Please allow me to introduce myself. I'm a man of wealth and taste.
-- The Rolling Stones
The OTC Plot Thickens.
Following the earlier articles discussing "creative" valuation of the OTC spot markets, this is the first of several articles on the same topic for OTC derivatives. The basic problem: OTC derivatives markets have become polluted by the dealer bank lust to report, and be compensated for, nonexistent value.
OTC derivatives were once the beginning of a solution to the exposure of banks and corporations to loss from changing interest rates and other changing prices. But OTC derivatives' purpose has been perverted by dealer bank obsession with market control. Today derivatives exist to enrich the shrinking number of ever-larger dealer banks at the expense of others. And worse, the enriched are not the stockholders of these banks. The book values of OTC derivatives are a pig in a poke. The enriched are senior management and derivatives traders themselves, through bonuses paid for illusory profit.
There are two abuses that create the inflated values of IRS. They seemed a nuisance when dealing in IRS began in the early 90's. They have become major abuses of dealer bank power.
- IRS create far more credit risk than the futures contracts they replaced. But thanks to changes in the bankruptcy code, the derivatives dealers are entitled to ignore the credit risk they create.
- IRS do not have a single market value. Each dealer values her portfolio herself.
It didn't have to be that way.
Who are the OTC dealer banks? In the US; primarily Bank of America (NYSE:BAC), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), and JP Morgan Chase (NYSE:JPM). In Europe; Barclays (NYSE:BCS), HSBC (NYSE:HSBC), Deutsche Bank (NYSE:DB), UBS (NYSE:UBS), and other assorted less significant players.
The first articles on the topic of OTC price manipulation, here, here, and here, considered manipulative pricing in the cash, or spot, OTC markets, once the only OTC markets. The articles paint an unflattering picture.
In the following articles the OTC derivatives markets are addressed, beginning with interest rate swaps (NYSE:IRS). The graph below, provided in the third quarter of 2016 Derivatives Report of the Office of the Comptroller of the Currency, shows that, for the four American Banks that trade 89% of all IRS with bank counterparties, IRS are by far the largest, by notional amount, of the derivatives that the banks report. The following articles first consider IRS, then also consider two other OTC derivative instruments. credit default swaps (CDS) and "one-offs."
The good news.
It is fashionable to be alarmist about the potential damage derivatives can do to the stability of the financial system. I do not share that fear. Yes, there will be another financial liquidity crisis. But the source will be something other than derivatives.
But. If a big bank fails, the world will be shocked at how much greater the failing bank dealer's valuation of her derivatives portfolio will be, compared to the bids made by the surviving banks.
The bad news.
My basic concern with IRS is one of valuation. I am certain that dealer inventories of IRS, like the dealer banks' portfolios of OTC spot instruments, are overvalued. OTC dealers use the OTC markets to build imaginary value. The risks associated with OTC derivatives are hidden; their values, inflated. And these risks are unnecessary.
The huge notional $320 trillion (end-June 2015, according to the BIS) amount of outstanding in IRS contracts could be replaced by a safer instrument, a hybrid of an IRS and a futures contract. The amount at risk could be reduced to amounts akin to the safer futures margins, less than 5% of current IRS exposure. Exchange-trading of the futures-IRS hybrid would make prices transparent. The CME Group (NASDAQ:CME) is where the futures-like version of IRS would logically be housed, although it would be interesting to see the competitive effect of locating them elsewhere. But it must be outside the clutches of the stifling SEC. London comes to mind.
Futures. The derivatives instruments that work.
Futures technology, the safest, most transparent, trading technology on the globe, might have been a successful end of the story of derivatives. That was not to be. The problem was that futures are the proverbial square peg in a round hole. Futures are marked-to-market daily in cash. Banks and corporations, in contrast, recognize receipts on loans and deposits when scheduled payments are made. The difference creates an accounting problem. When futures are used to stabilize net interest income, stabilized net income appears to be volatile, because the timing of reported gains in futures markets does not match the timing of reported losses on loans and deposits.
Interest rate swaps solve an accounting problem.
Dealing in IRS was introduced solely to fix the accounting problem created by futures. In the wake of the listing of Eurodollar futures in 1981, bankers/futures mavens like me went to work, applying futures to risk management problems. Futures were, according to our plan at the time, the most efficient way to close interest rate mismatches. But the accounting issue proved insoluble. After three years of debating with bank regulators and accountants, contending that accounting rules should change to match reported futures cash flows to their intended use, we threw in the towel. We then modified an existing instrument, the IRS. We dealt them as counterparties instead of matching other counterparties for a fee - the practice in the past. The market exploded.
Killing a fly with TNT.
Looking back on that decision, it is an understatement to say we lacked foresight.
Without getting into the weeds, the basic economics of IRS trading at the beginning was that the customer would pay for the added credit risk of a swap, compared to futures, in return for the swap's accounting advantage. As dealers, we marked our swaps to market, so we could trade futures without the accounting problem. Our value added was to solve the customer's accounting problem in return for a spread above LIBOR for the credit risk we absorbed, built into the rate we charged.
But we failed to consider the exploding growth of a market that, to our mind, was only an accounting device.
Exemption from the stay in bankruptcy.
The mistake we made was to underestimate the leverage of derivatives dealers in Congress, and to underestimate the ability of greed to counter economic logic.
The dealers rapidly began to spin straw into gold. Combine that with the aura of newness of OTC derivatives, and with the fact that derivatives dealers were typically highly analytically trained. There was a feeling throughout the banking system that derivatives would be the fundamental driver of profits in finance, if not in the economy as a whole, for some time. This belief was a hopeless exaggeration of the possible.
But it had a salutary effect on derivatives dealers' position in the eyes of bank regulators. The result was a carte blanche from Congress. The derivatives dealers exploited the green light to do the outrageous. Derivatives were exempted from the stay in bankruptcy.
In other words, the credit risk that had been the basis for premiums in the original pricing of derivatives was seemingly waved away by the Congressional wand! A failing customer was no longer a risk. She was fresh meat. A dealer could seize a failing customer's collateral, value it instantly without taking bids, and cancel any existing swap-related obligation to the same customer. And exemption from the stay in bankruptcy meant there was no bankruptcy court involved to assure fairness. The exemption from the stay amounts to financial rape.
A few of the more skeptical among us saw this auspicious development through jaundiced eyes. The first law of risk management: Risk cannot be created or destroyed. It can only be transferred. And we knew where the risk was headed. It was no longer the dealers' problem. It became their counterparties' problem. A customer service was transformed by Congress into a customer abuse.
The second IRS problem: a missing market price.
Derivatives second problem rapidly came into play as well. Derivatives have no common market price.
The next article explains how that fact spins the dealers' straw into gold.
Ask yourself this: Since dealers solve no accounting problems when they trade with each other, why do dealers trade with each other at all? My desk had no interest in trading with other dealers, because we had no accounting problem to solve.
A swap between two dealers is just a bet - one dealer loses what the other wins. No value whatsoever is created when one dealer trades with another.
There is, of course, an explanation. And it's not pretty. The next article will address it.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.