FRTB, volatility scaling and swaps under SOFR

The week on, May 18–24, 2019

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Fund-linked structured products face extinction under FRTB

Global market risk capital standards carry sky-high charges for fund derivatives

Volatility scaling unravels as market patterns shift

Waning power of quant approach could be a reason for trend following’s malaise

Swaps users mull ‘big bang’ for SOFR discounting

Cleared and bilateral US dollar swaps could move to SOFR discounting on the same day in 2020


COMMENTARY: What has happened to volatility?

Volatility scaling has been good to quant investors for many years – but its performance has started to wobble in recent months, leading disillusioned fund managers to suspect there has been a fundamental change in the way the financial markets work.

Previously, the argument for volatility scaling was sound: leverage up your bets when volatility is low, and derisk as volatility rises. For trend following strategies, this would mean getting into trends heavily in their early stages, then gradually exiting as rising volatility signalled the end approaching, minimising losses when it finally reverses.

But this is no longer the case. Often, trends flatten off with decreasing volatility before reversing – volatility scaling in this case would lead funds to ramp up leverage just in time for the reversal to bring them heavy losses.

And there’s doubt too over the use of common metrics such as value-at-risk for volatility. Increasing kurtosis and skew means VAR tends to underestimate volatility by up to 50% compared with Cornish-Fisher VAR, which takes these attributes of the curve into account – extreme market moves are becoming more frequent, and VAR is missing them, in other words. (There are other reasons too to suspect problems with volatility investing – reported last year on the possibility of rigging the Vix equity volatility benchmark).

Some suspect the problem is in Washington – generally low-volatility conditions interrupted by an abnormal number of sudden spikes, produced by generally benign macroeconomic conditions interrupted by the periodic tweeting of unusual policy statements. This is temptingly plausible. But a more credible alternative is that this represents a shift in market structure – the speed and volume of information transmission is overwhelming participants, leading to a situation in which bad news is simply ignored until it becomes impossible to do so, and then it causes a sudden shift.

Sudden systemic shifts are also characteristic of complex, tightly coupled networks – and the argument that traders are swamped by information certainly undermines the basis of agent-based simulations that assume each market participant can assimilate unlimited data. The tougher question is what to do about it. Even tougher than that is the question of what state the market will shift to next – potentially one even more tightly coupled and even less stable.



Morgan Stanley’s credit valuation adjustment (CVA) capital hit $1.8 billion in the first quarter, up from $1.5 billion at the end of 2018 and $1.6 billion in the same quarter a year ago. Morgan Stanley was the only US global systemically important bank to post a substantial CVA capital increase year-on-year, with most of its peers recording steep declines in their charges.



“In 2008, one of the gravest moments in the crisis was when AIG was teetering. And I remind you that the US government was forced to pump in $200 billion to keep it solvent. But the equivalent crisis today would still see us as having no meaningful backstop and support mechanism for the AIG equivalents of today” – Grigorios Markouizos, Citi

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