The Twisted OTC Derivatives Markets: Interest Rate Swaps, Part II

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by: Kurt Dew

Summary

This is the second article explaining why dealer banks’ interest rate swaps are inevitably overvalued.

The absence of a quality market valuation of interest rate swaps portfolios necessarily biases dealers’ portfolio valuations upward.

This will be true regardless of the integrity of each dealer’s price.

This upward bias is exacerbated by the fact that the dealers’ customers don’t determine the value of their derivatives transactions.

It's too bad that all these things, can only happen in my dreams. Only in dreams. In beautiful dreams.

-- Roy Orbison

Where is the value-added to the economy of the OTC derivatives market? How much of it is real; how much, in the minds of derivatives dealers? This is the second article addressing this question for the interest rate swaps (IRS) market.

The last article listed two sources of dealer abuse that create the inflated values of IRS.

  1. IRS create far more credit risk than the futures contracts they replaced. The derivatives dealers are entitled to ignore it.
  2. IRS do not have a single market value. Each dealer values her portfolio herself.

That last article explained how credit risk works in favor of dealers. Changes in the bankruptcy code have made credit risk a blessing - a win-win proposition from the dealer's point of view.

This article focuses on the most obvious part of each dealer's swap valuation that is a fiction created by OTC trading practices. Because every dealer determines the value of her own book, we can show that she systematically books her average swap at a value greater than the value she could recover if she offered her swaps to other dealers.

What is the value of an interest rate swap?

The basic question: "What is the value of a derivatives trade?" is more difficult to answer than might be thought. To consider the question of a derivative's value, begin by separating dealer transactions from customer transactions.

The phantom value of customer derivatives trades.

A typical customer never values her derivatives positions, because the value of the derivative is beside the point to a hedger. A well-crafted customer trade is designed to assure that other business of the customer is insulated from loss resulting from changes in price.

Take the case of an oil refinery that has acquired crude oil to be refined to produce gasoline sold in advance to a gasoline distributor for delivery in six months. The refinery has based the price at which it sold gasoline for delivery in six months on the spot crude price - say $60/barrel. But the crude oil is still underground. The deal with the driller is for delivery of the crude in 6 months at the going market price. To assure a net profit, the refiner does a crude oil swap, promising to settle in six months, paying the refiner the difference between $60/barrel and the spot price in six months. If the price of crude rises to $70/barrel next month, the refinery is not going to book a capital gain. The refinery will wait until the crude is delivered, then show the price of the crude, the value of the derivative, and the combination, which will be $60.

Since an interest rate swap has, on average, a five-year maturity, with semi-annual payments, the customer will book each of ten payments when they occur, along with the income differential between asset yields and liability costs that the swap was protecting. The value of the swap is neither known by the customer nor reported to stockholders, because it doesn't matter.

The important implication of this fact. A dealer values her trades with customers. But the customer neither knows, nor asks, what the value of the dealer's side of the trade is. The customer has, however, posted collateral that the dealer considers sufficient to cover the value of the dealer's position in the event of a fail.

But since the customer does not value the dealer's obligation to her, collateral calls from the customer to the dealer may not happen. Thus collateral sufficient to cover losses to the customer in the event of a dealer fail is doubtful. What's more, the customer has nowhere to go to find the market value of her derivative when the dealer fails. Derivatives price data exist, but the prices refer to currently traded derivatives. Her derivative will have different terms - different dates at which payments are made, and a maturity other than an even number of years. The effect is replacement values will all be quoted to her at a premium to market prices, bad news for the customer.

To make a long story short, the customer is in an inferior position in bankruptcy. If the customer is bankrupt, we described the disastrous effect in the last article. The dealer can only profit from her bankruptcy. If the dealer is bankrupt, the customer's lack of awareness of the derivative's value means she has likely not made collateral calls. If she is owed money, she won't receive it, since the derivatives trade is cancelled. Ultimately, customer trades are more valuable for dealers than customers, due to dealer awareness of their need for protection in bankruptcy.

Dealer-to-dealer trades.

When derivatives dealing was getting off the ground, it came as quite a surprise to me that dealers regularly traded with each other. At first the reason was obvious. People got into the business who were clueless. Since they were in no sense my customers, I found trades with them to be delicious. But that, of course, couldn't last.

It is apparent that a trade between dealers makes no sense. An IRS is simply an agreement between two parties to exchange payments in the future. One party or the other must win. The other loses what goes to the winner. In short, it's a bet. Dealer-to-dealer swaps add no value whatever to the financial system. But the dealers regularly trade together.

But there is an explanation. Most markets impose the external discipline of market price on participants. If you trade exchange-traded shares, for example, your accountant and the tax man will expect your portfolio to be valued at the appropriate closing price. If buyer wins, seller must lose.

But for interest rate swaps, and other derivatives, there is no appropriate closing price. Suppose for a minute that stock prices were traded like that. Both buyer and seller know the last trade and the price at which they can find a party to take the other side. But the reason buyer is buyer and seller is seller; their difference of opinion about the next price. Buyer expects higher; seller, lower. But if they each determine the value of their trade separately at the end of the day, they will both be right!

Quants run amok.

Of course, when the accountants and tax people arrive at the dealer's desk, there has got to be a story that plausibly explains portfolio value. But you don't need to look beyond SA to see that there are multiple plausible stories of portfolio value, no matter what you trade. And, in the multi-trillion dollar IRS market, it didn't take long for those stories to get seriously complex and mathematically sophisticated. Enter the new profession, "Quant." This is what we call an employee of a derivatives desk that has more math than the dealer bank's accountants and regulators. Hence, she can produce derivatives valuations that withstand scrutiny, since nobody understands them. Since there is no market to challenge her, it really doesn't matter if she is dead wrong.

The OTC cash markets of the first three articles are opaque to the dealer banks' customers and to the public. The OTC derivatives markets are opaque to those groups, but also to others, including the senior management of the dealer banks themselves. The dealer banks' quarterly reports affirm that nobody, other than the traders and staff that report derivatives valuations, know how these values are determined.

Not that derivatives' traders seek to manipulate prices in their own favor. The problem would exist in any market that does not identify a single relationship between yield and value. And in many cases in derivatives trading, the relationship that determines value is proprietary. The dealer could tell you why she made so much money. But if she did that, she would have to kill you.

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.

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