Three regulatory bodies warn that all is not well in the huge and opaque world of derivatives
By M.S. | PARIS
It must have seemed like a no-brainer in 2009. Leaders of the G-20 vowed to get control over the huge and opaque world of derivatives blamed by many for precipitating the financial crisis that had engulfed them. The most common sorts of derivatives (contracts that take their value from the performance of an underlying asset) were to be traded on recognised platforms, cleared through central counterparty systems with high collateral requirements and reported to trade depositories. The markets would be safer, banking supervisors would know where everyone stood, and taxpayers could sleep quietly at night, knowing they were unlikely to have to bail out the world’s financial system again.
But things are not going that smoothly, three unrelated reports in the past few days suggest. On January 15th the Senior Supervisors Group reported to the Bank for International Settlements’ (BIS) Financial Stability Board that "firms' progress toward consistent, timely, and accurate reporting of top counterparty exposures fails to meet supervisory expectations as well as industry self-identified best practices on counterparty exposures. Data quality is of particular concern.”
Not to exaggerate the supervisors’ concern, banks have improved, the group said. But many still do not know and cannot figure out quickly who owes what to whom. (For the gory details, read the report.)
Market fragmentation is a worry too. That is mainly because American regulators—notably the Commodities and Futures Trading Commission—have moved faster than their European opposite numbers. Whether and how European firms are to comply with their requirements remains unclear and controversial.
On January 21st the International Swaps and Derivatives Association, which represents market participants, put out a report analysing trading in interest-rate swaps (IRS) before and after October 2nd 2013, when a slew of new American rules came into force. “The market for euro IRS has appeared to fragment significantly,” the number-crunching found. “Volumes of cleared euro IRS between European and US dealers dropped 77% since October 2013 indicating a breakdown of cross-border trading relationships.” Two separate, smaller pools of liquidity appear to be replacing a global one. This matters because the bigger the market the greater the chance of good liquidity, keen prices and a diversified range of participants.
A third cautionary note was sounded today by the Depository Trust and Clearing Corporation (DTCC), and this one has to do with collateral. The tougher rules that are being put in place are supposed to make markets more resilient and reduce risk. But new requirements in various spheres could mean that anything between $800 billion (Bank of England, 2012) and $4 trillion (BIS, 2013) of high-quality collateral is needed by banks and other financial-market participants. Margin calls on transactions in derivatives are expected to increase dramatically too. “This will have a major impact on both liquidity and risk—the operational nightmare scenarios are endlessly identifiable,” the DTCC found, “…the reality is that collateral challenges will be far more extensive than what has been reported thus far.”
One of these problems is clearly transitional. Europe and America will eventually get their act together. And the benefits from shifting derivatives trading onto recognised platforms (mainly, more transparency) outweigh temporary losses until they do.
The other two are more worrying. Bankers have had more than four years to get their head around consolidating and measuring counterparty risks. And it has been clear for some time that good collateral was going to be gold dust. The fact that the conversation now seems to be mainly about “collateral management” and “transformation”—ie, making one asset do the work of two, or converting a slightly ropey asset into a more prepossessing one—is somehow not wholly reassuring.
