Category Archives: regulation

Exelon’s On- and Off-Balance Sheet Collateral Costs

In covering the Intercontinental Exchange’s decision to move its energy swap trades onto its futures exchange, the Wall Street Journal’s Jacob Bunge and Katy Burne cited data on the power company Exelon in order to highlight how this move might impact end-user costs:

One company worried about costs, Exelon Corp., said in a regulatory filing on May 10 that “even if the new regulations do not apply directly to us, [its power plant subsidiary Exelon Generation] estimates that a substantial shift from over-the-counter sales to exchange cleared sales may require up to $1 billion of additional collateral.”

But the $1 billion figure is only half the story. The other half of the story is the contingent capital that Exelon saves. But since that contingent capital is off-balance sheet, it is commonly overlooked, leading both corporate executives and reporters to significantly exaggerate the cost of using cleared futures exchanges.[1]  In comparing the financing costs of non-margined OTC trades against the financing costs of exchange-traded derivatives, it’s important to look at both the on- and off-balance sheet capital demands.

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Turn a Blind Eye to Credit Risk?

When a bank makes a loan to a business it assumes some risk that the loan will go bad. Regulators, when they do their job, demand that the bank estimate that risk and hold capital against it. That’s safe and sound banking.

What if a bank embeds the same loan inside a derivative it sells to the business? Should the regulators treat that credit risk the same and demand that the bank estimate that risk and hold capital against it? Six U.S. Senators say “no.” They want bank regulators to turn a blind eye to credit risk so long as that risk is packaged inside an OTC swap. So much for safe and sound banking.

Yesterday Senator Mike Johanns (R-Neb.), Mike Crapo (R-Idaho), Herb Kohl (D-Wis.), Jon Tester (D-Mont.), Pat Toomey (R-Pa.) and Kay Hagan (D-N.C.) filed a bill (S. 3480) designed to block bank regulators from recognizing the credit risk embedded in OTC derivatives sold to end-users. Naturally the Senators’ press releases wax lyrical about how their bill protects these end-users by lowering their costs of managing risk. This is a dangerous illusion.

All American businesses suffer when the U.S. financial system is made unsafe and unsound. Following on the Dodd-Frank Act, banking regulators last year proposed a sensible rule finally requiring banks to properly recognize the credit risk embedded in the derivatives they sell. That’s safe and sound banking, and if this country can find its way back to a safe and sound banking system all of America’s businesses will benefit.

The proposed bill seeks to reverse course, directing bank regulators to turn a blind eye once again to obvious risks. It’s a seductive proposition. With a stroke of a pen, the Senators believe they can save a few businesses the costs associated with this credit risk. But no act of law can actually erase the credit risk and the associated cost. The proposed bill only encourages more unsound trading and the accumulation of unaccounted for risk. For a short while, certain businesses will benefit by not having to pay full fare for the risks they add to the banking system. It’s always good while the party lasts. But, in the end, we all lose.

OTC RIP

On Monday, the Intercontinental Exchange, ICE, announced that as of January 2013 all of its cleared OTC energy swap products would switchover and be traded as futures products.

This is one of the outcomes of the Dodd-Frank Act’s reform of the OTC derivatives markets. A very large fraction of swap transactions are economically identical to futures transactions, and the only rationale for that portion of the OTC market had always been evasion of regulation. Now, with the OTC swaps market subject to a parallel set of regulations substantially comparable to the regulation of futures contracts, the rationale for trading many products as OTC swaps is gone.

The OTC swaps market will continue to provide customized products not suitable for trading and clearing on futures exchanges, and in its press release, ICE confirmed that that portion of its OTC swaps business would remain: “All uncleared swaps will continue to be listed on ICE’s OTC platform, which will register as a swap execution facility.”

During the debates over reform of the OTC swaps market, much was made of the OTC market’s ability to offer customized products. While this ability was advantageous, its relevance to the size of the OTC market was always exaggerated. ICE’s announcement for its energy products is likely to be just the first in a major switch back to futures trades for a sizable fraction of the OTC market. The exact extent and the timeline for this switch will depend on many factors, including the ongoing battles over how specific rules are implemented and the ongoing shakeout in the future business model for banking.

Show me, per Dodd-Frank

The finance lawyer who blogs at Economics of Contempt has a very nice summary of what is required for JP Morgan to claim that the trades at the CIO unit are allowed under the Volcker Rule because they were “portfolio hedging”. It is a more comprehensive and textual version of our requirement that JP Morgan “show me”.

Show me

JP Morgan’s $2 billion loss on credit derivatives traded by its Chief Investment Office (CIO) has moved the debate over implementation of the Volcker Rule to the front page. Many claim that these trades are a clear example of the type of speculative, proprietary trading banned by the Volcker Rule. JP Morgan CEO Jamie Dimon insists otherwise, claiming the trades were intended as a hedge, which is clearly permitted under the Volcker Rule. Public discussion on the matter is confused, in part because many people are unclear about what defines a hedge and what defines a speculation. Who can blame the public when the premier vehicles for speculative trading are known as hedge funds?

Moreover, the current battle over financial reform and the Volcker Rule gives bankers an incentive to escalate the confusion. They want to continue their speculative trading, and that can only be done by labeling it either hedging or market making. Clarity is not their ally. When regulators, legislators and pundits advocate bright line tests for hedging, these bankers ridicule them as simpletons, accusing them of applying a dangerously unsophisticated understanding of financial markets drawn from a bygone era. These simpletons, they complain, fail to grasp the complexity of the modern world that bankers are tasked with mastering in order to serve the needs of society.

So, in order to try to make some progress and gain some insight from the JP Morgan case, let us first step back from the details of the current trades and losses, and from the debate over the Volcker Rule, and instead gain some clarity on the concept of hedging. Then we can double back and analyze the JP Morgan case in light of a sensible notion of hedging.

Two points about hedging…

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Morgan Stanley says potahto

You like potato and I like potahto,

You like tomato and I like tomahto,

Potato, potahto, tomato, tomahto!

Let’s call the whole thing off!

            from Let’s Call the Whole Thing Off by George & Ira Gershwin

This past Tuesday was the closing date for Comment Letters to the CFTC on its proposed Volcker Rule, and this gives us a second batch of responses to consider. The letter submitted by Morgan Stanley (back in February) is interesting because in Attachment 2, the company focuses specifically on commodities and provides three Example Customer Transactions that Morgan Stanley alleges would be impaired by the proposed Rule. These examples help to make concrete the actual activities that the banks allege are uniquely provided by banks and that are endangered by the Volcker Rule.

For today, let’s focus on just one of Morgan Stanley’s three examples:

Example B, Helping a Major U.S. Airline Reduce Jet Fuel Related Costs.

As part of a Chapter 11 restructuring, a leading U.S. airline sought Morgan Stanley’s help to reduce its operating costs, working capital requirements, and balance sheet usage associated with its jet fuel supply. Prior to bankruptcy, the airline managed a large jet fuel supply operation in which it maintained up to a month’s inventory, creating significant operational overhead and a need for costly financing. To reduce these expenses, Morgan Stanley provided the airline a long-term contract for delivery of jet fuel, typically one day prior to the airline’s daily need to service its fleet. Morgan Stanley provided all logistical support and sold the airline jet fuel at a lower price than it was paying previously. This enabled the airline to reduce its operating expenses, reduce the size of its balance sheet and lower its overall interest expense.

I’m missing the part where Morgan Stanley explains how this is market making. Continue reading

CVA Lessons: Is it better to charge or to subsidize credit risk?

One often hears that competition promotes the efficient and weeds out the inefficient. Yes, but only insofar as there is a level playing field. Give special privileges to certain players, and the best might end up dominated by the inefficient.

Analysts who overlook the power of privileges may mistake dominance for efficiency, getting backwards the true state of affairs.  They also miss that the distortion reduces the welfare of society and redistributes wealth and power in favor of the inefficient.

That’s true in any industry and especially relevant in the case of the dominance of OTC derivatives markets over exchange trading during the last three decades.

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Banking apples and oranges

Vikram Pandit, the CEO of Citigroup, used an opinion piece in last week’s Financial Times to make an interesting proposal on risk disclosures: banks and other financial institutions should be required to report how their internal modeling assesses the risk in a “benchmark” portfolio. Regulators would define the contents of this hypothetical portfolio, and banks would report “a hypothetical loan/loss reserve level, value at risk, stress-test results and risk-weighted assets.”

It’s a useful proposal that could give investors and other market participants additional useful information. But it also has its limitations, and does not resolve some inherent problems with risk-based capital requirements, and does not eliminate the need to control bank size and risk by other means.

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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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Exelon, E.On and the Volcker Rule

The Volcker Rule contained in the Dodd-Frank financial reform act bans banks from proprietary trading. In order to implement the Rule, it is necessary to distinguish proprietary trading activities, which are proscribed, from market-making activities and other traditional banking functions, which are allowed.

Many traders at banks claim that this distinction is impossible to make in any rational way. Also that it will bury them in a maze of complex and arcane rules and costly compliance systems.

Nonsense.

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