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

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Wed, 18 Dec 2013

Clearing of OTC Derivatives

Dr. David Murphy of the Deus ex Machiatto blog has published a comprehensive book on clearing of OTC derivatives (OTC Derivatives, Bilateral Trading and Central Clearing, Palgrave Macmillan, 2013). I was surprised that the author information on the book cover flap does not mention the blog at all but gives prominence to his having been head of risk at ISDA. Had I found this book at a book shop, the ISDA connection might have made me less likely to buy the book because of the obvious bias that the position entails. This was a book that I read only because of my respect for the blogger. Many publishers have obviously not received the memo on how the internet changes everything.

The book presents a balanced discussion of most issues while of course leaning towards the ISDA view of things. Many of the arguments in the book against the clearing mandate would be familiar to those who read the Streetwise Professor blog. Yet, I found the book quite informative and enjoyable.

In Figure 10.1 (page 261), Murphy summarizes the winners and losers from the clearing reforms. To summarize that highly interesting summary:

Obviously, the clearing mandate has not quite worked out the way its advocates expected. Clearing was originally expected to lead to greater competition and reduce the dominance of the big (G14) dealers. Murphy explains that the big dealers will actually benefit from the mandate as they can more easily cope with the compliance costs.

I am not disturbed to find corporate end users listed as losers. If Too Big to Fail (TBTF) banks were being subsidized by the taxpayer to write complex customized derivatives, these products would clearly have been under priced and over produced. When the subsidy is removed, supply will drop and prices will rise. This is a feature and not a bug.

If the price rises sufficiently, end users may shift to more standardized and simpler products. Of course, this will imply basis risks because the hedge no longer matches the exposure exactly. This matters less than one might think. The Modigliani Miller (MM) argument applied to hedging (which is actually very similar to a capital structure decision) implies that most hedging decisions are irrelevant. The only relevant hedging decisions are the ones that involve risks large enough to threaten bankruptcy or financial distress and therefore invalidate the MM assumptions. Basis risks are small enough to allow the MM arguments to be applied. Inability to hedge them has zero real costs for the corporate end user and for society as a whole.

One could visualize many ways in which the market may evolve:

  1. The reforms could lead to the futurization of OTC derivatives. That might be the best possible outcome – exchange trading has even more social benefits than clearing in terms of transparency and competition. The increased basis risk is a non issue because of the MM argument.
  2. Another possible outcome could be a reduction in end user hedging and consequently a smaller derivatives market. Under the MM assumptions, this need not be problematic either.
  3. The worst possible outcome would be an OTC market that is even more concentrated (G10 or even G5) and that uses clearing services provided by badly managed CCPs. This would be a nightmare scenario with a horrendous tail risk.

Posted at 16:21 on Wed, 18 Dec 2013     View/Post Comments (0)     permanent link

Tue, 17 Dec 2013

Electronic Trading

There was a time not so long ago when equities traded on electronic exchanges and everything else traded on OTC markets. We used to hear people argue vehemently that electronic trading would not work outside of the equities world. The belief was that the central order book could not handle large trade sizes. Algorithmic and high frequency trading changed all that. We learned that large trades could be sliced and diced into smaller orders that the central order book could handle easily. With exchanges offering lower and lower latency trading, a big order could be broken into pieces and fully executed faster than a block trade could be worked out upstairs in the old style.

Slowly the new paradigm is expanding into new asset classes. The 2013 triennial survey shows that electronic trading has virtually taken over spot foreign exchange trading and is dominant in other parts of the foreign exchange market as well (Dagfinn Rime and Andreas Schrimpf, “The anatomy of the global FX market through the lens of the 2013 Triennial Survey”, BIS Quarterly Review, December 2013). The foreign exchange market has ceased to be an inter bank market with hedge funds and other non bank financial entities becoming the biggest players in the market. As Rime and Schrimp explain:

Technological change has increased the connectivity of participants, bringing down search costs. A new form of “hot potato” trading has emerged where dealers no longer play an exclusive role.

The next battle ground is corporate bonds. Post Dodd Frank, the traditional market makers are less willing to provide liquidity and people are looking for alternatives including the previously maligned electronic trading idea. McKinsey and Greenwich Associates have produced a report on Corporate Bond E-Trading which discusses the emerging trends but is pessimistic about equities style electronic trading. I am not so pessimistic because in my view if you can get hedge funds and HFTs to trade something, then it will do fine on a central order book.

Posted at 18:03 on Tue, 17 Dec 2013     View/Post Comments (1)     permanent link

Fri, 13 Dec 2013

The Pharoah's funeral plans

Post crisis, there has been a lot of interest in ensuring that large banks prepare a living will or funeral plan describing how they will be resolved if they fail. Though this does look like a good idea, I think there is a catch which is best illustrated with an example.

Some of the most successful funeral plans in history were of the Egyptian Pharoahs who began their reigns with the construction of the pyramids in which they were to be entombed. If anything, this would have increased the cost of the funeral. It is very likely that left to their successors, the pyramids would have been less grandiose. Moreover, to a finance person it is obvious that the present value of the cost increased because the pyramids were built earlier than required.

Much the same thing may be true of the banks as well. Funeral plans may make regulators complacent about excessively large and complex banks; as a results, the costs would be higher when they do fail. Banks may also incur a lot of wasteful expenditure to prepare and defend funeral plans that may ultimately prove useless. The existence of these plans may lead to delays in taking prompt and corrective action for vulnerable banks. Why shut down a bank now when you believe (perhaps wrongly) that it can be shut down later without great difficulty? In short, the plans may allow mere words to substitute for real action.

Posted at 15:54 on Fri, 13 Dec 2013     View/Post Comments (1)     permanent link