Goldman Sachs Portfolio Strategy Research has a fascinating research piece out today on equity correlation markets. It does good work as a piece of research because (1) if you like equity derivatives, it’s got all sorts of fun charts and technical stuff and (2) if you don’t, it’s got a hard sell: trade equity corr with Goldman!
There are many market participants that are affected by the level of equity correlations but are not yet trading correlation actively. So far, the market has been primarily one-way; banks selling correlation and hedge funds and proprietary trading desks buying it for the positive carry. We believe that the correlation market can become a new area in which institutional investors could add alpha.
The equity correlation market, which is pretty niche-y, lets investors bet on how dispersed the returns of stocks will be in the future. And the trade to make now, Goldman thinks, is to sell correlation, which “appears attractive,” meaning that current implied correlation is much higher than they think realized correlation will be in the future: Read more »
As Marc Faber prepares for war and Europe tries to figure out Italy, derivatives trade group ISDA wants you to know that one thing is safe: OTC derivatives.
This might surprise you, since they’ve been famously called “weapons of mass destruction” and since counterparty risk in the over-the-counter derivatives market has been a big motivating force behind regulatory changes. But ISDA concludes that that risk is no big deal:
The [report] shows very limited counterparty credit losses at the bank level. Since 2007, losses on OTC derivatives positions in the US banking system due to counterparty defaults have totaled less than $2.7 billion, a period that includes the failures of over 350 banks with assets of more than $600 billion, as well as the failures of firms such as Lehman Brothers, Fannie Mae and Freddie Mac.
The ISDA report includes this chart, from the Office of the Comptroller of the Currency, showing credit losses (how much U.S. banks actually lost on their derivatives counterparties not paying what they owed) and net credit exposures (credit risk as a percentage of outstanding notionals):
Losses peaked in 1Q09 and have never been more than $1bn in a quarter, even when Lehman filed. Which suggests that maybe derivatives counterparty risk really is no big deal? That’s ISDA’s claim – that, and that additional Dodd-Frank regulation of derivatives won’t help much.
Of course this report has some caveats: Read more »
Many people are surprised that investment banks want their customers to buy things that they are selling. If a customer buys a bond, then the bank doesn’t own it any more – but isn’t that a conflict of interest? Wasn’t that bond designed to fail? Shouldn’t the banks only sell bonds to their customers that they’d rather keep themselves?
Given that mindset, we’ve seen many calls to turn market makers into fiduciaries for their customers. But Dodd-Frank started small, changing the rules mainly for derivatives dealers who interact with “special entities” (muni issuers, pension plans and endowments – who are presumed to be less sophisticated / more likely to blow all their money on sewer swaps), providing that those dealers will be treated as “advisers” and will have to act in the best interests of their special-entity counterparties if they recommend transactions to them.
The SEC recently released proposed business conduct rules under Dodd-Frank, and today law firm Cleary Gottlieb gave them a pretty positive review. In particular, they like that there’s a way for dealers to get out of the best-interests rules:
Read more »
Blanche Lincoln’s famed derivatives legislation, which would basically prevent any big bank from ever trading CDS again, has already been chastised by Barney Frank. Now, a senior Treasury official has essentially delivered another blow to the Lincoln legislation.
In a briefing for reporters today, Assistant Treasury Secretary Michael Barr said the derivatives rules were not part of the administration’s four “core objectives” for financial reform. Translation: The Lincoln legislation can die a slow death for all we care. Read more »
Barney Frank just delivered a speech at Compliance Week’s annual conference in Washington D.C. and he seems to have confirmed what Goldman Sachs analysts told us yesterday – new legislation that forces banks to spin-off their derivatives business probably won’t make it into the final financial reform bill. Read more »
Sen. Blanche Lincoln, Arkansas Democrat, was able to push her controversial derivatives amendment into the financial regulatory reform bill yesterday, despite threats from Wall Street. And any banker that thinks Blanche is going to back off derivatives reform after she wins the Arkansas primary runoff on June 8 has no clue how hard-nosed she really is.
“Suggestions that my provisions are the result of the current political climate are completely baseless,” Ms. Lincoln told DealBook. “I am not concerned about politics when Americans are depending on us to ensure that our financial system is secure.”
We’ll see about that. In the meantime, we wonder if Sen. Lincoln is tough enough to do a Dunkaroo – an old Arkansas drinking tradition perfected in Little Rock. Read more »
The guys at Citi are smarter than anyone else on the Street, which is why they are about to launch the first derivatives EVER that will pay out in the event of a financial crisis.
As Chris Whalen, at Institutional Risk Analytics, told us about the news: “It’s cute. Though a bit ironic coming from them.”Yes, it’s ironic and the mere concept could be funny if it weren’t that scary.
Read more »
We may now have a winner in the derivative blame game competition. Following other successful forays by municipalities, such as Jefferson County, AL, into the derivatives world, the mayor of a small Italian town that was burned by an interest rate swap pins the blame on a combination of peer pressure and the swap agreement being “impossible to understand”. Having lost money on the swap since mid-2007, mayor Ortenzio Matteucci, is now a leading expert on the pitfalls of herd mentality.
“At the time I thought: Can the Province of Terni, the City of Terni and all the other municipalities bigger than us, such as Milan, be all wrong?” said Matteucci, 59, dressed in a blue polo shirt and jeans. “You can make a mistake if you don’t have an appropriate and deep knowledge of this and just follow what other local governments do.”
‘Impossible to Understand’ Swap Burns 290-Person Italian Hamlet [Bloomberg]
The word is out on the Obama administration’s plan for derivative regulation. CFTC Chairman Gary Gensler outlined the plan before the Senate Committee on Agriculture, Nutrition, and Forestry today. Derivative dealers can look forward to new rules surrounding, “capital requirements, initial margining requirements, business conduct rules and reporting and record keeping requirements.” In his testimony Gensler stated that the new rules aim to achieve four main objectives:
• Lower systemic risks;
• Promote the transparency and efficiency of markets;
• Promote market integrity by preventing fraud, manipulation, and other market abuses, and by setting position limits;
• Protect the public from improper marketing practices.
Regarding the highly scrutinized world of customized derivatives, Gensler set out four criteria for determining whether or not a derivative contract qualifies as customized and therefore avoids the requirement of trading through an exchange:
•The volume of transactions in the contract;
•The similarity of the terms in the contract to terms in standardized contracts;
•Whether any differences in terms from a standardized contract are of economic significance;
•The extent to which any of the terms in the contract, including price, are disseminated to third parties
And so it begins.