back to the basics: the impact of collateral requirements on the use of otc derivatives by final...

Giuseppe Ballocchi, CFA

University of Lausanne and Board of Governors, CFA Institute

Collateral Management Forum, Vienna, 29 May 2015

Back to the basics: the impact

of collateral requirements on

the use of OTC derivatives by

final clients

3

The purpose of derivatives: risk transfer

• Financial markets: a risk transfer engine (although imperfect and incomplete)

• R. Schiller: The New Financial Order

– We need to create more financial derivatives to hedge fundamental risks

• Derivatives: very often the best tool to transfer (i.e. take on or lay off) risk (but there

are derivative-induced risks as well…)

• In the current uncertain macroeconomic environment, there is more interest for tactical

asset allocation and extreme risk protection.

• If appropriate derivatives are not available for hedging, or too costly or cumbersome,

the real economy suffers.

4

A few findings

• Macroeconomic Assessment Group on Derivatives (Cecchetti et al., BIS, 2013, p. 3):

“…the group found little prior analysis of how derivatives can affect the

economy”.

5

Deriving the economic impact of derivatives: growth through risk management (The Milken Institute, 2014, but funded by CME Group). The study concludes that from 2003 to 2012 in the US derivatives:

– added 150 billion to US GDP

– boosted employment (0.6%) and industrial production (2.1%)

There are a few studies showing positive microeconomic impact ( e.g. Bartram, Brown and Conrad (2011) conclude that derivative usage results in risk reduction and in an increase in firm value for large sample of non-financial firms from 47 countries.

The impact of derivatives on the economy

6

A short case study: a leading Swiss public pension fund

1. In order to avoid damaging home bias in investing, derivatives to hedge currency

risk are indispensable:

– Swiss pension fund assets amount to about 115% of GDP, i.e. 50% of the total

Swiss stock market cap (which is itself exceptionally high as a fraction of GDP)

2. To control duration: IR swaps

3. To mitigate inflation risk: inflation swaps and commodity swaps

• Note: risk management , including hedging of unwanted risks, cannot be conducted on

the basis of the most probable scenario (or the best forecast), but must consider

worst-case outcomes.

• This very conservative, prudently managed pension fund with absolutely no leverage,

ends up with a gross nominal derivative position that can be larger than its assets.

7

A short case study: the challenges

• Regulatory uncertainty and extraterritorial reach of regulation:

– Avoid Dodd Frank by not having US counterparties (fragmentation in ISDA survey)

– Subject to EMIR, but without the temporary clearing exemption available to

European pension funds

• Lack of certainty about collateral safety (depending on segregation

model/jurisdiction), (with related reputational risk).

• Operational issues (including collateral availability and cost) and costs.

8

Are assets used as collateral well protected ?

9

Assessing the safety of posted collateral under nearly all circumstances requires a thorough legal analysis. A future crisis may also lead to unforeseen circumstances and unprecedented measures (see Vestia case study).

A simple economic framework: compare the credit risk arising from derivative operations to the overall portfolio credit risk and avoid correlated credit risk e.g.:

– Reduce direct exposure to the credit of financial institutions in the presence

of operational exposure from collateralization

– Reduce exposure to systemic risk if one is making extensive use of CCP

Collateral safety

10

Central counterparty clearing does not remove credit risk from the system.

It just redistributes it. But it also increases transparency.

– It removes the need for the Asset Owner to establish an independent

valuation (necessary for effective credit risk mitigation in the bilateral mode)

Will central counterparties become unmanageable hot spots of systemic risk?

Not enough thought has been given to the needs of the final Client (who is not a

clearing broker).

Central counterparty clearing

11

After a few teething problems in its operational set up, CCP clearing (and

other regulation) is going to enhance systemic stability, ensuring that

derivatives are manufactured safely, and serve the intended purpose, for the

benefit of the economy.

– Regulation-induced liquidity reduction (e.g. in fixed income) is not

altogether unintended, but meant to drive home the true cost (and limits)

of liquidity provision.

BIS Macroeconomic Assessment Group on Derivatives

– The macroeconomic impact of OTC derivatives regulatory reform are

likely to be positive, with a long run GDP impact of between 0.09 to

0.13%.

The optimistic view on regulatory developments

12

Tight coupling: the components of a process are critically interdependent, they are linked together with little room for error or time for recalibration or adjustment.

– Charlie Chaplin’s caricature assembly line in The Mechanical Age

– Causes: Nonstop information flow and unquenchable demand for instant

liquidity. It is accentuated by leverage and some risk management

practices.

The Regulation Trap: the natural reaction to market breakdown is to add layers of protection and regulation. But it may lead to unintended consequences, compounding crisis rather than extinguishing them because the safeguards add even more complexity which creates more failure.

Source: R. Bookstaber

The pessimistic view: complexity and regulation

15

A Copernican revolution ?

• Status quo:

– The financial stability debate does not focus sufficiently on the current and potential

needs of derivative end users, and the wider macroeconomic impact of derivative

use.

– The finance industry is too self-referential (J. Kay).

• What should happen ? A Copernican revolution.

– Put final clients first !

– Holistic analysis of cost/benefits of derivatives for the entire economy, balancing the

need for financial stability against the cost imposed by derivative regulation,

including the financial instability that could arise from not using derivative

strategies as hedging tools because of their costs or any access barriers.

– Fiduciary duty: the gold standard, as opposed to suitability, which is inferior by

far.

16

The perspective: we must take the point of view of the Asset Owner (and

final client).

This is a holistic perspective that cuts through many layers of agents and

complexity.

The profound understanding of client needs that ensues is a source of lasting

competitive advantage

– Collateral (and generally OTC derivative implementation) is a challenge,

but also a wonderful opportunity to get closer to the client.

But it is quite difficult to achieve (e.g. silos).

Putting end users first in derivative space

17

Asset Owners (and their agents) should adopt a holistic perspective

– Risk analysis e.g. in the asset/liability management framework

– Mitigation/hedging of unwanted risks as per Board-approved risk appetite

– Consideration of implementation aspects of derivative strategies and the

interplay with the entire portfolio

Investment and risk governance for an Asset Owner

18

Asset Owners (and their agents) should adopt a holistic perspective:

– Risk analysis e.g. in the asset/liability management framework

– Mitigation/hedging of unwanted risks as per Board-approved risk appetite

From Collateral Optimization 1.0 (where collateral assets and derivative

strategies are given), to Collateral Optimization 2.0, where derivative

strategies (including collateral issues) are examined in the asset allocation

process (and the collateral value of assets is taken into account):

– Derivative strategy implementation is part and parcel of investment

strategy: collateral cannot be relegated to a back office implementation

issue. It should be elevated to the Investment Committee.

Elevating the profile of collateral management

19

Understand our instrument universe

– Which derivatives make up the lion’s share of our exposure (globally and

on a per counterparty basis) ? Is it FX, IR, inflation swaps, commodity

swaps or other ?

Understand the level of instrument complexity

– Do we deal mainly in plain vanilla instruments ?

– If not, why ? It is often preferable to have a simpler and liquid (albeit

imperfect) hedge, rather than a customized, complex and illiquid one.

Customize strategies, not building blocks !

Estimate realistic collateral needs and availability of eligible collateral

General checklist

20

Derivative implementation is inherently multidisciplinary:

– Credit and liquidity risk

– Advanced derivative valuation and collateral

– Specialized multi-jurisdictional legal issues

– Operational concerns

It is challenging to assemble all these competences with the needed

synergies

– Even if especially large players in principle have all of this, how can it be

brought to bear for the end user, i.e. the asset owner ?

Many challenges….

21

Implementation shortfall (A. Perold, 1988): difference between real performance and paper performance

– Takes into account execution cost and opportunity cost (the cost of not

trading or delaying trading), e.g. in transition management

– Generally recognized as the best measure of implementation cost

My conceptual proposal to evaluate the implementation of investment strategies with derivatives:

– Augment the implementation shortfall measure to take into account

collateral flows from collateralization

– Take into account the risks (e.g. operational, counterparty, liquidity,

systemic) due to the derivative strategy

A conceptual framework to assess implementation of derivative strategies

22

- 1081

- 23

+ 316

+ 701

- 103 + 36

- 15

Commission

Price

Impact

Trader Timing

Opportunity

Liquidity

Supplying

Liquidity

Neutral

Liquidity

Demanding

Trading Conditions

- 178

- 60 - 327

Source: Wagner (Handbook of

Portfolio Management)

The iceberg of transaction costs (basis points)

23

Impact of changes in regulation on derivatives

It is quite difficult to foresee the impact

– Higher capital requirements (e.g. from Basel III) may reduce liquidity, but impact

may be smaller than for bond trading, and liquidity may be filled by non-banks

– Dodd/Frank and EMIR bring advantages, as well as costs

Simple and short-dated derivatives are unlikely to be affected

Larger bid/ask spread for longer maturity derivatives and a move away from complex derivatives are likely.

In the implementation shortfall framework we recommend, derivatives are likely to remain the best instrument to lay off unwanted risk or to take on tactical exposure.

24









25

Any measurement is subject to error (which in classical physics means deviation

from the true value):

– Statistical error, which can be essentially eliminated if the measurement can

be repeated an arbitrarily large number of times

– Systematic error, which is caused by inherent limitations of the measurement

method, and can be lessened only by improving the method itself

A measurement is:

– Accurate, if its deviation from the true value is small

– Precise, if repeated measurements yield very similar observations

A measurement can be precise without being accurate, if its systematic error is

large.

Valuation: a few key concepts from physics

26

Finance is more complex than physics: there is no such thing as the true value

of an OTC derivative

– We must recognize that systematic error can be very large (model error,

sudden drying up of liquidity, etc).

But physics still helps: there is a confidence interval around the true value.

This confidence interval results from valuation uncertainty (statistical and

systematic error in physics terms).

If the difference between our valuation and that of the counterparty is within

this confidence interval, there is no reason to start a dispute.

Valuation uncertainty

27

Preparing for crisis is onerous, but quite beneficial.

Among the (many) issues to address:

– Operational continuity and speed of response

– How challenging will it be to replace terminated derivatives operationally

and liquidity-wise ? It will be quite difficult if we are demanding liquidity in

a crisis scenario.

– Assess correlation of collateral in our hands and exposure. E.g. this

correlation was quite favourable for equity lending with top quality

government bond collateral.

Good news: the crisis provided us with a number of case studies (but not yet

for CCP failure … )

Preparing for crisis: the failure of a major counterparty

28

Conclusions

We need a Copernican revolution: the collateral (and derivative)

debate must be focused on end users.

– Regulation must take into account macroeconomic effects and not create

create suboptimal outcomes by making hedging unduly difficult or costly.

The regulation trap should be avoided.

– Collateral management is an excellent opportunity to create lasting

competitive advantage by putting end users first and gaining unique

insight into their needs and objectives.

Implementation shortfall and the iceberg of transaction costs as

conceptual tools to evaluate the implementation of derivative strategies.

Derivatives are likely to remain the best instrument to lay off unwanted risk or

to take on tactical exposure.

29

Recommendations

Keep making a judicious use of derivatives, and at the same time keep monitoring:

Changes in regulation and the creation of new instruments

Changes in derivative liquidity and market structure, in the light of existing

positions, and the liquidity requirements of existing strategies

Toward Collateral Optimization 2.0: collateral and the implementation aspects of

derivative strategies:

– Must be considered as part and parcel of investment strategy and cannot be

relegated to a back office issue.

– Their interplay with asset allocation must be taken into account at the investment

strategy level.

– A wide range of multidisciplinary competences must be brought to bear.

30

Back to the basics: the impact of collateral requirements on the use of OTC derivatives by final clients. The value added by derivatives in portfolio management and to economic activity Optimistic (and pessimistic) scenarios for the future of OTC derivatives Open challenges Pragmatic guidelines for derivative usage

31

Are derivatives dangerous ?

32

The purpose of derivatives: risk transfer

• Financial markets: an imperfect and incomplete risk transfer engine

– Regulation should not add to imperfection (e.g. unjustified barriers to entry, national

segmentation, etc.)

• R. Schiller: The New Financial Order

– Creation of financial derivatives to hedge fundamental risks

• Derivatives: very often the best tool to transfer (i.e. take on or lay off) risk (but there

are derivative-induced risks as well…)

• In the current uncertain macroeconomic environment, there is more interest for tactical

asset allocation and extreme risk protection.

• If appropriate derivatives are not available for hedging, or too costly or cumbersome,

the real economy suffers.

33

Standard theory assumes that derivative market makers can lend and borrow at

the risk-free rate

In reality funding and collateralization impact derivative pricing

A valuation framework to make such impacts into account has become available

(Johannes and Sundaresan, Bianchetti, Piterbarg, Fuji and Takahashi)

Collateral agreements and derivative pricing

Interest Rate Swap

Properties: - Maturity - Pay frequencies for both legs - Day count conventions for both legs - Floating leg index: Libor 3m, 6m, EONIA… - Fixed leg coupon rate <= traded value

A B

fixed

floating

35

Interest Rate Swap

36

Rate projection

37

Rate projection: Single curve approach

6m 12m quoted implied

03/10/2000 5.0400 5.1569 5.1515 5.1441 0.7372

EURIBOR FRA 6x12|delta| (bp)date

Rate projection: Single curve approach

- The single curve approach does not work since the 2007 crisis!

0,0000

20,0000

40,0000

60,0000

80,0000

100,0000

120,0000

140,0000

160,0000

180,0000

200,0000

10

.3.2

00

0

2.1

5.2

00

2

6.3

0.2

00

3

11

.11

.20

04

3.2

6.2

00

6

8.8

.20

07

12

.20

.20

08

5.4

.20

10

9.1

6.2

01

1

EUR FRA 6x12 market vs. single curve implied

39

Cash collateral in the same currency of the trade reduces to discounting at the

collateral rates.

Cash collateral in a different currency introduces an additional cross currency basis.

Cash collateral in a choice of currencies introduces a non-linear cross currency

basis adjustment

Taking into account actual rules in collateral agreement and effective collateral

management practice requires additional correction terms, some of which need to

be accounted for at collateral account netting sets.

This is why it is recommended to post collateral in the instrument currency, without

optionality in the CSA agreement (as in the Standard CSA), to obtain the most

favourable transaction price.

Impact of collateral currency on valuation (Trovato)

40

Model risk in illiquid markets

Illiquidity and jumps/gaps increase model risk

Evaluation risk (i.e what I called systematic risk earlier on): how does the market

price attainable in the market differ from the mark-to-model evaluation price ?

− Uncertainty in model inputs (e.g. implied volatility curves)

− Model risk

− Liquidity (and market access) risk

− The more complex the derivative, and the further away it is from liquid options with

transparent prices, the larger the evaluation risk

41

Liquidity: market and funding liquidity (Borio)

Liquidity: more easily recognized than defined

Working definition: a market is liquid if transactions can take place rapidly and with

little impact on price (affects the implementation shortfall of a trade)

Liquidity is generally not observable (it can be measured only through proxies)

Generally ignored in standard financial models (which assume frictionless markets)

Market liquidity has several dimensions:

Tightness (e.g. bid/ask spread)

Depth (maximum size of transaction that is absorbed without affecting price)

Immediacy: speed at which orders can be executed

Resiliency: ease with which prices return to normal after temporary order

imbalances

Funding liquidity: ability to “cash in” value (either via sale or access to external funding)

Critical for the orderly execution of trades (hence for market liquidity)

42

Optical illusion related to asset illiquidity

Asset illiquidity frequently leads to serious risk underestimation

Illiquidity (and price smoothing from revaluations based on quotes without transactions or mark-to-model) result in lower apparent volatility. Examples: lower volatility of real estate versus

equity, returns of some hedge funds, subprime.

Stale (or smoothed) prices of an illiquid asset result in apparent lower correlation with liquid assets

Is advertised alpha in part a liquidity risk premium ?

− What is left of alpha if we account conservatively for liquidity risk ?

Unrealistically smooth return patterns are especially suspicious

43

Liquidity and option prices

Option price:

1. Replication cost through dynamic hedging

2. Plus a premium in implied vol (and smile) to historical vol if there is

market asymmetry (option market makers are typically short vol)

“Implied volatility can be thought of as a yield paid to investors for providing

insurance to the market” (Reiss)

Higher funding costs, and reduced availability of risk capital widen the arbitrage

channel: small misspricings are no longer arbitraged away

Illiquidity increases model risk (especially when models do not take liquidity into

account)

– Jumps (not taken into account by Black Scholes) may become more material

44









45









46

Conclusions

We need a Copernican revolution: the collateral (and derivative)

debate must be focused on end users.

– Regulation must take into account macroeconomic effects and not create

create suboptimal outcomes by making hedging unduly difficult or costly.

The regulation trap should be avoided.

– Collateral management is an excellent opportunity to create lasting

competitive advantage by putting end users first and gaining unique

insight into their needs and objectives.

Implementation shortfall and the iceberg of transaction costs as

conceptual tools to evaluate the implementation of derivative strategies.

– It is crucial to evalaute long term collateral needs for the chosen

derivative strategy

47

Recommendations

Keep making a judicious use of derivatives, and at the same time keep monitoring:

Changes in regulation and the creation of new instruments

Changes in derivative liquidity and market structure, in the light of existing

positions, and the liquidity requirements of existing strategies

Collateral and the implementation aspects of derivative strategies:

– Must be considered as part and parcel of investment strategy and cannot be

relegated to a back office issue. S

– Their interplay with valuation must be taken into account at the investment strategy

level.

– A wide range of multidisciplinary competences must be brought to bear.

48

Regime of opaque systemic risk with high policy and political uncertainty.

The current discussion about fixing finance is tired (R. Urwin).

– Charlie Chaplin’s caricature assembly line in The Mechanical Age

– Causes: Nonstop information flow and unquenchable demand for instant

liquidity. It is accentuated by leverage and some risk management

practices.

The Regulation Trap: the natural reaction to market breakdown is to add layers of protection and regulation. But it may lead to unintended consequences, compounding crisis rather than extinguishing them because the safeguards add even more complexity which creates more failure.

Source: R. Bookstaber

The current macro

49

A few findings

• ISDA survey (February 2014) of derivative end-users

– Administrative burdens are even more of a concern than hedging costs.

– Geographic market fragmentation, induced by regulation, has a negative impact on

end users ability to manage risk and increases cost.

– OTC derivatives are very important for the firm’s risk management strategy. Their

use in the second quarter of 2014 will be constant.

• BIS Macroeconomic Assessment Group on Derivatives

– The macroeconomic impact of OTC derivatives regulatory reform are likely to be

positive, with a long run GDP impact of between 0.09 to 0.13%.

back to the basics: the impact of collateral requirements on the use of otc derivatives by final...

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