The International Swaps & Derivatives Association (ISDA) just completed their 25th annual general meeting last week in San Francisco with much less fanfare compared to last year’s meeting in Beijing that closely coincided with the implementation of Big Bang Protocol. While there was no major news to announce, here is a sampling of some of the topics discussed:
– Commitment to increasing the use of central clearing, including expanding the number of products covered to include things like sovereign credit default swaps,
– Incentives needed to increase the use of central clearing,
– A possible decline in innovation in structured finance,
– Regulation of some OTC derivatives as possibly an important step to preventing too big to fail and a future crisis,
– The Treasury’s displeasure with the current level of commitment and steps taken toward increasing “transparency, standardisation and more effective collateral requirements.”
– Defending the use of OTC Derivatives despite shouldering perhaps more than its fair share of the blame,
– Pointing to the possible negative effects over-regulation or over-caution,
– Warning on proposed changes to close-out netting,
– Expectations of increased trading costs in OTC derivatives amid potentially higher capital charges and margin requirements,
– The current levels of collateral held against OTC derivatives ($3.2 trillion)
Interesting issues
One of the interesting issues that received debate and coverage throughout the gathering was the the process or concern in determining margin and collateral requirements in a centralized clearing house versus the existing process in most bilateral CDS trades. ISDA just reported that the collective collateral held against derivatives trades fell from $4 trillion in 2008 to $3.2 trillion last year with about 83% of that in cash and 14% in government securities.
With a bilateral trade, margin and collateral levels are usually pre-set or agreed to at the inception of a transaction and do not change throughout the life of the contract. This is an important concern for participants that are very sensitive to market risk or volatility as it makes risk management more certain and easier. Central clearinghouses, however, reserve the right to continuously change margin and collateral requirements throughout the life of the contract and this can make risk management much more uncertain and complicated.
For example, a company like Warren Buffet’s Berkshire Hathaway which is often admired or recognized for its relatively strong focus on risk management would likely not be as interested in the types of credit default swap trades it has previously purchased if margin and collateral requirements were continuously changing (the way they would using a CCP).
As taken from Berkshire’s latest 2009 annual report,
“Only a handful of our contracts require us to post collateral under any circumstances. At last year’s low point in the stock and credit markets, our posting requirement was $1.7 billion, a small fraction of the derivatives-related float we held [$6.3 billion]. When we do post collateral, let me add, the securities we put up continue to earn money for our account.
Finally, you should expect large swings in the carrying value of these contracts, items that can affect our reported quarterly earnings in a huge way but that do not affect our cash or investment holdings. That thought certainly fit 2009’s circumstances. Here are the pre-tax quarterly gains and losses from
derivatives valuations that were part of our reported earnings last year:
Quarter /$ Gain (Loss) in Billions
1 / (1.517)
2 / 2.357
3 / 1.732
4 /1.052
As we’ve explained, these wild swings neither cheer nor bother Charlie and me. When we report to you, we will continue to separate out these figures (as we do realized investment gains and losses) so that you can more clearly view the earnings of our operating businesses. We are delighted that we hold the derivatives contracts that we do. To date we have significantly profited from the float they provide. We expect also to earn further investment income over the life of our contracts.”
And in Note 12 of the financial statements:
“With limited exceptions, our equity index put option and credit default contracts contain no collateral posting requirements with respect to changes in either the fair value or intrinsic value of the contracts and/or a downgrade of Berkshire’s credit ratings. Under certain conditions, a few contracts require that we post collateral. As of December 31, 2009, our collateral posting requirement under such contracts was $35 million compared to about $550 million at December 31, 2008.”
Probably the best example of exactly what would change can be summed up from a line in the report summarizing Berkshire’s 2009 derivatives changes.
“We have since changed only a few of our positions. Some credit contracts have run off. The terms of about 10% of our equity put contracts have also changed: Maturities have been shortened and strike prices materially reduced. In these modifications, no money changed hands.”
Berkshire had no problem last year (or any other year) because no money changed hands – however, in any kind of centralized clearing party solution, money will HAVE to change hands and there will be cash outlays (or inlays if a trade moves in one’s favour) and this would makes the risk management function at a company even as strong as Berkshire much more complicated.
Berkshire and other beneficiaries of the existing setup and system may stand neutral or even be moderately supportive in public on the efforts to centralize clearing for OTC derivatives like CDS for everyone else on Wall Street but centralized clearing with the proposed methods of implementation are certainly not beneficial to Berkshire and other strong counterparties that are able to dictate their own terms when trading. Given another year like 2008 where Berkshire ran up short-term mark-to-market losses that at times likely exceeded $3-4 billion, Berkshire posted no collateral with counterparties as security on its contracts according to its public financial reports. Such an arrangement would be impossible to accomplish with centralized clearing but hats of to Warren for arranging that one.