Category Archives: OTC reform

End-User Horror Stories #1 – FMC

horror victim

ISDA, the trade association for OTC derivatives, released a paper today purporting to document the dangers of derivatives reform. As usual, the alleged victims are ‘end-users’, the non-financial firms using derivatives to hedge risk. The paper is organized around 4 case studies of firms and their OTC derivative hedges, and makes specific claims about their specific hedges. This is a refreshing change from the usual vague generalities, so it is worthwhile examining those claims in some detail. Moreover, ISDA hired two accomplished finance professors to author and lend their credentials to the paper, so there is a promise that the arguments will have more substance than the usual lobbying pitches.

Unfortunately, the promise of something new is unfulfilled. The paper repackages old, debunked claims. Its arguments are shallow and unpersuasive.

Take as an example the case of the chemical company, FMC, and its hedge of natural gas prices. Although the abstract says that the authors will examine hedge effectiveness, the accounting treatment and the impact on earnings per share, in fact, the paper does none of those things. Instead, it makes two other points which I will examine in turn.

First, the ISDA paper claims that the reform increases FMC’s administrative burden of hedging. How? By forcing FMC out of the OTC derivative market and into exchange traded futures. It takes a cumbersome assemblage of 13 futures to reproduce what can be done with 1 OTC swap. The paper implies that managing this cumbersome assemblage is costly, although it never really accepts the burden of quantifying the extra cost.

This argument does not stand up to scrutiny. The whole premise is wrong. The reform does not prohibit FMC from using OTC swaps instead of futures. So why is the comparison of 13 futures to 1 OTC swap relevant? The paper never explains the premise. It’s just implicit in the comparison of the burden of managing an OTC swap against managing a package of futures. Moreover, suppose we imagine that the OTC market was outlawed. Even then, there is nothing in FMC’s customized swap that cannot be reproduced in the futures market. Clearly the risk profile can be perfectly reproduced, as the package of 13 futures demonstrates. So the only problem we are left with is the administrative burden. FMC cannot handle the 13 contracts itself in house. That’s why it’s dealer constructed a packaged swap. But our imaginary prohibition of the OTC market doesn’t outlaw all forms of financial services. FMC’s banker is free to offer the service of managing a package of 13 futures which replicates FMC’s desired risk profile. In fact, that’s exactly what FMC was getting from its OTC derivative dealer. And you can be sure that FMC paid for that service, although the paper’s authors conveniently overlooked the price charged. There is absolutely nothing in the derivatives reform that stops FMC from outsourcing the management of its natural gas exposure using futures contracts. And there is absolutely nothing in the ISDA paper to suggest that it is more costly for the finance industry to provide that service using futures contracts.

Second, the ISDA paper claims that the reform increases the amount of margin FMC must post, and the paper calculates the margin on FMC’s natural gas hedge. The paper implies that this extra margin is an extra cost. This assumes a false equality between margin paid and cost incurred. An OTC derivative saves FMC the burden of paying margin only by having the dealer extend FMC credit. You can be sure that FMC is charged for that service. Unfortunately, the ISDA paper completely overlooks the price paid for credit risk. My paper on “Margins, Liquidity and the Cost of Hedging,” with my colleague Antonio Mello, shows that when you take into account credit risk, FMC’s costs are exactly the same whether they use the non-margined OTC swap or a fully margined futures package.

Flash Futures

flash boys

Michael Lewis has written a gripping and penetrating book about high frequency trading and the current state of U.S. equity markets. Lewis, of course, knows how to tell a good tale, so the book is fun to read. But the big payoff is insight. The book is astonishingly good at crystallizing what’s going on and why.

Flash boys is all about stock markets, where the accidents of history happened to have spawned a particularly freakish evolution of automated trading. Derivatives markets have only a cameo role through the geographic placement of stock futures in Chicago. In the news frenzy following the book’s release, securities regulators have put out obligatory releases meant to tamp down public anxiety. According to Silla Brush at Bloomberg, the CFTC’s Acting Chairman Mark Wetjen was among them:

“I don’t have the impression at the moment that futures markets are rigged.” The CFTC and its enforcement division are reviewing trading practices in the futures market to ensure they aren’t manipulative, Wetjen said. The agency is also reviewing relationships between exchanges and trading firms, he said.

Hopefully, the reviews Chairman Wetjen is referring to are substantive. Insiders know that the issues at hand in Flash Boys are all too pertinent to derivatives markets. The precipitating event underlying the story is technological change. The drama is in how social forces negotiate that change. Nothing distinguishes derivatives markets from equity markets in the grand scheme of things. But, more accidents of history did initially immuniz derivatives markets from some of the ugliest practices detailed in Lewis’ book. But derivatives markets are undergoing a major restructuring in the wake of the 2008 financial crisis, and that restructuring undermines some of that immunity. So it is vitally important that the CFTC take full advantage of the breathing room it has in order to harness technology in the service of vibrant markets serving the productive economy. Otherwise, the confluence of these two streams—derivatives reform and technological change in trading—could prove treacherous.

Never give information to the enemy.

Loose Lips

Douwe  Miedema of Reuters covered yesterday’s meeting of the CFTC’s Technology Advisory Committee and reports that:

The U.S. derivatives watchdog on Monday chided the industry for providing gappy data on the $630 trillion market… “I do want to get away from the handholding,” said Vincent McGonagle, the CFTC’s head of the Division of Market Oversight. “It is clear that there are issues where parties are not reporting,” he said.

What is he talking about?

I’m guessing that this is an example. ICE Trade Vault is a Swap Data Repository for commodity products, including financial power. In addition to running its data repository, ICE is a lead platform for trade in these products. According to data compiled by one of its platform competitors, Nodal Exchange, and provided to the CFTC’s Division of Market Oversight, the data feeds from ICE Trade Vault lack some of the most pertinent information about transactions:

…of the 33,030 financial power transactions reported by ICE Trade Vault in 2013, we found that 21,054, or 64% were listed as “exotic” and lacked basic transaction information such as the unit of volume and the product transacted. Furthermore, only 11,973 transactions, or 36%, of all financial power transactions reported by ICE Trade Vault contained any price information.

We were also dismayed to see that for even the relatively well described transactions denominated in Megawatt Hours (MWh) reported by ICE Trade Vault, the vast majority (11,214 of 11,893 transactions, or 94.5%) had, at best, only a generic region or Regional Transmission Operator (RTO) or Independent System Operator (ISO) identified. We believe this lack of specificity is largely unwarranted. For example, many transactions reported by ICE Trade Vault simply show “PJM”, a Regional Transmission Operator covering all or parts of 13 states plus the District of Columbia. However, on ICE Futures U.S., ICE offers futures contracts covering 13 distinct zonal locations and four hub locations within PJM, providing a ready basis for more specific locational reporting for ICE Trade Vault as well. Financial power information is really only useful if it conveys what product is traded (specific power location), at what price, and for what volume. This information is available on only 607 of the 33,030 financial power transactions, or 1.8%, as reported by ICE Trade Vault.

Trade reporting is the law, but there is obviously a long way to go before its a reality.

Where Are We in the Reform of OTC Derivatives Markets

Here is my take on the current status of the reform. It’s a chapter in a report put out by the Americans for Financial Reform and the Roosevelt Institute titled An Unfinished Mission: Making Wall Street Work for Us. Here’s the link for the full report.

The Value of Clearing Derivatives

financial dominos

What are the costs and benefits of the reform of derivative markets now taking place? A report released last week by the Bank for International Settlements (BIS) pegged the central estimate of the benefits at 0.16% of annual GDP.[1] With US GDP at something more than $15 trillion, that’s $24 billion annually. For the OECD as a whole, the figure is nearly triple that.

Approximately 50% of the benefits are due to the push to central clearing. Continue reading

Be careful how you swing that hatchet!


During last year’s debate about the Volcker Rule, Morgan Stanley commissioned a study by the consulting firm IHS that predicted dire consequences for the U.S. economy. I called the study a hatchet job. My main complaint was that the study made the obviously unreasonable assumption that the bank commodity trading operations would be closed down and not replaced. IHS even excluded the option of having banks sell the operations.

So this story in today’s Financial Times gave me a good chuckle:

US private equity group Riverstone is leading talks on an investment of as much as $1bn in a new commodities investment venture to be run by a former Deutsche Bank executive…

Morgan Stanley is considering a sale or a joint venture for its commodities business… James Gorman, Morgan Stanley’s chief executive, last October said the bank was exploring “all form of structures” for its commodities business.

Glenn Dubin, Paul Tudor Jones and a group of other commodity hedge fund investors last year bought the energy trading business from Louis Dreyfus Group and Highbridge Capital, the hedge fund owned by JPMorgan Chase. The parties later renamed the business Castleton Commodities International.

And so, another industry funded hatchet job on the Dodd-Frank financial reform ages poorly.

Would you like fries with that 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.

Margins, Liquidity and the Cost of Hedging


Our paper on end-users and the cost of margins is now out in Morgan Stanley’s Journal of Applied Corporate Finance.

3 points on the futurization of swaps

Today, the CFTC is hosting a Roundtable on the “Futurization of Swaps.” More than 30 people from various parts of the industry are speaking. I’m on the first panel. Here are 3 points I’ll be making:

Continue reading

Futurization wheat and chaff


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



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