Leverage OTC Clearing & Interdealer Risk Management

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1 OTC Clearing, Volcker Rule and Transaction Strategy: Changing market dynamics & liquidity for Corporate Treasurers Presented by Larry Tabb (Founder & CEO) PRMIA Global Risk Conference New York, NY May 2012

2 Agenda OTC Clearing Margin the critical determinant Basle III Capital the other lever Volcker How do you define prop trading What does this mean to the corporate treasurer? 2

OTCD reform primary focus: reducing systemic risk and increasing overall market transparency Source: TABB Group Focus High Level Concerns Clearing All Eligible Products must be cleared; End users

3 OTCD reform primary focus: reducing systemic risk and increasing overall market transparency Source: TABB Group Focus High Level Concerns Clearing All Eligible Products must be cleared; End users exempt Regulators determine eligibility Hedge exemption may create loopholes Trading Cleared contracts must be traded on a BOT or SEF Unclear if matching utilities can register as SEF Trading requirement doesn t apply if no SEF or BOT offers trading Registration Reporting Dealers & Mgr Swap Participants must register. Capital will be more tightly regulated All OTCD must be reported to a trade repository Dual registration with SEC & CFTC w/be Operational nightmare Key terms are still undefined Unclear how regulators will monitor systemic risk Multiple repositories & clearinghouses limit transparency

4 Goal of G20 is to change derivatives market. The existing market is bilateral with dealers in the middle Hard Inventory Corporation (end user) Existing Market Structure Futures Exchange Corporate End User Minerals Accept Dealer 1 Inventory Bid Hedge Fund Asset Valuation/ Agriculture Balance Sheet Risk Energy Treasurer Bid Bid Dealer 2 Dealer 3 Asset Manager Inter-dealer broker Currency Corporate End User Asset Manager Corporate end users accumulate risk through their day to day business. This could be inventory, commodities, currencies, credit or interest rate risk. They work with dealers to model the risk and solicit bids from one to multiple dealers to hedge that risk. The corporate treasurer picks a dealer who wins the deal. The dealer typically will try to find and end user or a financial institution that wants the opposite risk and will try to sell it to another counterparty. Sometimes the dealer with use and Interdealer broker to lay off the risk with another dealer Source: TABB Group 4

5 Regulations propose forcing standardized swaps to be matched by SEF, centrally cleared, & centrally reported Trade Info Source: TABB Group 5 Hard Inventory Minerals Inventory Agriculture Energy Currency End User Corporation (end user) Treasurer Asset Valuation/ Balance Sheet Risk Bid Bid Bid Accept Proposed Market SEF Members Large Dealer 1 Large Dealer 2 Large Dealer 3 SEF Trade Info & Market Data SEF Members Dealer 1 Clearing Firm 1 Prime Broker 1 Clearing Fund Margin Asset Mgr Trades & Margin Small Dealer 1 Hedge Fund Prop Shop Hedge Fund Insurance Co Asset Mgr Hedge Fund Insurance Co Trade Clearing Repository House

6 Log Scale Basis Points (bps) (Log Scale) Basis Points (bps) (Log Scale) Multi-lateral trading reduce spreads & OTCD cost structure but when looking at spreads in bp $10,000.0 Bid-Ask Spread Comparison First Million E-02 Bid Ask Spread Comparison Same Day, Same Time (for ETD) 30y IRS Fut $1,000.0 $100.0 $10.0 $1,500 $400 $50 $25 $18.75 $7.83 OTC CDS Single (HY) CDS Single (HG) CDS Index (HG) 10y IRS CDS Index (HY) 1.0E E E E S&P 500 Fut CDS Single (HY) CDS Single (HG) CDS Index (HG) 10y IR Swap CDS Index (HY) $1.0 $0.1 $0.0 $0.500 $0.400 $0.018 $0.010 ETD 30y IRS Fut Eurodollar Fut S&P 500 Fut 5y IRS Fut 30y T-Bond Fut 1.0E E E y IRS Fut 30y T-Bond Fut Eurodollar Fut Source: CME, TABB Group

7 Transition from OTCD to ETD infrastructure shifts cost this needs to be managed or it will backfire For illustrative purposes only Implicit and Opportunity Costs Bid / Ask Margin Implicit and Opportunity Costs 50% 50% 40% 35% 30% 30% Explicit Costs Admin/Legal Clearing Exchange New Costs 50% 10% 20% 20% 30% 35% 15% 10% 10% 10% 10% 10% 70% Broker Fees Explicit Costs 20% 15% 5% 5% 10% 10% OTCD ETD Bilateral (Pre- 2008) Transformation ( ) Reform ( ) Exchange/SEF (Post ) Broker Fees Admin / Legal Fees Exchange Fees Clearing Fees Margin Bid-Ask Spread

8 US$ Billions US$ Billions As OTCD shifts to cleared, market is ~2t undercollateralized; however, may only need to raise $240b 5,000 4,000 3,000 Gross Credit Exposure (GCE) Collateral Commitment (Single Counted) % of GCE Growth of Collateral in OTCD 45% 45% 3,520 50% 40% 30% 2,000 1, ,576 20% 10% 0% 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1, Targeting OTCD Collateral Requirements Comparison of the ETD and GCE Margin Benchmarks Source: BIS, ISDA,TABB Group 1,900 2,036 1,545 2,014 3,508 3,256 4,699 4, GCE Benchmark ETD Benchmark 3,776 3,520 8

9 Margin, % of Notional (log scale) Margin, % of Notional Posting initial margin changes the entire cost analysis of OTCDs vs other risk transfer products 18% 16% 14% 12% 10% 8% 6% Sample Initial Margin Levels ETD/OTCD Rates Derivatives In some cases, astronomical margin levels for uncleared and/or long duration risk transfer products could virtually kill off certain products. 4% 2% Maturity (years) 0% CME Futures (Customer) CME Futures (Member) ERIS Futures CME OTC USD IRS LCH OTC USD IRS Uncleared OTC (Futures Mulitple) Uncleared OTC (Cleared Swaps Multiple) Source: CME, LCH, ERIS, CFTC, TABB Group 10.00% 1.00% 0.10% 0.01% Maturity (log scale)

10 While end-users were specifically carved out of Dodd-Frank, the ll be dragged in the back door Hard Inventory Minerals Inventory Agriculture Energy Currency End User Corporation (end user) Treasurer Asset Valuation/ Balance Sheet Risk Swap Balance Sheet Capital Charge Dealer SEF Margin Asset Mgr, HF, or Ins. Co. Dealer Clearing Fund Margin If End-User does custom swap with dealer bank 1) If dealer holds subject to higher capital req. & Volcker 2) If dealer sells to other end user, and don t clear subject to higher capital on both sides unless they fully offset 3) If 2x end user and cleared - margin Source: TABB Group Clearing House 4) if dealer sells other side via SEF margin no offset Dealer costs with be higher 10

11 Basel III will force banks to have more capital also reduce demand for overnight money Ensure banks have larger capital cushion Move bank capital from 2% Tier I capital to 6% Tier I capital of risk-weighted assets With a 2.5% surcharge for larger organizations Also with a 2.5% pro-cyclical surcharge or relief Also new liquidity coverage ratios Requires banks to hold high-quality liquid assets to cover its total net cash outflows over 30 days This is a real challenge Most investment banks are financed overnight 11

12 Volcker rule is to stop proprietary trading Premise Banks should not be using federally guaranteed deposits, or central bank backstop to be making leveraged bets Ban short-term proprietary trading except for Customer facilitation trades Underwriting commitments Market making operations Trading is US Sovereign / and Govt backed debt Insurance companies for their insurance products 12

13 Problem is how do you define market making, or for customer benefit? Customer Dealer Customer transaction Market Dealer Market Market Making Market Dealer Market Proprietary Position Pre-position? Market Dealer Time Customer 13

14 Treasury points to prop as Employment of strategies using greater risk Market making needs to meet near term customer demands prop, no customer interaction Market making revenue fee driven Commissions and spreads rather than principal risk Salary & bonus structure focused on fees and not profits / balance sheet usage But --- many products are traded OTC out of a dealers inventory what is risk vs. what is prop? 14

15 Downside of an improperly defined Volcker Rule Dealers don t know bounds More likely not to take positions / risk to avoid Fines / penalties Bad press Dealers shrink from areas of greatest impact Illiquid products Illiquid debt Corporate bonds, Illiquid/custom swaps, lower quality ABS tranches Any trading product that there is not a liquid market 15

16 If banks / dealers leave these markets Spreads will widen Fewer customized products / illiquid products will be created Eventually an agency market will develop for more liquid products We would anticipate that newer players will move in Will be more like equities market than credit market Smaller dealers will have less capital Will be able to take smaller positions However most likely to leverage speed instead of balance sheet May see the development of HFTs in the credit space 16

17 From a treasurer perspective A moribund secondary market means Wider spreads on illiquid financial products Harder for all but the largest to issue debt (or equity) Debt will become more standardized (In attempt to make more liquid) And in best case, where HFTs move in Liquid products become more tightly quoted but illiquid stay moribund Also may content with fragmented execution infrastructure Basle III means less demand for overnight cash Lower interest on repo Incentives to push overnight investing out 30 days Swaps will become more expensive, dealers Will reserve greater capital or, Put up margin on your behalf 17

18 OTC Clearing, Volcker Rule and Transaction Strategy: Changing market dynamics & liquidity for Corporate Treasurers Presented by Larry Tabb (Founder & CEO) PRMIA Global Risk Conference New York, NY May 2012

Technology Implications and Costs of Dodd-Frank on Financial Markets. Larry Tabb Founder & CEO TABB Group

Technology Implications and Costs of Dodd-Frank on Financial Markets Larry Tabb Founder & CEO TABB Group CFTC TAC Washington DC March 1, 2011 Contents Workflows High Level Existing High Level Proposed