Category Archives: financial innovation

Fear of the Future-ization of Swaps #1

The reform of the derivatives market, like other parts of financial reform, has been a very slow moving process. As when a giant ocean tanker is being slowly turned around, progress is so slow that it can be hard for the naked eye to confirm that the event is actually happening until the great ship’s silhouette overtakes a distinctive landmark on the horizon. And derivatives market reform, too, is happening. Each time the reform slowly approaches a new landmark on the horizon, the fact of reform is confirmed once again to proponents and opponents alike. And each time this happens, there are new howls from opponents that the ship’s current course will surely lead to disaster.

The current occasion for complaints goes under the heading “futurization of swaps.” Pre-reform, derivatives could either be traded in regulated marketplaces, generally called futures markets, or in the un-regulated marketplaces, generally called the OTC swaps market. The Dodd-Frank Act brought regulation to the OTC swaps market. Those regulations are only now beginning to take effect, or the deadlines are approaching. As that happens, companies on all sides of the derivatives markets are beginning to rethink where they should do their derivatives business. Should they continue to trade swaps, or can they get the same result using futures? Should they continue to market swaps, or should they now market futures? The swaps marketplace used to have the advantage of being unregulated, but as that advantage appears to be disappearing, where is the rationale for swaps? Derivative consumers and producers alike are giving the futures markets a fresh look. Some swap products have been relabeled and moved over to futures markets. Other, new futures products are being developed as substitutes for old swap products.

Obviously a major shift of business from the swaps market to futures markets threatens major business interests. Throughout the legislative battles leading up to Dodd-Frank, and the rulemaking and legislative battles surrounding implementation, the big banks that controlled and profited from the OTC swaps market hoped to preserve their monopoly. So far, they have mostly failed. The current debate about the ‘futurization of swaps’ is a major milestone in the process, and it is no surprise that it is raising new howls. These interests are complaining that the legislation is killing the swaps market, ruining a valuable financial innovation.

In the coming days, I will look at various arguments being made against the futurization of swaps. None of them hold up.

You say ‘futures’ like it’s a bad thing.

Early last month, the Intercontinental Exchange (ICE) announced that it was transitioning its cleared energy swaps products into futures products. That move precipitated a chain of commentary warning that other swaps business might soon transition to the futures markets. The blame is placed on various alleged problems with the CFTC’s rulemaking for swaps. CFTC Commissioner Scott O’Malia is a prominent voice making this argument recently.

What if this switch is a feature and not a bug?

Once upon a time, all derivatives trading was regulated, with transactions taking place on an exchange and with positions cleared and margins posted. Then along came the OTC swaps market, which grew enormously, far surpassing the futures markets.

Why?

Many champions of the swaps industry point to flexibility as a major advantage of swaps—the terms of a swap can be tailored to each customer’s needs. Futures, because they must be standardized, are too inflexible.

There is a grain of truth in this, around which is spun a giant ball of misrepresentation.

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“A lot of weather we’ve been having lately.”

The winter of 2011-2012 was the fourth warmest on record in the U.S., according to the National Oceanic Atmospheric Administration (NOAA). One consequence of this has been a sharp drop in demand for natural gas use to heat buildings, and that is a hit to the bottom line of many gas distribution utilities with revenues tied to the quantity of gas consumed. For example, the Delta Natural Gas Company, a Kentucky utility, reported in its second quarter 10Q that:

Heating degree days were 78% and 84% of normal thirty year average temperatures for the three and nine months ended March 31, 2012, respectively, as compared with 102% and 105% of normal temperatures in the 2011 periods. … For the three months ended March 31, 2012, consolidated gross margins decreased $890,000 (7%) due to decreased regulated and non-regulated gross margins of $707,000 (7%) and $183,000 (6%), respectively. Regulated gross margins decreased due to a 26% decline in volumes sold as a result of warmer weather, as compared to the same period in the prior year. … Non-regulated gross margins decreased due to a 26% decline in volumes sold due to a decline in our non-regulated customers’ gas requirement, partially offset by a decline in the cost of gas and the sale of natural gas liquids.

Some of this quantity risk might be hedgeable using weather derivatives. And hedging this risk can decrease the volatility in corporate cash flow, increasing both the company’s debt capacity and its dividend ratio and ultimately raising shareholder value.

A research paper by Francisco Pérez-González of Stanford University and Hayong Yun of the University of Notre Dame, forthcoming in the Journal of Finance, uses this setting to explore the question of whether financial innovation is useful to the real economy. They take the case of the innovation of weather derivatives in 1997 as a kind of natural experiment and explore the cash flow volatility situation for natural gas and electric utilities before and after the introduction of this risk management tool. Altogether, they examine stock market and financial statement data on 203 companies over the years 1960 to 2007. Their data show that the utilities most likely to use weather derivatives are those with the greatest cash flow sensitivity to weather, and that those that do make use of the derivatives significantly decrease the volatility of their cash flows. This increases the debt and dividend ratios of these utilities, and ultimately their share prices, too.

Can Hedging Save Greece?

As a part of its restructuring of debt, the Greek government has decided to issue GDP-linked securities:

Each participating holder will also receive detachable GDP-linked Securities of the Republic with a notional amount equal to the face amount of the New Bonds of the Republic issued to that participating holder. The GDP-linked Securities will provide for annual payments beginning in 2015 of an amount of up to 1% of their notional amount in the event the Republic’s nominal GDP exceeds a defined threshold and the Republic has positive GDP growth in real terms in excess of specified targets.

The payout on these securities goes up and down with the country’s ability to pay. Yale professor Robert Shiller has been advocating this type of financing for a while, including in the most recent issue of the Harvard Business Review. A small number of countries have tried this before. The recent case of Argentina is notable since its GDP-linked bonds have paid off handsomely.

What about the U.S.? Could GDP-linked bonds be helpful in managing this country’s debt burden? That’s the case the advocates are making. Although the idea isn’t yet mainstream, it has at least made an appearance deep in the slide deck delivered by the Treasury’s Office of Debt Management to the Treasury Borrowing Advisory Committee last year.

Not everyone is enthusiastic about the idea.

The Value in Futures

Today’s Wall Street Journal has a piece by Ian Berry about the possible restructuring of the CME’s rice futures contract. The design of the contract determines how effectively “farmers, elevator operators and beer brewers” can use the contract to do their hedging. The article is about problems that have shown in up in recent times and proposals to fix them. These problems impact how farmers and others manage their operations and investments:

“We are losing rice acres to other crops, and the lack of ability to comfortably hedge is a major reason,” said John Owen, a Louisiana producer who has chaired a committee with the U.S.A. Rice Federation, a trade group, to examine the issue.

Farmers said growing rice becomes too risky if they can’t lock in prices at the start of the season. Most of their expenses come up front, so they need some assurances on what they will get for their crop.

“We need to get our rice farmers back to farming rice,” said John David Frith, a farmer in East Carroll Parish, La., where a vast majority of growers have stopped planting the grain.

Designing the terms of a futures contract is a tough problem. Getting it right is how a market like the CME helps make the economy more productive.

The Promise and Pitfalls of Indexed Debt

The promise

We saw two recent commentaries by eminent economists advocating the use of indexed debt instruments.

Ken Rogoff, of Harvard’s Economics Department, was interviewed in the McKinsey Quarterly about the current Great Recession and what can be done about it. Among a number of other points about long-run structural reforms, he says that:

And then I’d say governments need to find ways to spark market innovation in indexing debt instruments. If we had housing loans indexed to, say, regional housing prices, as Bob Shiller has advocated, it would have helped a lot and provided better incentives to borrowers and lenders. If in 200 or 300 years, we’re experiencing fewer and milder financial crises, it will be because we figured out how to put some basic indexation clauses into debt that make it a little less vulnerable to systemic risk.

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Repo Tricks

Brokers dealers and investment banks get a substantial amount of their funding from the repo market. In a typical repo, party #1 (the borrower) gets funds from selling securities to party #2 (the lender); when the repo matures the transaction is reversed: party #1 repurchases the securities by paying party #2 the initial funds plus interest (the repo rate).

To protect the lender, the funds initially received by the borrower are less than the market value of the securities used as collateral. The difference, reflecting the credit risk of the repo borrower and the volatility in the prices of the securities, is commonly referred to as the haircut. To make matters straight, a repo contains bilateral credit risk for both the lender or the borrower might default.

U.S. accounting standards determine that repos be treated as secured financing (FAS 140, §218) in the case of arrangements to repurchase or lend securities typically with as much as 98 per cent collateralization (for entities agreeing to repurchase) or as little as 102 per cent overcollateralization (for securities lenders). In secured financing the loan is reported by the borrower as a liability, while the funds received go to the asset side of the borrower’s balance sheet. More important, in secured loans, the securities remain in the books of the borrower. The idea is that the borrower maintains control of the collateral because it has received sufficient funds to repurchase the securities even if the lender defaults.

The problem is that setting an interval [98-102] opens the opportunity for dubious accounting. Suppose that a borrower agreed to a $1M repo with a haircut higher than 2 per cent for liquid fixed income securities, say 4 percent. Then, it would be judged as not having received sufficient funds to repurchase the securities. The repo transaction would then be reported as a sale of securities plus a forward contract to repurchase for $1M securities valued at $1.04M. The sale of securities would be recorded as a credit entry for $1M in cash, but no associated loan. The repo does not increase the liabilities. Furthermore, the cash can be used to pay off additional loans.

This is how an increase of $1M in liabilities can show up in the books as a reduction of $1M in liabilities. According to the Valukas report (2010) this is how Lehman systematically deceived the markets.[1]


[1] See “Hidden debt: From Enron’s Commodity Prepays to Lehmon’s Repos 105s”, Donald. J. Smith, The Financial Analysts Journal, October 2011.

Corporate financial policy deciphered (2)

In the upcoming years, European telecoms need to issue an average of €30 billion in bonds. But financial market instability suggests that even highly credit-worthy companies may have trouble gaining access to funds.

Liquidity risk management once again became a pillar of corporate financial policy following the Lehman collapse in 2008. It involves a continuous exercise of cash control and refinancing plans that goes far beyond the traditional purpose of bridging temporary imbalances between receipts and disbursements.

For the past two and half years we have been living with the ominous threat of a financial market freeze. These concerns were highlighted by the events of the past week, described in a June 24, 2011, Financial Times article by Michael Mackenzie and Nicole Bullock:

Investors are withdrawing cash from money market funds heavily exposed to short-term debt issued by European banks out of fear that a Greek default could spark contagion across the region’s financial sector.

At the same time there is increasing reluctance among US banks to lend to their European counterparts in the past two weeks…

Investors have not forgotten how some money market funds, viewed as cash-like holdings, had short-dated Lehman Brothers debt and lost money after the bank declared bankruptcy in September 2008.

Once banks stop lending to each other out of concern with counterparty risk, money markets shut down and short-term credit to corporations ceases.  When this happens, companies have to support themselves without backup, a situation which can be exacerbated if key customers and critical partners do not meet their obligations.

Companies therefore need their own liquidity sources to be robust enough to carry them through periods of disruption.  They need to ensure capital availability and a tight grip over operating cash flows in different scenarios, selecting for each scenario the appropriate actions that reduce the probability and/or impact of bad events, for a given degree of residual risk tolerance.

Most importantly, companies must correctly simulate their debt refinancing needs, adjust debt maturities to the risks of a market freeze, diversify alternative funding sources, and ensure that the available credit facilities are committed, unrestricted and long term.

Liquidity risk management is necessary for companies to implement their strategic goals and avoid costly business interruptions.  It is often said in finance that “cash is king”. It certainly is so when cash is the difference between success and failure, life and death.  When equity financing is not viable and good assets sell below their full value, companies should remember: long live the king.

Is financial innovation good for the economy?

The Great Financial Crisis and the role played by certain financial innovations, such as credit default swaps and synthetic securities has made a number of people question the value of financial innovation. A premise of our risk management course is that financial innovation is valuable, both to the individual company and to society at large. But it is always useful to re-examine and question a premise. Here are links to some of the critiques that have recently been made in the public debate precipitated by the Crisis.

Memorably, Former Chairman of the Federal Reserve Paul Volcker quipped that the only really useful financial innovation he’d seen in the past 20 years was the automatic teller machine. A more complete presentation of his thoughts can be found in a give-and-take with bankers and others hosted by the Wall Street Journal. Excerpts from the transcript can be found here.

Princeton Economist, Paul Krugman, has written often in his New York Times column and blog that many forms of financial innovation have been harmful, not helpful. Some of these can be found here, here, here, here, here and here.

MIT economist Simon Johnson and his coauthor James Kwak have also made a strong argument questioning the value of financial innovation in an article in the magazine Democracy, as well as on their blog, Baseline Scenario, which can be found here.

The Dark Side of Financial Innovation

There is a paper by Brian Henderson and Neil Pearson soon to be published in the Journal of Financial Economics (pre-publication working paper is available for free here) that documents significant overpricing of a complicated structured equity product marketed by investment banks to retail customers. The authors evaluate a set of SPARQS created by Morgan Stanley between 2001 and 2005. SPARQS stands for Stock Participation Accreting Redemption Quarterly-pay Securities. These are a classic derivative security in that they repackage the payoff from an underlying equity security.

The authors find that on average customers pay 8% above the fair market value for securities. On the assumption that Morgan Stanley is producing a uniquely valuable payoff structure that customers find it difficult to produce for themselves, it could make sense that the bank might charge a premium. In fact, it would have to in order to cover its own costs of manufacturing the payoff. However, the size of the premium in this case is very large. So large, in fact, that the authors document that customers should expect to earn less than the risk-free rate of interest. Moreover, the payoff structure seems to be similar to what can be obtained from more pedestrian securities already easily obtained in the marketplace. So the product offers no unique hedging value that could offset the high price paid. The authors point out that “…most SPARQS investors would likely have been better off investing in non-interest bearing accounts.”

Henderson and Pearson present the results as a challenge to the claim that financial innovation always makes the world better.

Financial institutions’ ability to create securities providing state-contingent payoffs tailored to the needs or desires of specific investors or groups of investors seems especially conducive to achieving these potential benefits. But there is a darkside to the ability to create instruments with tailored payoffs. If some investors misunderstand financial markets or suffer from cognitive biases that cause them to assign incorrect probability weights to events, financial institutions can exploit the investors’ mistakes by creating financial instruments that payoff in the states that investors overweight and payoff less highly in the states that investors underweight, leading the investors to value the new instruments more highly than they would if they understood financial markets and correctly evaluated information about probabilities of future events.

It will be interesting to see if someone challenges the valuations or the argument made with them.