November 9, 2015

A sharp intern who had worked in the risk department of a European bank once asked me if I thought that anyone really knew how the bank worked, voicing her inner doubts on the capabilities of her superiors. She was a smart cookie who wisely decided to surrender the idea of a career in banking rather than face the prospect of doing something she could not understand which is a poor showing for my efforts at some rudimentary explanations.

The easiest way to imagine how a bank works, really, is to just picture yourself setting up shop and taking your first dollar in deposit.

The dollar would be your liability and you need to put it to work by lending out the dollar at a higher interest rate than what you paid for the deposit. But for conservative reasons, not every single cent from the dollar can be put to work and in Singapore’s case, banks can only lend out somewhere between 13-21% of that monies and it is only logical that they penalise borrowers by passing the cost of the monies retained, presumably at a poorer return.


Rules and more rules, of course, are necessary to keep things in order, to prevent the bank from lending depositors hard earned monies to the highest bidder, or lending all their monies kept in call accounts (that can be withdrawn at moment’s notice) for a 30 year mortgage and such. All too necessary with centuries of bank failures to prove for it as banks chased profits because bank managers were paid a portion of those profits and preying on the instinct of human greed, which is perhaps the easiest job in the world.

As rules got more complex, banks strode ahead with some so called off balance sheet items, the most commonly known one as being the foreign exchange swap which does not add to the balance sheet of the bank, being a simple buy and sell of one currency for another between 2 different points in time. And thus, we have the first derivative contract – a product that is derived from an underlying asset – which in this case is a simple one of the differentials between 2 interest rates.

As long as an underlying exist, it is possible to derive an earthquake index, or even a cherry blossom index for tour agencies reliant on the the timing of the blossoms for their dear livelihoods.

Bankers are no longer bankers but financial engineers these days and so good are they at that “numbers game”, that it is possible to make money from anything as long as you have an underlying to trade and derivatives, like bonds, are OTC products which means that they are arms length transactions between 2 counterparts gentleman style.

It is an endless game of cat and mouse between regulators and banks which culminated in the Lehman crisis or the Global Financial Crisis (“GFC”) where Lehman Brothers, a 158 year old institution, collapsed from its inability to honour its debts due to its inability to raise more debt which would have saved it, had they managed to borrow in time.

Ingenuity struck during the crisis as banks found themselves short on the profit front and facing massive shortfalls in regulatory capital, as necessity is the mother of invention and the need to survive prevailed and “profits” (or rather profitable reserves) came from the most unlikely source, the devaluation of their liabilities because bank debt/bond prices fell which allowed some gains in the form of debt valuation adjustment (DVA). Therefore, instead of recognising their liabilities as 100, it was possible to recognise that they only owed 90 cents from prevailing market prices, 10 cents “profit”?

Thus the regulators brought on the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2010, with the main aim of main street protection, increasing transparency and accountability in the marketplace. Part of the new regulations required increased capital surcharges and sufficient collateralisation on their derivative contracts which meant most standard derivatives had to be centrally cleared, no bank in the world unexempted, if they wished to do any business with an US entity and bank.

And given that US banks are mainstay for market liquidity in global banks and derivatives, there is little choice.

When they ran out of DVA, in stepped the FVA back in 2012, the funding valuation adjustment which was basically recognising that they could borrow cheap again.

Then the CollVA and IMVA came about – Collateral Valuation Adjustment and the Initial Margin Valuation Adjustment, when banks realised they could save capital by playing around with the type of collateral they posted and received for their derivative trades.

I recall my dear friend, a derivatives and bond trader, lamenting to me that she had to not only consider the interest rates when trading but the collateral type as well. It is well possible to make profits by dealing at the same price between 2 counterparts, a buy and sell trade simultaneously, just based on the difference between the collateral they posted and foreign banks loved their Singaporean counterparts for their SGD dollar collateral then even if the Singapore local banks were blissfully unaware, then, that there was such a profit to be made.

Another friend had this to say last year.

The state of the art today is:

1. For pricing, you use CVA and FVA

2. For accounting, you use CVA, DVA and FVA.

To be precise IFRS 13 only requires you to report CVA and DVA. JP Morgan under the leadership of Jamie Dimon reports FVA in addition to CVA and DVA. You will see why this makes perfect sense in a moment.

Let us first go back to first principles. When one enters into a derivatives transaction, one implicitly grants one’s counterparty an option to default (the quantification of this is the CVA) and, at the same time, one also receives an option to default (the quantification of this is the DVA). In other words: one sells credit protection on one’s counterparty (CVA); and one buys credit protection on oneself (DVA).

After the failure of Lehman, market actors began to treat plain vanilla interest-rate (IR) swaps as defaultable IR swaps. The right way to price and risk manage this defaultable IR swap is to use a credit/IR hybrid model that takes into account the existing portfolio with the counterparty. We can call this the macro credit/IR hybrid model. We contrast this with mainstream micro IR models that use IR only to price IR swaps. The micro models are oblivious to credit and the pre-existing portfolio (i.e. diversification benefits of the portfolio). As you can imagine, to get the quants to rewrite the micro models into macro models is a mathematical headache. Even if you have done that, running the macro models in the front office is going to take computational power and time. It is not surprising that banks decided to keep the micro models, and create an xVA desk to manage the counterparty risks separately.” 

Yes, there are not enough PhDs in this part of the world to do this or not enough know-how to supervise those PhDs to do this. Yet we would be unsympathetic to know that regional banks were just learning that it is more profitable for themselves to help companies issue bonds at 6% to sell to private clients while lending clients money at 2% to buy those bonds than give out that 6% loan to the companies. Thanks to regulations, of course.

Now my dear friend tells me of a new product that has taken off in derivative world. Not so new as it is perhaps 9 to 12 months old, but nonetheless new enough to warrant Bloomberg creating new tickers for this category of trade. It is the CME-LCH basis swap, 1 to 30 years.

Wait a minute, Chicago Mercantile Exchange and the London Clearing House? Why is there a need for a product that does nothing except change the clearing agents of a derivative? The current market value for a such a trade, apparently favours CME at the moment, which means that there is more demand for CME clearing than LCH. Yet, why did the banks not just choose CME at the outset, to pay a price for changing at the present?

This is the beauty of regulations yet again, and something that few regional banks are paying attention to, buckling as they are under the onerous task of computing the CVA and FVA as they trade presently, topics that may even sound alien to the smaller players in the border markets. And, make no mistake that this cost will be passed onto them, unknowingly, as they deal with the more sophisticated GSIBs (Global Systemically Important Banks).

Warren Buffett described derivatives as “weapons of mass destruction”.

Recently, he reaffirmed his view that they pose a threat to the global economy and financial markets and that “at some point they are likely to cause big trouble”, lending themselves to “huge amounts of speculation” which will only rear their ugly heads when the market experiences a black swan event.

The total nominal amount of over-the-counter (OTC) derivatives contracts outstanding in the world at December 2014 was $US630 trillion ($815 trillion), according to the latest statistics from the Bank for International Settlements in Switzerland. That is about eight times the size of estimated world gross domestic product of $US75 trillion. The BIS statistics show that the bulk of the nominal value of OTC derivatives is from interest rate contracts totaling $US505 trillion.

Deeper and deeper into the widening gyre, things shall, not yet, fall apart… And no amount of regulation would be able to stop us that plunge into the widening gyre, courtesy of Yeats, even as talk of restoring the Glass-Steagall Act (to restrict risk taking business for commercial banks) emerges in the US Presidential debates. The Glass-Steagall Act which was repealed in 1998, essentially saw banks transfer risk taking to investment banking units just as banks are transferring risk taking to hedge funds right now.  And where will the more proficient PhDs work ? At the top paying banks or at the Fed or SEC?

It has nothing to do with lay people?

Think again.

The cost is borne by depositors and investors alike and is factored into that new insurance policy you buy not to mention, the next CoCo AT1 Basel 3 loss absorption note/bond your banker tells you is a good investment.

Make a little effort to understand a little of it? Wise intern girl would have been a great risk manager for her inquiring mind.

Because as Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.” Replace the word “compound interest” with “derivatives”!