willing to give up the big upfront fee and instead share in the net income and the risks with the concert organizers. What’s really daring about this proposal of a self-confident singer turned entrepreneur, is that Kid Rock wants to lower ticket prices to just $20 (instead of $80+). Wow!

Some think that Kid Rock is motivated by an ego that thrives in exhilaration with a house packed with fans, who otherwise would not be able to afford a memorable night out. Others say that low concert ticket prices are used as a mechanism to boost sales of his records afterwards. Others venture that seeing the man perform makes you a lasting fan. Perhaps, but I don’t believe this is the whole story, simply because Kid Rock’s idea had to pass mustard with the concert organizers.

What Kid Rock seems to understand is that there are a lot of other things that people buy when they attend a concert, from drinks, food, parking, to all the paraphernalia that is stimulated by the overwhelming emotions experienced in such events. All of these can bring big bucks that are directly related to what’s going on stage! In fact, listening to Kid Rock’ Bawitdaba makes people so excited, with all the lights shining, the bodies in constant motion and the collective singing, that one feels the instant desire to gulp down another beer, even if it costs three times more than at a local liquor store. The lyrics anesthesiate any remaining sense of frugality.

The Wall Street Journal calls the deal with Live Nation Entertainment “unorthodox”. Really? This is optimal risk sharing and the right alignment of interests between the parties involved. In the process, monopoly rents might get cut a bit. And when all this happens at once, there are truly big welfare gains.

“They can’t read your brain, but they can read your lips”, Kid Rock, but “they get scared when they hear that you were coming with hits”. Big Hit, indeed!

Regret in the here and now, joy in a parallel universe

Morgans

Steven Davidoff, the New York Times’ Deal Professor, thinks that management and shareholders at the Morgans Hotel Group got suckered back in October 2009 when they sold their souls a PIPE for cash. Davidoff implies that the investor, Ronald Burkle’s Yucaipa Companies, is doing fine, while management and the other shareholders are squirming to escape as various control triggers are closing in on them.

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Would you like fries with that McSwap?

McSwap

Last week the OTC swaps market took a big step towards the creation of standardized interest rate swaps. Pushed by the buy-side, ISDA developed a “Market Agreed Coupon” or MAC contract with common, pre-agreed terms. From the ISDA press release:

The MAC confirmation features a range of pre-set terms in such areas as start and end dates, payment dates, fixed coupons, currencies and maturities. It is anticipated that coupons in the contract will be based on the three- or six-month forward curve and rounded to the nearest 25 basis point increments. Effective dates will be IMM dates, which are the third Wednesday of March, June, September and December. The initial currencies covered include the USD, EUR, GBP, JPY, CAD and AUD. Maturities will be 1, 2, 3, 5, 7, 10, 15, 20 and 30 years.

This is good for end-users. Dealers have long used superfluous customization as a tool to blunt competition and maintain margins. Creating a subset of contracts with standardized terms will make the interest rate swap market more efficient in many ways.

Some in the industry worry this just feeds the trend to futurization of swaps:

“It’s quite speculative to try to figure how this will turn out, but on the one hand a more standardised product is presented as more homogeneous, which is good for OTC markets, while on the other, you could argue the more a product is standardised, the less differentiated it is from futures and ultimately could lose out to straight futures activity,” says one New York-based rates trader. “I think there is a fear that this standardisation process creates a much easier path towards futurisation. You could argue this is one step closer towards promoting the success of swap future contracts.” (RISK magazine, subscr. required)

But that ship had already sailed. The G20 specifically rejected the old model of faux customization, and mandated standardization in support of improved transparency and clearing. Whether standardization happens within the OTC swaps space, or via futurization is a detail.

Can Hedging Save Cyprus?

Lenos Trigeorgis has a piece in the Financial Times’ Economists’ Forum advocating the use of GDP-linked bonds for Cyprus.

Suppose that its steady-state GDP growth is 4 per cent and that fixed interest on EU rescue loans is 3% per cent Instead of the fixed rate loan, Cyprus could issue bonds paying interest at its GDP growth minus 1% (the difference between the average growth rate and the EU bailout rate). If GDP growth next year is 0 per cent, lenders would pay the Cypriot government 1%, providing Cyprus with some relief in hard times. But if after, say, 10 years GDP growth is 7 per cent, lenders would instead receive 6 per cent. In essence, during recession EU lenders will provide insurance and interest subsidy to troubled Eurozone members, helping them pull themselves up, in exchange for higher growth returns during good times. Increased interest bills in good times might also discourage governments from sliding back into bad habits.

As we’ve written in a couple of earlier posts, this is easier said than done. But it’s certainly thinking along the right lines.

Futurization wheat and chaff

classroom

Finally, a journalist has located a real cost of futurization, as opposed to the many imagined ones.

 

Futurization advances in interest rate products

The NYSE Liffe is moving to adapt their futures products to grab more business away from the OTC swaps market. It announced changes yesterday to enable large block trading in 3 of its products–three month Euribor futures, three month sterling futures and long gilt futures. The block trades will be handled on its Bclear system. The service is scheduled to be available starting December 10.

The FT’s coverage is here. It will be interesting to see how the new service does and how it affects the overall flow of trade in those futures contracts.

This looks to me like another example of the futures marketplace easily being expanded to offer a service in standardized derivatives formerly performed OTC. There was never any special economic rationale for this business in standardized derivatives being handled OTC. This move exposes, once again, the fallacy that the OTC swaps market was dominated by customized products that are ill-suited to standardized markets like futures exchanges.

Futurization #4 — an agenda item for the CFTC hearing

In a speech this past Friday, CFTC Commissioner Scott O’Malia once again voiced his concern that burdensome swap dealer registration rules and disadvantageous margin requirements for swaps may be driving the futurization of derivatives trading. He proposed that the Commission host a hearing on the futurization question in order to inform development of the right rules for the swaps market.

In order for a hearing to be informative, it is essential to put the right questions on the agenda. I suggest the Commission squarely ask what swap markets are for?

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Futurization #3 — long live innovation and customization

Defenders of the OTC swaps model like to talk a lot about the ability to custom tailor the terms of a swap to each customer’s particular needs, and also about the room given to innovate new product designs. The listed futures exchange model cannot accommodate this degree of innovation and customization. That’s true, as far as it goes.

Fortunately, the Dodd-Frank OTC derivative reforms preserve a space for this element of the OTC swaps model. Customized swaps are still allowed. Swaps that implement new product designs are still allowed. Exchange trading is not mandatory for all swaps. Clearing is not mandatory for all swaps.

When we talk about futurization of swaps, we are talking about the larger subset of swaps that are either already marketed as off-the-rack products, or that can be easily repackaged as such. This represents the vast majority of OTC swap trading.

Dodd-Frank was architected to allow standardized derivative trading either on the newly created swap exchanges or on the pre-existing futures exchanges. The current talk about futurization is all about the choices being made for trading these standardized derivatives. Instead of transitioning onto swap exchanges, they are moving out of the swaps marketplace and onto the futures marketplace. Customized derivatives will have to continue to be offered as swaps, which Dodd-Frank explicitly allows.

Moving standardized derivatives onto exchanges, and clearing those transactions can benefit customers. There is a lot to be gained from encouraging efficiency and product development in ready-to-wear derivatives.

Artisinal production has its benefits, but mass production does, too. The Dodd-Frank reform permits both.

SEC Staff examines copper ETFs with blinders on

The SEC is currently considering whether to allow JP Morgan and Blackrock to list new copper ETF’s on the NYSE Arca. Some copper industry players oppose the listing, as does U.S. Senator Carl Levin and the advocacy group Americans for Financial Reform. Comment letters can be found here. Earlier this month, SEC Staff in the Division of Risk, Strategy, and Financial Innovation filed a memo reporting its empirical analysis that downplays any potential problem. That memo is a testament to how America’s financial regulators too often fail in their duty to protect the sound functioning of US financial markets.

The SEC staff asks two narrow questions.

First, is there a simple and enduring mechanical link between the flow of money into a commodity ETF and the price of copper. They answer, ‘no.’

Second, is there a simple linear relationship between copper inventories and copper prices. Again, they answer, ‘no.’

The Staff’s analysis is faulty in many ways. Both industry players and the advocacy group Americans for Financial Reform filed careful, detailed critiques of the econometrics and reasoning. These are well worth reading, and thoroughly impugn the soundness of the Staff’s conclusions.

What alarms me most is the narrow scope of the questions that the Staff posed, even had they bothered to do a thorough analysis of those questions. A proper regulator needs to assure that the market functions well. There are any number of ways in which its operation can be disrupted. We have a long, long history of commodity markets in the US, and that means we have a long history with market manipulation and other price distortions. We have a long, long history with financial markets in the US, and that means we have many experiences with asset bubbles, especially in the recent past with the dotcom and housing bubbles, as well as the oil price bubble. Neither of the two empirical tests the SEC Staff examined touches in any way on the issues one would want to examine in order to assure the sound functioning of the copper market and the healthy contribution that financial trading could make to the market. The mechanical link the Staff searched for would not show up in a market rife with manipulation. Nor is that mechanical link necessarily symptomatic of an asset price bubble. So failing to find such a link provides no assurances that this market will function properly. And it is alarming that the SEC Staff does not explore any of these other important issues that must be settled. Just as the SEC Staff did in the Madoff case, it carefully asks the wrong questions and thereby comes to easy answers.

Personally, I’m confident that financial markets have a valuable contribution to make in extending the efficiency and productivity of the real economy. I believe that’s true for all commodity markets as well, copper included. But making that happen requires active engagement by US regulators, and not a ‘see no evil’, hands off, laissez faire approach. That way lies market disruption and an undermining of the productivity of the economy.

The SEC can do better. It must. American industry depends on it.

Futurization #2 – why?

Why Futurize Swaps?

Futurization is the movement of derivative trades out of the OTC swaps marketplace and into the futures marketplace. There are different ways in which this shift may take place. Economically, they all have one thing in common: a recognition that there is in fact nothing special about swaps as a financial instrument. In general, any package of risk that can be structured via a swap can also be structured using futures and options contracts that can be traded in the futures marketplace.

The essential distinction between the OTC swaps marketplace and the futures marketplace is the regulatory rules, not the product designs that can be offered. Of course, a difference in regulatory rules can be economically significant, too. But it is important to keep straight the real source of any economic impact.

Prior to the Dodd-Frank Act, the OTC swaps marketplace lacked regulatory oversight, transparency and clearing, and the vast majority of derivative trades were executed in this marketplace as a result. After the Dodd-Frank Act, all OTC swaps trades are subject to regulatory oversight, and the vast majority must be traded transparently and cleared. There are exceptions that allow the OTC swaps market to continue offering swaps that are custom designed, and therefore ill-suited to exchange trading and clearing. However, for the vast majority of swaps, the Dodd-Frank Act removed the main advantage of the OTC swaps marketplace. With the mandates of oversight, transparency and clearing, the main raison d’être is gone.

Consequently, all players in the industry are now reassessing the choice of venue for derivatives trades: the OTC swaps market or the futures market. When the new calculus leads them out of swaps and into futures, that is the essence of the futurization of swaps.

How is the futurization of swaps to take place? I group the different ways into two main categories.

First, in many cases, plain vanilla futures and option contracts can easily substitute for swaps.

This is exemplified by the recent decision by the ICE to simply switch its cleared energy swaps into futures contracts. There was more to it than simply changing the package label, but not much more. ICE’s cleared energy swaps may be a special case for the ease with which such a transition can be executed, but from an economic standpoint it is much more representative than is yet widely recognized.

The vast majority of interest rate and foreign exchange swap transaction could be readily supplanted by plain vanilla futures and option contracts, as can other commodity swaps. For example, the CME’s IMM has long offered interest rate and currency futures which serve the same risk packaging function as interest rate and currency swaps. But these products were overshadowed by the OTC swaps marketplace because that marketplace had the advantage of not being regulated. Now that the Dodd-Frank Act has imposed comparable regulatory rules which remove the advantage of the OTC marketplace, these products may once again come out from under the shadow of the OTC and steal back the business. That hasn’t happened yet. But be patient.

A second, more contorted category involves attempts to somehow trade swaps, but to do it under the futures regulatory rules. These are the so-called “swap futures”. One example comes from the CME, which, in September, announced plans to launch its interest rate swap futures product. This is a futures contract where the underlying product is a traditional interest rate futures contract. So long as the customer owns the futures contract, the margining and other regulatory rules of the futures exchange apply. But, if the contract is held to delivery, then the customer finds itself holding an OTC swap, and the margining and regulatory rules of the OTC swaps marketplace then apply. Another example comes from the upstart Eris Exchange, which launched its interest rate swap futures product back in 2010. Instead of making the underlying product an actual swap, Eris cash settles its futures product to mimic those on an OTC swap.

This second category has all the buzz, currently. But perhaps not for long. The push for this second category is predicated on the idea that it is possible to have the best of both worlds—the current regulatory arbitrage benefits of the futures marketplace along with the economic advantages of swaps. But there never were any special economic advantages of swaps, so the underlying rationale for swap futures is faulty. After the buzz dies down, and the players recognize the problem, the action may turn back to the first category. On that, we are still waiting. Be patient.

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