Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

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Sun, 31 Dec 2017

Why do banks use Credit Default Swaps (CDS)?

Inaki Aldasoro and Andreas Barth have a paper “Syndicated loans and CDS positioning” (BIS Working Papers No 679) that tries to answer this question in the context of syndicated loans. Unfortunately, they frame the problem in terms of hedging and risk reduction; I think this is not a useful way of looking at the usage of CDS by banks, though it makes perfect sense in other contexts. For example, if business is worried about the creditworthiness of a large customer, it might want to buy CDS protection. It is effectively paying an insurance premium to eliminate the credit risk, while earning the profits from selling to this customer. This works because credit risk is incidental to the business transaction.

For the bank, however, credit risk is the core of the business relationship. The natural response to concerns about the creditworthiness of a (potential) customer is to limit the lending to this customer. Granting a loan and then buying CDS protection is just a roundabout way of buying a risk free bond (or perhaps a very low risk bond). It is much simpler to just buy a government bond or something similar.

When we see a bank grant a loan and simultaneously buy CDS on the loan, we are not seeing a risk reduction strategy. Rather the bank has determined that this roundabout strategy is somehow superior to simply buying a government bond. We should be evaluating different scenarios that could cause this to happen:

  1. As in the earlier example of a non financial business, the bank is looking at the profits from the totality of the customer relationship that could be at risk if it did not grant the loan.

  2. The CDS is mispriced, and the bank is able to earn a higher yield than a government bond for the same level of risk. Effectively, the bank is arbitraging the bond-CDS basis. A hedge fund that is expecting an improvement in the credit profile of a company could either go long the bond or sell CDS protection on the bond. The former would require financing the investment at the relatively high funding cost of the hedge fund. In imperfect markets, it can be better for a well capitalized bank to buy the bond (financing the purchase at its low funding cost) and buy CDS protection from the hedge fund. Particularly, after the global financial crisis, this scenario has been quite common.

Aldasoro and Barth find that weaker banks are less likely than strong banks to buy CDS protection on their loans. They argue that weak banks have lower franchise value and have less incentive to hedge their risks. Bond-CDS arbitrage provides a simpler explanation; stronger banks have a competitive advantage in executing this arbitrage, and are likely to do it more than weaker banks.

Similarly Aldasoro and Barth find that lead arrangers are more likely to hedge their credit risk exposures than other syndicate members. This fits nicely with the total customer profitability explanation: the hedged loan may be similar to a government bond, but the syndication fees may make this a worthwhile strategy.

Posted at 17:25 on Sun, 31 Dec 2017     View/Post Comments (0)     permanent link


Sun, 17 Dec 2017

Bitcoin and bitcoin futures

After bitcoin futures started trading a week ago, there has been a lot of discussion about how the futures market might affect the spot price of bitcoin. Almost a decade ago, Paul Krugman discussed this question in the context of a different asset – crude oil – and gave a simple answer:

“Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price.”

Krugman explained this with a direct example:

Imagine that Joe Shmoe and Harriet Who, neither of whom has any direct involvement in the production of oil, make a bet: Joe says oil is going to $150, Harriet says it won’t. What direct effect does this have on the spot price of oil – the actual price people pay to have a barrel of black gunk delivered?

The answer, surely, is none. Who cares what bets people not involved in buying or selling the stuff make? And if there are 10 million Joe Shmoes, it still doesn’t make any difference.

Back then, I argued in my blog post that Krugman’s analysis is quite valid for most assets, but needed to be taken with a pinch of salt in the case of assets like crude oil, where the market for physical crude oil is so fragmented and hard to access that:

Most price discovery actually happens in the futures market and the physical markets trade on this basis. In an important sense, the crude futures price is the price of crude.

Is bitcoin like crude oil or is it an asset with a well functioning spot market where the Krugman analysis is right, and the futures speculation is largely irrelevant? The cash market for bitcoin has some difficulties – the bitcoin exchanges are not too reliable, and many investors find it hard to keep their wallets and their private keys safe. Are these difficulties as great as the difficulty of buying a barrel of crude, or selling it?

When cash markets are not functioning well, cash and carry arbitrage (and its reverse) futures markets may make the underlying asset accessible to more people. It is possible that A is bullish on bitcoin, but does not wish to go through the hassles of creating a wallet and storing it safely. At the same time, B might be comfortable with bitcoin wallets, but might be unwilling to take bitcoin price risk. Then B can buy bitcoin spot and sell cash settled bitcoin futures to A; the result is that A obtains exposure to bitcoin without creating a bitcoin wallet, while B obtains a risk free investment (a synthetic T-bill). Similarly, suppose C wishes to bet against bitcoin, but does not have the ability to short it; while D has no views on bitcoin, but has sufficient access to the cash market to be able to short bitcoin. Then D can take a risk free position by shorting bitcoin in the cash market and buying bitcoin futures from C who obtains a previously unavailable short position.

When there are many pairs of people like A/B and many pairs like C/D; the creation of the futures market allows A’s demand and B’s supply to be reflected in the cash market. If there are more A/B pairs than C/D pairs, the introduction of bitcoin future would push up the spot price of bitcoin. The reverse would be the case if the C/D pairs outweigh the A/B pairs. If there are roughly equal number of A’s and C’s, then they can simply trade with each other (Krugman’s side bets) with no impact on the cash market.

It appears to me that the introduction of futures has been bullish for bitcoin because there are quite many A/B pairs. There are significantly fewer C/D pairs for two reasons:

  1. There are not too many C’s though there are plenty of people who think that bitcoin is a bubble. Smart investors rarely short a bubble: there is too high a risk of the bubble inflating even further before collapsing completely. As Keynes famously wrote, the market can remain irrational longer than you can remain solvent. The most sensible thing to do for those who see a bubble is to simply stay clear of the asset.

  2. There are not too many D’s because it is not easy to borrow bitcoin for shorting it. A large fraction of the bitcoin supply is in the hands of early investors who are ideologically committed to bitcoins, and have little interest in parting with it. (In fact, bitcoin is so volatile that the most sensible strategy for those who believe in the bitcoin dream is to invest only what they can afford to lose, and then adopt a buy and hold strategy). Moreover, lending bitcoin requires reposing faith in mainstream finance (even if the borrower is willing to deposit 200% or 300% margins), and that trust is in short supply among those who were early investors in bitcoins.

The situation could change over a period of time if the futures market succeeds in moving a large part of the bitcoin supply into the hands of mainstream investors (the A’s) who have no commitment to the bitcoin ideology.

Posted at 15:02 on Sun, 17 Dec 2017     View/Post Comments (0)     permanent link


Sat, 09 Dec 2017

SEC Regulatory Overreach

I have repeatedly worried about regulatory overreach (here, here and here); while most of the examples in those posts came from India, I was always clear that the phenomenon is global in nature. In a blog post (at CLS Blue Sky Blog) Johnson and Barry carry out an analysis of the US Securities and Exchange Commission (SEC) which documents the overreach of that regulator.

The Dodd Frank Act of 2010 greatly expanded the ability of the SEC to initiate proceedings in its own administrative courts before an Administrative Law Judge appointed by the commission instead of filing the case in a federal court. Since around 2013, the SEC has relied more on these proceedings which give substantial advantages to the SEC – less comprehensive discovery rules, no juries, and relaxed evidentiary requirements. A study by the Wall Street Journal showed that the SEC wins cases before its in-house judges much more frequently than before independent courts.

Johnson and Barry show that even this “home field” advantage is not enough – the SEC seems to be overreaching or overcharging its cases to such an extent that it is losing a number of high-profile administrative cases. They conclude:

When it began to shift away from filing cases in district court, it likely believed it would see more success in administrative proceedings, but that has not consistently been the case. Although the SEC is still winning many of its administrative cases, its recent losses reflect a failure to evaluate the strength of its proof, particularly in cases where scienter evidence is thin, or overall evidence of alternative theories consistent with innocence is equally strong.

Posted at 18:24 on Sat, 09 Dec 2017     View/Post Comments (0)     permanent link


Thu, 07 Dec 2017

Surveillance by countervailing power

I have long argued that it is a mistake to think of surveillance as being done solely by disinterested regulators who have no axe to grind. As I wrote in a blog post a decade ago, “complaints by rivals and other interested parties are the best leads that a regulator can get.”

But these rivals and other interested parties can go beyond complaining to the regulator; they can take matters into their own hands. This can often be the best and most effective form of surveillance. A recent order by the US Commodities and Futures Trading Commission (CFTC) against Statoil illustrates this very well.

According to the CFTC, Statoil traders bought physical propane in the Far East with a view to push up the Argus Far East Index (FEI) which was the reference price for Statoil’s derivative contracts on NYMEX. However, Statoil’s plan to profit by creating an artificial settlement price for the Argus FEI did not materialize as hoped. The CFTC quotes one of the Statoil traders:

Also, quite a few of the players in the market have a vested interested in holding the [Argus] FEI down and they have been willing to sell cargoes . . . at discounted prices . . . Statoil have bought 5 cargoes over the last week but this has not been enough to keep the [price] up.

So one group of players are trying to rig the price down, while another set is trying to do the opposite. Their efforts neutralize each other, and the market basically policed itself. The regulator can of course watch the fun and impose a penalty on one (or even both parties), but its actions are largely irrelevant.

Incidentally, the episode also shows that market manipulation is not the exclusive preserve of evil private sector speculators: Statoil is the Norwegian government oil company.

Posted at 21:30 on Thu, 07 Dec 2017     View/Post Comments (0)     permanent link


Fri, 01 Dec 2017

In the sister blog and on Twitter during August-November 2017

There were no posts on the sister blog (on Computing) during August-November 2017 other than cross posts from this blog.

Tweets during August-November 2017 (other than blog post tweets):

Posted at 20:48 on Fri, 01 Dec 2017     View/Post Comments (0)     permanent link