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Derivatives – what’s my problem?

Sometimes I can be very obstinate and unhelpful, and as with all of us I have particular bugbears that I can’t help but seize on in conversation. One of them is my seething resentment and annoyance when people say things like:

Derivtweet

I am a derivatives market professional. I eat sleep and breathe them – hopefully you can discern this from my paper portfolio posts, I freakin’ love the things:

 https://socialistinthecity.wordpress.com/2015/03/09/paper-portfolio-march-update/

But just because I love them doesn’t mean I unconditionally support them in all circumstances. I think of derivatives as being financial firearms. One may be fascinated with firearms, own collections of them, and use them for target shooting, but that does not mean one has to think that all civilians should be issued with one and told to crack on. When I step up to defend derivatives in a public forum, it is not because I believe they are an unconditionally good thing, but because accuracy is important, and alarmism distracts us from addressing the very real systemic financial issues we have. So let me clarify what exactly my problem is with the way people talk about them.

Joel’s tweet above is the most irritating bit of alarmism of all. Let me say this once and for all. The notional ‘size’ of a derivatives contract bears only incidental relation to the risk of that contract. Size does not matter. The cleanest, neatest way to place a bet on whether a Central Bank hikes interest rates is to do an interest rate swap that starts on the day of the next rate setting meeting, and ends on the day of the meeting after. One enters into a contract to pay a fixed rate, and receive the overnight rate at which banks lend and borrow. In Europe, this is called an ‘ECB EONIA’ swap. The standard traded size for such contracts is EUR 2.5bio. WHAT? 2.5bio??? Yes. I have clients who manage only hundreds of millions of Euros who trade these with me pretty regularly. How can they do this? Well, look at the actual cashflows, and there are only 2, at the end of the swap:

Fixed rate payer pays  Fixed rate * notional  * number of days/360

Floating rate payer pays  Average Eonia fixing * notional * number of days/360

Currently, the EONIA rate is -0.08%. Yes negative. Banks pay each other to borrow money.  So let’s say I think rates will go up, so I enter into this swap as the fixed rate payer at -0.08%, from one ECB meeting date (15-Apr) to the one after (03-Jun). Now lets say I ballsed up, and the ECB cut rates by 20bp, so the average EONIA fixing over the life of the swap is -0.28%. Surely I’m screwed? That is the worst possible outcome for me – I was betting on higher rates and they cut. And I did EUR 2.5bio! OH NO!

Well, it’s bad but not that bad. Actually, I only lost EUR 681,000, so 0.03% of the notional of my trade. Y’all can check my maths!

Not only does notional not matter, netting does. If I enter into the above swap with one of my counterparties, I’m probably going to want to hedge it by doing something pretty similar. And then that next guy is going to do something pretty similar too. And so on. And all of those trades will be counted into that $700trio number, even though no one in the chain of transactions has much actual exposure to the underlying.

Now this isn’t to say that derivs are safe or that notional doesn’t matter. Clearly, trades with bigger notionals and all other details identical are bigger. Equally clearly, if my client goes bust owing me a tonne of money, and I’ve got an offsetting trade to another guy where I owe him money, I’m in trouble. In a world where banks have captured regulators so effectively that they guarantee themselves state support if they get into difficulties, that could be a problem for everyone, but the issues is not the derivatives here, it’s the lobbying that created a situation where a few big players run the entire game and can’t be allowed to go bust. Regulation is part of the problem here. Only a few large players can, in the age of Dodd Frank etc, afford the overhead of the massive compliance effort to run a modern swap dealing operation. This is not to say that all regulation is wrong, but it is to say that the dominant model of a few humungous firms dominating the financial markets is the real issue.

And this is my real problem with the entire conversation about Derivatives, especially amongst the left. It feels like when you discover the derivatives market for the first time, you’ve stumbled on the source of all financial instability. The crazy notionals the arcane terminology, the ‘lack of regulation’ (love that claim, try working on a swap dealing desk…) etc. But you really haven’t. There is no purported problem that derivatives cause, systemic instability, mis-selling etc, that couldn’t be solved by removing the enormous power of the few large banks who run the financial game. The issue, as ever, is too much power with too few people. The kind of ‘OMG, $700trio!’ alarmism that dominates most of the conversation obscures the structural issues at the heart of how the financial system exploits the rest of the economy to enrich a few white old men, and it doesn’t help solve the problems.

PS: I LOVE explaining derivatives and any other financial market topics of interest to people. So please, ask me.

Definitions:

Swap: a financial contract where two parties agree to swap one set of cash flows for another. Typically, the expected value of these flows will be the same.

Interest rate swap (market standard): the standard for interest rate swaps is to exchange a fixed rate for a floating one. For example, one might enter into a swap paying 1.5% annually, and receiving semi annually whatever the £ 6 month libor rate turns out to be.

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22 thoughts on “Derivatives – what’s my problem?

  1. michael jones says:

    So, how was it that all those sme , cash rich breweries etc were sold swaps that went bad and killed them.eg m&b ?

    • simplysellside says:

      Ask the execs at the big uk banks who greenlit selling products with unlimited downside, or that weren’t true hedges.

      Even better, reflect on why these smes were dealing with some sales guy, not their branch relationship manager.

      The banking system in this country pits an economy of small and medium size firms against a few enormous banks full replete with lawyers, compliance officers and bright young things looking to make their mark. Smes need boring, small, local banks. We all do.

  2. Luke says:

    ” Y’all can check my maths!”

    It would be great if you actually set out your maths. Then we, the great unwashed, could check it.

    Remember you’re preaching to people who either never knew much maths, or haven’t done any since they left school.

    I have a maths/stats A level, A grade, but have not done anything more complicated than multiplication and division for thirty years. I don’t really know what “bp” are.

    I applaud your aims and I hope I don’t seem hostile, but if you aim to engage with non-finance bods, you have to come down a level. Or maybe decide it’s too complicated for us. (Maybe that’s true). I did understand the point about netting, btw.

    • simplysellside says:

      Thank you for commenting and not just going ‘uh f*ck this guy and his jargon’. Happy to explain!

      A ‘bp’ is 1/100th of a percent. You might also hear them called beeps.

      A swap is a generic name for any contract where one set of cash flows is swapped for another. In the case above, a fixed cashflow is swapped for one that is dependent on EONIA. If EONIA is high, the cash flow dependent on EONIA is higher.

      If I believe EONIA is going to go up, I therefore pay the fixed leg, and swap that for the EONIA leg, which I believe will end up being more valuable.

      You say you’ve done nothing more complex than multiplication, and thats all you need here! I’ve described both legs of the swap fully above so you can follow through the calculation.

      Its not complicated, just unfamiliar!

  3. Luke says:

    And another thing – you’re assuming we know what a swap is. I’m not sure if I do. Maybe, maybe not. I don’t know.

    Again, sorry to be argumentative to someone who is trying to explain things to non-specialists.

  4. Richard says:

    The issue with respect to gross notional is not that there is a much lower industry net exposure but that you can’t net after bankruptcy i.e. JPM and Citi couldn’t net out their Lehman derivative exposure with each other but both had to crystalise claims and rehedge their books. Whilst the next book hedge for the market was relatively small finding your offset was next to impossible and it was a mess. The most shocking thing almost 7 years on is that the industry has managed to stall the move to an exchange and central netting to a significant extent. As you point out this is partly a result of the increased size and strength of the biggest players.

    • simplysellside says:

      Indeed – though in fairness has something to do with RM going bankrupt if they had to pay margin to reflect the mark to market of their positions…

      Your point about notionals mattering for winding up after bankruptcies is true, but still truer of a 30y swap than a 1m so again, notional is only contingently important!

  5. Tim Bassett says:

    As someone who modelled plenty of derivatives and risk managed them the issue for me about notipnal is not the OMG numbers but accounting.

    Derivatives are zero sum activity (and negative after costs) but there is no mechanism to ensure that both parties merk using the same model/curve/vol/correlation etc; in fact a lot of structures are sold precisely because the buyer will not and both sides book a profit (eg many life expectancy type products). This leads to the issue that there is a phantom asset/liability accros the system as a whole – which do you think is more likely given even honest markers naturally shade their book

    As long the notional grows the phantom asset gets bigger and nobody care but if it starts to shrink then it starts to be unwound and losses appear.

    To estimate the size of this asset we must multiply the semi-gross (sum of institutions individual gross after netting internally stuff marked of same curve etc) by an estimated frictional amount eg 10bp and an estimated DV01. Even if you use pretty conservative numbers you still get to something quite large.

    Until we enforce a common year end and full reconciliation (my asset must equal your liability) we will never know – the rather ironic thing being that crude valuation system wide would produce less macro errors than everyone trying to be the most accurate but disagreeing slightly.

    The issue is not confined to derivatives, also applying to many other accounting assets/liabilities with derivative like aspects (eg long term contracts, biological all assets) but derivatives the one with the most systematic danger (plantation cos go bust all the time without many people caring, banks not so much)

    • A common year end reconciliation is a fine idea – if you have written anything on that, or have any links, please do post for the benefit of others.

      Also note your own typo:

      “there is no mechanism to ensure that both parties merk using the same model”

      Merk = London slang for kill – how prosaically appropriate 🙂

  6. Adam says:

    I checked your maths. I get around -14k EUR. It sounded like you were saying the swap maturity was 1 day (but maybe it was 2, either way I don’t get your answer). P&L=(fixed rate-floating rate)*notional*days/360 = (-0.28% + 0.08%) * 2.5e9 * 1/360 = -13,889

  7. BigAl says:

    As you allude to in the piece the issue with derivatives is that they are like financial firearms, but the licensing is nowhere near as strict (well at least in the UK).

    Transparency is key and as shown by many of the misselling scandals, clients buying swaps with more leverage on the downside than on the upside clearly didn’t understand what they were getting into (and these were relatively simple swaps or collars).

    When you get onto more structured products such as Target Redemption Notes or Snowball swaps they’re like weapons of mass destruction – both parties really need to know what they’re doing and that extends to modelling as Tim Basset points out above. The simplicity of the termsheet description belies the complexity required to model the damn things.

    So I second Tim’s suggestion above, especially for Structured products where initiaitives such as clearing and margining seen in simpler flow products are unlikely to ever come about.

    • simplysellside says:

      You’re right and not trivially right either! I’m coloured in my perspective as I’m a vanilla flow guy.

      I think however that the issue of there being uncertainties in marks and therefore reported market and counterparty risk would be greatly mitigated by reducing concentration. More players would mean a greater need for transparency. The problem for me remains too much power in too few hands. Crises like the savings and loans debacle teach us that systemic risks can still arise with more players, but also that such crises are resolvable in a way that doesn’t engender so much moral hazard.

      Thanks for the thoughtful response!

  8. Ty Kelly says:

    The Texan in me marvels at the use of “y’all” and “maths” in the same sentence. I hadn’t known that “y’all” was making inroads on British language, but am very sure that “maths” hasn’t made it to Texas!

  9. CreditRider says:

    Well, I am also a security guy and use derivatives and support most of what you say. But the critics have a point for several reasons:

    1) You are the middle man who does hedge his trades but the financial system has end users (hedge funds, pension funds, insurance companies, etc.) who do not hedge and use derivatives as a one way bet (to enhance yield in a low yield world) and those suffer if things go wrong.
    2) Your example above does intentially play with small numbers in deltas. 20 bps dip in rates at the short end is big but it is not at longer maturities of the yield curve, just remember that wild move in treasuries a few months ago.
    And increasing leverage in the system will probably make these moves even bigger today.
    3) Derivatives are increasingly used to enhance performance by mutual funds (as the IMF recently warned). That increases leverage in the system. And it does so because investors only have to put up small margins for high volumes of notional. If the market moves against them they quickly have to sell as they cannot bear heavy losses in today’s low yield world.
    4) You mentioned IRS as an example of derivatives. Fine. But there are also Credit Default Swaps (my field of experience) and FX derivatives. And volatility there can be much higher than in IRS which, in a selloff, speeds up selling and infects other derivative and cash markets.

    So the sum of 70 trn is not scary to me but who uses them these days scares me a lot.

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