Category Archives: OTC reform

Eyes on the prize in financial reform #1: the Volcker Rule

The Financial Times’ Tracy Alloway has a nice piece that crystallizes concerns circulating among many observers regarding reforms to the banking system. New rules designed to increase the safety of the banking system are forcing banks to get smaller in a number of ways. But are these reforms just pushing the same risks off into the shadow banking system?

The public discussion is muddled in a couple of ways. A few useful distinctions can help to separate sensible concerns from baseless anxiety. A good place to start is the Volcker Rule. Alloway writes that “Some proprietary trading businesses that are no longer allowed at deposit-taking US banks under the Volcker rule have morphed into newly minted hedge funds.”

This is exactly what is supposed to happen. It does not reflect a worrisome expansion of the shadow banking system.

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Prop trading under the guise of hedging: The forgotten lesson of Metallgesellschaft and the Volcker Rule

In the world of finance, the name Metallgesellschaft (MG) is known primarily as one of the early “derivative disaster” cases. MG was a metal, mining and engineering company, and the 14th largest corporation in Germany. At the start of 1994, the company stood on the brink of bankruptcy because of more than $1 billion in losses racked up by a small trading office in New York with a big bet in oil futures. MG’s debacle sparked a vigorous debate—our contribution is here, and a collection of many contributions is available here.

MG was short on a set of long term contracts for the delivery of refined oil products to small businesses for periods of up to 10 years. Many of the contracts were negotiated with a fixed price, while others had more complicated terms. On the other side, MG was long a set of crude oil futures or OTC swap contracts for delivery in one to six months. Taken together, this looked like a long dated short position in the physical hedged by a short dated stack of futures. The critique focused on two questions. First, was the short dated stack a successful value hedge, or had traders at MG failed to accurately “tail the hedge”? Second, did the attempt to hedge such a long horizon physical obligation using derivatives subject the firm to one-sided margin calls, producing a liquidity crisis that the firm could not withstand? From these two questions flow a host of related questions about alternative designs of a better hedge, about the accuracy with which the accounting reflected the underlying financial reality, and governance.

From the narrow perspective of financial engineering, these are all useful questions to consider. However, these questions all start from the premise that the task is to hedge the company’s given exposure on the physical contracts. That is what the situation looked like at first glance, from outside. But courtesy of the acrimony between the team that crafted the failed futures trading strategy and the corporation that dismissed them, a number of internal documents with details on the strategy became public.

Those documents reveal that this premise was incorrect. The traders at MG operated under a very different premise: the long futures position was the real source of profit. If it had been up to them, they would have concentrated on building it up. However, corporate risk management rules limited the quantity of long futures contracts to the volume of physical deliveries. The traders, therefore, had an incentive to market the physical delivery contracts. The more they expanded their long positions in the futures contracts, the more they could loosen the limits imposed by the internal risk limitations, and expand speculative trades. The long futures position only looked like a hedge. In fact, it was a speculation. Traders used hedging to engage in risk taking.This was a classic prop trade disguised as a hedge of a customer facing transaction. When the prop trade blew up, it nearly brought down the entire firm. This aspect of the case is often forgotten.

Eighteen years later, this lesson from the MG case has renewed relevance in light of the $2 billion trading loss by trader Kweku Abdoli at the Delta One desk of the Swiss bank UBS. That spectacular loss gave a fresh reminder of the dangers posed by prop trading at banks, and of the need for prohibitions like the Volcker Rule. So long as taxpayers are the backstop for banks, the traders, the management and shareholders do not suffer the full penalty of the risks from trading. Opposition to the Volcker Rule by bankers is strong, and takes many forms. They argue that any customer facing business, like a Delta One desk, is protected from the prohibition by the mere fact that it is customer facing. This is nonsense. Thankfully, the current draft regulations for the Volcker Rule look to all of the fingerprints of prop trading, and do not provide any such simplistic exceptions. Both the MG case and the UBS case show that prop trading can operate under various guises. It’s prop trading that is the problem, regardless of how it is cloaked.

It’s not all about end-users.

The US Chamber of Commerce is hosting a “fly-in” of corporate representatives tomorrow to lobby Congress and regulators on derivatives reform. They are advocating for a House bill (H.R. 1610) that would block financial regulators policing the risk on bank balance sheets.

The Chamber says it wants to allow end-users to buy swaps and other derivatives without posting margin.

But that’s not really what’s at issue. The Dodd-Frank Act already includes a specific exemption for end-users who are hedging their business operations.

What’s at issue is how much credit risk ends up on the balance sheet of banks. Banks are free to sell end-users non-margined swaps. But each non-margined swap the bank sells adds credit risk to the bank’s balance sheet. That credit risk adds up.

A prudently managed bank will have policies, procedures and controls to assess how much total risk it has in its portfolio of non-margined swaps. It will have to put aside capital in proportion to the risk.

Not all banks can claim to have an impeccable track record in managing the risks on their derivatives portfolios. As if 2008 wasn’t enough of a lesson, the recent $2.3 billion loss at UBS is another reminder. Apparently at UBS the cause was compliance failure. Systems cost banks money, and the incentives to dedicate resources to maintain controls at times vanish. Remember BP’s Horizon deepwater well? No difference, here.

Risk management is also quite challenging when banks and swap dealers offer counterparties tailor-made and complex derivatives contracts – the so called Level-3 assets, which may not trade and are priced based on an in-house model, precisely the swaps that are non-margined.

All this calls for banks to put aside more resources to manage risks and more capital.  The problem is that both eat into banks’ return on equity.

In April, five regulators – the Federal Reserve Board, the Farm Credit Administration, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, and the Office of the Comptroller of the Currency – published a proposed rule detailing what would be required of the banks. Under the rule, banks are free to sell an end-user a non-margined swap. But banks must have appropriate policies in place to assess and manage the risk and must put aside capital to cover the risk.

H.R. 1610 is a directive to the financial regulators to turn a blind eye to the credit risk from non-margined swaps.

From exemption to exemption, from special case to exception, if we follow the Chamber down this path, we will find ourselves in another financial mess.


It is becoming clear that the UBS scandal that rocked financial markets last week is not just about a single trader suddenly gone awry. UBS’s controls – both in risk management and auditing – failed miserably. Top bankers in the investment banking arm of UBS didn’t have a clue about what was going on in the trading desks and in the back office. When a kid can so easily blow a $2.3 billion hole in the balance sheet, and cause so much damage to the reputation of a top tier bank, there’s something awfully wrong.

But the failures of the system go beyond UBS alone. Kweku Adoboli made trades that apparently didn’t require prompt confirmation with its counterparties. Why? Because in Europe, where UBS’s Delta-One trading desk is based, the vast majority of trading in exchange-traded funds (ETF) occurs over the counter (OTC), in bilateral trades. The rapid growth in ETF trading (a profit center) has outpaced spending in back-office and reporting activities (a cost). According to the Wall Street Journal, a report published in 2009 states that over three quarters of European ETF trading didn’t require any reporting.  The Bank of England, among other supervisory authorities, has called attention to the growing complexity and interconnectedness of ETFs. Unregulated OTC trading also makes them obscure. The inherent lack of transparency of OTC markets provides a fertile ground for misrepresentation and outright fraud. It is also likely that opacity makes it much harder to measure the risks taken by ambitious traders.

The European Commission is now carefully saying that it will look into the possible regulatory implications of the case. The Commission, scared to death by the banks’ threat to leave if new regulations are imposed, has ignored the lessons of the 2008 Jerome Kerviel affair, responsible for Societé General’s $7.2 billion mishap with ETFs and related OTC derivatives transactions. It would serve the European Union well if it learned from the US, where ETF trades are reported and cleared through public and open exchanges. No opacity, less room for cheating.

The Cosmetics of Collateral Transformation

Responding to the new regulatory reforms such as the Dodd-Frank Act in the US, banks are now marketing “collateral transformation” services. A good source for various materials on this issue is Tracey Alloway’s coverage in FT Alphaville.

What are these services? How are they connected to the reforms? Should we be worried?

Collateral transformation is a fancy name for a particular type of loan, as shown in the top three boxes of the figure below. A company/fund trading a standardized derivatives contract cleared by a central counterparty (CCP) must post a margin. Initial margins are posted with cash and government securities; variation margins are posted with cash. Holding cash for the purpose of posting margins exacts an opportunity cost, for it earns less than if invested in less liquid securities. The bank steps in and offers to lend the company/fund the cash for collateral at the CCP, and the company/fund provides less liquid securities it holds in the balance sheet to the bank as collateral. In addition to providing the company/fund with liquidity, the bank structures the arrangement to easily mesh with the mechanics of trading, settlement and so on, so as to minimize the administrative costs to the institutions that are its customers. See this brochure and this article.

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Central Clearing can economize on collateral

Reforming the financial system involves not only the grand public battles over legislation and rulemaking, but also the substantial trenchwork that falls to staffers in the many agencies responsible for carrying out the mandates. And it is heartening to observe this work advance. One of the many interesting analyses being produced en route is a study by Daniel Heller and Nicholas Vause at the Bank for International Settlements (BIS), the international organization of central banks. The purpose of the report is to produce an estimate of the financial resources that Central Counterparties (CCPs) would need to safely clear interest rate and credit default swaps. Central clearing of derivative trades is one of the major mandates of the Dodd-Frank Financial Reform Act in the U.S. and of comparable reforms in Europe.

In a number of our previous posts, we have emphasized that end-users have much to gain from the central clearing mandate—see here, here, here and here. Central clearing creates the possibility to reduce the total amount of credit risk in the system, lowering the overall costs to the various parties using derivatives, including non-financial companies seeking to hedge their commercial risk. One reflection of how risks can be minimized, depending upon how the mandates are implemented, shows up in Graph 6 of this BIS study, reproduced below.

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Distinguishing proprietary trading from hedging

Good internal risk controls involve carefully distinguishing between different types of trading. Many companies that do significant trading to hedge their market risks explicitly forbid proprietary trading. Others explicitly try to profit from proprietary trading, but it is still important to keep the proprietary trading book separate and under proper control.

So, for anyone interested in this issue, it is instructive to watch the implementation of the Volker Rule — section 619 of the Dodd-Frank Act — which restricts the proprietary trading operations at the major banks. Last week, Politico’s Morning Money posted a study by Deloitte discussing how regulators might identify proprietary trading and the measures banks would need to take to clearly mark transactions as “market making” or other permitted activities as opposed to proprietary trading.

While the Volker Rule is about banks, and this blog is about end-users, it will still be informative to end-users to watch how this process plays out at banks. After all, proprietary trading is proprietary trading, wherever it is pursued, and the fingerprints of proprietary trading are likely to be similar, too.

Two other good reads on the telltale markers distinguishing proprietary and other trading are a paper by NYU’s William Silber, and an old paper by Braas and Bralver in the Journal of Applied Corporate Finance (paywalled).

Central clearing lowers end-user costs

One of the most controversial aspects of the financial reform in the US and Europe is the mandate that many derivatives trades will have to be cleared in central counterparty clearinghouses (CCPs). CCPs stand behind the losses in the event that a trader defaults.  To protect the clearinghouse against trader defaults, users of derivative contracts processed in CCPs will need to post margins.

But margins are expensive; they require traders to have spare cash or unused credit capacity; and margins need to be explicitly accounted for. Opponents of clearing have directed their criticisms at these points, complaining that margins crowd out other corporate investment. They also argue that margins have negative implications at a more macro level: variation margins can trigger panics; and out of concentrating risk, CCPs will become dangerous dens of systemic risk. Altogether, clearing under the proposed rules won’t change things for the better, they argue.

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Playing “pretend” with credit risk

On Thursday last week, members of the US House of Representatives Michael G. Grimm (R-NY), Gary Peters (D-MI), Austin Scott (R-GA), and Bill Owens (D-NY) introduced a bill to add another dangerous loophole to the Dodd-Frank legislation’s capital and margin requirements on OTC derivative dealers.

It’s even more difficult than usual for those not on the inside to grasp what is going on here. The press release is all about motherhood and apple pie, and the bill itself is all about amending Section 4s(e) of the CEA as added by section 731 of the Dodd-Frank Act so that paragraphs (2)(A)(ii) and (2)(B)(ii) do not apply when, blah blah blah. The real substantive issue isn’t touched on explicitly in either source. But here’s the deal as far as I can tell.

The bill is an attempt to block swap margin and capital requirement rules proposed last April by a set of financial regulators.

This bill demands that financial regulators turn a blind eye to certain specific risks on a bank’s balance sheet. If the risk arises from the sale of a non-margined derivative to an end-user, the bank is supposed to pretend the risk doesn’t exist. The regulator cannot demand that the bank hold capital against that risk.

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The Collateral Debate Inches Forward

Last week, the Coalition for Derivative End Users filed a new comment letter with bank regulators on the rulemaking for the Dodd-Frank reform of the OTC derivatives markets. The Coalition has taken a lead role in lobbying to expand the end-user exemptions on clearing and margins. One interesting thing about the letter is how it betrays progress in the intellectual debate on the cost of margins.

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