at ICAP: RESET & ReMATCH
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1 Basis Risk Mitigation services at ICAP: RESET & ReMATCH Guy Rowcliffe CEO RESET and BRM Group July 2012
2 Definition of basis risk Basis Risk is defined by the Derivative Consulting Group Glossary as: The risk of loss arising from the difference between the economic or legal terms of two derivative transactions that are intended to hedge each other Investorpedia.com explains this further: What Does Basis Risk Mean? The risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other. This imperfect correlation between the two investments creates the potential for excess gains or losses in a hedging strategy, thus adding risk to the position 2
3 Risk mitigation services at ICAP ICAP own and operate two industry leading basis risk mitigation services: RESET and ReMATCH RESET reduces the basis risk from fixings on financial instruments such as term rate fixing risk, FX non-deliverable forwards (NDF) fixing risk and inflation fixing risk. It also addresses structural imbalances within trading portfolios such as floating/floating basis ReMATCH rebalances the illiquid basis and market risks inherent in many Credit Default Swap (CDS) portfolios Both technologies remove significant quantities of these second order risks from the market and operate in ways distinctly different to voice and electronic market places 3
4 Understanding a leading risk mitigation platform To set the scene, it is best to take a look at perhaps p the largest basis risk mitigation platform in the market today and answer the following questions: What do RESET do? How do they do it? Why is it of value to their customers? 4
5 Some key facts about RESET RESET transacts significant risk mitigating trade volumes and its use is widespread d across the trader community: Total notional volumes traded since inception: $900+ trillion 375 client banks and 3,000+ individual users 700, transactions last year or more than 2,500 per day 5
6 RESET risk mitigation RESET provide a service which focuses on risk mitigation in the interest rate derivative market RESET enables banks and their traders to execute Forward Rate Agreements (FRA s) s), Single Period Swaps (SPS s) s), and Non Deliverable Forwards (NDF s) to offset, remove or reduce the outstanding reset (or fixing) risk from their trading portfolios 6
7 Reset or fixing risk explained What is reset or fixing risk and where does it come from It is a 2 nd order risk within interest rate derivative portfolios resulting from the structure of the instruments traded and a mismatch of exposures over time It is an unwanted by-product of the core trading activity 7
8 IRS floating rate cashflows 8
9 IRS floating rate fixing 9
10 IRS floating rate fixing 10
11 How RESET operates RESET Traders fill in Once filled Sophisticated RESET sends sends a Portfolio spreadsheet on day of run their matching options, credit limits for counterparties in, it is ed back to RESET proprietary algorithm and multi year risk management expertise trade results back to the trader and to all customers and position interests before a specified cut-off point confirmations go to back office 11
12 How RESET operates in detail We provide a preset mid market curve (there is no bid/offer spread) with FRA prices for every day s value out to approximately 1 year in the future These are the prices at which all participants will trade if liquidity and individual matching criteria allow The curve is a snapshot of the market determined from a poll of market participants All potential participants receive the prices before executing any trades The service allows only market neutral transactions. Every buy must be offset by an equal and opposite amount of notional sell (just for different future value dates) Every trader can individually select from a number of standard matching criteria and restrictions that determine which combinations of offsetting trades can be done, from the full set of positions submitted to the service. Each selected criteria or restriction is incorporated into the algorithmic solution o The service is only run periodically (not daily or live). For example, in liquid currencies such as USD, it is run weekly every Monday Traders submit portfolios during the late afternoon and execution only occurs overnight, once all the data has been collected and the matching algorithm run on the full data set 12
13 Why RESET is valuable to our clients 1 basis point on $1m for 3 months is worth approx $25 In a $400m deal that is a risk of $10,000 per basis point move in Euribor/Libor, every 3 months, for the few days between offsetting fixings Portfolio owners will have fixings of this type nearly EVERY SINGLE DAY Average daily Euribor/Libor volatility reached as high as 8-10 basis points during the credit crisis Removing offsetting positions removes exposure to this risk and is demonstrated graphically on the next slides 13
14 Typical IRS portfolio fixing exposures (client X) 14
15 Same client X portfolio after a RESET run 15
16 Now moving to ReMATCH ReMATCH was established by ICAP in 2009 to perform basis risk mitigation for credit derivatives Credit derivatives market size in gross notional outstanding: $25 trillion (DTCC) Credit derivatives market size in net notional outstanding: $2.5 trillion (DTCC) However, there is a significant risk management challenge: Net Open Position (NOP) is a multiple of net notional outstanding NOP adds all net notionals per maturity date across the curve Net notional risks change quarterly for individual market makers Managing micro curve risks is extremely difficult Exiting of odd-dates is often cost prohibitive Little liquidity Curves are hard to define Results in accumulations of unwanted risk 16
17 ReMATCH ReMATCH offers a solution ReMATCH s proprietary technology allows clients: Access to pooled liquidity on many maturity dates; allowing the opportunity to exit these forward risks Mid-market execution which removes prohibitive crossing of bid-offer The ability to rebalance their portfolios utilising a range of powerful controls A discreet moment for the industry to access across-the-curve liquidity ReMATCH success in this area: Over $600 billion in NOP reduced Deep penetration into the topical Western Sovereign and Emerging Market Sectors New solutions; Working with industry experts to development of a solution 17 to mitigate additional second order risks; such as Quanto
18 Portfolio risk mitigation methodology (generic) CLIENTS: Client 1 Client 2 Client 3 Client 4 Client 5 3 KEY CLIENT INPUTS: Curve Opinions Risk Portfolios Risk Constraints P&L Tolerance PLATFORM ACTIONS: Curve Normalization & Smoothing Matching Algorithms Platform output: Bulk Trades ALL AGREED: Trade Execution and Processing 18
19 Characteristics of RESET and ReMATCH compared to ICAP s voice and E-Platforms Feature Platform type Voice or Reset ReMatch E-Platform Price determination Bid-offer Platform sets a mid market price Market type Continuous Regular scheduled (weekly or less frequent) Platform sets a mid market price Irregularly scheduled Risk positioning Individual risk assuming Bulk risk mitigating Bulk risk mitigating Risk input Individual trade interest Portfolio level risk interests Portfolio level risk interests inc bid or offer Execution model Trader driven execution Platform determined execution Platform determined execution Results Individual transaction Bulk runs of transactions Bulk runs of transactions 19
20 Revenue models Generally they follow the same charging methodologies as the voice businesses and established norms for the products traded. d So vary from fractional percentages on notional amounts and linked to the tenor of trades to fixed amounts per million traded Across both businesses and all products it is a varied value proposition. Charges should be viewed in relation to the underlying volatility of the risk they reduce and the liquidity of the relevant market The scale of charges goes from a significant discount to voice execution where volumes are high, liquidity good, and underlying volatility low.to a premium in the more illiquid, highly volatile markets where the risk mitigating value is particularly high 20
21 Performance and opportunity These basis risk mitigation technologies remove significant risk from the financial system. An increasingly valuable capability in today s regulatory and risk focussed environment RESET and ReMATCH showed a 13% increase in revenues last year despite an economic backdrop of persistent, low and stable interest rates. This is a fundamentally unattractive environment when you consider that LIBOR volatility should be the main demand driver for significant areas of the core business In the case of RESET expansion of services into additional markets and asset classes such as inflation, floating/floating g basis and government bonds have been major steps towards leveraging both the core business model and the strength of the ICAP franchise. Additional opportunities and projects are in development In the case of ReMATCH direct potential within its original core area remains untapped whilst additional types of basis risk within the CDS space present significant opportunity. A Quanto service was launched last year to significant success and more recently an Indices product has been rolled out 21
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