The Fuss about Derivatives
Many of us know the following figure Zerohedge is publishing time and again in revised versions in articles about Deutsche Bank:
For example, when Tyler Durden asks:
Or when he is writing about
to give only a few examples.
Derivatives have a bad reputation for at least three reasons:
Leverage allows moving markets with comparably small funds.
Speculation may drive markets into self-fulfilling prophecies and an upward or downward spiral of chain reactions.
Risk taking exposes investors to the danger of high losses with unforeseeable consequences for the financial system as a whole.
Derivatives are suspected to increase the volatility of market rates and prices. Furthermore, banks with high derivatives exposures such as Deutsche Bank are dreaded as source of contagion and systemic risk. When the IMF recently stated in its Financial Sector Assessment Program that “among the G-SIBs (globally systemically important banks), Deutsche Bank appears to be the most important net contributor to systemic risks, followed by HSBC and Credit Suisse,” all eyes went immediately to Deutsche’s derivatives portfolio.
On the other hand, derivatives are a blessing for those who involuntarily are exposed to market risks and who use these instruments for hedging purposes. Banks often argue that their high volumes of derivatives are to a large extent reflecting the needs of their customers and their own efforts to hedge their resulting positions.
So how bad are derivatives and how critical is the size of a high derivatives exposure?
A derivative is a financial contract that derives its value from a specific market reference, such as a common stock index, interest rate, commodity, credit or currency. Contracts are available as customized over-the-counter (OTC) derivatives, including swaps, forwards and options, and as standardized exchange-traded derivatives, such as futures and futures options. In the latter case, the exchange acts as an intermediary to all transactions making them relatively straightforward to track. The vast majority of trading, however, is conducted over the counter with little transparency for regulators and outside observers.
The following figure illustrates the principle with a simple hypothetical foreign exchange transaction: A foreign currency is bought forward for delivery after two time periods in order to make a profit from its future development. All details of the contract – the amount, the forward rate the trader has to pay, and the maturity – are agreed at the beginning. At the end of the second period, the buyer gets the foreign currency which he hopes to sell in the spot market at a higher price than the forward rate that he had agreed to pay initially. The difference between the spot rate at maturity and the initial forward rate multiplied by the respective amount will be his profit – or loss in case his expectations are not met.
The figure shows the development of the currency’s spot rate (s) and expected spot rate (se) over the two periods as well as the forward rate (fA) at which the currency is bought in point A. In A the forward rate is higher than the spot rate, but the trader expects the spot rate to rise.
For the end of the second period the trader expects a difference between spot and forward rate (denoted by c) which would allow him to make a profit. But he is wrong. The exchange rate first rises, even stronger than he expected, but in the second period it ends in a steep fall. Selling his forward currency in the spot market, the trader incurs a loss which is determined by the difference between spot and forward rate denoted by d.
Note that, had the transaction instead been only for one period, the trader would have made a profit from the difference between spot and forward rate denoted by b.
Here we have the typical reasons why derivatives are regarded with suspicion.
The derivative in this case is the forward contract which derives its value from the underlying currency.
Leverage results from the fact that in the interdealer market due to established market customs the trader who incurs a loss pays only the difference between the spot and forward amounts (this explains why in German this kind of trade is called “Differenzgeschäft” (speculation on differences)).
Speculation becomes highly attractive under these circumstances. For the profitable trade no money is needed. Even in case of loss the required cash is usually only a fraction of the nominal amount of the transaction. Comparably small sums suffice to establish large positions which in turn may affect rates and prices. As they say, here the tail is wagging the dog.
Risk is high. Compared to the initial transaction a loss may appear small. But, as soon as a trader never intended to risk more than a fraction of the notional or nominal amount it may easily eat up – or even exceed – his planned investment.
According to the statistics of the Bank for International Settlements, foreign exchange derivatives make up the second largest segment of the global OTC derivatives market. This category includes all deals involving exposure to more than one currency, whether in interest rates or exchange rates. Beside outright forward contracts as the one described in the example, they include foreign exchange swaps, currency swaps (including cross-currency interest rate swaps) and currency options:
In general, an outright forward contract is “a contract between two parties for the delayed delivery of financial instruments [in the above example a currency] or commodities in which the buyer agrees to purchase and the seller agrees to deliver, on an agreed future date, a specified instrument [in the example the currency] or commodity at an agreed price or yield. Forward contracts are generally not traded on organised exchanges, and their contractual terms are not standardised.” (BIS 2016) (The standardized version of a forward contract traded on an exchange is called a futures contract. There, the exchange’s clearing house becomes the opposite party to both buyer and seller once a trade has been completed thereby reducing or eliminating counterparty risk.)
A foreign exchange swap is an exchange of two currencies for a specified period with a reversal of that exchange at the end of the period. A foreign exchange swap consists either of a combination of a spot and a forward leg or of two forward trades with different maturities.
Currency swaps are a combination of interest rate and currency instruments. They consist of an exchange of streams of interest payments in different currencies for an agreed period of time and of principal amounts in different currencies at a pre-agreed exchange rate at maturity.
Currency options are contracts sold for a premium that give the buyer the right, but not the obligation, to buy (in case of a call option) or sell (put option) a specific quantity of a currency at an agreed exchange rate during a specified period.
But, the majority of OTC trades are not in foreign exchange derivatives but in single-currency interest rate contracts. These are “contracts related to an interest-bearing financial instrument whose cash flows are determined by referencing interest rates or another interest rate contract (eg an option on a futures contract to purchase a Treasury bill). Interest rate contracts include forward rate agreements, single-currency interest rate swaps and interest rate options, including caps, floors, collars and corridors.” (BIS 2015)
A forward rate agreement (FRA) is “an interest rate forward contract in which the rate to be paid or received on a specific obligation for a set period of time, beginning at some time in the future, is determined at contract initiation.” (BIS 2016)
An interest rate swap is “an agreement to exchange periodic payments related to interest rates on a single currency; can be fixed for floating, or floating for floating based on different indices.” (BIS 2016)
An interest rate option is a contract that gives the holder the right (but not the obligation) to pay or receive an agreed interest rate on a predetermined principal during a specified period.
Beside these two groups of instruments the BIS statistics include further categories (BIS 2015):
Equity derivative contracts are “contracts that have a return, or a portion of their return, linked to the price of a particular equity or to an index of equity prices.”
Commodity contracts are “contracts that have a return, or a portion of their return, linked to the price of, or to a price index of, a commodity such as a precious metal (except gold which is subsumed under foreign exchange derivatives), petroleum, lumber or agricultural products.”
In recent years, policy attention has increasingly focused on Credit Default Swaps (CDS) and other credit derivatives. They comprise a large range of sometimes complex products such as single- or multi-name CDS instruments and index products (Tissot 2015). According to the BIS definition
credit derivatives are “contracts in which the payout is linked primarily to some measure of the creditworthiness of a particular reference credit.The contracts specify an exchange of payments in which at least one of the two legs is determined by the performance of the reference credit. Payouts can be triggered by a number of events, including a default, a rating downgrade or a stipulated change in the credit spread of the reference asset. Typical credit derivative instruments are CDS, credit spread forwards and options, credit event or default swaps and total return swaps.”
Furthermore, the BIS is collecting data about “other” derivatives:
“Other” derivatives are “any other derivative contracts, which do not involve an exposure to foreign exchange, interest rate, equity, commodity or credit risk. Those include, for example, inflation-indexed derivatives, volatility derivatives, dividend derivatives, weather derivatives, property derivatives or freight derivatives as well as any derivatives with non-standard underlying which are developed for particular clients.”
The OTC derivatives market is huge. End of December 2015 the notional amount of outstanding contracts as one indicator of the total positions taken by market participants worldwide was $493 trillion. Many of these instruments are much more complex than the described example of an outright forward transaction and measuring the size of the market as an indicator of the related risks is a daunting task.
In 2015, the Bank for International Settlements published reporting guidelines for its semi-annual OTC derivatives statistics at end-June 2016 which give an idea of the challenges involved (BIS 2015):
One measure of market size is notional amounts outstanding. This is the nominal value of all the deals concluded and not yet settled on the reporting date.
For example, the notional amount of a swap is the underlying principal amount upon which the exchange of interest, foreign exchange or other income or expense is based.
For equity and commodity-linked contracts the notional amount is the quantity (number of units) of the commodity or equity product multiplied by the contract price of a unit.
For credit derivatives the contract amount to be reported is the nominal value of the relevant reference credit.
Notional amounts outstanding provide useful information about the structure of the OTC market, but they do not allow drawing conclusions about counterparty credit exposures and the real amounts at risk. This explains why the BIS is looking at derivatives’ amounts outstanding in terms of gross market value in addition. If contracts were settled immediately, this value would represent claims and liabilities of counterparties.
Gross market values measure the cost of replacing outstanding contracts at prevailing market prices: Typically they are much smaller than notional amounts:
“Gross market values are defined as the sum of the absolute values of all open contracts with either positive or negative replacement values evaluated at market prices prevailing at the reporting date. Replacement values stand for the price to be received or paid if the instrument were sold in the market at the time of reporting. Market values are the amounts at which a contract could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. If a quoted price is available for a contract, the number of trading units should be multiplied by that market price. If a quoted market price is not available, the reporting institution should provide its best estimate of market value based on the quoted price of a similar contract or on valuation techniques such as discounted cash flows.” (BIS 2015)
In the case of forwards and swaps, the market or replacement value of outstanding contracts is either positive, zero or negative, depending on how underlying prices have moved since the contract’s initiation. For example, in our hypothetical forward transaction above one would compare the forward rate at the initiation of the contract at time A with the forward rate for the same settlement date at the time of reporting. If the latter is lower the contract has a positive market value, if it is higher the market value is negative.
For swaps that involve multiple payments, the market value is the net present value of the payments to be exchanged between the reporting date and the contract’s maturity.
For cross-currency swaps with an exchange of principals at maturity the present value of all cash flows, including principal amounts, should be included. The reason is that if the market exchange rate moves by the maturity date, the contracting parties will get back more or less units of their ‘home’ currency. This would affect the market value of the contract at any point in time, which is what should be recorded. BIS 2015 gives an example:
“For example, Macquarie (Mac) enters a cross-currency swap with JP Morgan (JPM). On the signing date, Mac borrows USD103 from JPM and lends AUD100 to JPM (so the exchange rate in the CC swap is fixed at 1 AUD = 1.03 USD). If, at the reporting date, the forward exchange rate for the maturity date of the swap is 1 AUD = 1.05 USD, then Mac can expect to profit on the exchange of principals at maturity. In particular, Mac will return USD 103 to JPM and receive AUD100 from JPM, but the AUD100 from JPM will be worth USD 105, so that the market value of the contract at the reporting date is USD 2 (ignoring any contribution from the interest payments, which should also be included if these have a non-zero market value). If Mac and JPM have also traded another derivative, eg an equity total return swap (TRS) that has a market value of +USD 1 to JPM (and hence –USD 1 to Mac), then we just need Mac to report a gross positive market value of USD 2 and a gross negative market value of USD 1.”
Options are different. Quoting the BIS again:
“Unlike forwards or swaps, OTC options have a market value at initiation, which is equal to the premium paid to the writer of the option. Throughout their life, option contracts can only have a positive market value for the buyer and a negative market value for the seller. If a quoted market price is available for a contract, the market value to be reported for that contract is the product of the number of trading units of the contract multiplied by that market price. If a quoted market price is not available, the market value of an outstanding option contract at the time of reporting can be determined on the basis of secondary market prices for options with the same strike prices and remaining maturities as the options being valued, or by using option pricing models. In an option pricing model, current quotes of forward prices for the underlying (spot prices for American options) and the implied volatility and market interest rate relevant to the option’s maturity would normally be used to calculate the “market” values.
Gross positive market value would be the sum of the current market values of all purchased options, and gross negative market value would be the sum of the values of sold options. Options sold and purchased with the same counterparty should not be netted against each other, nor should offsetting bought and sold options on the same underlying.”
A third concept measuring the size of the OTC market is the gross credit exposure. This concept takes into account that in practice contracts between counterparties can be netted. The prerequisite is that there are legally enforceable bilateral netting agreements.
Gross credit exposure is calculated as the gross market value minus amounts netted with the same counterparty, and across all risk categories (Tissot 2015). The following figures give an idea of the market size reduction achieved by calculating the gross market value and gross credit exposure compared to notional amounts outstanding.
Coming back to Deutsche Bank whose derivatives position is attracting so much attention. In its annual report, the bank publishes both notional amounts outstanding and positive, negative and net market values. In addition, it reports a figure for total positive market values after netting and cash collateral received. These are the results for 2015:
On December 31, 2015 Deutsche Bank’s total notional amount outstanding of derivatives was €41.940.034 million or almost €42 trillion. This is the Zerohedge figure. The first indication that – albeit still huge – this is less dramatic than it seems is that more than 15 percent or €6.580.441 million was exchange-traded business which is generally considered safer than OTC trades.
The total notional amount of OTC contracts was €35.359.593 million. Of this €15.632.548 million or about 44 percent was cleared through central counterparties (CCP). This is another aspect which may modify the judgment. Central clearing is “a key element in global regulators’ agenda for reforming OTC derivatives markets to reduce systemic risks.” (BIS 2016)
“A CCP acts as an entity between two counterparties, becoming the buyer (resp. seller) for every sellers (resp. every buyers). When a contract is cleared by a CCP, there is an operation called “novation”. This consists in replacing the initial contract by two new contracts: one between each of the two counterparties and the CCP.” (Tissot 2015)
For interest rate related derivatives which with over 76 percent of notional amounts made up the biggest part of Deutsche’s OTC derivatives in 2015 the CCP-cleared share was even higher (over 55 per cent). Further, more than 48 percent of the bank’s credit derivatives related contracts were CCP-cleared. In contrast, for currency related trades the figure is less than 5 percent of notional amounts. Equity/index related and commodity contracts are not cleared by a CCP.
Total positive and negative market values of the bank’s OTC trades were €512.297 million and €493.213 million respectively. By netting and by taking into account cash collateral received the total positive market value was reduced even further to €53.202 million – “peanuts” compared to €42 trillion notional amount.
So, what’s the fuss about these derivatives positions?
In my view, the problem is less the figures themselves than the assumptions behind the various concepts:
As a rule, replacement values are found or calculated under “normal” market conditions ignoring the fact that, be it for the individual bank or the system as a whole, in a crisis – and this is ultimately what the fuss is all about – markets do not behave “normally”. Prices may fluctuate wildly or even be no longer available because market makers stop answering the phone or counterparties cease to exist. Furthermore, these are exactly the scenarios where the results of banks’ inhouse models to provide the required “best estimate of market value” in case market prices are not available become highly unreliable.
The concept of netting ignores the interconnectedness of major players and the consequences of a counterparty’s default. Five years ago, in November 2011, Zerohedge reminded the world of a situation in 2008 when about 74 percent of CDS trading took place among 20 dealer-banks worldwide and “Gross” was on the brink to become “Net”:
“In theory, if a bank owns $50 billion of Greek bonds and has sold $50 billion of credit protection on that debt to clients while buying $90 billion of CDS from others, its net exposure would be $10 billion. This is how some banks tried to protect themselves from subprime mortgages before the 2008 crisis. Goldman Sachs and other firms had purchased protection from New York-based insurer AIG, allowing them to subtract the CDS on their books from their reported subprime holdings.
Yet what happened next is a vivid memory to all:
When prices of mortgage securities started falling in 2008, AIG was required to post more collateral to its CDS counterparties. It ran out of cash doing so, and the U.S. government took over the company. If AIG had collapsed, what the banks saw as a hedge of their mortgage portfolios would have disappeared, leading to tens of billions of dollars in losses.
“We could have an AIG moment in Europe,” said Peter Tchir, founder of TF Market Advisors, a New York-based research firm that focuses on European credit markets. “Let’s say Greece defaults, causing runs on other periphery debt that would trigger collateral requirements from the sellers of CDS, and one or more cannot meet the margin calls. There might be AIGs hiding out there.”
As Tyler Durden wrote elsewhere:
“This accounting gimmick works in theory, however in practice the theory falls apart the second there is discontinuity in the collateral chain.”
When replacement concepts fail and netting agreements become futile one likely consequence is that market participants turn again to notional amounts for clues of the dangers looming ahead. These may overstate the amounts at risk associated with derivatives, but at least they are “real”- and, inspite of the progress in clearing and settlement in recent years, and declining exposured due to regulatory changes, still breathtakingly high. Not only at Deutsche Bank.
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