Swap meet By Donna Block   Share      E-Mail    Discussion    Print Story Published October 31, 2008 at 3:58 PM

EXECUTIVE SUMMARY Brawling has broken out over how to regulate the CDS market and who should oversee the job. Enticed by a likely lucrative business, clearing companies and exchanges are vying to establish trading platforms. CME, NYSE, ICE, Citadel and others all want in on the market.

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Regulators looked the other way while credit default swaps grew into a $60 trillion threat to the world’s financial system. Now the CDS market is getting plenty of attention, and brawling has broken out over how to regulate it and who should oversee the job.

Enticed by what promises to be a lucrative business, clearing companies and exchanges are vying to establish trading platforms. The Securities and Exchange Commission, the Commodity Futures Trading Commission and the Federal Reserve Bank of New York are claiming the right to be the primary regulator of derivative securities. And various congressional committees are bickering over which will have jurisdiction to oversee the market and the agency eventually assigned to supervise it.

Already, three federal agencies and one state agency have different ideas for how the market for credit default swaps should be regulated. Meanwhile, congressional finance, banking and agriculture committees that oversee the regulators are also jockeying for position. There appears to be agreement that the market should not operate without added oversight, but disagreement is wide over how to structure a market for CDSs and how direct the government’s oversight should be.

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Businesses trying to establish the new market include CME Group Inc.; NYSE Euronext Inc.; IntercontinentalExchange Inc. or ICE; Eurex, the derivatives arm of Deutsche Börse AG; and Knight Capital Group Inc. Futures giant CME, with hedge fund Citadel Investment Group LLC, is offering to create a platform that would clear trading of credit default swaps by matching buyers and sellers, guaranteeing that both would have the financial strength to stand behind their trades. Then, on Oct. 30, ICE announced it agreed to acquire the Clearing Corp. and signed agreements with nine banks, bolstering its position to establish its trading platform.

Initially, it looks like Ben Bernanke’s Federal Reserve will oversee the nascent trading platform. According to ICE officials speaking on a conference call last week, the exchange sought to design a clearing model for CDSs that would be subject to Fed oversight, since the central bank was taking a pre-eminent role in addressing the credit crisis.

The Fed wants details on how CDSs would be settled by a clearinghouse, how trades would be processed, what safeguards exist if a trader or a dealer defaults and how the system will protect against a financial crisis.

But the SEC also wants to regulate CDSs, as does the CFTC. It’s unclear whether the Fed will maintain its oversight or whether it will eventually hand it off to one of the other agencies.

The Commodities Futures Modernization Act barred the CFTC from regulating most swap products in 2000. During the swaps explosion, neither the CFTC nor the SEC were willing to buck the Bush administration’s deregulation policies. With markets in disarray, both are fighting for the right to preside over swaps. The CFTC says they’re futures contracts and thus are under its jurisdiction. The SEC says they’re financial instruments with no connection to agriculture or raw materials futures.

Despite the SEC’s recent abysmal performance, Chairman Christopher Cox has said the agency is prepared to regulate swaps with the same authority it has over stocks and bonds. The CFTC may argue that at least one industry proposal for a new platform for settling swap contracts would give it top duties.

Walter Lukken, the CFTC’s acting commissioner, told lawmakers at an Oct. 14 hearing that current law exempts swaps from regulation and that “wholesale regulatory reform will require careful consideration.” He should know — Lukken helped craft the law barring the CFTC from regulating most swap products when he was a Republican congressional staffer. Enron Corp., the biggest energy derivative merchant in the U.S. at the time, lobbied heavily for the exemption, which was sponsored by then-Sen. Phil Gramm, ­R-Texas. Now Lukken is conceding that some regulatory structure is necessary.

Congress could simply merge the SEC with the CFTC. Treasury Secretary Henry Paulson proposed such a step in March, saying a single securities and futures regulator would better reflect how deeply entrenched Wall Street is in many markets. And before the House Committee on Oversight and Government Reform last week, Cox said he “strongly supports” a merger.

New York state has moved recently to regulate some CDS contracts because of their insurance component, proposing that the seller may have to be licensed as an insurer in New York.

The outcome of the turf war will have practical implications for how the platform will work. The CFTC and the New York Fed favor a less regimented clearinghouse platform; the SEC wants a more formal exchange.

The clearinghouse would charge a fee and act as an intermediary that would guarantee transactions between swaps traders. To make those guarantees, the clearinghouse would require traders to maintain sufficient capital in their accounts. That would make it hard to trade without the money to cover a contract in case of default.

Working with the New York Fed is the ICE, which plans to set up in New York under Fed authority. Some of the country’s biggest banks, including Goldman, Sachs & Co. and Morgan Stanley, established ICE. In June it bought Creditex Group Inc., which executes and processes swaps in the U.S., Europe and Asia. Creditex and subsidiary Markit Group Ltd. recently liquidated swaps of Fannie Mae, Freddie Mac and Lehman Brothers Holdings Inc. That could give it a leg up in the battle.

CME Group and hedge fund Citadel would not only trade CDSs on a new platform but also use CME’s clearinghouse to clear swaps. CME would get involved as counterparty in every CDS trade and manage the credit exposures from the time the trade is made to when the trade is officially settled. The CFTC now oversees its operation.

NYSE Euronext London-based subsidiary Liffe also plans to process and clear swaps. The service, announced in July and called Bclear, now clears equity derivatives trades and would remove counterparty risk by using LCH.Clearnet Group Ltd. as a central counterparty to all the CDS contracts it processes.

If Congress grants the SEC power to oversee swaps, the agency could set up several exchanges, similar to the New York Stock Exchange and Nasdaq.

Stephen Figlewski, a professor of finance at New York University’s Stern School of Business, wrote in a recent paper that the over-the-counter CDS market needs such an exchange. Clearinghouses “are too fragile, too loosely regulated and too opaque,” he wrote.

There’s been resistance: An exchange would reduce the ability to customize CDS contracts, reducing their profitability. “Trading CDSs on an exchange will make them much more standardized,” says Howard Spilko, a partner at Kramer Levin Naftalis & Frankel LLP in New York. Spilko adds that CDSs have specialized terms that go with them that counterparties need to negotiate. “They’re not plain vanilla.”

CDSs were toxic partly because they were traded and retraded past the point of knowing who the original sellers were and their value. That uncertainty had a snowball effect with each failure. The use of an exchange provides a middleman for each transaction, so the buyer and seller are identified. If there is a problem, fallout is limited. Swaps would be marked to market each day.

Dealers also fret that their lucrative business will be transformed, with exchanges not only executing but designing their own products. “Exchanges are not just a utility anymore, they’re a competitor,” says Ron Paul, a former general counsel to the CFTC now with DLA Piper’s alternative asset management team in New York.

It’s doubtful, however, that one platform or exchange will be the sole recipient of so much business. Competition should make it less expensive for parties to trade. What will be more telling is whether the desire to concentrate liquidity and have a deep pocket will necessitate one platform winning out over other exchanges and dealers. Whichever company is picked must offer what thus far has been absent in the market for CDSs: transparency and more efficient risk management.

Much depends on how Congress settles its own jurisdictional squabbles. The turf fights among congressional committees with a claim to jurisdiction will be fierce. Authority over a giant new trading platform will bring presiding lawmakers not only power, but offer a new source of campaign contributions from the financial industry. “It’s a minefield,” says one former agency official who would not be identified. “Even if Congress decides they want to do something … it becomes a power play among the committees as to who will continue to get Wall Street support.”

One industry expert is wary of any congressional mandate regulating CDSs, saying a global regulator is needed. “We need a global structure, a modern coherent regulatory regime; otherwise, you’ll have a patchwork of regulation.”

Tags

• CDS market
• CFTC
• Christopher Cox
• Citadel
• Clearing Corp.
• CME
• Deutsche Borse
• Fannie Mae
• Federal Reserve
• Freddie Mac
• Goldman Sachs
• IntercontinentalExchange
• Knight Capital Group
• LCH.Clearnet Group
• Lehman Brothers
• Morgan Stanley
• NYSE Euronext
• SEC

http://www.thedeal.com/newsweekly/features/swap-meet.php

http://www.ft.com/cms/s/0/cec36c5e-a122-11dd-82fd-000077b07658.html

First internet access for sovereign CDS

By David Oakley

Published: October 23 2008 22:12 | Last updated: October 23 2008 22:12
Government credit default swaps are to be published on the internet for the first time, in a sign of the increasing importance of these instruments as the economic and financial crisis deepens.

Only a few months ago, the cost of insuring government debt was rarely focused on by investors because most countries were considered stable. This was reflected in their relatively steady CDS prices, which provided little opportunity to make money.

But since the collapse of Lehman Brothers last month and the decision of governments to guarantee financial debt, this has changed. Even the biggest and richest economies, such as the US and UK, have seen sharp swings in their cost of protection.

Markit, the data provider, will provide the prices on its website in the next week, together with the prices of the main CDS indices that track the credit risk of companies in Europe, the US and Asia, which are already published.

Suki Mann, credit strategist at SG CIB, said: “Sovereign credit default swaps have become sexier as the economic health of governments and their economies has become the story. They are much livelier now than they were only a few months ago. More investors are looking at them.”

The CDS prices of the emerging market nations have seen the most dramatic movements of late.

Argentina, for example, saw its CDS price jump to 4,000 basis points – the highest sovereign spread in the world – on Thursday. This means it costs $4m to insure $10m of Argentine debt over five years. It has jumped nearly 1,000bp this week. Other big movers include Russia, which has jumped to 1,000bp; Ukraine, trading at a record 2,800bp; and Pakistan, which saw prices rise to 3,000bp at one point on Thursday.

These countries are all suffering from the dramatic rise in risk aversion and deepening fears over the severity of the global slowdown.

Credit default swaps have grown dramatically in the past five years with the market now valued at $54,000bn in outstanding contracts.

See www.markit.com
Copyright The Financial Times Limited 2008

Credit crunch upsets 30-year rate swaps

By Michael Mackenzie

Published: October 23 2008 19:14 | Last updated: October 23 2008 19:14
The turmoil in financial markets has taken hold of the strategically important trade in long-term interest rate derivatives, pushing rates to levels once thought to be a “mathematical impossibility”.

Such interest rate “swaps” are the most widely traded over-the-counter derivative and are important for insurers, pension funds and other companies that need to fund liabilities decades in the future.

Investors use swaps to lock in interest rates for 30 years or more, trading a floating rate, based on the London interbank offered rate (Libor), for a fixed rate. The latter is typically based on US Treasury yields, plus a premium, called the “swap spread”, which reflects the risk of trading with a private counterparty, as opposed to the government.

On Thursday, the 30-year swap spread turned negative after briefly flirting with such levels earlier in the month. This implies investors are somehow reckoning that they are more likely to be paid back by a private counterparty than by the government, which can print money.

“Negative swap spreads have been considered by many to be a mathematical impossibility, just like negative probabilities or negative interest rates,” said Fidelio Tata, head of interest rate derivatives strategy at RBS Greenwich Capital Markets.

Traders and analysts believe this unprecedented state of affairs reflects aftershocks from the demise of Lehman Brothers and capital constraints at surviving banks – as opposed to a loss of confidence in the US government.

The Lehman bankruptcy is important because it led to the termination of outstanding contracts, many highly complex.

With many participants scaling back activities of all kinds, investors have had trouble filling holes in their portfolios, upsetting the normal relationship between the swap spread and the “risk-free” Treasury yield.

For much of this year, the 30-year swap spread averaged between 30 and 55 basis points over the 30-year Treasury yield. It fell from 15bp on Monday, to zero on Tuesday and was “negative” on Thursday. Implied 30-year swap spreads for Europe and the UK have been negative since the demise of Lehman.

“Insurance companies and pension funds woke up and realised that their existing swap contracts had been torn up and that they needed to replace them,” said William O’Donnell, UBS strategist. He said the collapse in swap spreads also reflected the prospect of rising Treasury supply.

Copyright The Financial Times Limited 2008

http://www.ft.com/cms/s/0/a7e9c544-a12a-11dd-82fd-000077b07658.html

Fair Game

First Comes the Swap. Then It’s the Knives.

By GRETCHEN MORGENSON

Published: June 1, 2008

INVESTORS don’t often get a peek inside the vast, opaque and unregulated world of credit default swaps, those privately traded insurance contracts that essentially allow participants to bet on or against a debt issuer’s financial condition. (Remember, these are the same instruments that played such a pivotal role in the collapse of Bear Stearns.)

But the legal battle between UBS, the Swiss investment bank, and Paramax Capital, a group of hedge funds in Stamford, Conn., is giving investors a gander at how this freewheeling market works.

The view is instructive, given the unknowns in the huge and growing credit default swap market and the unease about its potential to wreak havoc on the financial system. Experts say the legal case is also the first of what will probably be a flood of disputes between the big banks and hedge funds that typically strike swaps deals.

Like a homeowner’s policy that insures against fire or flood damage, credit default swaps are intended to cover losses to banks and bondholders when companies that have issued debt are unable to pay it back. The nominal value of the insurance outstanding is now $62 trillion, up from $900 billion in 2000.

Although this figure, also called the notional amount, overstates the risk in the market to a degree, such swaps do promise to make up for losses that result if a borrower defaults. And that risk is real — as well as very, very large.

There is no central market where investors can watch credit default swaps trade and see their prices. Each transaction is conducted away from regulators’ prying eyes. While there are common aspects to many of these contracts, so-called bespoke deals also exist, hand-tailored to the requirements of the parties involved in the transaction.

The swap that is central to the UBS-Paramax dispute is one of these customized deals, dating from May 2007, well into the mortgage crisis. The swap was created to insure $1.31 billion in highly rated notes that reflected performance of subprime mortgages in a collateralized debt obligation underwritten by UBS.

The swap insured these notes, known as the “super senior tranche” of the debt obligation, because they were rated triple-A by both Standard & Poor’s and Moody’s Investors Service.

Officials at Paramax declined to comment on the litigation and the swap that led to it. A UBS spokesman said the company “is confident in the merits of our case.”

According to the story that unfolds in the court documents, in early 2007, UBS approached Paramax, a small hedge fund with just $200 million in capital, to insure the notes. After months of discussion, Paramax established a special-purpose entity to conduct the swap and capitalized it with $4.6 million.

Under the terms of the deal, UBS would pay Paramax 0.155 percent of the $1.31 billion in notes annually for its insurance and Paramax would deposit collateral to back the swap, increasing it if the value of the underlying notes declined.

That they did. Almost immediately.

By early November, UBS had asked Paramax for $33 million in additional collateral. Paramax refused, and UBS sued the fund, contending breach of contract, in mid-December 2007 in New York State Supreme Court. Paramax filed a counterclaim in January.

In court filings answering the complaint, Paramax tells its side of this story — and intriguing it is. The fund said it knew when it entered into the swap with UBS that the swap was risky and could require a good deal more capital than it had to deploy if the underlying securities fell in value. Paramax was concerned, the court filing said, that UBS could mark to market downward the value of the notes, causing a call for more collateral beyond the initial $4.6 million.

To allay the fund’s concerns, the documents say, Eric S. Rothman, the UBS managing director who arranged the deal, assured Paramax that mark-to-market risk was low. During a Feb. 22, 2007, phone call, Paramax contends in the filing, it was informed by Mr. Rothman that “UBS set its marks on the basis of ‘subjective’ evaluations that permitted it to keep market fluctuations from impacting its marks.” The filing also says: “Rothman explained that he was responsible for all marks on UBS’s super senior positions and that he could justify ‘subjective’ marks on the Paramax swap because of the unique and bespoke nature of the deal.”

Mr. Rothman is no longer employed at UBS. He could not be reached for comment.

In later discussions, according to court documents, Mr. Rothman contended that even if significant defaults arose in the underlying mortgages, UBS’s marking of the position “might not be as bad as you’d first think.”

On April 10, the hedge fund’s filing said, Mr. Rothman pressed Paramax to “please close this trade already”; in mid-May, the hedge fund pulled the trigger on the deal.

Six weeks later, in early July, Paramax said, it received its first margin call from UBS, for $2.36 million. On Aug. 10, UBS asked for an additional $12.7 million in collateral from Paramax and, on Aug. 22, called for almost $14 million more. The margin calls added up to almost $30 million, more than six times what Paramax had posted in initial collateral.

PARAMAX subsequently arranged with UBS to substitute the credit default swap with a restructured note that would not generate further margin calls. Based on those discussions, over the summer Paramax supplied UBS with $29.3 million to cover the margin calls.

But UBS submitted another margin call to Paramax in November, which the hedge fund declined to cover. Paramax contends in its filing that UBS’s margin calls exaggerated changes in the market.

On Dec. 10, UBS announced that it would take a $10 billion write-down in the fourth quarter of 2007, much of it related to “super senior” holdings like those it had insured with Paramax. Three days later, UBS advised Paramax that a default had occurred in the notes Paramax had insured. In December, after failing to reach a settlement with Paramax, UBS sued the hedge fund. Paramax responded by filing a counterclaim, asking that UBS return the $33.9 million that it lost in the swap.

John P. Doherty and Richard F. Hans, law partners at Thacher Proffitt & Wood, argue that the UBS-Paramax case is only the beginning of lawsuits relating to credit default swaps.

In “The Pebble and the Pool: The Global Expansion of Subprime Litigation,” an article published this year by Thomson West, they wrote: “In addition to losses resulting from corporate default on the underlying loans or bonds, the credit default swap market may also feel stress from the repricing of risk following the deterioration of corporate and/or household credit, as well as a rise in corporate bankruptcies stemming from the subprime market failure.”

The credit default market has ballooned recently, at least in part because of low default rates on corporate bonds. In such a benign environment, participants may have had little concern about the solidity of the entity agreeing to insure, known as the counterparty, or about problems with the swaps’ performance.

Those days are over. And as defaults rise, the optimistic assumptions are likely to come up short. But learning about the details of these disappointments will surely be educational.

http://www.nytimes.com/2008/06/01/business/01gret.html?sq

=swaps&st=nyt&scp=1&pagewanted=all

Foreigners May Rescue New York Real Estate

Buyers Pick Up Slack of Wary Americans
Amid Weak Dollar

By JOSÉE ROSE
February 14, 2008

NEW YORK — Manhattan’s luxury real-estate market may feel an unusual chill from the Wall Street crowd this spring.

Despite early worries that 2007 bonuses would fall dramatically below the record levels set in 2006, overall bonuses only came in about 5% lower. But at companies such as Merrill Lynch & Co., a greater percentage of these bonuses was paid in stock rather than cash. Combined with the continued housing meltdown, credit mess and recession fears, luxury-real-estate agents have noticed a lot more caution among buyers using Wall Street bonus money. However, the wariness of Wall Street is being offset by growing interest from foreign buyers who see New York luxury real estate as a bargain right now, especially in light of the weak dollar.

“It’s caution versus eagerness, when comparing Wall Street buyers to foreign buyers,” said Ivana Tagliamante, senior vice president at Halstead Property in New York. She said foreigners probably account for 50% of condo showings today, a figure that was closer to 10% two years ago.

Elizabeth Lee Sample and Brenda Powers, brokers at Brown Harris Stevens, agreed, saying three out of five prospective buyers are foreign, up from one out of five buyers a year ago. “Foreign buyers are more than picking up the slack of the American buyer, without question,” Ms. Sample said. “There’s a huge demand from foreign buyers right now, more so than last year, and that’s making up for Wall Street hesitancy.”

The usually eager Wall Street crowd has taken a step back this year and, while they are still buying luxury real estate, they are “shopping carefully,” said John Burger, senior vice president and managing director of Brown Harris Stevens. “People may not feel as liquid after their 2007 bonus as they did after their 2006 bonus,” he said.

According to data from Brown Harris Stevens, the number of luxury sales, involving properties priced at $5 million and more, rose 20% for the first six months of 2007. “At that end of the market, some of that has to be attributed to Wall Street bonuses,” said Gregory Heym, executive vice president and chief economist at Terra Holdings LLC, a privately held real-estate company.

Louise Phillips Forbes, executive vice president of Halstead Property, said she has noticed a cautiousness among buyers spending around $2 million. However, “there’s 30% more buyers because of Europe,” she said.

Louise Sunshine, developer director of Alexico Group, a real-estate development company in New York, agreed. “People are much more conscious of what they are paying for,” she said. “Last year they were over-the-top in terms of luxury. This year it’s not quite as frivolous.”

For 2008, it is back to basics and, in real estate, that means space, location and lighting, according to Mr. Burger. “These are the fundamentals that you can’t change, and they are crucial at the top of requirements,” he said.

Buyers with whom Ms. Sunshine worked “are looking for more at-home amenities.” She cited sales at the Laurel condominium on the Upper East side, a building that includes a triathlon training center, a family lounge, game room, arcade, computer room and library. She explained that, for families living at places like the Laurel, “the public spaces of the building are extensions of their home space,” and they want to make sure they have top-notch amenities if they are paying top dollar.

But despite the desire to have more space or a better location, market turmoil is causing some buyers to hold on to their properties for a little bit longer. For example, some buyers with whom Ms. Forbes is working decided to put off making a real-estate decision. “They’re deciding to wait six months,” she said. “Or if they’re bidding on something, they’re just giving the asking price.”

Ms. Tagliamante said that at the end of January when the stock market fell, two purchasers withdrew offers. “One tried to renegotiate the price for about 10% less than what they were expected to pay,” she said.

Compounding the situation is the shortage of luxury properties on the market. According to Jacky Teplitzky, a managing director at Prudential Douglas Elliman in New York, the number of luxury apartments (including co-ops and condominiums) fell 35% to 887 units for the fourth quarter compared with the fourth quarter of 2006.

Ms. Forbes said there has always been a scarcity of luxury apartments above the $5 million mark, and Ms. Teplitzky said one reason for the shortage of Park Avenue and Fifth Avenue apartments “is that people are staying put because they want to see how this situation will play out,” she said.

Agents said that, despite the uncertainty of the financial markets, they are still making deals, citing the condominiums at the Laurel, 15 Central Park West and the New York Plaza at Fifth Avenue and Central Park as prime locations of interest.

“Clearly, 2007 was the year the Manhattan residential real-estate market hit its peak levels across the board,” said Mr. Burger. “In 2008, the sentiment is that there’ll be a certain leveling off.”

Write to Josée Rose at josee.rose@wsj.com

 “The system has just completely frozen up – everyone is hoarding,” says one bank treasurer. “The published Libor rates are a fiction.”

Sense of growing crisis over interbank deals

By Gillian Tett

FINANCIAL TIMES

Published: September 4 2007 21:34 | Last updated: September 4 2007 21:34

As bankers have returned to their desks this week after the summer break, they have been searching frantically for signs that the markets are gaining a semblance of calm after the August turmoil.

However, the money markets are notably failing to offer any reassurance. While the tone of equity markets has calmed, the sense of crisis in the interbank markets actually appears to be growing – especially in London.

In particular, the cost of borrowing funds in the three-month money markets – as illustrated by measures such as sterling Libor or Euribor – is continuing to rise, suggesting a frantic scramble for liquidity among financial groups.

This trend is deeply unnerving for policymakers and investors alike, not least because it is occurring even though the European Central Bank and the US Federal Reserve have taken repeated steps in recent weeks to calm down the money markets.

“What is happening right now suggests that the moves by the Fed and ECB just haven’t worked as we hoped,” admits one senior international policymaker.

Or as UniCredit analysts say: “The interbank lending business has broken down almost completely . . . it is a global phenonema and not restricted to just the euro and dollar markets.”

If this situation continues, it could potentially have very serious implications.

One of the most important functions of the money markets is to channel liquidity in the banking system to where it is most needed.

If these markets seize up for any lengthy period, there is a risk that individual institutions may discover they no longer have access to the funds they need.

This danger has already materialised for vehicles that depend on the asset-backed commercial paper sector – short-term notes backed by collateral such as mortgages.

In recent weeks, investors have increasingly refused to re-invest in this paper.

As Axel Weber, a member of the ECB council, admitted this weekend: “The institutions most affected currently are conduits and structured investment vehicles . . . Their ability to roll these short-term commercial papers is impaired by the events in the subprime segment of the US housing market.”

This problem is affecting the wider banking system because these vehicles are now tapping other sources of finance – mainly liquidity lines from banks.

It appears that the prospect of receiving new liquidity demands has prompted banks to rush to raise funds – and, above all, hoard any liquidity they hold.

The high demand from banks to secure liquidity for the next three months, coupled with their desire not to lend out what liquidity they have, has made it virtually impossible to execute trades – even at the official prices quoted for such borrowing.

That has created some extraordinary dislocations such as the fact that the cost of borrowing three-month money in the sterling Libor markets is now higher than borrowing six-month or 12-month money. “The system has just completely frozen up – everyone is hoarding,” says one bank treasurer. “The published Libor rates are a fiction.”

This situation could become increasingly dangerous in part because many other markets, such as swaps, are priced off the three-month Libor and Euribor rates. So the interbank freeze could have knock-on effects throughout the financial system.

A more pressing problem is the large volume of asset-backed commercial paper due to expire in coming weeks, which is set to increase the scramble for cash by the banks. “Money market stability needs to return as soon as possible,” says William Sels, of Dresdner Kleinwort. Jan Loeys, of JPMorgan, notes: “The longer it lasts, the greater the risk that the current liquidity crisis will worsen.”

The crucial uncertainty is what, if anything, policymakers can do to combat the sense of panic. Some observers hope the problems in the sterling market, at least, may dissipate when the current maintenance period at the Bank of England comes to an end.

Others, such as Mr Weber, have suggested that banks themselves need to raise more funds in the capital markets to meet liquidity calls. However, many private sector bankers, for their part, say that radical steps from the central bankers are needed to remove the sense of panic.

Whether the central bankers are willing or able to really help – in the UK or anywhere else – remains the great question.

Additional reporting by Paul J Davies

Copyright The Financial Times Limited 2007

http://www.ft.com/cms/s/0/d7a4be24-5b1c-11dc-8c32-0000779fd2ac.html

The quest for alpha

Chris Skinner on developments in cross asset trading and the search for liquidity.At a recent conference, one of the speakers started by saying: “Alpha is what it is all about.” He got this look of interest from half the audience and confusion from the other half. After all, much of what goes on in the investment markets is about as understandable as Greek, excluding those of you living in Greece of course. Alpha is all about finding liquid markets to gain higher margins and increased returns. Liquid markets are becoming harder to find as technology opens access for all, and the search for alpha is all about the search for liquidity. What are the major trends in this area?

It is probably worth saying that the chap at the conference who was discussing alpha was me. I had been tasked with presenting the logic for multi-asset class trading, or cross-asset class trading as some refer to it.

I define cross-asset class trading as the ability to trade in equities, fixed income, futures, options and foreign exchange in a single transaction.

Not everyone agrees with that definition as we are currently a long way away from the ability to deal in all markets globally across all instruments today, but this is surely where we are striving to get to.

How this is delivered is also open to question. For example, some people talk about multi-asset trading as being in a single transaction on a single screen using a single platform. Again, that is taking things further than I would push them, as some people do not want a single screen and others think, in today’s world of service oriented architectures, a single platform is not required either. Therefore, I will stick to my definition of trading in as many instruments as I want globally in a single click. That is what cross-asset class trading means to me.

The reason people want this from their technologies is due to the search for alpha - the search for the most liquid markets and the highest returns. In particular, hedge funds have driven this trend.

Hedge funds are becoming the leaders of the pack in terms of setting the buy-side trends. As one asset manager said to me recently, “I used to compete with tracker funds and indices, then with Merrill Lynch Investment Management and now with the merged BlackRock” who, as it happens, recently merged with Merrill Lynch Investment Management.

BlackRock is a mixture of fund management, hedge fund and fund of fund, and is one of the largest asset managers. “As of June 30, 2006, BlackRock’s pro forma assets under management totalled $1.045 trillion across fixed income, liquidity, equity, alternative investment and real estate strategies.” In other words, BlackRock is providing cross-asset class fund management.

BlackRock is not alone. For example, one of the largest hedge funds is Citadel whose home page says: “Our team of professionals allocates investment capital across a highly diversified set of proprietary investment strategies in nearly every major asset class.”

Question: Why are the hedge funds so focused upon multiple asset classes?

Answer: The search for liquidity.

What is actually happening is that the markets worldwide are automating the easy using cross networking index-tracking technologies. In other words, the traditional fund manager now has the low-cost technology infrastructure in place to provide passive fund management that purely keeps track of the FTSE’s and S&P’s of this world. What the institutional investor wants is therefore humans traders involved in designing asset allocation strategies and portfolio analytics that are far out-stripping the general stock indices. They are challenging traders to really deliver value-add; and the value-add is higher returns with lower risk. That is what they expect, and are getting, from the hedge fund and other alternative investment market players and that is why more and more investment is being pooled through the hedge fund markets.

You only need to look at these two statistics to see what is happening:

• Assets under management of the hedge fund industry totalled $1.225 trillion (Q2, 2006) up 19% on 2005 and twice the total of 2003;
• Hedge funds account for 32% of credit-default swap sellers and 28% of buyers, up from 15% and 16% in 2004.

Hedge funds are driving the markets, the investment pools, the liquidity, because hedge funds are delivering higher returns with lower risk to the institutional investor.

Just look at the volatility of active fund managers dealing primarily in equities versus hedge fund managers dealing in all asset classes. The active equity manager delivers higher returns on some occasions, but lower returns at others. There is also little predictability. Meanwhile, the hedge fund manager buys equity and hedges it with a buy-write, an option that offsets the risk. As they do this, they are delivering higher returns more consistently, more predictability, more reliably.

To illustrate the point, TowerGroup analysed the market movements between 1998 and 2005 in the USA. Equities delivered an average performance of 3.78% with volatility of 18.26%, whilst hedge funds delivered 12.23% performance returns with only 12.06% volatility. Which would you prefer?

That is why the hedge fund markets are soaking up institutional investors’ assets, as the buy-side moves from active equity fund management towards alternative investment strategies using hedge funds to manage the portfolio.

How do the hedge funds deliver such returns with low comparative volatility?

Arbitrage.

What the hedge fund manager does is finds arbitrage opportunities. For those unfamiliar with the area, arbitrage is a fundamental of derivatives, hedge funds and the capital markets, and is basically finding price differentials between assets so that you can make a quick buck.

Rather than making up my own example of how it works, here’s one from Wikipedia:

“Suppose that the exchange rates in London are £5 = $10 = ¥1000 and the exchange rates in Tokyo are ¥1000 = £6 = $12. Converting ¥1000 to $12 in Tokyo and converting that $12 into ¥1200 in London, for a profit of ¥200, would be arbitrage.”

That is a very basic version of arbitrage. In fact it is so basic, it hardly ever happens as hedge fund managers push these strategies further and further. The first push was through black box algorithmic and program trading strategies where the hedge funds put all of these complex rules into trading engines that look for real-time arbitrage. An example would be:

(i) if Microsoft’s price drifts 2% outside the Volume Weighted Average Price (VWAP) during any fifteen minute period; followed by
(ii) the S&P500 moving by 0.5%; whilst
(iii) dollar:yen spread pricing moves up or down by 0.05%
(iv) all within a two-minute period; then
(v) buy Microsoft with a Dollar spot-forward option

Even that’s nowhere near as complicated as some of the hedge fund multi-asset trading strategies being used today. In fact, the hedge funds are heading towards multi-everything - multi-asset, multi-venue, multi-country, multi-broker … in real-time, 24*7, globally.

This is because hedge funds are increasingly being driven to deliver greater and greater returns to their clients and so it’s all about the search for alpha - the search for liquidity.

The thing is though, that the arbitrage strategies outlined above - where you are trading across multiple assets and markets with multiple data streams involving complex, time-critical event sequences under real-time constraints - would have been impossible a few years ago.

What has happened?

Technology.

The technology drive is delivering cheapness of processing, networking and connectivity, combined with increasingly powerful application solutions and services. And many of these solutions can be dropped in anywhere through SOA.

This means that the hedge funds are pushing the boundaries of what technology can do more and more each day. They have to, in order to find liquidity. That is why it is no longer good enough just to have a black box algorithmic trading strategy. Hedge fund managers want rocket science, not black boxes (for more on this see Tools of the trade).

That is also why the markets are moving towards multi-asset dealing … because they can. The fact is that the markets are no longer bounded by execution venue, exchanges, geographies, brokers and dealers. There are no boundaries in today’s markets. The markets are liquid and trading moves to where liquidity is highest.

That is why the sell-side is responding by extending their services to cover all the bases required for liquidity. That is why many of them have acquired Execution Management Systems (EMS) in the last year or so, such as Goldman Sachs’ purchase of RediPlus, Citigroup’s buyout of Lava Trading, Lehman Brothers’ absorbing RealTick and Nomura’s recent swallowing of Instinet and Chi-x.

In fact, Order Management Systems (OMS) and EMS is all becoming blurred as we move into Advanced Execution Systems (AES). AES tries to deliver a truly integrated buy and sell side through technology. That is why trading, dealing and execution are all becoming seamless, as brokers place execution engines into exchanges through co-location services across integrated OMS and EMS. The result is that the dealers who can provide liquidity by placing business the fastest in real-time will be the winners.

The thing is though, that the sell-side may be placing a nice veneer over their systems by acquiring, combining and front-ending but, behind the scenes, many are desperately trying to keep up with the demands of today’s markets.

As hedge fund managers demand high-speed, low latency connections across all execution venues of choice, sell-side players are struggling.

The trouble is that a lot of these broker-dealers are sitting with old structures and processes still in place. So, we talk about multi-asset trading and you look under the roof of most brokerage houses and find they have an integrated multi-asset dealing desk … but underneath the desk are all the old cables, pipes, silo’s and functions. In other words, an integrated dealing desk backed up by a multi-platform, multi-function middle and back office.

This will not deliver on the promise that the hedge fund folks are after. They want truly integrated globalised markets, not some fudged together sticking plaster with a patchwork quilt of technology behind it. Added to which, the more that systems are front-ended and non-integrated, the more latency in the systems. And latency is what it’s all about. Those who shave off the nanoseconds are winners.

That is why the winners will be the Tier 1 broker-dealers, who are now leveraging their technology budget to build truly integrated capabilities across all execution venues, including their internal ‘dark pools’. Dark pools are financial markets not available or visible to the general public, such as orders on a broker’s internalisation engine made available through an electronic cross network (ECN), with a great example being the recent dark pool launched by Instinet and Credit Suisse.

This means that the heavyweight players - UBS, Citigroup, JPMC, Goldman Sachs, HSBC, Merrill Lynch and so on - will all be able to leverage their multibillion dollar technology budgets whilst the rest will be struggling. After all, if you cannot provide liquidity with low latency across global markets and instruments, what can you provide? That is the question being asked of the exchanges.

The stock exchanges were fine as liquidity pools for trading in the equities of their national markets a decade ago, but today - in this globalised cross-networking cross-asset class, multi-everything world - what is the role of an exchange?

That is the question and challenge being raised from all angles. By regulators through MiFID and RegNMS. By markets, through multi-everything hedge strategies and sell-side pressures to deliver anytime, anywhere execution. And by technology providers as they develop new algorithmic, all-singing all-dancing order management and execution management systems. No wonder we are seeing the bloody battles amongst exchanges to increase their critical mass for liquidity.

The most aggressive player appears to be the NYSE who not only has expanded their geographic footprint through the purchase of Euronext, alongside investments in the India’s National Stock Exchange (NSE) and possible deals with Japan, but has also expanded its offer from pure equities trading through to multiple products and trading platforms covering cash equities, exchange traded funds (ETFs), options, bonds and other new businesses.

This is the nature of the new world of multi-everything.

Exchanges are competing with sell-side for liquidity and execution, whilst the buy-side are being led by complex globalised hedge fund strategies as investors seek the funds that deliver the highest returns with the least volatility. All of this being driven and supported by low latency, low cost, highly networked and globalised technologies, applications and systems which interconnect and deal continuously in real-time,

In some ways, I cannot believe that I wrote that last paragraph because, ten years ago, the fund management world was being rattled by low-cost automated tracker funds that followed the market indices. That was nothing compared to what we see today, with hedge fund globalised arbitrage trading across all asset classes, brokers, markets, venues, exchanges, networks.

The technology deployed ten years ago was the leading-edge at the time, but was nothing compared with the grid, blade, IP networked, real-time world we deal with today. Almost like comparing the first space rockets with the space shuttle, the tracker fund computing of 1997 is antiquated when compared with hedge fund algorithmic computing of 2007.

Ten years from now, will this force for complexity continue?

Probably.

The longer-term will see more specialisation of boutique brokers around technology plays which allow direct connectivity for rocket scientist fund managers to create the most automated, globalised, macro-trading arbitrage strategies around micro-market, micro-volume block executions.

The day of the multi-everything fund is already here. The day of the multi-everything at a micro-level fund is the next game. The game of trading in fractions of markets using pieces of instruments in faster and faster volumes. The game of using nanosecond arbitrage to deliver alpha returns. The game of searching for alpha: the game of searching for liquidity…

…either that or someone will pull the plug on all the systems and we will all return to open outcry.

Chris Skinner is CEO of Balatro, chairman of the Financial Services Club, and a director of TowerGroup.

Web links: www.towergroup.com, www.fsclub.co.uk, and www.balatroltd.com

Author’s email: Chris Skinner

http://www.finextra.com/fullfeature.asp?id=861

Contents

1. Credit derivatives: a brief overview

2. The credit derivatives market

3. Main uses of credit derivatives

4. Floating-rate notes

5. Asset swaps

6. Credit default swaps

7. Total return swaps

8. Spread and bond options

9. Basket default swaps

10. Portfolio default swaps

11. Principal-protected structures

12. Credit-linked notes

13. Repackaging vehicles

14. Synthetic CDOs

15. Valuing defaultable bonds

16. The credit curve

17. Main credit modeling approaches

18. Valuing credit options

19. The basics of portfolio credit risk

20. Valuing basket default swaps

21. Valuing portfolio swaps and CDOs

22. A quick tour of commercial models

23. Modeling counterparty credit risk

24. Anatomy of a CDS transaction

25. A primer on bank regulatory issues

App. A Basic concepts from bond math

App. B Basic concepts from statistics

 

Understanding Credit Derivatives and Related Instruments
	Quality:
	Technical:
	Author:		Antulio N. Bomfim
	Year:		2005
	Edition:		1
	Publisher:		Elsevier
	Format:		Hardcover
	Pages:		339

http://www.riskbook.com/link_topic/risk_management_liquidity_risk.htm