Monthly Archives: April 2014

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.