Category Archives: Dodd-Frank

How large is the taxpayer subsidy to Too-Big-To-Fail banks?

The issue came up yesterday when Fed Chairman Ben Bernanke testified before the Senate Banking Committee. Senator Elizabeth Warren cited a Bloomberg report that put the number at $83 billion to the 10 largest U.S. banks. The Bloomberg figure is extrapolated from the finding of an IMF study that the backstop provided to banks lowers their cost of borrowing by approximately 0.8 percentage points.

Matt Levine at Dealbreaker makes the provocative claim that “The Too Big to Fail Subsidy is Negative Sixteen Billion Dollars”. This comes in the second round of Levine’s tit-for-tat with Bloomberg. His original critique started off with a reasonable and incisive drill down into the numbers.[1] Now, after an effective rejoinder by Bloomberg, he abandons the two main points from his original critique and substitutes new ones.

Continue reading

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

Prop Trading at JP Morgan

JPMorgan’s management released its Task Force Report (Report) on the trading losses at its Chief Investment Office (CIO). It’s very clearly written tick-tock and provides a good account of how various controls broke down. Taking for granted the task assigned to the traders running the CIO’s Synthetic Credit Portfolio, the report outlines where things went wrong.

As an accident of timing, the losses were first disclosed in the midst of a public debate about the Volcker Rule’s prohibition on proprietary trading at banks. So, for the public, the case became a test of whether the proposed regulations implementing the Volcker Rule had any teeth: would they prohibit the trades being done at JPMorgan’s CIO once they came into force? Management has always contended that the Synthetic Credit Portfolio was run to hedge the bank’s natural long position in credit risk, and that it was not proprietary trading and would not be prohibited under the Volcker Rule. That contention is repeated summarily in the Report when it gives an introductory overview of the Portfolio’s origin and operation. But, the contention is never actually substantiated: indeed, the Report does not purport to address the prop trading question directly.

There is much in the Report that would lead a reader to doubt management’s contention and to conclude instead that the Synthetic Credit Portfolio was a classic example of prop trading.

A key forensic test for distinguishing prop trading from hedging is the compensation criteria. A hedger’s success is not measured by his or her own profit and loss on the hedge trades. Instead, a hedger’s success is measured by how well his or her own profits and losses track and set off the losses and profits on the assets being hedged. The metrics for performance on hedging should incentivize minimizing net risk. The metrics should measure net risk reduction. When the desk reports big profits — after netting out the matched positions — that’s a bad sign, not a good one. The JPMorgan Report strongly suggests that the traders on the Synthetic Credit Portfolio expected to be rewarded on their own profit and loss, not on how successfully they hedged the bank’s natural long position. That compensation system fits prop trading, not hedging.

The Report does briefly consider the wisdom of the compensation scheme, but not from the perspective of the Volcker Rule and identifying prohibited activities. Instead, the Task Force was just concerned with the question of whether the profit and loss criterion was overvalued to the exclusion of other criteria management imposed on the unit.

So, it looks as if JPMorgan’s CIO, and its Synthetic Credit Portfolio provide a useful test case for the Volcker Rule going forward. The original regulations proposed for implementing the Rule did include an assessment of compensation criteria. Whether that will continue in a final rule is yet to be seen. And then comes the question of enforcement.

 

 

Futurization wheat and chaff

classroom

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

 

Congressional Intent & Futurization

The Capital Markets subcommittee of the House Financial Services Committee held a hearing yesterday on the derivatives portion of the Dodd-Frank Act — Title VII. The question of the futurization of swaps captured a good bit of attention.

House Hearing

Representative Bachus, who chairs the full Committee, said (at 14:04 in the video),

If all derivatives were supposed to be traded on an exchange, then they would all be futures. [Swaps] are differeent from exchange listed products, and imposing the listed futures or equity market model on [swaps] is not the mandate of Title VII.

Continue reading

How Futures Can Steal Market Share from Customized Swaps

alterations

Many people underestimate the threat that futures markets pose for the OTC swaps industry because they have been suckered into thinking of swaps as carefully custom tailored instruments. It’s true that a small fraction of the OTC swaps market cannot be replicated in the futures marketplace. And it is good that the Dodd-Frank Act preserved a space for customized swaps. But the vast majority of swaps are not custom tailored, or the custom tailoring is so inconsequential that it will be an easy matter for the futures market to serve the same purpose.

Even when the swap does contain some important element of customization, that is usually not the whole story. Many customized swaps can be broken up into 2 pieces: (i) a basic, plain vanilla swap, plus (ii) a small bit of customization that adapts the plain vanilla swap around the edges. The futures market can substitute for the plain vanilla swap, and then the OTC swap market can provide the customization around the edges.

It’s like buying a suit ready-to-wear, but having the tailor adjust the hems or waistline a little bit. So long as the adjustments are small, its an economic alternative to true customization.

An illustration of how a custom swap can be broken up into two pieces appears in an article by Sean Owen, Director of Fixed Income Research and Consulting at Woodbine Associates, published in a recent special issue of the Review of Futures Markets. He breaks up an irregularly amortizing 10-year interest rate swap into (i) a 7-year bullet interest rate swap, and (ii) a customized swap that produces the irregular amortization relative to the 7-year bullet. (H/T to CFTC Commissioner Scott O’Malia for highlighting the article)

measure

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?

Continue reading

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.

It never hurts to check the data

This coming Friday the CFTC will be hosting a Research Conference on derivatives markets. The agenda touches on HFT, swaps market structure and the financialization of commodities.

Continue reading