Swap stays, FX clearing, and the value of real options

The week on Risk.net, August 29 - September 4, 2020

7 days montage 04092020

The unintended impact of swap stays on financial stability

In a world where swaps leverage is shrinking, bankruptcy stays could do more harm than good, says economist

The FX swaps client clearing comeback

With possible price savings and non-bank competition, chatter about the service is picking up again – but significant hurdles remain

Valuing scenarios with real option pricing

Risk managers could use Black-Scholes to help drive strategy, writes René Doff


COMMENTARY: Room to breathe

Risk.net looked at the contentious issue of swap stays this week – the European Banking Authority (EBA) is pushing to create a rule allowing regulators to delay closing out derivatives deals when one counterparty fails, on the grounds that this would make resolution easier.

The rule already exists for trades entirely within the European Union. But the EBA wants it to be inserted into all European swap deals, even those with a non-EU party on one side. There are a couple of immediate issues with this and one rather less immediate, but more fundamental.

The first issue is that the rule will be wrapped up in the revised version of the Bank Recovery and Resolution Directive. But four jurisdictions – the big four, in financial market terms, of France, Germany, Italy and the UK – have already gone ahead and put in this requirement at a national level several years ago, based on the original directive, BRRD I. Banks had to repaper thousands of contracts in those countries; they’re not keen on the idea of doing it again to meet a slightly different set of EU-wide requirements based on BRRD II.

To complicate matters further, the UK has since left the EU and is now hovering in a sort of semi-detached state, with the final relationship between the two former partners unclear.

And there’s another question that needs answering. US economist Samim Ghamami argues this week: are swap stays actually a good idea? Maybe not, new research suggests – or, put another way, “good idea for whom?”

They certainly make the resolution authorities’ jobs easier by giving them more control over the failing bank’s cash outflows, and are therefore a good idea for those relying on an orderly resolution.

They’re not great for the failing bank’s derivatives counterparties. In fact, full termination might be better as long as banks are not highly leveraged in derivatives because it will mean less risk of contagion, with the sudden lack of cashflow pushing counterparties over the edge as well. The bigger the failing bank, the bigger each of those interest groups will be – and it’s really at the tail end of the curve, with a major derivatives counterparty failing, that problems arise.

If that does happen, it is probably a result of systemic rather than idiosyncratic factors – meaning the counterparties will be struggling as well, even before the first failure is announced.

It looks, in short, as though swap stays may be a good idea only in situations where having them doesn’t really matter in the big picture. No doubt they’ll make resolving the failure of a small counterparty easier. But in that scenario, how bad can things really get? Meanwhile, their impact on a major resolution is far more difficult to quantify.


STAT OF THE WEEK

Up to 50% of Shell’s FX spot volume is executed via algorithm, totalling hundreds of billions of dollars a year

 

QUOTE OF THE WEEK

“We have a system [in debt issuance] that functions with an enormous amount of manual input and constant reconciliation. Interconnectivity between stakeholders is driven by phone calls, emails, emails with attachments, PDFs, Word documents, Excel spreadsheets – very old tech” – Charlie Berman, Agora

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