Tag Archives: derivatives

SEC delays Dodd-Frank Act derivatives measures

12 Jun

Bloomberg reported:

“The U.S. Securities and Exchange Commission will delay some Dodd-Frank Act derivatives measures scheduled to take effect in July, giving regulators more time to finish rules for the $601 trillion market.

Dodd-Frank, the financial-regulation overhaul enacted last year, set a mid-July deadline for measures designed to improve transparency and reduce risk in the over-the-counter swaps market. The SEC and the Commodity Futures Trading Commission are continuing to seek comment on rules, and have said they would miss the scheduled completion date for some measures.

Registration of derivatives such as credit-default swaps could “unnecessarily impede” use of clearinghouses meant to reduce risk, the SEC said in the proposal, which was released for public comment.”

Clearing houses are aggregating risks at a dangerous level. I would prefer to take the other side of the SEC. The clearing houses are going to increase risks. There is absolutely no way they can regulate an overwhelmingly speculative $601 trillion casino. 

CLEARING HOUSE BUBBLE: Who is watching it?

4 Jun

LCH.Clearnet is one of the leading global clearing houses worldwide.

A brief description from their website explains the role of LCH.Clearnet and the function of a clearing house more specifically:

‘LCH.Clearnet is the leading independent clearing house group, serving major international exchanges and platforms, as well as a range of OTC markets. It clears a broad range of asset classes including: securities, exchange traded derivatives, commodities, energy, freight, interest rate swaps, credit default swaps and euro and sterling denominated bonds and repos; and works closely with market participants and exchanges to identify and develop clearing services for new asset classes.

A clearing house sits in the middle of a trade, assuming the counterparty risk involved when two parties (or members) trade. When the trade is registered with a clearing house, it becomes the legal counterparty to the trade, ensuring the financial performance; if one of the parties fails, the clearing house steps in. By assuming the counterparty risk, the clearing house underpins many important financial markets, facilitating trading and increasing confidence within the market.

Initial and variation margin (or collateral) is collected from clearing members; should they fail, this margin is used to fulfill their obligations. The amount of margin is decided by the clearing house’s highly experienced risk management teams, who assess a member’s positions and market risk on a daily basis. Both the soundness of the risk management approach and the resilience of its systems have been proven in recent times.’

LCH.Clearnet is 83% owned essentially by the investment banks and 17% by the exchanges. The company’s website states that their ‘market leading interest rate swap clearing service, SwapClear, has cleared over 1.5 million OTC IRS trades since launch in 1999. It currently has 49 clearing members and its portfolio contains 850,000 trades with a notional value in excess of $266 trillion.’ The $266 trillion is the net notional and it is important to highlight that this is not the exchanged principals.

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Derivatives as a mechanism to hedge

9 Apr

Stephenson (1967) conducted a monkey experiment aptly narrated by another blogger Safetynut:

Four monkeys were put into an observation room with one banana on the floor. The monkeys were wired so that the researchers could give each monkey a mild shock. When the first monkey approached the banana and tried to pick it up, he received a mild shock.

When the second monkey approached the banana, the first monkey became very agitated and attempted to stop the second monkey from touching the banana. Any monkey who touched the banana received a mild shock. Suffice it to say that the monkeys learned very quickly that touching the banana was an unpleasant experience.

Now for the most interesting part of the story. One of the four original monkeys was then replaced with a new monkey. As this new monkey approached the banana, the other three became extremely agitated, and succeeded in stopping the new monkey from touching the banana. A short while later, one of the remaining three original monkeys was replaced with a new monkey.

As this new monkey approached the banana, the other three monkeys, including the one who had just replaced the first monkey, became extremely agitated and stopped the new monkey from touching the banana. This replacement process continued until all of the original four monkeys had been replaced with new monkeys.

None of these new monkeys would touch the banana, and whenever a new monkey came into the observation room, he was quickly taught not to touch the banana. In effect, none of the remaining monkeys understood what would happen if they touched the banana — they just knew that they should never touch it. These monkeys were immersed in this culture and were completely unaware of the reasons for their behaviour.

This is a great real-life example of repeated behaviours that are learned / acquired without understanding cause and effect. This is very similar to the ways in which governments operate. They lack effective controls and insight; the vast majority of interest rate derivatives, credit default swaps, fixed income and equity options are not to hedge farmers output or to hedge fuel costs for airlines; they are purely an instrument for speculators. Enforcing margins of 30 or 70 basis points on deal structures is insufficient; sales are wrongly incentivised to push deal quantity including 30 year durations. Current PV’s are extrapolated into the stratosphere to determine future PV’s; it’s mostly imagination.

For those working within the investment banking community you will be well aware that the majority of the deal volume in derivative and esoteric financial products are heavily weighted towards the hedge fund community. Hedging fuel costs or agricultural produce is not the main function of derivatives; derivatives like Warren Buffet has stated are: “financial weapons of mass destruction” that could harm the whole financial and wider system.

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