Despite recent bad press, derivatives remain a significant force in the global economy. Grellan O’Kelly explains why their use is important to the financial markets.
The last year and a half has been characterised by severe market volatility resulting in extraordinary pressures on the capital markets. Normal practices and assumptions have been stress tested in a manner no one predicted. The collapse of two hedge funds at Bear Stearns in July 2007 was arguably the start of the current crisis and some large financial organisations have since suffered huge write-offs, with some estimates that these could eventually amount to significantly more than $1 trillion Some of the financial institutions involved ultimately saw senior personnel resign in light of the losses suffered. The scale of the write-offs and lack of market liquidity has led, in certain cases, to insolvency and a pressing need for the public recapitalisation of credit institutions in many of the developed economies. Many media commentators and informed parties are convinced that the use of derivatives has been central to the spread of the crisis to almost all asset classes (‘contagion’). Specifically they assert that valuation practices, risk parameters, models and risk management practices have all been found wanting.
In the years prior to the current market crisis, the pace of financial innovation had been breathtaking. Products that had barely existed a few years ago turned into multi-billion dollar markets. Derivatives and structured products were in the vanguard of this growth and their influence has spread particularly quickly across the capital markets, especially in the world of credit, equities and commodities. Their use also led to an explosion in securitisations, structured finance and other ‘originate and distribute’ techniques that have led to large swathes of the financial markets becoming more opaque in terms of the inability of regulators, investors and the banks themselves to identify who holds the risks and in what form. A good example of this is the CDO (Collateralised Debt Obligation) market. These products can be relatively transparent in terms of their underlying assets, but there’s a myriad of more complex hybrid CDOs such as CPDOs (Constant Portfolio Debt Obligations) and synthetic CDO note issuances that have presented huge valuation problems for global capital markets.
Nonetheless, derivatives continue to represent a significant and important force in the global economy. So before we explore the primary users of derivatives and structured products in Ireland, let’s briefly recap on the main derivative instruments.
Derivatives – an overview
It’s fair to say that there’s a general lack of knowledge on the types of derivatives traded in the markets today, what they’re used for and the risks they carry. Allied to this is a certain amount of confusion as to what ‘financial leverage’ means, and indeed what are its associated financial implications. What, therefore, do derivatives actually bring to the table other than risk and confusion?
These are some of the important reasons why derivatives are important to the financial markets:
- They offer the ability to increase trading capability;
- They allow leverage;
- They allow customisation of requirements;
- They can be used to both increase and decrease risk exposures; and
- Their use can save significant transaction costs.
The key element to understanding derivatives is the effect of ‘leverage’. This can mean different things to different people, but it’s generally seen as the fuel that gives derivatives their potency. The use of leverage allows users to commit a relatively small amount of cash (generally known as premium or margin) to obtain exposure to the full returns of the associated underlying asset. If, for example, a trader wants exposure to US Treasury Bills, he could simply buy, say, $1m worth of the T-bills for cash. Or he could use a derivative and gain the same amount of exposure for only, say, $50,000. This, as you can see, gives the trader a leverage factor of 20, which means that for every 1% rise or fall in the underlying value of the T-bills, the trader will gain or lose 20% of his investment.
Product Types
Derivatives generally fall under two headings: exchange-traded and over-the- counter (OTC), the former being traded on a regulated market and the latter via a bi-lateral agreement with a single counterparty. The basic derivative product types can be categorised under the following headings: -
- Forwards: These are generally OTC contracts and common examples are forward FX contracts or forward rate agreements.
- Futures: These are generally exchange-traded instruments and, like forwards above, commit the buyer or seller of the futures contract to meet the specific terms of the contract, for example to buy or sell a particular bond at a specific price on a specific date.
- Options (puts and calls): These contracts allow the buyer the option of whether or not to meet the terms of the agreement depending on whether it is beneficial or not. They may be either OTC or exchange-traded.
- Swaps: A hugely important and influential OTC instrument that allows two parties to swap cashflows on any type of underlying asset. Common examples are interest rate, credit default and total-return swaps.
- Contracts for Differences: These OTC instruments offer exposure to the equity markets at a small percentage of the cost of owning the underlying shares.
It’s also important to know that certain complex products, such as securitisation notes, embed derivatives in their structure, meaning that the risk-reward payoff of those products can change dramatically. An example of this is a credit-linked note (CLN) that may embed a credit-default swap (CDS) in its structure in order to increase the yield to investors – but with a definite downside if the CDS is forced to pay out on the occurrence of a ‘credit event’.
Risk Management
A crucial requirement when considering the use of derivative instruments is the need for a robust ‘matrix’ structure of quantitative and qualitative risk management techniques to be in place. It is also worth emphasising that derivatives should not be risk managed in isolation to the rest of the portfolio as the two are normally inextricably linked. What are the most common risk management techniques? While the list below is not exhaustive, it does give an indication of the level of sophistication required to manage derivative risks, dependent on the use of such instruments in any particular company. However, it is also crucial that risk managers have appropriate expertise, knowledge and ability. Without these qualities, the risk models may not be constructed correctly, the users of the instruments may be given too much latitude and the numbers generated may not be fully understood. Non-quantitative characteristics such as tenacity, the ability to be contrarian and an enquiring mind are crucial for any effective risk manager!
Common Risk Management Approaches
The following represents a list of the most common risk management methodologies and approaches used in controlling the risks inherent in the use of derivatives and complex products.
- Value at Risk (including stress and back-testing)
- The Greeks (1) (including volatility)
- Pricing (in-house and external)
- Notionals
- Stop-losses
- Credit Limits and models
- Credit Spread Sensitivities (e.g.DV01)
- Correlation Sensitivities
- Liquidity models
- Various committees (trading, new business, credit, etc)
- Heavy reliance on internal / external audits
- Collateral Management
- Up-to-date IT infrastructure
- CRD Limits
- Modelling
- ISDA Agreements
There are many more techniques and methodologies that can be used, but it’s always worth emphasising that the risks inherent in using derivatives should never be underestimated.
The Irish Regulatory Environment
In line with international experience, Ireland has seen significant growth in the use of derivatives over the last 20 years, primarily in our financial sectors such as banking, insurance and funds. However, when looking at the outstanding derivative positions (notional values) of our main banks as reported in their annual reports, the amounts are extremely small when compared to the total global amounts. A recent BIS survey(2) on global OTC positions shows that global notional amounts come to a staggering $516 trillion. The most recent disclosures from our two main retail banks show that their gross notional exposures amount to €640 billion, only 0.17% of the total. The following is a brief overview of the use of derivatives in each of the main regulated financial sectors, noting that access to accurate data on derivative products is not always publicly available.
Credit Institutions
Derivatives are primarily used by Irish credit institutions for hedging purposes (for example managing currency and interest-rate exposures), meeting client needs and proprietary trading. It’s possible to estimate the extent of this use by referring to the annual reports of the large Irish banks, and the overall impression from reading these reports is that there does not appear to be a material use of derivatives for proprietary trading.
In terms of regulatory oversight, the Financial Regulator has responsibility for the day-to-day supervision of all Irish licensed credit institutions. An integral part of that remit is to ensure that credit institutions hold adequate capital for the risks they face. The Capital Requirements Directive (CRD – European Directive 2006/48/EC and 2006/49/EC) sets out the regulatory rules and capital requirements for credit institutions and investment firms (see below). It was transposed into Irish law by the European Communities (Capital Adequacy of Investment Firms) Regulations 2006 (S.I. No. 660 of 2006) and European Communities (Capital Adequacy of Credit Institutions) Regulations 2006 (S.I. No 661 of 2006) and through the Financial Regulator’s CRD Implementation Notice. These Statutory Instruments and the CRD Implementation Notice provide the primary framework for the application of regulatory capital requirements in Ireland.
Investment Firms and Stockbrokers
Regulated investment firms use derivatives primarily for meeting client needs, for example providing risk-management solutions. From reviewing the public information available on some of these firms, it is clear that the speculative use of complex instruments is not material and as such the use of ‘leverage’ is minimal. Similarly, Irish regulated stockbrokers act predominantly for borrowers and investors and so also mainly use derivatives and other complex products to meet client needs. Both investment companies and stockbrokers will also use derivatives for internal hedging and risk reduction purposes.
In addition to the CRD mentioned above, the other significant piece of legislation for these firms is the Market in Financial Instruments Directive (2004/39/EC). The Financial Regulator supervises all MiFID authorised investment and stockbroking firms, some of which are members of the Irish Stock Exchange.
Investment Funds
There are almost 5,000 Irish regulated funds (including sub-funds) with assets under management of €800 billion with the majority of these being UCITS (the highly regarded pan-European retail fund vehicle). Funds may, and do, invest in every form of derivative and structured product. There are specific requirements for the different types of fund that dictate the specific instruments allowed and the levels of leverage permitted. In this regard it is worth noting that UCITS may only employ incremental leverage through the use of derivatives of 100% of their NAV whereas a QIF fund (3) may effectively have unlimited leverage levels. Funds invest in derivatives and structured products for both hedging and speculative purposes.
Irish authorised funds operate under a system whereby the fund administrator, the trustee (custodian), the auditors and the board of directors (or trustees) play a central role in ensuring that regulatory requirements in relation to the use of derivatives and structured products are adhered to on an ongoing basis. These administrators and trustee/custodians are authorised by the Financial Regulator in accordance with the provisions of the Investment Intermediaries Act, 1995 (‘the IIA’) or fund legislation, and they are responsible for the processing and, to a certain extent, risk management of client derivative positions (mainly valuation responsibilities).
Insurance Companies
In reviewing what insurance companies are allowed to do, all available information suggests that regulated insurance and reinsurance companies primarily use derivatives and complex products for risk reduction purposes and meeting client needs. Life companies must meet the requirements of Statutory Instrument (S.I.) No. 360/1994: European Communities (Life Assurance) Framework Regulations, 1994 and non-life insurers are governed by S.I. No. 359/1994: European Communities (Non-Life Assurance) Framework Regulations, 1994. Both of these instruments include rules on the prudent valuation of assets and liabilities, and also set a ‘solvency margin’, i.e. the minimum capital requirement by which assets must exceed liabilities.
This solvency margin is based on the size of technical provisions, premium income, sums insured and claims. It is worth noting that the Solvency II project will introduce a new riskbased solvency system for all EU insurers and reinsurers in 2012.
The ‘Unregulated’ Sector
It is also worth mentioning the use of complex products (which may or may not use derivatives) in the ‘unregulated’ sector. In recent years Ireland has become an increasingly popular jurisdiction for the establishment of special-purpose securitisation vehicles (SPVs) for structured finance transactions. This is particularly applicable to repackagings, synthetic and cash-flow CDOs, asset-backed commercial paper programmes, credit card receivables, mortgages, loan participation note structures and a host of other receivable financing transactions. The favourable tax laws that apply to SPVs established under Section 110 of the Taxes Consolidation Act 1997 enable such vehicles to be, in most cases, tax neutral. In a further extension of the favourable tax treatment of such structures, the Finance Bill 2008 proposed that measures are introduced to establish Ireland as a location of choice for vehicles intending to trade in the carbon credit markets and to extend the types of assets that can be securitised by Irish SPVs.
Conclusion
The last number of years has seen a veritable ‘arms-race’ in terms of product innovation. The use of the ‘originate and distribution’ credit risk transfer model has also been critical in the spread of risk around the globe. But the fortunes of derivatives and structured products have differed greatly since the start of the credit crisis. While the global trade in derivatives has increased, structured products have seen their markets all but collapse. The CDO market has effectively stalled. Interestingly enough on the derivatives side, product innovation has adjusted to the new market conditions with strategies such as volatility-arbitrage, correlationtrading and dispersion-trading appearing more frequently. Due to the higher risk factors at play in the markets at the moment (for example higher levels of volatility and defaults), more mature (‘vanilla’) interest rate, equity, FX and credit derivative products are being used for their risk-reduction qualities. However, this increased use, combined with extreme market volatility, has added further operational and legal risks into the mix. The increase in derivatives trading appears to have increased the backlog of OTC trade confirms, with operational staff facing mounting piles of paperwork linked to soaring trade volumes in the credit derivatives market, exacerbated by the effect of recent ‘credit events’ such as the collapse of Lehman Brothers and the Icelandic banks. The collapse of such large counterparties has highlighted the need for coordinated solutions and, as a result, there is now a strenuous international focus on establishing a central clearing counterparty arrangement for the vast OTC credit derivatives market. If successful, this should have the effect of reducing the impact of default by large market participants as well as reducing systemic risk.
Are derivatives to blame for the current crisis? I believe that blaming derivatives for the crisis, despite their complexity, is akin to blaming the thermometer for the fever. However, it is clear that, once the crisis has passed and the dust has settled, there is a greater need than ever to ensure that all the risks associated with the use of such instruments are fully understood, both from a micro and macro perspective, and that regulators, industry and all affected stakeholders continue to work together to ensure that the benefits that can accrue from using these instruments in a controlled manner are not thrown out with the bathwater.
1 The ‘Greeks’ measure the sensitivities of derivatives to changes in underlying parameters such as the underlying asset movement (the delta).
2 Bank for International Settlements, Triennial and semi annual surveys on positions in global over-the-counter (OTC) derivatives markets at end June 2007 (published November 2007).
3 Qualifying Investor Schemes: Collective Investment Schemes (CIS) are only available to high net-worth individuals and subject to minimum investment limits. They are therefore more likely to be complex and high-risk structures
Grellan O’Kelly, FCA, works in the Policy Section of the Financial Institutions and Funds Authorisation Department of the Financial Regulator and can be contacted at grellan.okelly@financialregulator.ie. Any views expressed in this article are made in a personal capacity and are not intended to represent the views of the Financial Regulator.
Under the list of risk management measures is Notionals and ISDA Agreements.
Notionals are a measure of the amount of trading activity, but do not give any indication of the risk in a portfolio. Imagine two equal and opposite trades both with a notional of $1bn. Your gross notional is $2bn, your net notional is zero.
ISDA Agreements needs more expansion. All OTC business in the world is executed within and using the ISDA legal framework. Within that framework is an optional annex called a Credit Support Agreement, which both parties must negotiate and agree, in order to then exchange amounts of collateral to mitigate credit risk.
Many large dealers will require more collateral from their smaller buy-side parties to reflect their respective risk - although in the current market its the major dealers who are collapsing more than the buy-side who are winding down more gracefully.
Regards, Bill Hodgson, www.adsatis.com