Risk: Is anyone else seeing this trend of clients deciding not to hedge with derivatives because of additional costs?
Guillaume Amblard: Having to post collateral on a daily basis is a big operational issue, especially on the corporate side. Clearly, it will decrease the hedging activity. I don’t think we want to get to a system where our way of reducing systemic risk is giving an incentive for people not to hedge their risk. This liquidity drain is a huge issue, because it comes at a time when the public and politicians want a bank such as BNP Paribas to lend more to the real economy. Clearly, the greater the liquidity constraints, the less banks will be able to lend to the real economy.
One clearing house per asset class is the most efficient and systemic risk-reducing model – that should be the aim
One thing to keep in mind is that the goal of these regulations is reducing systemic risk. Will having small and medium-sized enterprises post initial margin really reduce systemic risk? I think it would fundamentally worsen their risk management, because it could force them to sit on risk rather than hedge it or take mismatch risk.
Risk: Touching on the Greek issue, some commentators have questioned the performance of the sovereign credit default swap (CDS) market during the Greek debt restructuring and have suggested the instrument didn’t work as many people had expected it to work. How effective has the CDS market been?
Eric Litvack: Whether the CDS market functioned as people expected it to – I’m not sure that’s really the issue. The CDS market performed precisely as it was designed to. If there were expectations that it should do something different from what the contract said, then there was an issue with people not actually understanding what the product was and what sort of risk cover they were buying. The CDS contracts on Greece have functioned as they were designed to do. They did not trigger for certain events that were not credit events, and the determinations that came through on that were pretty much unanimous. When there was a forced restructuring, it then triggered the CDS contract. So in that respect, the CDS performed precisely as it was designed to do – no more, no less.
We’ll probably take away a number of lessons from the event and, having looked at this through the prism of how a sovereign restructuring occurred, there are probably some lessons as to how we want to change the rules slightly to make the market more efficient in the future.
Michele Faissola: It is important to stress the CDS market did exactly what was written on the tin. The problem is there has been a lack of understanding on the dynamics. I read press reports before the auction saying there will be a huge payment now the CDS contracts have been triggered, but people failed to understand that everything is almost fully collateralised, so the cash was already paid as the CDS was deteriorating. There wasn’t any big surprise for the seller of protection.
Risk: What lessons do you think the industry can learn from the Greek situation?
Stephen O'Connor: Through each credit event, there are observations along the way and the potential to improve things for next time. Once the dust has settled, people will look back and ask how it could have worked better. This is the first instance of a big sovereign restructuring, with various new instruments being part of the package. People will say ‘given those factors, 80% of which we had thought about but 20% maybe we hadn’t, then what have we learned?’ And the market will come together – buy side and sell side – and make certain changes, so that next time it is even better.
But I would agree that no market participant has really been surprised. External observers perhaps might be surprised that the aggregate positions were quite low. If you add up everybody’s net position across the whole market, it was only about $3 billion, and that was fully collateralised. So not much money changed hands on the settlement date.
Risk: Is it too early to identify the areas that will change?
Michele Faissola: One area where we have learned we need to do a better job is educating the general public. When you have a large event, the level of interest goes well beyond the industry specialists. In some respects, we need to do a better job in educating the general public in terms of how these things work. This is not like an insurance contract – it is slightly different, and we need to ensure people appreciate the differences. But I don’t believe there has been anybody who is a heavy user of the instrument that is disappointed at this point.
Risk: What are your key concerns at the moment?
Guillaume Amblard: My key concern is the unintended consequences of certain regulations. A lot of the regulations are aimed at reducing systemic risk, but if every sector of the financial industry has more constraints, it reduces the liquidity and the capital of the overall market. That has unintended consequences for liquidity, which results in increased volatility, increased illiquidity and increased costs of hedging for corporates, sovereigns and hedge funds. That is an important thing to keep in check.
Eric Litvack: What concerns me most is that we may be missing the forest for the trees. There is a lot of attention being given to the role of markets – the role of derivatives – and trying to reduce the amount in which banks can interact in the market. I think that is taking the wrong conclusions from the crisis. If you go back through the crisis and look at the institutions that got into trouble, most of them managed to do it without any market exposure. The Icelandic banks bought all sorts of industrial assets, but weren’t particularly active in the markets; the Irish banks were heavily into property developers, but weren’t particularly active in markets; a number of US banks got into trouble over origination rather than markets; a number of UK banks got into trouble with very traditional banking activities, not markets. When you look at all that, what you have got is thinly capitalised institutions financing long-term illiquid assets with relatively short-term unstable funding – that is the real issue, and it is being addressed by the Basel III reforms. That is what we should be concentrating on, rather than trying to decide what kind of market activity is good activity and what kind of market activity is bad activity. I don’t really think there is such a thing as good or bad market activity – there is just market activity.
Stephen O'Connor: It all comes down to the need to get these rules right across the globe. If we get them wrong, they can be very harmful. If there are measures that take liquidity from markets and cause draconian levels of capital or margin to be taken out of the system, then that is harmful to liquidity. When liquidity is harmed, it reduces investment returns and has consequences for the real economy as well. So there is a pendulum here. Isda is very supportive of measures to improve the safety and soundness of markets but if that pendulum swings too far and liquidity is affected, it reduces investment returns for asset managers and it is more expensive for corporations to trade. Some of them might not hedge, which could be catastrophic.
To the extent banks are required to either withhold liquidity reserves through initial margin or capital reserves, it is a form of quantitative tightening, and there are estimates just in the US of more than $1 trillion that might be taken off bank balance sheets that could ordinarily be deployed into the economy. So, overall, the most important thing is to strike the right balance between safety and soundness on the one hand, but preserve liquidity and market access on the other.
Topics: International Swaps and Derivatives Association (Isda), European Market Infrastructure Regulation (Emir), Dodd-Frank Act, Basel III, G-20, Commodity Futures Trading Commission (CFTC), European Securities and Markets Authority (Esma), Central counterparty (CCP), Central clearing, Greece, Credit default swap (CDS), Video
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