Wednesday, July 31, 2013

Derivatives: Making Sense of Where We Are

The world of derivatives is in a purgatory state--a prolonged holding pattern until regulators finally finish new rules that will govern how they will be sold, traded, valued, cleared and reported. Regulators and financial institutions in the industry have dragged their feet in annoying, painstaking ways. What will eventually happen to how they will be traded?  How will be big banks respond? What will they do? When will the industry decide?

How will banks compensate for the billions in revenues that could evaporate when the derivatives playing field is re-landscaped?

The stories have  been told often over the years how derivatives markets have surged and soared, how derivatives have become a market of trillions (measured by the "notional" or face value of the derivatives traded globally).  The credit-default-swaps market is said to be over $25 trillion. (That would be "notional" face value, not actual market value or market outstandings.)

The story is also told often about how derivatives markets are opaque, sometimes illiquid, often misunderstood or too complex and how markets are dominated by banking behemoths that dictate pricing spreads, trading procedures, collateral requirements and who gets to join the inner circle of dealers.

WHAT REALLY IS A "DERIVATIVE"?

"Derivatives" is a financial term that today encompasses a wide range of financial activity. The term was rarely used before the mid-1980s, although some forms of derivatives have existed for as long as there have been viable trading markets.  In current times, a derivative might include almost any financial instrument that is influenced by market risks and credit risks, but is not a director investment into a corporate entity.  In other words, it encompasses all that is not an equity investment, a plain-vanilla bond, or a loan. 

Derivatives, by convention, include options of all kinds (puts, calls and collars), convertible bonds (and other "hybrid" instruments), interest-rate swaps, credit-default swaps, equity-linked swaps, commodity swaps, index trading and index swaps, and currency swaps.  They include futures trading--those traded on
exchanges and those traded "over the counter."

Frequently, derivatives will include forward foreign-exchange transactions.  For most in finance, the term will include mortgage-backed securities, CDOs, CLOs, IOs, POs, CDOs squared, synthetic CDOs, and synthetic CLOs, And if we dare get fancy, they include swaptions, "knock-out" swaps, and CAT (catastrophe) bonds.

Derivatives creators adore acronyms, complexity, quantitative analytics and the lure of something new and different.  Derivatives managers enjoy the open-round gush of profits.  Financial theorists and financial engineers embrace whiteboards of equations and calculus that try to define the behavior of these instruments.

Derivatives, the term, captures just about any complicated instrument that doesn't sound like a stock, bond or loan.  The finance media define derivatives as financial instruments "the value of which are based on other securities and instruments"--a catch-all phrase that often doesn't explain exactly what they are or how they perform in live markets.

THE APPROACH OF BIG BANKS AND DEALERS

Here is how large banks and hedge funds that have dominated prominent segments of the market define and approach derivatives--at least until now, while the global business model for trading derivatives is under threat:

1.   The first institution to conceive, create, build a model, sell, and trade a new derivative gets to determine and mark the playing field or the "rules of the game."

2.  The first few firms, usually large banks, that leap into the arena of a new derivative product determine the profit dynamics--how profit margins and spreads are determined, how positions are valued, and how prices are reported. Therefore, they become the core of large dealers that dominate the new market at the outset.  They will behave in ways to ensure they maintain control of the market--especially the lucrative pricing spreads.

3.  The large dealers who control the market decide when and how to open it up to new clients and counter-parties.  This permits the new market to grow, boosts liquidity, and spawns a large number of "end-users," who often use the derivative for risk-management or hedging purposes.

4.  The large dealers and their inner circle will design the marketplace such that the growing number of "end-users" (corporations, manufacturers, small funds, and individuals) must arrange trades by going to one of the large dealers.

5.  Large dealers, banks and hedge funds are able to maintain control of markets (and profits) because of advantages in capital resources, systems and technology, and information.  They can survey, see, comprehend and act upon all the activity that occurs around them.
6.  Large dealers, because they control pricing, spreads, and profits, have little incentive to change the status quo, except to increase activity and liquidity and reduce counter-party risk (the risk of clients and counter-parties defaulting on trades).

7.  Once they understand the new product and market behavior, speculators abound and will pounce on any opportunity to take advantage of market abnormalities or inefficiencies. They will likely be specialized hedge funds and funds that house "quant-jocks," but they may also (at least in the past) be the proprietary trading units of large banks and dealers.

8.  Large dealers, because they control the market, can determine the price reported among themselves, prices reported to other interested end-users, and prices reported to the public.

9. Large dealers determine, as they see fit or with guidance from regulators, how the transactions are "cleared" (settled, paid for, or consummated formally) and how they protect themselves from "default risk" by setting rules for how end-users participate (for example, by pledging collateral or requiring they meet certain capital standards).

Large banks and dealers claim they haven't managed these markets ruthlessly. They argue there has been sufficient self-policing and adequate oversight from regulators and industry-related organizations.  (ISDA, for example, is an industry association that continues to set common standards for trading, documentation, reporting, and collateral-pledging. Markit is an independent company that offers pricing services.)
Then came the financial crisis.

Then came the public's charges that improper selling and trading of derivatives explains why the crisis unfurled and infected much of the global economy. 

Then came Dodd-Frank legislation and regulation.  Dodd-Frank was a comforting anecdote to the crisis. It had the right themes and provided outlines to make markets safe. But Dodd-Frank didn't stipulate tough  deadlines. 

Armed with Dodd-Frank powers, regulators have a blueprint and a vision for how derivatives markets should be overhauled.  They have been tardy, however, in writing the thousands of rules, line by line, that will redesign markets from front to end.  Because derivatives are amorphous financial instruments and don't fall easily into categories, regulators fuss among themselves about which body should have the most oversight.  The debates among the SEC, the CFTC, the securities and derivatives exchanges (NYSE, ICE, NASDAQ, CME, etc.) are part of the reason for delays.  The Federal Reserve, FDIC, FHFA, and OCC have opinions, too.  An alphabet smorgasbord of sometimes conflicting input.

In  spirit, regulators seek to require most commonly traded derivatives be bought, sold, traded and reported on a major exchange with pricing and dealer transparency rules.  Commonly traded derivatives must be cleared and settled (all post-trade operations) via an approved, recognized arrangement, usually funnelled through large well-capitalized banks and overseen by established clearinghouses.

Regulators knew, too, large dealers and banks weren't going to sit still and let millions/billions in profits wither away. Until banks figured out a way to re-engineer their business models to generate profits while strapped by new rules, they would stall the implementation of regulation and continue to squeak out profits. Or they would retreat to their finance labs to craft other ways of making money from derivatives dealing.

WHAT'S ON THE HORIZON?

Where are we now? Where do we go from here? Will reforms do what they are intended to do--reduce risks in the system, reduce the likelihood that trading won't implode into market nightmares, and prepare institutions for the next crisis?

1.  Banks are rebuilding their derivatives-trading desks, reorienting them toward customer activity and customer flow and allocating proper amounts of capital to support them, as required by Basel III regulation. Some banks are downsizing their desks, not able to make economic or regulatory sense from the wave of regulation.

2.  But big banks won't go away sheepishly.  Revenues from derivatives soared until the late 2000s. They will continue to eke out profits until the economics and capital requirements dictate that old models make no sense.  The biggest and best dealers (including Goldman Sachs and JPMorgan) will develop new, different business models to generate profits. 

3. Massive regulation, oversight and public concern will discourage banks and hedge funds from creating new derivative products--at least not as rapidly as the 1990s and early 2000s, when new products flew off the shelves.  Not long ago, large banks seemed to roll out a fancy new acronym for a new product every other quarter, always a moment of pride for them and for the quantitative experts they had hired to think them up.

4.  Regulators, in an effort to come to a conclusion soon, will unveil new rules (thousands of them), but will probably soften some of them, compromising with banks and hedge funds, yielding to some of their unrelenting lobbying efforts.

5.   "Pain vanilla" activity (basic swaps, basic forwards, will thrive, even with thinner profit margins. The big banks will compensate with volume and take advantage of other banks exit derivatives activities.

It will have been a long haul, and it won't be over soon. Derivatives markets are huge, impactful, and complex.  This story still has many chapters remaining.

Tracy Williams

See also: 

Monday, July 29, 2013

State Of The Art Products: All That Glitters Is Not Gold

Images insurance
Companies compete seriously to outdo each other with the product that they deem will solve their customers’ problems in the short and long run. The market is bombarded with products of all types with promises overlapping each other of miracles they can do. Words like “revolutionary”, “cutting edge”, “new improved”, “enhanced”, and many other advertising language types are used to entice customers into buying. This is part of the marketing plan of many companies and if carried out consistently, often succeeds in drawing many customers to them. It is common knowledge that no product is perfect, despite all the promises and every product has the potential to lead to an accident, damage, loss or any other negative incident. This is what makes it very important for companies to source for product liability insurance quotes to safeguard themselves and the users of their products.


For many manufacturing companies, this kind of insurance is an excellent investment because it provides protection for hidden defects and flaws in the original design in the production process. It also protects a company from misleading marketing campaigns which tend to over-promise and under-deliver. The costs that people incur when they use the products and incur negative outcomes become the source of many court suits because clients usually want their money back because products did not perform as required. Apart from insurance protection, a company should there be very careful with the claims they make for product quality, handling instructions for safe use and return policy agreements. 


In the beauty industry, customers are much more liable to personal injury and damage. This is because, beauty therapy like hair care, skin and body treatment, body enhancements, massages and many other types of personal care services are performed directly on the customer’s person. This is a riskier kind of business because the service provider has to rely on their customer to give them all the information they need to perform their work. Since many customers do not fully know themselves, all kinds of things can happen like allergic reactions, burns, cuts, bleeding and other negative outcomes during the course of their personal care. Without the encompassing protection of beauty therapy insurance, a personal care service provider leaves themselves wide open to all kinds of litigation from furious customers.  

Stories abound of beauty treatments gone badly. Many times this damage is temporary and can be rectified, however, other times the damage causes permanent scarring and disability, loss of hearing in one or both ears, loss of sight in one or both eyes, damage to vital organs like the kidneys or liver from chemicals used, disfiguring of body parts and breakage of limbs, among many other side effects.  Although a personal care service provider may go the extra mile in providing trained personnel to handle client issues, insurance is the best option for those unforeseen eventualities that tend to crop up just when things look like they are getting better.

Tuesday, July 16, 2013

Learn TA from the Teacher of the Teacher

Everyone knows that I do conduct stock analysis classes for the general public, however I 'm not selfish to recommend to people who would like to learn advance technical analysis knowledge from a very dedicated teacher who is more than qualified to teach the course. He is also my teacher, Mark Lim.

Course: CFTe/ CMT online Masterclass in Financial Technical Analysis

Website: http://www.tradermasterclass.com/

  • Course Format: online webinar
  • Duration: 30 weeks
  • Commencement Date: 15-8-2013
  • Course Schedule: One online lesson per week
  • Lesson Times: Thu 7:45pm - 10:45pm


To know more, please visit his website or contact Stella on 012-4994885



Monday, July 15, 2013

Basel III: Becoming Real


For those who work in or work with financial institutions, it's nearly impossible to avoid discussions of financial regulation.  It's everywhere.  It can be the drudgery of banking, deal-making, trading, lending, and investing.  But in an environment that is hustling to rid itself of the stark memory of the financial crisis, it's inescapable. 

Financial regulation, Dodd-Frank and Basel III are hot summer topics this year, because it's time for the deliberation to stop and for the rules to become real.  Large banks, such as Bank of America, Goldman Sachs, and Citigroup, have sprinted tirelessly to get ahead of the 900-plus pages of Basel III regulation-- rules drafted by the Basel Committee on Bank Supervision, which includes 27 nations, and intended to have more meat than the rather languid rules of Basel II and Basel 2.5.

Basel III regulation consumes the minds of CEOs and global heads of legal, risk, and compliance.  Trying to gain a fierce grip around the Basel III monster requires resolve, patience, an obsession to detail and resources to hire people and invest in infrastructure to keep up with everything.

The essence of 900 pages of guidelines and rules is that capital is king, that enormous of amounts of bank capital act as a safe financial cushion in times of crisis, whether the crisis is caused by in-house failures or by system-wide troubles.  Basel III details explain the calculations banks must make to determine the precise amount of capital they must maintain for the level of business (measured by the level of assets--assets on and off the balance sheet) they are engaged in.  

To avert confusion of what is an asset and what comprises capital and to discourage banks from using financial tricks to circumvent the rules, Basel III painstakingly defines "assets" and "capital." It also permits other regulatory bodies (such as the Federal Reserve) to define assets and capital further and add their own pages to the existing rules. In other words, the Federal Reserve can choose to make the requirements tougher, as it did in early July.

Capital requirements differ for different kinds of banks, for banks of various sizes, and for large banks (like JPMorgan Chase, Wells Fargo, or Bank of America) that have what many say is extraordinary impact on the global financial system.

This month, the Federal Reserve took bold steps in the Basel III roll-out by tweaking the leverage rules, causing bank CEOs and compliance officers to squirm even more. The Federal Reserve proposed stricter leverage limits:  No matter how risk-averse a bank's balance sheet can be, the Federal Reserve proposes that the largest banks (those with assets exceeding $700 billion) must maintain $6 capital for $100 of assets, implying a maximum leverage (total assets-to-capital ratio) of 16-to-1.  (Basel III is more lenient at $3 capital/$100 assets, permitting leverage to rise about 30-to-1.)

What irks banks most nowadays are (a) the vast amounts of resources, time, and people they must deploy to comprehend and keep ahead of the rules and (b) the uncertainty of what's to come from further rules imposed by the Federal Reserve and other regulators. What has frustrated banks the past few years, until they begin to accept it as a matter of the way things are in the new world of banking, was the impact of increased capital requirements and reduced leverage on banks' returns on equity.  More capital and lower leverage, quite simply, imply lower ROEs.

Outside the offices of senior bank managers, what does Basel III mean to everybody else--bank shareholders, finance professionals, bank clients, and finance students pondering careers in banking?

1.  If there is another tumultuous financial crisis, most banks complying with Basel III will be better able to endure it.  Governments won't likely need to inject billions in new capital to give the banking system a spark.

2.  If one large major bank struggles and implodes, its collapse won't likely cause system-wide turmoil, won't threaten the global financial system, or won't cause hundreds of its counter-parties and clients to tumble with it.

3.  Regulators and market-watchers might forecast better which large banks are vulnerable and could be threats to cause damage to the financial system. They may be able to diagnose a sickness in the system before it causes a global plague.

4.  Banks, not able to exploit leverage and constrained by rules from taking exorbitant risks, must settle for returns on capital in the 10-15% range, if they even manage themselves efficiently and maintain large market shares.  Days of regular 20%-plus returns will be almost impossible to achieve. With relative higher amounts of capital on the balance sheet, they won't be able to use debt to get boosts in ROEs.

5.  Economists and business leaders appreciate concerns about risks, weak balance sheets, and burdensome leverage and debt levels.  Some fear, however, good banks might become too strapped by rules and will become less willing to take prudent risks--risks that include lending to corporations, small businesses and start-ups that provide swift thrusts to a lagging economy. 

Others fear an irony.  Banks limited from growing balance sheets with debt will try to book as many high-risk, high-return loans and activities as possible to boost returns.

6. Banks will hire and might be willing to pay a premium for expertise in compliance, reporting, risk management, and systems.  Complex regulation will require experts to interpret rules, gather data, calculate requirements and report to regulators--in real time, all the time, for the rest of time.

Banks would have preferred to hire new people for revenue-generating businesses or deploy capital for new businesses and expansion. But they have accepted they must build stronger compliance and risk-management structures and show shareholders, regulators and politicians they are taking new regulation seriously. (In 2012, JPMorgan Chase reported it would take 3,000 employees and nearly $3 billion in costs to comply with new, ongoing regulation--over 14,000 different rules from all forms of regulation, not just Basel III rules.)

6.  Senior bank managers will spend more time acting as arbiters among business units scrambling for a precious piece of the bank's balance sheet.  There will be more defined rules for capital allocation:  Who will get to use increments of capital for business purposes? And who will be able to maximize the amounts allocated to them?

7.  Banks will obsess over their capital numbers.  They must develop strategies for how to comply with rules today and in 2018-19, when most rules take effect.  Should they  issue more equity in large amounts now to increase capital and proudly show excess amounts before rules are in effect? Should they maintain excess amounts to show markets, shareholders and regulators they are flush with capital, amply above requirements?  Or should they not raise capital, but choose to scale down businesses, assets and risks, based on current levels of capital? 

8.  Bank boards, sector leaders, subsidiary heads and senior managers will knock themselves out, figuring out how to squeeze more return from the balance sheet, how to nudge ROE upward one more percentage point. They face monstrous challenges to do so without increasing risk levels and credit exposures, without the privilege of growing assets any way they could in years gone by. Solutions to this problem won't come easily.

Basel III has rumbled into town. Many rules go into effect in 2014. It's a reality, no longer an academic concept or a discussion paper in volumes by professorial types in Europe. Banks knew these days were coming and have been preparing them, but they still know it will be a constant, everyday struggle to tame the impact of 900 pages of guidelines.

Tracy Williams
See also: