The Cats and Dogs of Derivative Instrument Regulation

Posted by Susan Mangiero on July 07, 2011

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In survey after survey, capital market participants complain about regulatory overload and complexity. The last thing any compliance officer wants to have happen is that his or organization is trying to do everything right but ends up on the wrong side of the law because rules differ across jurisdictions. Then there are the clever arbitrageurs who recognize regulatory differences as opportunities to exploit loopholes.

In the case of the global over-the-counter derivatives market, sized in excess of $600 trillion in terms of notional principal amount, Reuters reporter Jim Brunsden describes disparate mandates from European Union and U.S. regulators, respectivley. According to "Differing EU, U.S. Derivative Rules May Discriminate, Groups Say" (July 6, 2011), margin amounts and "different sets of licensing rules on cross-border business" could introduce costly uncertainty for investors.

In a July 5, 2011 letter to The Honorable Timothy Geithner and Commissioner Michael Barnier, ISDA and other financial market organizations listed some of the extra-territorial concerns that should reflect coordination:

  • Licensing, authorisation or registration rules for entities to trade derivatives;
  • Application of margin requirements to banks, broker dealers and asset managers with operations throughout the world;
  • Extent to which foreign operating entities would be subject to competing authorities in multiple jurisdictions even when the parent entity is complying with home country regulations;
  • Standards for recognition of central counterparties ("CCPs") in each others' jurisdictions to minimize ambiguity; and
  • Indemnification provisions as relates to data collection by U.S. based Swap Data Repositories ("SDRs"), pursuant to the Dodd-Frank Act.

Those institutional investors that employ derivatives - directly or indirectly - are wise to track the regulatory discussions underway. Their costs, and related investment performance, are likely to be impacted by the constraints borne by major market dealers.

For further information, check out the following items:

Risk Management Survey Says More Work Is Needed

Posted by Susan Mangiero on July 05, 2011

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After the last few years, it seemed that risk managers were finally getting their due respect. Alas, a new survey suggests that more work remains to be done. According to "Too good to fail? New challenges for risk management in financial services" by Rob Mitchell with the Economist Intelligence Unit, "Inculcating and embedding a stronger enterprise-wide risk culture remains an ongoing challenge."

Sponsored by SAS, this March 2011 inquiry (and June 2011 report) finds that organizations still grapple with complexity, with about half of the 315 executives expressing concerns that their "employer's risk management processes are well placed to deal with volatility" and roughly one out of three organizations being able to thoroughly vet tail risk. (Note that "tail risk" is typically defined as the chance that investment prices or returns will be "extreme" in that realized performance falls outside of three standard deviations from the average.)

Other findings of the survey suggest that the risk management function is getting support, albeit limited, from atop the corporate food chain. More than forty percent of respondents announce that "their management boards have beefed up their risk expertise." One-half of polled professionals claim that "their boards are demanding more rigorous risk reporting."

A central message of the survey is that risk management reforms are underway but that risk management needs to be seen as less of a support function and more of a strategic mainstay that addresses organizational fortunes on a holistic basis. When asked about areas in which the skills of risk management professionals should be improved, one out of every three respondents cite the "ability to see the interdependencies between different categories of risks to the organisation."

Main barriers to effective risk management include regulatory uncertainty, "poor communication across departments," incomplete data, absence of authority for the risk management role, "lack of adequate investment" and poor real-time "(intra-day) risk management." With Basel III looming for a 2019 implementation, systematically important financial institutions ("SIFIs") could see profits lowered as capital requirements tighten, forcing more and better attention to be paid to the relationship between the cost of offering various products and services and risk mitigation.

In Risk Management for Pensions, Endowments and Foundations, Dr. Susan Mangiero talks about the urgent need for training across functions and job titles so it is alarming that 44 percent of respondents cite a 7 percent drop in the risk management training of the general workforce in 2011 from 2010. Fifty-four percent of risk executives describe a 9 percent decline in data quality and integrity with mergers and acquisitions leading to a related problem of disparate information technology systems. Without a good process in place to collect information, it is hard to measure and manage risks thereafter.

At a time when risk management is arguably as important as it has ever been in terms of protecting enterprise value, Financial Times reporter Justin Baer writes that "US regulators are warning banks to protect their risk-management staff and systems from any planned cost cuts as Wall Street grapples with a challenging year of meagre results." "US banks warned against shedding risk staff" references the Senior Supervisors Group of global bank regulators as urging financial institutions to do much more in the area of building a robust risk mitigation infrastructure.

Should an elephant fall, the audience will hear a thud. Should global financial institutions give short shrift to improving risk management policies, procedures, systems and practices (for those companies for which this applies), the economic "noise" will be deafening. Now is not the time to move backwards with respect to risk management.

Note to Readers:

SEC Proposals For Swaps Dealers - A Lot At Stake

Posted by Susan Mangiero on July 03, 2011

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In her June 29, 2011 comments, SEC Chairman Mary Shapiro laid out proposed rules for over-the-counter swaps dealers, pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act. In addition to mandating more and better communication about potential conflicts of interest (and related pay to play problems) for special entities such as pension plans, financial institutions will have to "provide the counterparty with information concerning the daily mark for the security-based swap." For ERISA plans, security-based swap dealers would likely have to transact via independent agents of the plan sponsors who in turn would be deemed fiduciaries.

Interested persons can respond to the U.S. Securities and Exchange Commission before August 29, 2011. Rules proposed by the U.S. Commodity Futures Tradign Commission ("CFTC") have generated a range of comments. One in particular caught my eye about the need to provide valuation numbers as well as scenario analysis results in the context of a pension plan's portfolio. Given the increased use of swaps by institutional investors around the world to manage risk, this notion has appeal.

Suggested links for readers include the following:

ERISA Fiduciaries Under Attack: Key Litigation and Regulatory Developments

Posted by Susan Mangiero on June 27, 2011

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Courtesy of Strafford Publications, Dr. Susan Mangiero spoke on the topic of ERISA investment fiduciary pain points and the role of service providers. She was joined by esteemed colleagues Andrew L. Oringer (Partner, Ropes & Gray) and Christine A. Dart (Vice President, Chubb & Son) in a lively and informative debate about current ERISA litigation trends, "must do" action items regarding ERISA fiduciary liability insurance procurement and the vetting of investment decisions relating to fees, third parties, use of derivatives, hard-to-value investing, leverage and risk management.

Click to read the transcript of comments by Dr. Susan Mangiero on the topic of ERISA investment fiduciary considerations.

Click to order a recording of the full 90-minute program entitled "ERISA Fiduciaries Under Attack: Key Litigation and Regulatory Developments."

Company Boardrooms and Pension Plans

Posted by Susan Mangiero on March 04, 2011

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Russell research strategist, Mr. Bob Collie, writes about the growing liabilities and assets of large public U.S. corporations. Large indeed!

According to 2010 data, 16 publicly traded U.S. corporations boast membership in what he refers to as the "$20 billion club." Their combined balance sheet liabilities of $740 billion or roughly 40% of corporate America's pension IOUs gives them investment muscle in terms of market price movement and influences what and how financial service providers deliver retirement plan solutions.

While improving economic conditions boosted assets by $21 billion to $619 billion, declining interest rates pushed liabilities upward wih a "total shortfall of assets below liabilities of $121 billion" or about the same as 2009 levels.

I concur with conclusions made by Mr. Collie that companies are going to be forced to reckon with their defined benefit plans. Figuring out where the cash will come from in order to write checks to participants is one challenge. Another task will be conducting a capital budgeting analysis of the money going to meet pension IOUS instead of investing in positive net present value projects. Notably however, studies do suggest that companies often need to provide good benefits in order to attract talent. This means that the costs of employee benefit plans (retirement, health, profit-sharing) must be netted against the expected advantages of having a productive workforce in place as a result of providing incentives.

A reasonable response by corporations would be to include retirement plans as part of enterprise risk management ("ERM") activities. However, in a study I conducted with the Society of Actuaries in 2008, the results were sobering. Specifically, "Pension Risk Management: Derivatives, Fiduciary Duty and Process" by Dr. Susan Mangiero summarizes survey results about ERM for 169 organizations with pension plans as follows:

  • Only 30% of companies that used derivatives in their pension plans had corporate Chief Risk Officers in place.
  • Of those roughly fifty organizations, only 25% of them or about 12 companies included pension plans as part of their corporate risk endeavors.
  • Only 25% of organizations that used derivatives in their pension plans had ever discussed a link between Sarbanes-Oxley obligations and ERISA fiduciary duties. For those organizations that did not use derivatives in their pension plan, only 19% had discussed corporate governance versus pension governance.

Note to Readers:

Regulatory Scrutiny of High Frequency Trading

Posted by Susan Mangiero on February 28, 2011

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In case you missed it, CFTC commissioner Bart Chilton gave a memorable speech about new species making their way into the financial ecosystem. Asserting that speculators are an important part of the futures market, Mr. Chilton adds that nearly $200 billion of money from hedge funds, pensions and index funds (what he labels the "Massive Passives") reflects concentrated positions that "has the potential of moving markets, of influencing true price discovery" and causing grief for "hedgers who use markets to manage commercial business risks." Until a new rule to mandate speculative position limits is in place, the regulators will need to track who does what and when and in what amounts. Click to read "New Species: How Market Participants Have Evolved in Financial Ecosystems: Speech of Commissioner Bart Chilton to the American Public Gas Association Winter Conference," February 1, 2011.

Elaborating on his animal kingdom analogy, he refers to high frequency and algorithmic traders as cheetahs and worries that "cheetahs could roil a market." He's right that technology is so much more powerful than in the past, allowing millions of dollars to flow within seconds. What is less clear is whether and how the CFTC and other regulators will slow down the pace to allow commercial hedgers to execute transactions at a reasonable price (if indeed the net economic effect of trading slowdowns will benefit hedgers).

To get a better handle on optimal policy, the U.S. Securities and Exchange Commission ("SEC") sought comments from the public in 2010 about equity market structure, including "high frequency trading, order routing, market data linkages, and undisplayed, or "dark," liquidity." In September 2010, the U.S. Commodity Futures Trading Commission ("CFTC") and the SEC presented their "Findings Regarding The Market Events of May 6, 2010" with a description of rapid price swings that day, the role of a large "algo" trader and the absorption of selling pressure by high frequency traders, fundamental buyers using futures and equity market arbitrageurs. According to "Flash crash report will not stop HFT debate" by Aline van Duyn and Telis Demos (Financial Times, October 5, 2010), three areas of concern remain:

  • Who should be constrained in terms of trading limits
  • How transparency can be achieved for all trades
  • Whether time outs from trading in a particular instrument can stem the tide of rapid fire responses by market participants.

From an institutional investor perspective, transparency around trades seems to be an increasingly important sticking point with respect to how their billions of dollars are treated by financial institutions that are hired to trade on their behalf. Mounting lawsuits about fees, conflicts of interest and pricing is evidence that some concern exists about whether the buy side thinks they are getting a fair shake.

Two Takes on Gold

Posted by Susan Mangiero on February 22, 2011

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Gold has received a thumbs up from J.P. Morgan as a form of collateral for repurchase and securities lending transactions. This means that someone will need to assign a value for each unit of physical bullion and then store the amount that relates to estimated counterparty risk. According to "J.P. Morgan Will Accept Gold as Type of Collateral" by Carolyn Cui and Rhiannon Hoyle (Wall Street Journal, February 8, 2011), illiquidity fears have discouraged financial institutions from accepting gold as collateral in the past. The World Gold Council website reports that trading is a 24-hour operation, rendering the global gold market as "deep and liquid."

In contrast, a few days later, it was reported that a 300 million euro pension fund, the Stichting Pensioenfonds Vereenigde Glasfabrieken ("SPVG"), was directed to reduce its gold holdings from 13% of its assets to between 1% and 3%. The reported concern on the part of the Dutch pension regulatory body, the Nederlandsche Bank ("DNB") is price risk. Although gold has risen from $600 per ounce to in excess of $1,000 per ounce since 2008, when the Dutch glassmaking company's retirement scheme purchased bullion, a drop in value could lower the solvency ratio.

Several issues come to mind about the use of gold for financial purposes. For one thing, if I am investing in the stock of a bank that accepts gold as collateral for a large amount of transactions, I'd like to know if the bank is hedging the metal and, if so, to what extent. I'd also like to understand how they price commodities like gold and the frequency with which they reassess counterparty risk. For an institutional investor like a pension fund that holds gold as an investment, it would be helpful to understand: (a) whether they own physical quantities or stock in a company that mines the metal (b) how value is assessed and on what basis (c) whether gold holdings are hedged and, if so, to what extent (d) what role gold plays (i.e. diversification, safety, etc). An economic analysis of the risk-return for gold, like anything else, is paramount and must consider multiple factors, some of which are listed here.

Swaps Can Bite Investors

Posted by Susan Mangiero on February 07, 2011

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In "'Swaps' Add a New Risk" (February 7, 2011), Wall Street Journal reporter Ari I. Weinberg writes that little is known about the use of over-the-counter derivative instruments by mutual funds and that the risk of non-performance by a swap counterparty must be considered.

Having worked on several derivative trading desks, I have direct experience dealing with swap contracts, pricing, hedging and counterparty risk. As the saying goes, there is no free lunch. The use of an interest rate, credit and/or currency swap can help an asset manager hedge price variability or enhance returns. The ex-ante economics must consider the riskiness of the party on the opposing side of the contract and much more.

Since Enron and other mammoth bankruptcies of companies that used swaps in large amounts, U.S. bankruptcy law has changed to allow for netting of bi-directional cash flow obligations. Additionally, collateral is often posted (with the amounts being determined by a host of factors such as creditworthiness of the posting entity, type of collateral, existing borrowing facilities, deal structure and so on). New regulations mandate the use of a central clearing house for swaps, heretofore traded privately among mainly large global banks. Even with all of the so-called reforms, work remains.

Attorney Rose DiMartino with Wilkie Farr & Gallagher LLP is quoted in the Wall Street Journal article about her observation that the quality and quantity of disclosure about the use of swaps by investment funds can vary considerably. Attorney Mark Perlow with K&L Gates LLP urges guidance from the regulators about the use of swaps as a leverage creation mechanism. I concur with both sentiments but add that measuring leverage is part of the challenge. Moreover, with respect to disclosure, it's critical to understand what derivative instrument has been used and how, along with understanding more about collateral posted and the nature of the counterparty involved. Consider the following example:

  • An equity swap is used by Investment Fund A to hedge its long positions.
  • The same structure swap is used by Investment Fund B to take an activist stake in Company X, in anticipation of a management reshuffle and an increase in share price sometime soon.
  • Yet another asset pool managed as Investment Fund C may employ the identical type of swap as part of a multiple leg transaction that allows it to gain exposure to a sector not otherwise available by investing directly.

The  risk-return profile is going to differ across funds. Even if all three mutual funds reported the identical swap on its filings, one would still need to play financial detective (assuming he or she had access to further details) to understand how the use of swaps is likely to change things.

In addition, there is the issue of valuation. Some swaps are straightforward to price and some are not. You could have the same over-the-counter swap valued by two or more independent pricing services and get different numbers that are far apart if the derivative has a complex structure that veers from the standard fixed to LIBOR arrangement.

Investors do need more information about the use of derivatives by mutual funds. The question is whether they will get sufficient clarity to properly assess risk.

Interested readers can link to "SEC Proposes Joint Rules with CFTC to Define Swap Related Terms" (December 3, 2010) and/or "SEC proposal would give customers clarity on pricing" by Sarah Nl. Lynch, Reuters, February 2, 2011.

Also check out "The Role of the Financial Expert in Valuation of Derivative Instruments" by Susan Mangiero, Expert Evidence Report, BNA, 2004. Note that BVA, LLC is now known as Fiduciary Leadership, LLC.