The Risky Business of Splitting Hairs
Plans to shelve a commonly cited statistic for the size of the derivatives market make sense, but may prove harder to accomplish than many realize.
Derivatives haven’t had a banner month. It’s not every day that prominent religious leaders single out a financial product for scorn, yet that’s what Pope Francis did on May 16, when he called derivatives a “ticking time bomb.” Credit default swaps (CDS) came in for particular ethical criticism.
Then there’s the battle between Blackstone and Goldman Sachs over a financing deal for homebuilder Hovnanian. Blackstone’s GSO Capital Partners Unit had offered the firm an attractive financing package in return for intentionally skipping an interest payment, triggering the CDS Blackstone owned, ensuring a payout. Goldman, which had the other side of the contract, objected strenuously, and the Commodity Futures Trading Commission (CFTC) took the unusual step of issuing an advisory notice about respecting the purpose for which financial instruments are intended. While the two patched up their agreement, the CDS market took another knock to its reputation that it can ill afford.
Yet the problems with derivatives as a whole run deeper still, with ongoing arguments pointing to how the very structure of the market is still in flux, and in turn, how risk in this market is analyzed and modeled.
Take the concept of notional amount outstanding, a measure of a contract’s worth that takes into account all money associated with a transaction. Going by notional value, according to statistics from the Bank for International Settlements, the global market was worth $532 trillion by the end of 2017. For context, the US national debt level is around $21 trillion. Yet notional amount has received something of a backlash this year as an accurate means of depicting what actually goes on inside derivatives markets. CFTC chairman J Christopher Giancarlo has been a particular agitator for change in this regard, saying in a February 1 speech that using such astronomical figures as a means of measurement “has done nothing to bring clarity to newspaper accounts, policy discussions in Congress, or regulatory-policy setting in the decade since the financial crisis.”
In January, CFTC staff published a paper on using a different metric instead—Entity-Netted Notionals—as a means of more accurately quantifying the actual level of risk in derivatives markets. Using this means of calculation, notional amounts across interest-rate products, which make up the bulk of global derivatives trading activity, across US reporting entities, fell from $109 trillion to $15 trillion as of December 15, 2017.
The CFTC’s push has received support from various corners of the industry, and on May 25, the International Swaps and Derivatives Association (Isda) published a research paper that demonstrated the extent to which notional amount has become a standard tool of regulatory policy. It is used, for instance, in European regulation to widely determine thresholds in trading activity, after which an entity must clear its transactions through a central counterparty. This method is also employed in Australia, Hong Kong, Singapore and Canada for the same reasons.
Crucially, however, it is also being used to determine which entities will become subject to rules on posting margin for non-cleared derivatives. September 2020 is commonly cited as the “big bang” moment when the compliance threshold drops from entities with $750 billion in outstanding swaps to $8 billion. Notional amount also appears in reporting obligation thresholds, risk capital requirement frameworks—where notional amount is one of the factors used to determine systemic importance and set minimum capital amounts for counterparty risk—and trading obligations.
Getting the measurements right is, clearly, a task of paramount importance. But given how ingrained notional amount is as a factor in calculating risk, it seems unlikely that forward progress will be made on a harmonized basis any time soon. And changing the paradigm at a crucial moment when the rules kick in could introduce delays to important dates that are not only hard to get around, but dangerous to ignore, too.
Only users who have a paid subscription or are part of a corporate subscription are able to print or copy content.
To access these options, along with all other subscription benefits, please contact info@waterstechnology.com or view our subscription options here: http://subscriptions.waterstechnology.com/subscribe
You are currently unable to print this content. Please contact info@waterstechnology.com to find out more.
You are currently unable to copy this content. Please contact info@waterstechnology.com to find out more.
Copyright Infopro Digital Limited. All rights reserved.
You may share this content using our article tools. Printing this content is for the sole use of the Authorised User (named subscriber), as outlined in our terms and conditions - https://www.infopro-insight.com/terms-conditions/insight-subscriptions/
If you would like to purchase additional rights please email info@waterstechnology.com
Copyright Infopro Digital Limited. All rights reserved.
You may share this content using our article tools. Copying this content is for the sole use of the Authorised User (named subscriber), as outlined in our terms and conditions - https://www.infopro-insight.com/terms-conditions/insight-subscriptions/
If you would like to purchase additional rights please email info@waterstechnology.com
More on Emerging Technologies
Hub to lay off 20% of staff, sources say
Hub’s CEO says this is simply a case of a startup trying to stay nimble and efficient; others say it points to deeper issues.
Fighting FAIRR: Inside the bill aiming to keep AI and algos honest
The Financial Artificial Intelligence Risk Reduction Act seeks to fix a market abuse loophole by declaring that AI algorithms do not have brains.
Waters Wrap: The rise of AI washing… and regulation washing?
The SEC recently levied fines against two investment advisors over “AI washing”. Anthony takes issue with the announcement.
This Week: Brown Brothers Harriman, BNY Mellon/Nvidia, Cboe, Eurex, and more
A summary of the latest financial technology news.
This Week: SS&C unveils T+1 preparedness scorecard; S&P/DTCC; SmartStream & more
A summary of the latest financial technology news.
The bank quant who wants to stop genAI hallucinating
Former Wells Fargo model risk chief Agus Sudjianto thinks he has found a way to validate large language models.
Prepare now for the inevitable: T+1 isn’t just a US challenge
The DTCC’s Val Wotton believes that firms around the globe should view North America’s move to T+1 as an opportunity—because it’s inevitable.
Man Group’s proprietary data platform is a timesaver for quants
The investment firm’s head of data delves into its alt data strategy and use of AI tools to boost quant efficiency.
Most read
- Women in Technology & Data Awards 2024: All the winners and why they won
- Witad Awards 2024: Above and beyond award (vendor)—Susan Bennett, Tradeweb
- Fighting FAIRR: Inside the bill aiming to keep AI and algos honest