How Should OTC Derivatives be Reformed?

1. How Should OTC Derivatives be Reformed? Michael AgyenPrempeh

2. Structure • OTC Derivatives, how they are employed and the size of the market • The Benefits of Derivatives • Is Regulation Necessary? • Which Regulation? (Macro-Pru) • Regulation; How and why.

3. Derivatives • General definition of a ‘derivative’ • An asset whose performance is derived from the value of an underlying asset. (Lecture Notes) • Derivative contracts • give the right (and sometimes the obligation) to buy or sell a quantity of the underlying asset. • or to benefit in another way from a rise or fall in the value of the underlying asset. • Using ‘Options’ and ‘Forwards’ as the fundamental building blocks of derivatives, a broad spectrum of risk and risk management tools can be created.

4. Benefits of Derivatives • Risk Management: • Derivatives are a very effective tool for aligning the actual risks of an entity with its desired risk. • Hedging is the primary means of risk mitigation e.g. a commodity producer taking out a futures contract to supply a specific quantity at a given price before harvest or a small company swapping its floating rate loan for a higher fixed rate loan with a bigger company better equipped to absorb fluctuations in interest rates. • The flexibility afforded by derivatives mean even speculation (which connotes risky activity) can be employed as part of the risk management strategy of an entity. CFA Level 1: Purposes and Benefits of Derivatives (Chapter 15.10) http://www.investopedia.com/exam-guide/cfa-level-1/derivatives/purposes-benefits-derivatives.asp

5. Benefits Of Derivatives • Improved Market Efficiency • Derivatives allow investors to gain exposure to a class of assets without purchasing the actual underlying asset. When costs of investing via both channels differ, investors will choose the cheaper option, reducing demand for the more expensive option and reducing the price until an equilibrium is reached. • Price Discovery • Pricing of derivatives required the employment of a host of relevant factors to arrive at prices which can objectively be accepted as an alternative to the uncertainty face by parties. CFA Level 1: Purposes and Benefits of Derivatives (Chapter 15.10) http://www.investopedia.com/exam-guide/cfa-level-1/derivatives/purposes-benefits-derivatives.asp

6. Is Regulation necessary? • Basic Legal Argument: • The writer of a derivative and their counterparty enter into formal agreement to buy, sell and make payments as necessary. It only makes sense to ensure that parties have at least a reasonable capacity to fulfil the obligations under these contracts. • ‘Too Interconnected to Fail’ • If organisations are truly too important to the market to fail, the best approach is not to incentivise failure by providing bailouts or implicitly guaranteeing their survival when they have mismanaged shareholders’ investment. • The identification of SIFI’s (discussed at length later) is therefore a very necessary part of regulation. • Proven Effects of Lack of Regulation / Regulatory Failure • The failure of AIG, the system-wide effects associated and the costs to the public. • Regulation is necessary to prevent a repeat of these events.

7. AIG for Example • AIG FP wrote credit default protection to the tune of $447bn • As of December 2007, its debt to equity ratio was 11:1. (no reasonable capacity to meet its obligations) • Even from an uneducated standpoint, exponentially increasing your exposure to any form of credit risk increases the potential incidence of default ad the sheer volume of claims. • Gaps in regulation: Where AIG’s AAA credit rating was extended to its subsidiary but the same regulatory discipline was not required of it. (AIG FP was not regulated by state-based insurance regulation) Baranoff E, 2012; An Analysis of the AIG Case: Understanding Systemic Risk and Its Relation to Insurance

8. Why Regulate OTC Derivatives? • Their ability to facilitate excessive risk-taking and leveraging make them tools whose misuse have devastating effects for the market (Financial Crisis). The size of the OTC Derivative market ($692,908bn outstanding at June 2013), the system wide chains of potential counterparty defaults and the wide use of derivatives make their regulation necessary. • Their continued use without effective regulation make them open to misuse as the complex, volatile nature has not been fully accounted for in existing regulation. • The low level of regulation in effect in 2008 had a redeeming impact on the level of systemic risk posed by the failure of Lehman Brothers failure and the defaults on its outstanding derivate contracts. (Duffie et. Al, 2010) • Improve market efficiency through the elimination of non-beneficial processes. Regulatory requirement for the introduction of ‘portfolio compression’ effectively halved notional amounts of CDS trades. (Duffie et. Al, 2010) • BIS Industrial Data (http://www.bis.org/statistics/dt1920a.pdf)

9. Which Regulation and How? • Macro-Prudential Regulation • Regulation should aim for sound individual institutions in a stable, well defined overall market. • The roles of individual institutions in the wider market should be taken in context for regulatory purposes. Warehousing institutions for example should be able to prove a reasonable capacity to meet obligations in the absence of hedging. • The mandatory use of central clearing counterparties (CCPs) for OTC derivatives to reduce the incidence of defaults across the board. • Establishing procedures for greater transparency of information concerning OTC derivatives including regular price and volume information updates for all traders of OTC derivatives. • Co-ordination of prudential regulation, reporting requirements and capital adequacy rules to ensure their combined efficacy. Also level playing field across borders to offset arbitrage by MNCs.

10. Central tenets of OTC Trading reform • Capital Adequacy Requirements • New Basel III Requirements Identify Some Important Points. • The Effects of Market Cycles on Capital Requirements and regulation as a countering tool. • A better understanding of Risk which takes not only instruments and traditional liability into account but also recognises the unique effects of an organisation’s corporate governance on its risk profile. • The Liquidity of Assets Recognised as Safe Capital. • On the Final Point However, the proposed ‘Core Tier 1’ capital requirements do not adequately require the liquidity of capital to be varied as the nature of risks change.

11. Micro-Prudential Regulation • The focus on market wide risk does not mean ignoring individual institutions’ risk. • The enforcement of Capital Adequacy, corporate governance and performance related bonus stipulations should be strongly aligned to individual institutions set-up. • The reform of remuneration systems especially need an understanding of different organisation’s operational models as opposed to industry-wide decrees.

12. Managing Behaviour, Remuneration Accurately linking performance to Bonuses. • The incentive for firms to concentrate on short-term activity and targets should be offset, possibly through additional capital requirements for certain institutions and transaction taxes which demotivate non-value adding activity. • The requirement for bonuses to mirror the life cycles of the performance assets which underlie them. Many examples can be found in the immediate post crash effort (Goldman Sachs for example introduced non-transferable time constrained stocks as remuneration)

13. To Conclude • The objective of regulation isn’t to hinder the normal operation of a market. Banning prop trading for example, does not encapsulate the right approach. The objective of regulation is to curtail undesirable practice, resolve the market wide problems which arise from externalities and encourage effective market operation. • Regulation should combine macro-pru and micro-pru approaches (preferably by different agencies e.g. FCA, PRA and the FPC) • Risk is not a single identifiable object but a dynamic set of possible outcomes for an organisation. Regulation should therefore be carried out as a system which mitigates the various possibilities instead of a set of stipulations focusing on previously observed risks. • The all important level-playing field (Co-ordinated introdction of standards as in Basel agreements)