How to move OTC Derivatives
Markets on to Exchange
A Detailed Guide For Leaders & Specialists
A comprehensive hybrid
solution is presented:• All the advantages of
exchange trading can be
realized without breaking the
existing business logic of our
liquid OTC markets.
• The proposal is regulator
friendly, will reduce systematic
risk and will still be completely
sell-side and buy-side friendly.
Contents
How To Move OTC Derivatives
Markets On To Exchange
Introduction
1
How To Migrate OTC Derivatives Onto
Exchange Without Damaging The Market
2
A. Why reforming OTC-markets is potentially problematic
2
Why banks fear the EET model
2
Why end users don’t like CCPC
3
Valuation issues
3
B. A new (hybrid) exchange trading model
4
A harmonious first step
4
A further useful step
6
Example: How To Move CDS Onto A Hybrid Exchange
8
A. OTC CDS and the compromises made to clear them
8
8
Key features of OTC CDS
B. About x-CDS
10
Developments in OTC CDS viewed from an x-CDS perspective
10
Relationship between x-CDS and electronic futures
10
C. How to offer OTC-like CDS whilst actually trading x-CDS
12
Notes
16
Epilogue
Back cover
Introduction
The purpose of this document is to publicise a new paradigm for addressing the problems
posed by so called1 OTC derivatives. The proposals are not backed by any think-tank, NGO,
government department or large institution, but please do not be put off from giving this guide
the attention it deserves simply because I am acting alone2 – These ideas are regulator friendly,
will reduce systematic risk and will still be completely sell-side and buy-side friendly3.
If you have taken an interest in the role of these markets during the recent financial crisis you
will already know that change is needed and also what general form change should take:A. The unrestricted use of a particular sub-class of OTC derivative known as CDS of ABS
accelerated the irresponsible subprime lending behaviour of certain US banks and was
also the leading factor behind the spread of the resulting bad debt exposures to other
institutions both globally and in the US.4
B. In addition the web of contractual links generated by the mainstream OTC derivatives
markets is known to have posed a systematic risk in the recent banking crisis. As a result
banks at the centre of this contractual web were seen as “too big to fail” and have allegedly
been subject to so called moral hazard, further increasing systematic risk.
C. In these circumstances it appears that forcing OTC derivatives onto exchange would
be a sensible idea based on the fact that EET5 futures and options markets have operated
efficiently in the past and that these EET products are derivatives. If one set of derivatives
provide regulatory transparency plus low systematic risk in bad times (i.e. just the features
OTC reformers are looking for) then why not move others onto the same platform?
Unfortunately, trying to force OTC derivatives onto exchange has become very controversial: Both
genuine and imagined obstacles preventing progress towards exchange trading have resulted in
some policy makers moving in favour of clearing only rather than exchange traded “solutions”6.
Fully formed solutions for moving OTC swaps and other derivatives markets onto exchange
are very rare7 – Hopefully this document will help people of influence to transcend the earlier
debate and provide a new way forward towards exchange-like trading. If you are a political
leader, central banker, market regulator, financial journalist, exchange executive, a derivative
supplying bank, or an end-user please read this guide and/or circulate it to your colleagues
or staff.
The recent global financial crisis requires that we respond to it8: I believe that you have a duty to be
open to good ideas just as I have a responsibility to make the ideas presented in this guide more
widely known. If you have any questions please get in touch.
Pavel Pinkava
[email protected]
January 2010
1
How To Migrate OTC Derivatives Onto
Exchange Without Damaging The Market
In this section I will:-
A. Why reforming OTC-markets
is potentially problematic
A. Describe some of the reasons why moving the OTC
derivatives markets onto a traditional exchange, or even
Although an EET model would seem to be the way forward the
onto a clearing only model, is potentially problematic.
consensus has shifted, amid lobbying from banks, towards
accepting that a central counterparty clearing (CCPC) only
B. Present a hybrid exchange/clearing-only model which
“solution” can be desirable without an exchange platform.
supports the handling of (formerly) OTC derivatives in a
As if this level of dilution was not enough end-users have
manner that overcomes all problems. The new model
asked to be exempted from even a CCPC model.
provides for both pure exchange trading at its centre and
apparently OTC-like markets at its periphery, all within a
Why banks fear the EET model
connected and efficient whole.
The reason banks prefer a post-trade CCPC only model is
that they fear the alternative. Under an unsophisticated EET
The hybrid model maintains the regulatory benefits of
model all aspects of the market (pre-trade, trade-matching
reduced systematic risk and increased transparency of
and post-trade) would become open to all comers. Such a
less tailored proposals. However it moves beyond these
model is viewed by banks as potentially making the business
by introducing margining reforms that meet “end-user”
of supplying (formerly) OTC derivatives unprofitable:-
needs whilst simultaneously safeguarding the relationships
between the liquidity providing banks on the “sell-side” and
1. The ability of competitors to indulge in “cherry picking”
their customers on the “buy-side”.
and hence “franchise breaking” of individual bank to enduser relationships, would prevent profitable services from
funding loss making offerings.
2. The emergence of so called “free-riding” behaviour by
relatively minor players “fronting”9 the big banks’ bid-ask
spreads would result in these (formerly) major liquidity
providers failing to secure enough flow business to
The assumption that the interests of
existing OTC market users cannot
be fully aligned with the interests of
reformers and regulators is wrong
remain profitable.
Reduced profitability or increased loss making by the
banks that formerly supplied the OTC market would of
course be disastrous for liquidity. In the worst case under
an unsophisticated EET model. liquidity could disappear all
together, undermining10 the CCPC-house associated with
the exchange. For this reason a clearing only solution could
paradoxically pose less systematic risk than a failed attempt
at a full-blown EET market.
2
OTC derivatives are described as
complex when mostly they are not
Similarities between OTC and EET
Valuation issues
Another reason banks don’t like exchanges is that many of
OTC derivatives are often described as complex when
them do not understand the subtleties of the EET model:-
mostly they are not.
• For example EET products are perceived as fully
Thus for example you do not have to be a markets wizard to
standardized and transparent yet there are products where
understand when having an option to pay USD 15 million in
an end-user can specify within certain limits, the terms of
exchange for receiving EUR 10 million on some date three
trade e.g. the exercise price, expiration date, exercise type,
calendar months from today may have value – This occurs
and settlement calculation of so called “flex options”. Of
when USD 15 million costs less than EUR 10 million on the
necessity these trades occur apart from the central public
foreign exchange market (or equivalently when EUR 10 million
auction market and are privately negotiated.
costs more than USD 15 million). The option will be valuable
• Furthermore “block trades” are routinely permitted in the
because it gives the option owner the right to buy something
EET model in specified futures, options or combination
for less than its market price, and this is why the instrument is
transaction products. Although such trades are subject
useful in hedging against rising prices.
to minimum transaction size requirements they too are
Likewise it is easy to add the concept of losing your option
privately negotiated. The distinction between the OTC
if EUR/USD trades up to 1.60 between now and the date in
and EET liquidity provision models is therefore less clear
question. Yet the option I have just described is a 3 month
cut than many bankers believe.
EUR Call USD Put Struck at 1.50 with reverse knock-out at 1.60
and is considered an “exotic” option. Hedgers might buy such
Why end users don’t like CCPC
an option because it is cheaper than the simpler one.
From the point of view of end-users both an EET model and a
The truth is that complexity arises mostly around valuation
CCPC-only model create an equally burdensome overhead.
issues i.e. working out a price of an “exotic” option is relatively
This is because under either alternative they would have to
more complex than working out the price of a simpler
service daily margin calls which is not the case in the existing
instrument. Understanding what a derivative instrument is
OTC markets. Thus for example a derivative that may have
can be easy even when working out its fair price is hard.
previously been recorded using simple hedge accounting
would under either a full blown EET model or a CCPC-only
model require daily mark to market settlement. This in turn
would lead such end-user firms to have to keep a far greater
number of liquid assets on hand than at present, thereby
adversely affecting their asset mix and increasing their
business risk 11. However to exclude end-user counterparties
active in the OTC derivatives markets from any CCPC only
initiative would be disastrous – It would lead to a failure to
fully simplify the web of contractual links that characterize
the OTC derivatives markets and hence a partial or complete
failure of the reform process itself.
3
The new model provides for both
pure exchange trading at its centre
and apparently OTC-like markets at
its periphery, all within a connected
and efficient whole
B. A new (hybrid)
exchange trading model
Simple solution
A solution to the above apparently conflicted positions
is for the sell-side banks to explicitly pay to maintain their
The assumption that the interests of existing OTC market
“franchise” by posting initial and daily variation margin calls
users cannot be fully aligned with the interests of reformers
to the CCPC-house on behalf of their end-user customers.
and regulators is wrong.
To formalise this we can define various categories of
A harmonious first step
participation in the exchange:-
You can get a long way towards a solution simply by demanding
that all the needs of market actors are met – I will therefore
1. Guaranteed Accounts – These would be entities such
seek to meet the needs of regulators yet not exclude the needs
as the end-users listed in note 11 and even minor financial
of banks and end-users. Let’s begin by listing requirements in
players such as smaller funds whose initial margin and
the light of my analysis in section A above:-
daily variation margin calls are posted for them by their
guaranteeing member.
I. I think it is safe to assume that in an ideal world regulators
want all OTC derivatives to be moved onto a transparent
2. Full Members – These would be entities such as
exchange trading platform.
Such a solution would of
banks and other major financial institutions, including
course involve an associated CCPC-house that would
some of the largest funds, with the capacity and desire
make initial margin and daily variation margin calls. The
to post initial margin and daily variation margin calls on
solution would also have to involve all market participants,
their own positions.
including end-users.
3. Guaranteeing Full Members – These would be full
II. By contrast end-users do not want to have to post
members who in addition to servicing their own positions
initial margin and daily variation margin calls because
would also post initial margin and daily variation margin calls
such a move would adversely affect their businesses as
on any positions held by the guaranteed accounts they
already discussed above. They are therefore faced with
support.
a potential conflict with regulators and reformers.
honoured the exchange’s market making requirements
Only sufficiently capitalized full members who
could achieve guaranteeing member status. In other words
III. Also as already discussed above one of the things
that the major liquidity providing banks would ideally
want to achieve is to maintain their “franchises” i.e. tied
relationships with end-users.
4
these would be the “sell-side” banks of today.
I think it is safe to assume that in
an ideal world regulators want all
OTC derivatives to be moved onto
a transparent exchange trading
platform, involving all market
participants, including end-users
Details of first step explored
3) Each traded derivative element 13 held in an end-user’s
The above may at first appear a trivial way out of the problem
guaranteed account will generate a net accumulated
margin calls cause end-users in an EET model, however, the
daily variation margin balance that must be settled with the
details of this new solution turn out to have many admirable
end-user once that element expires. Thus at expiry either,
features:-
a) the end-user will be paid from margin accumulated at
1) The solution allows all the participants in the existing OTC
the CCPC-house on its behalf; or
derivatives market to develop direct links to the exchange’s
b) the end-user will have to repay variation margin owed to
CCPC-house:-
its guaranteeing member i.e. margin that was previously
a) The contract between a guaranteed account entity and
consumed by the CCPC-house.
its guaranteeing full member entity would be a market
The result is that a payment identical to a classic OTC
standard licensed by the exchange and requiring the
contract 14 would be made on the relevant settlement date
registration of all entities directly with the CCPC-house.
either to or from the end-user, respectively. This is why
Because it would define the relationship between a liquidity
the proposed model is being presented as an apparently
provider and their customer such a contract would play an
OTC-like market at its periphery i.e. because end-users’
analogous role to the ISDA Master Agreement in a classic
experiences are unchanged even though their positions are
OTC market structure (See point 2).
connected to the CCPC-house.
b) As the guaranteed accounts would be directly visible
4) If necessary the CCPC-house can close out positions in a
at the CCPC-house level it would be easy for regulators,
member or guaranteed account at the exchange using initial
accountants and auditors to check the exposure and/or
margin to finance losses just as in existing futures markets.
performance of each end-user’s derivatives position and
This is of course equivalent to close out netting under an
to collect accurate data on the whole market. I believe
ISDA Master Agreement:-
this could quickly lead to improved accounting rules
a) If an end-user defaults on a payment under 3)b) then
regarding derivatives.
the accumulated variation margin already paid in by its
2) The solution is a “hybrid model” because full members can
guaranteeing member must be recovered by the full
trade on an exchange-like central market whilst direct bank
member privately. Thus not only are the consequences
to client liquidity provision relationships are also preserved:-
ultimately borne by the guaranteeing member, as is
a) Guaranteeing full members would be obliged to make
only proper, but the immediate impact is minor on all
markets in the central order book for some of the most
other members and therefore poses a relatively low
liquid contracts, and full members would be required to
systematic risk.
trade via the order book whenever appropriate e.g. for
b) If a guaranteeing member itself defaults then unlike
standard sized on-the-run deals12.
the OTC situation the end-user is at once protected
b) The extent to which an end-user would seek or would
because any mark to market profits to date are held
be allowed direct access to other members, or even to
at the CCPC-house on its behalf as explained in 3)a).
the unrestricted central market, would be the subject of
Alternatively to avoid closing out positions the entire
negotiation with their guaranteeing full member. Such
guaranteed account could be transferred to a new
negotiation might involve broader access in exchange
guarantor perhaps under a prearranged fall back
for an end-user promising to supply some or all of their
agreement with another full member 15.
own margin.
5
5) Perhaps unexpectedly, the burden on full members that
A further useful step
post margin for the entities they guarantee would usually be
Two of the issues raised in section A above implicitly concern
relatively light:-
the bid/ask spread18 and our treatment of them will be
a) A derivative being margined in the guaranteed account
improved by a further simple innovation that I believe should
would in most instances have been supplied by the
be introduced as a final step towards a best-of-breed solution
guaranteeing full member itself. In such cases the
to reforming the (formerly) OTC derivatives markets.
guaranteeing member will hold a mirroring contract with
the CCPC-house:-
These two questions are:-
i) When its client goes into a net accumulated loss
the bank must post variation margin to its end-user’s
a) How do we discourage the emergence of destructive
guaranteed account. However these funds will be
“free-riding” behaviour in any central market with an
returned to the member as variation margin profits
active order book?
on its own mirroring position. The net impact will
therefore simply be that mark to market profits on the
b) How do we handle the issue of calculating fair values19
bank’s own position, that would ordinarily have been
for the many “complex” derivatives?
received as variation margin under an EET style model,
would remain unrealized and instead would merely be
To a large extent point a) has already been addressed
recorded in the guaranteed account as accumulated
through the introduction of guaranteed accounts that are
variation margin due from the client to the bank 16.
tied directly to their liquidity providing full members. You can
ii) When its client makes a profit the variation margin
also set a “tic size” to address this point in a traditional way20
paid into the end-user’s guaranteed account will
but the innovation I am about to present can address this
ultimately have come from the member paying
problem still further21.
margin on its own mirroring position. Thus mark to
market losses on the bank’s own position will always
On the topic of point b) is it easy to imagine that calculating
be realized.
fair values for “complex” derivatives is about discovering the
b) In the other cases where the derivative being margined
single price at which exposure to such instruments could be
in the guaranteed account has not been supplied by
fairly obtained from a liquidity provider. However to think this
the guaranteeing full member the bank would likely be
is to misunderstand the derivative supply process: A bid/ask
in the situation described in 2)b). The guaranteeing full
spread must cover the provider’s cost of doing business and
member would not therefore be fully burdened because
therefore cannot be ignored22.
of the bank’s ability to collect margin from its
6
client 17.
Comparison of OTC, EET and Hybrid Models
OTC
EET
Hybrid
Pre-Trade Transparency
None or Limited
Full
Limited for end-users
Post-Trade Transparency
None or Limited
Full
Full for regulators but
not for all participants
Participant Status
Clear distinction between
buy-side and sell-side
Typically all participants are
on the same level
Clear distinction between
buy-side and sell-side
Margining
End-users do
not pay margin
All pay
End-users do not pay
margin
Counterparty risks
Both banks and
end- users are exposed
Risks eliminated via
margining and
replacement liquidity
End-users are not exposed
to risk of shortfalls amid
efficient close out
Trading activity
Primarily privately
negotiated
Primarily central
auction market
Central auction market
for on-the-run interbank
market / otherwise
privately negotiated
Mark to market
Subjective
Centrally provided
mark to mid
Centrally provided
mark to close-out
The existing exchange traded model and the hybrid model mirror each other
It is interesting to notice that whereas the EET model allows end users with direct access to the electronic central market but
with only an indirect relationship to the central clearer, the hybrid model does the opposite: It provides end users with direct
access to the central clearer but with only an indirect relationship to the central market.
Respecting the bid/ask spread
I propose that the following features be included in the new
exchange trading model:i. That the bids and asks of guaranteeing full members be
the sole basis of settlement.
ii. That such bids and asks submitted as part of the end of
each day settlement process be processed not into single
End-users experiences are
unchanged even though their
positions are connected to the
CCPC-house but unlike the OTC
situation the end-user is protected
settlement prices (as in an EET model) but into separate
bid settlement prices and ask settlement prices.
iii. That variation margin called on long positions be
generated by reference to settlement bids and variation
margin called on short positions be generated by
reference to settlement asks.
The existence of the above privilege for guaranteeing
full members would underline the importance of their
responsibilities as set out in 2)a) whilst the daily settlement
process combined with the hybrid model would imply that
profits were not recognised prematurely by banks23.
7
Example: How To Move CDS
Onto A Hybrid Exchange
In this section I will discuss the
Credit Default Swap (CDS) market
in particular and will:-
A. OTC CDS and the compromises
made to clear them
Standard CDS vs. CDS of ABS
A. Brief you on classic OTC CDS and the reform of
In light of the recent sub-prime mortgage fuelled credit
the classic market introduced in 2009 in order to
crunch and global financial crisis, I feel I must begin any
make redesigned OTC CDS more suitable for central
discussion of OTC CDS by making it crystal clear that the
counterparty clearing (CCPC).
CDS of ABS implicated in the recent crisis are very different
from standard CDS. Whilst standard CDS are commendable
B. Describe some key features of my 2004 invention of so
and hugely useful risk management products, to my mind
called x-CDS24 and why this clearable product is superior
it is fair to describe CDS of ABS as being unnecessary
to the redesigned OTC CDS standards.
and even destructive, because they appear to have been
created simply to help lubricate the now discredited
C. Explain how a bank could effortlessly offer classic
originate-to-distribute business model. It was this model (a
OTC-like CDS to its customers via trading clearable
debased version of classic securitisation) that first infected
x-CDS within the hybrid exchange model presented in
US mortgage markets and then the global financial markets
the previous chapter.
with the mountains of bad debt that have ultimately landed
at the feet of governments. To be clear, I do not think the
It is hoped that the discussion of a concrete example in this
world would be any worse off if CDS of ABS never returned
section, although necessarily technical, will serve to highlight
to prominence or perhaps were restricted by statute. Rather
the advantages of my new proposals as set out in the
than making the mistake of lumping standard CDS together
previous chapter, and will also serve to introduce some of my
with similar sounding but actually quite different products25,
2004/2005 ideas for reforming the OTC-markets to a wider
standard CDS should be recognised as economically useful
audience than they have enjoyed so far.
hedging tools. Together with other valuable OTC derivatives
markets, all standard, loan-only and most26 index CDS
should be transferred onto exchange in an intelligent way i.e.
be put onto a hybrid exchange/clearing-only model of the
type described in the previous chapter. Such a move would,
Recently it has been particularly
painful to watch the OTC CDS
markets undergo half-baked
product redesigns in order to
facilitate central clearing...
forever de-stigmatise these markets27 as CDS speculator
and hedger positioning would become transparent to
regulators and the products themselves would become
better understood.
Key features of OTC CDS
I do not need to give a basic description of standard
OTC CDS here28. However, in light of the need for better
understanding highlighted above I will focus on those points
rarely discussed elsewhere.
8
It is hoped that the discussion of a
concrete example in this section,
although necessarily technical, will
serve to highlight the advantages
of my new proposals as set out in
the previous chapter
What do CDS do?
higher when they receive an upfront payment (i.e. they make
Before I continue, the record must be set straight on a major
a negative payment). When there is no upfront payment the
misconception: CDS are often erroneously portrayed purely
CDS is said to be a “par CDS” and the coupon rate is called
as insurance contracts against default, when in fact they
the “par coupon rate” or “par swap rate”
can best be understood in terms of their broader purpose
– CDS are mainly used to hedge the yield spread exposures
Classic OTC CDS
that arise naturally in portfolios of corporate and/or risky
Due to the way CDS are designed there is normally a close
sovereign debt.
relationship between the par coupon rate quoted in the
market at any one time and the credit spread in the debt
To be clear the primary purpose of most CDS is not to
markets at the same time – The par rate is therefore often
provide insurance per se but as traded instruments. Thus,
quoted by market makers30. The relationship also explains
they are used to hedge against a drop in the market value
why, for example, 5-year CDS on XYZ Corp can be such a
of investor holdings in underlying debt should credit spreads
useful hedging tool for the credit spread component of the
widen29.
market risk in a 5-year XYZ Corp bond:-
Furthermore as with all practically useful hedging
instruments there is also a major role to be played by active
a) When trading classic OTC CDS a newly generated
liquidity providers and speculators.
contract would be negotiated and booked using the then
prevailing par coupon rate i.e. without any upfront payment
The price of CDS contracts
and at a coupon rate hedgers would recognise as being
Because CDS are traded instruments the most important
close to the credit spread they know and understand.
feature of these contracts is their market price. The focus
b) Later if credit spreads widened and the hedger
should be on the way the fair price/premium fluctuates as
wished to lift their CDS hedge they could do so at a profit
market conditions vary over time and how this affects the
offsetting their mark to market losses on the debt they
value of existing deals. As already stated the focus should
were hedging i.e. the original CDS contract could now be
not be on the part of the swap that gives insurance against
sold back to the market and would command an upfront
default, although ironically the price in question is the
payment in the original coupon payer’s favour (now that
premium that market participants are willing to pay for the
par coupon rates in the market had increased above the
insurance element of the swap.
coupon rate set in the contract in a) above).
c) Conversely if credit spreads narrowed and the hedger
It is important to explain that premium can be paid as coupon
wished to lift their CDS hedge they could do so at a loss
or as coupon plus upfront i.e. via,
offsetting their mark to market profits on the debt they
1. Coupons payable quarterly in arrears with the coupon
were hedging i.e. the original CDS contract could now
rate quoted per annum; plus perhaps
be sold back to the market but this would also require
2. An upfront part payment that is either positive or
an upfront payment from the original coupon payer (now
negative relative to coupon payments.
that par coupon rates in the market had decreased below
Obviously since the total value of the default insurance being
the coupon rate set in the contract in a) above).
bought can’t be affected by the method used to pay for it,
the coupon rate will be lower when the protection buyer (i.e.
coupon payer) also makes an upfront payment but will be
9
Few people have considered the new product opportunities which the
transition from open outcry floor based futures trading to electronic futures
trading has created. Indeed even today when electronic trading is totally
dominant, the only kind of exchange traded derivatives available are futures
or options that theoretically could still be traded in the old fashioned open
outcry way without any computers at all
Clearable Redesigned OTC CDS
B. About x-CDS
In 2009 OTC CDS were redesigned and relaunched in a pair
of initiatives known as the “big bang” and the “small bang” for
North American and European referenced debt respectively.
Developments in OTC CDS
viewed from an x-CDS perspective
It has been frustrating to watch the slow pace in which the
The trouble with the classic market was that each new
OTC CDS market has converged with the proposals set out
deal was struck in the manner of a) above and as the par
in my “groundbreaking”31 design for x-CDS. Thus as early
rate fluctuated many deals with different coupons would
as July 2004 I had already understood the need for recovery
be agreed.
This in turn meant that multiple fair valuation
rate auctions, mandatory cash settlement and a credit event
calculations would be required at each end of day settlement,
committee which were innovations introduced to the OTC
even for what was a single CDS exposure type, in our
market by ISDA, its trade organization, only in 2005, 2009
example, a 5-year CDS referenced to XYZ Corp.
and 2009 respectively32.
The redesigned OTC CDS are simply classic OTC CDS but
Recently it has been particularly painful to watch the OTC CDS
restricted to only a handful of predefined standard coupon
markets undergo half-baked product redesigns in order to
rates: In redesigned OTC CDS, coupon rates can only take
facilitate central clearing in what to me appears a manifestly
on values chosen from a few preset choices and new deals
suboptimal manner given I have been aware of a better
will be agreed at the standard coupon nearest, but no longer
solution for the last five years! I invite those that are interested
always equal to, the par rate. The limited variety of deal ticket
in x-CDS to read the, now LIFFE-owned, patent application
coupons reduces the number of distinct deals to be valued and
(see note 31 for details), or to contact me directly, or both.
hence the number of end of day calculations required at the
namely that a) new deals are no longer struck at par which
Relationship between x-CDS
and electronic futures
means hedgers may need to make upfront payments as well
Few people have considered the new product opportunities
as coupon payments; and b) hedgers may fail to understand
which the transition from open outcry floor based futures
the link between upfront premium and the par rate, and by
trading to electronic futures trading has created. Indeed even
extension the link with the credit spread they know and
today when electronic trading is totally dominant, the only kind
understand. Making a product less user friendly just to make
of exchange traded derivatives available are futures or options
it more easily clearable is an unfortunate compromise.
that theoretically could still be traded in the old fashioned open
clearing house. However this improvement comes at a cost,
outcry way without any computers at all.
In light of the above preamble, it should not surprise you that
the key to my x-CDS invention, and my other inventions from
the same stable, is a fuller utilisation of the potential of the
electronic trading process, specifically by use of computer
based
mapping-algorithms.
These
mapping-algorithms
allow quoted x-swaps to be broken down into futures-like
10
For the front office trader the
products appear to mimic existing
OTC-swaps, whereas the rest of the
process is as hyper efficient and
robust as existing futures markets
components tradable and clearable in the tried and trusted
Differences between x-CDS and OTC CDS
EET environment. For the front office trader the products
We need to understand how x-CDS differ from OTC CDS in
appear to mimic existing OTC-swaps, whereas the rest of the
order to properly describe how to move the OTC CDS market
process is as hyper efficient and robust as existing futures
onto a hybrid exchange:
markets. Another outcome of this approach is that x-swaps
• As already mentioned the coupon rate of an x-CDS is
can be easily understood by analogy as they have the same
not a fixed deal price but a volatile market price subject
relationship to OTC-swaps as exchange traded futures have
to daily variation, coupled with daily variation margin
to OTC-forwards 33.
gains or losses.
• x-CDS accrue coupons in an unusual way in that the
To be specific because x-CDS are made up of futures-like
coupon due is drawn down gradually over the entire
components (the x-CDS coupons) they automatically benefit
quarterly period for which the coupon is effective.
from the characteristics of futures:-
• After a credit event both x-CDS and OTC CDS will pay
• x-CDS must obviously be clearable because their
out equal amounts in default compensation. However,
futures-like components are clearable.
coupon payments due after the credit event are treated
• Unlike OTC CDS deals, but like futures, x-CDS trade
very differently – Whereas the coupon payments of
without reference to any previous deal price – Whereas
an OTC CDS are cancelled, those of an x-CDS are
OTC-forwards remain locked in at their original deal price,
accelerated, with payments for all forward periods
futures contracts undergo daily legal variation of their
becoming due immediately.
price coupled with cash payments in the form of variation
Obviously the last point is a key difference and will, under
margin gains or losses: As truly exchange traded products
the same market conditions, tend to cause par coupon
x-CDS, like futures, effectively maintain their original deal
rates quoted in x-CDS format to be below those quoted in
rate without actually keeping their original deal
price34.
traditional OTC CDS format35.
• Because futures do not support upfront payments
neither do x-CDS – Thus in a manner clearly superior to
For completeness sake, I would also like to share some insight
OTC CDS, an x-CDS will always trade as a pure par coupon
as to why x-CDS cannot sustain the coupon cancellation
rate maintaining its relationship to the underlying credit
approach available in the OTC market and why coupon
spread and doing so without the need for any market
acceleration is the correct alternative:-
standard formula to calculate fair upfront payments.
• OTC-like termination would require the original deal
By comparison with the above features of x-CDS, the
coupon rate to be cancelled and this would require the
redesigned OTC CDS with their limited choice of pre-set
x-CDS product to lose its futures-like independence from
standard coupon rates and lack of hedger utility are a very
any previous deal price. This would of course create a
inelegant solution. As if this was not enough, another feature
paradox by contradicting our previous discussion on the
of x-CDS is that the design naturally generates system
nature of x-CDS.
implied x-CDS forward par rates and hence increases
trading opportunities and stimulates the creation of a full
credit term structure.
11
As promised I have demonstrated
how a bank can effortlessly offer fully
clearable classic OTC-like CDS to its
customers via trading x-CDS within
a hybrid exchange model of the type
presented in the previous chapter
• Also, as already discussed, a futures-like clearing
• Over-hedge
position
(to
deal
with
coupon
process requires daily legal variation of quoted price to
acceleration): Book an additional “over-hedge” of long
be coupled with cash payments in the form of variation
positions in the end-user’s guaranteed account each at a
margin.
Because these are cash payments the legal
price of 0.00% per annum in sizes based on calculations
price variation must to some extent represent changes
using an assumed recovery rate36 (e.g. 40%). This leads to
in the market based present value of the x-CDS and its
sizes of USD 75,000 for the first quarterly x-CDS coupon,
component coupons. Thus provided there is no credit
USD 50,000 for the second quarterly x-CDS coupon,
event the value of a single x-CDS coupon will start
and USD 25,000 for the third quarterly x-CDS coupon
being marked down as it begins to be drawn down i.e.
assuming 40% recovery.
once its quarterly period has begun. This will, of course,
continue until its quarterly period has ended and the
Proof
coupon has been fully marked down i.e. drawn down
You can confirm the equivalence of the OTC-like trade and
and hence fully paid. Thus the market value of x-CDS
the x-CDS by considering all possible outcomes37:
coupons is proportional to the protection period they
cover. Applying this principle to a credit event for which
i. no credit event
all forward protection in the form of forward x-CDS has
ii. a credit event at the end of the last coupon
become redundant, it is therefore intuitively acceptable
iii. a credit event at the end of the third coupon
that knocked-out coupons would be immediately marked
iv. a credit event at the end of the second coupon
down to zero, and that this drawdown would correspond
v. a credit event at the end of the first coupon
to the coupons being accelerated.
i. Equivalence under no credit event
C. How to offer OTC-like CDS
whilst actually trading x-CDS
Recall that in the hybrid model each accumulated daily
variation margin balance is settled by the end-user only once
the relevant element has expired. In this case the elements
Example
are x-CDS coupons which if no credit event has occurred are
Imagine a bank is a guaranteeing full member of the hybrid
drawn down to zero on their normal expiry date. Under these
market as described in the previous chapter and that in its
circumstances the end-user will pay the bank accumulated
role as a liquidity provider it sells a 1-year CDS on XYZ Corp
margin on the USD 10 million basic position equal to the
in OTC-like format to an end-user’s guaranteed account.
margin call generated by the x-CDS coupon price having
The deal is struck at a par premium of 0.60% per annum in
dropped from 0.15% to zero. The over-hedge positions do
a notional amount of USD 10 million and is easy to book in
not generate a margin call since these are transferred at zero
terms of x-CDS coupons as follows:-
price in the first place. Notice that the amount due under
• Basic position (providing exposure to default
the x-CDS positions is also the same amount due under the
insurance): Book four quarterly x-CDS coupons each at
allegedly equivalent OTC CDS contract.
the agreed price of 0.60% per annum (i.e. approximately
0.15% of notional depending on day counts), each in the
agreed size of USD 10 million, with the long positions in the
end-user’s guaranteed account and the short positions
in bank’s own account in favour of the dealer.
12
ii. Equivalence under a credit event at
v. Equivalence under a credit event
the end of the last coupon period
at the end of the first coupon period.
As far as the fourth x-CDS coupon is concerned USD 10
As far as the first x-CDS coupon is concerned USD 10 million
million is held in the basic position and there is no additional
is held in the basic position and there is an additional position
position in the over-hedge. If a credit event occurs at the end
of USD 75,000 in the over-hedge. If a credit event occurs at
of the fourth coupon period the x-CDS coupon position will
the end of the first coupon period the second, third and fourth
provide the same amount of default insurance as under the
coupons would be accelerated, resulting in a payment of
allegedly equivalent OTC CDS contract i.e. they both supply
USD 45,000 becoming due on the x-CDS i.e. three coupons
the notional amount of USD 10 million.
of 0.15% of notional. However at the assumed 40% recovery
rate the over-hedge neutralises this by generating exactly the
iii. Equivalence under a credit event at
USD 45,000 required. Meanwhile the basic x-CDS coupon
the end of the third coupon period
position will provide the same amount of default insurance as
As far as the third x-CDS coupon is concerned USD 10 million
under the allegedly equivalent OTC CDS contract as before.
is held in the basic position and there is an additional position
of USD 25,000 in the over-hedge. If a credit event occurs
Concluding remarks
at the end of the third coupon period the fourth coupon
As promised I have demonstrated how a bank can effortlessly
would be accelerated, resulting in a payment of USD 15,000
offer fully clearable classic OTC-like CDS to its customers via
becoming due on the x-CDS i.e. one coupon of 0.15% of
trading x-CDS within a hybrid exchange model of the type
notional. However at the assumed 40% recovery rate the
presented in the previous chapter. In general the recovery
over-hedge neutralises this by generating exactly the USD
rate assumption represents only a residual exposure to
15,000 required. Meanwhile the basic x-CDS coupon position
the actually realized recovery rate (see graph on page 14).
will provide the same amount of default insurance as under
Nonetheless I would expect banks to develop strategies for
the allegedly equivalent OTC CDS contract as before.
managing these residuals.
iv. Equivalence under a credit event at
It should be noted, also, that the process just illustrated would
the end of the second coupon period
normally work in the opposite direction to that presented.
As far as the second x-CDS coupon is concerned
Thus, the central market in x-CDS would be the dominant
USD 10 million is held in the basic position and there is an
interbank venue for price discovery and banks would price
additional position of USD 50,000 in the over-hedge. If a
liquidity provision of OTC-like CDS dependent on where
credit event occurs at the end of the second coupon period
the x-CDS market was trading. In other words the 0.60%
the third and fourth coupons would be accelerated, resulting
per annum offered to the end-user in the example would
in a payment of USD 30,000 becoming due on the x-CDS i.e.
typically not be a starting point. It would be the result of a
two coupons of 0.15% of notional. However at the assumed
break even calculation by the bank and would represent the
40% recovery rate the over-hedge neutralises this by
level where the end-user’s x-CDS overspend on the basic
generating exactly the USD 30,000 required. Meanwhile the
position38 could fully fund their x-CDS underspend on the
basic x-CDS coupon position will provide the same amount
over-hedge position.
of default insurance as under the allegedly equivalent
OTC CDS contract as before.
13
Recovery rate exposure: 5 year CDS
It is very common to have to make recovery rate assumptions
The graph shows the impact of an actual recovery rate
when handling CDS calculations even in the existing OTC
differing from a 40% assumed rate for a 5-year CDS struck
markets.
Thus for example the market standard formula
at a par premium of 0.60% per annum. As can be seen the
discussed in note 30 also requires such an assumption. The
x-CDS gives virtually the same exposure as the OTC product
uninitiated reader should not therefore be concerned that a
although at high (low) recovery rates the over-hedge
recovery rate assumption is needed to generate the correct
underperforms (over-performs) resulting in a tracking error.
over-hedge sizes.
x-CDS with overhedge performs similarly to OTC
3.00%
0% Actual Recovery Rate
40% Actual Recovery Rate
2.00%
60% Actual Recovery Rate
80% Actual Recovery Rate
100% Actual Recovery Rate
1.00%
(% of notional)
x-CDS with overhedge payout minus traditional OTC CDS payout
20% Actual Recovery Rate
0.00%
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
-1.00%
-2.00%
-3.00%
-4.00%
Year in which credit event occurs
14
4.00
4.50
5.00
Comparison of CDS Market Models
The experience of end-user customers trading x-CDS with an over-hedge within
a hybrid model is closely akin to their experience in the classic OTC CDS market:
Classic OTC
CDS (high
grade credit)
Redeisgned
OTC CDS
1:1 x-CDS in
EET model
x-CDS with
over-hedge in
hybrid model
1:1 x-CDS in
hybrid model
Pre-Trade
Transparency
None or Limited
Full
Limited for end-users
Post-Trade
Transparency
Limited
Full
Full for regulators but
not for all participants
Central market users pay
Margining
End-users need not pay margin
End-users do not pay margin as
this is done by their guarantor
Central market in terms of x-CDS par coupon rate
Trading activity
Coupon rate
Primarily privately negotiated in
terms of OTC par coupon rate
Par for new
trades, original
deal ticket
coupon for close
outs
Fixed standard
coupons
Recovery rate
assumption
Routinely required in upfront
payment calculations
Upfront
payments
Routinely required
Coupon
payment
Payment due at end of period
plus privately negotiated trades
with end-user customers
over-hedge
on trades with
customers
Always trades as a pure coupon
(x-CDS par rate is lower than OTC CDS par rate)
negotiated par
x-CDS rate for
end-users
Not required
negotiated par
OTC like rate for
end-users
Required for
calculating
over hedge
Occur only as part of normal profit
or loss through variation margin
Floating coupon rate generates daily
variation margin payments
Payment due only at coupon contract
expiry for end-users
Forward coupons are accelerated
Effect of
credit event
on coupons
Marking to
market
Forward coupons knock out
Difficult due to
large variety
of deal ticket
coupons
Easier due to
limited number
of standard
coupons
Forward coupons
appear to knockout on end-user
trades due to
over-hedge
Very easy as is based on closing x-CDS par rates in central
market with no recovery rate assumptions required
and requires recovery rate assumption
15
Notes
1 The epithet “OTC” stands for “over the counter”
and is used to denote markets in privately negotiated
instruments and indeed such instruments themselves.
2 Given the finance industry is full of smart people,
why has no one else developed and published a fully
workable reform like mine? I have two theories to offer
on the matter:
• Perhaps bankers have simply jumped to
conclusions and hence not seen it as being in
their own interests to think very deeply about how
to put OTC derivatives markets onto an exchange
like system?
• Or perhaps the topic itself is simply so esoteric
and technical that too few people other than
me have acquired the necessary breadth of
understanding, or indeed the will, to take a
sufficient interest?
If it is bankers’ fears that are the cause, then it is
rather ironic that the solution presented in this guide
not only poses no threat to the vested interests of the
sell-side banks but actually legitimises such interests
by aligning them with those of regulators and those of
the buy-side
Whatever the reason, I hope that the reader does not
jump to any negative conclusions simply because I am
at present acting alone. The ideas recommended in
this guide should be judged on their own merits and
not be prejudged simply because it is convenient.
3 The “sell-side” are the banks that supply OTC
derivatives whilst the “buy-side” are the end-users
who consume OTC derivatives as hedging tools.
4 These derivatives helped banks build and hedge the
so called collateralised debt obligations which brought
down banks as far away from the US housing market
as Germany. They also played a direct role in the
demise of AIG.
5 I use “EET” in contrast to “OTC” to denote the
“existing exchange traded” market model, or
instruments traded in that model, or indeed to denote
“existing exchange trading” as a process.
6 See for example “Reforming OTC Derivative Markets
– A UK perspective” by the Financial Services Authority
& HM Treasury, December 2009.
7 This document introduces a blueprint for workable
systematic reform which supports the full agendas
of regulators, liquidity providing banks and endusers... Although my earlier work was described
in the UK patents courts as “groundbreaking”,
it was not complete. This is because my earlier
inventions, which were wrested from me after a legal
action by my former employer LIFFE (The London
International Financial Futures & Options Exchange),
focused entirely on product related reforms and not
on creating a market structure that makes reform
both efficient and palatable. My original ideas have
yet to be implemented by LIFFE as a result of this
incompleteness, however, the full solution proposed
in this guide includes my previous work. Not only this
but it also details for the first time a hybrid market
model that can deliver OTC-like derivative products.
8 Blaming bankers’ greed and trying to curb bonuses
Energy North America, General Electric Company,
is not a very constructive or efficient response even
GID Investment Advisers LLC, Goodrich Corporation,
though it may be an expedient one for politicians:
Grove Property Fund LLC, Harley-Davidson Inc., HCA
• Bankers’ have been receiving large bonuses for
Inc., HCR ManorCare, Health Care REIT Inc., Helix
years and years so it is quite obvious that bonuses
Funds, Hersha Hospitality Trust, Hobbico Inc., Host
per se cannot be the primary cause of this crisis.
Hotels & Resorts Inc., IBM, Independent Petroleum
• Also, only a tiny sub-set of bankers’ dealing in
Association of America, Industrial Energy Consumers
sub-prime mortgages, CDS of ABS, CDOs, SIVs
of America, Information Technology Industry Council,
and other highly structured products can be said
International Housewares Association, Invenergy LLC,
to be at fault. It is not fair to tar all bankers with the
Johnson & Johnson, KBS Capital Advisors, KBS Real
same brush.
Estate Investment Trust, KBS Real Estate Investment
In the long run, no one will thank our leaders for
Trust II, Kinder Morgan, Lefrak Organization Inc,
cheapening such an important question with knee-jerk
Legacy Reserves LP, Lexmark, Loews Corporation,
attacks on bonuses when the real problems lie elsewhere
MarkWest Energy Partners L.P., MeadWestvaco,
and perhaps remain unattended.
Medtronic Inc., Meredith Corporation, Mid-America
Apartment Communities Inc., MidAmerican Energy
9 There is nothing wrong with tighter bid ask spreads
Holdings Company, MillerCoors, Millipore Corporation,
due to healthy competitive pressures. However,
Mississippi Manufacturers Association, Monday
posting speculative prices on exchange that are
Properties, National Association of Manufacturers,
entirely dependent on other liquidity providers’ prices
National Association of Real Estate Investment Trusts,
is effectively a negative parasitic behaviour that can
Natural Gas Supply Association, National Grid,
damage the long term health of the market.
National Gypsum Company, Newfield Exploration,
Northwestern Energy, Novation Capital, Novelis Inc.,
10 Unless there is liquidity a CCPC-house cannot
NRG Energy, Owens-Illinois Inc., PPL Corporation,
lay-off the risks it inherits from a failed member. Thus
Praxair Inc., Procter & Gamble, Progress Energy,
without liquidity a CCPC-house can become a source
PSEG, Questar Energy, Regency Centers Corporation,
of systematic risk rather than a solution to it.
Retail Energy Supply Association, Ryder System Inc.,
ScanSource Inc., Sempra Energy, Shell Oil Company,
11 In October 2009 a letter from a “Coalition for
Simon Property Group Inc., Simons Petroleum Inc.,
Derivatives End-Users” was sent to every member of
Southern Company, Stellar Industries Inc., Strategic
Congress explaining their concerns about “proposals
Hotels & Resorts Inc., Superior Graphite Co. , Superior
that would require all OTC derivatives used by
Woodcraft Inc., Tenaska Marketing Ventures, Tenaska
business end-users to be centrally cleared, executed
Power Services, Targa Resources, Tennant Company,
on exchanges or cash collateralized or subject end-
Teradata Corporation, The Boeing Company, The
users to capital charges” the letter was signed by
Commonwealth Group LLC, The Durst Organization,
171 entities including individual companies and some
The JBG Companies, The John Buck Company, The
umbrella organizations, namely:- 3M, Acadia Realty
Pinnacle Companies, The Process Gas Consumers
Trust, Air Products and Chemicals Inc., Allegheny
Group, The Real Estate Roundtable, The Williams
Technologies Incorporated, Alpha Natural Resources,
Companies, Thomas Properties Group Inc., TRW
AMB Property Corporation, AMC Entertainment
Automotive, United Launch Alliance, U.S. Chamber
Inc., Ameren Services, American Chemistry Council,
of Commerce, Vanguard Natural Resources LLC,
American Electric Power, American Forest & Paper
Vermeer Corporation, Volvo Group North America,
Association, American Gas Association, American
Washington Gas, Weather Risk Management
Residential Communities LLC, Anadarko Petroleum
Association, Weingarten Realty Investors,
Corporation, API - American Petroleum Institute,
Weyerhaeuser Company, Whirlpool Corporation, Xcel
Apple Inc., ARAMARK Corporation, Associated
Energy, Yocum Oil Company, and Zimmer Inc.
Estates Realty Corporation, Association for Financial
Professionals, Bayer Corporation, Behringer Harvard,
12 Such a requirement would not necessarily apply to
Boston Scientific Corporation, BP America, Brady
very large deals or for unusual dates e.g. dates not on the
Corporation, Brookdale Senior Living Inc., Bunge,
1w, 2w, 3w, 1m, 2m, ..., 1y, 2y etc cycle that is standard to
Business Roundtable, Cabot Corporation, Cargill
some products.
Incorporated, Caterpillar Inc., CDW Corporation,
Chesapeake Energy Corporation, CNL Financial
13 For example this could be a single cash flow
Group, Coca-Cola Bottling Company United Inc.,
within a swap.
Cohen Brothers Realty Corporation, Commercial
Developments International Inc., Commodity Markets
14 Provided, of course, that the traded contract
Council, Community Health Systems, Compass
carries the appropriate exposure in and of itself.
Minerals, Constellation Energy, Cooper Tire & Rubber
Company, Corporate Properties of the Americas LLC,
15 The new guarantor would have to replace initial
Covidien, Cummins Inc., Deere & Company, Devon
margin that was supplied by the old guarantor. The other
Energy, Digital Realty Trust, Direct Energy, Dominion,
details of the relationship between the new guarantor
Donaldson Company Inc., DTE Energy, Duke Energy
and the defaulting old guarantor could vary from case to
Corporation, Dynegy, Eastman Chemical Company,
case subject to negotiations and the extent to which one
Eaton Corporation, Ecolab, Edens & Avant, Edison
guarantor insured the other etc.
Electric Institute, EFCO Corp., El Paso Corporation,
Electric Power Supply Association (EPSA), Eli Lilly and
Company, Emdeon Inc., Enbridge Energy Partners
and Subsidiaries, EnCana Oil & Gas (USA) Inc.,
Energy Future Holdings, Entergy Corporation, Exelon
Corporation, Financial Executives International, First
Energy, FMC Corporation, Ford Motor Company,
Forest City Enterprises Inc., FPL Group, GDF SUEZ
16
16 As explained in 3)b) the end-user will eventually
24 I use “x-CDS” to describe my particular designs
what the DTCC has achieved in this space starting in
have to repay variation margin owed to its
for an exchange tradable CDS. I have also designed
2005. The irony is that I repeatedly tried to convince
guaranteeing member unless it defaults as explained
“x-IRS” and “x-OIS” as separate innovations each of
my ex-employer to accelerate their implementation of
in 4)a). Also as explained in 1)b) regulators,
which build on an underlying breakthrough concept.
my ideas and to cooperate with me but they became
accountants and auditors can easily confirm the level
Together I refer to these as “x-swaps”.
obsessed with conflict – an approach which has hurt
both me, themselves and obviously their shareholders
of accumulated margin owed to the bank. Indeed,
from the bank’s point of view given accumulated
25 CDS of ABS could easily be renamed as “pay-
too. I can say this with confidence because on their
margin is recorded for each traded derivative element
as-you-go-swaps” because of their distinct legal
own LIFFE have completely failed to make proper use
separately, it is easy to split this into current assets
structure and settlement mechanisms, which are very
of these inventions even though they spent so much
(due within one year) and long-term assets. Finally,
different from standard CDS.
money to secure them.
26 Some index CDS are actually index CDS of ABS.
32 Incidentally I was also the first person to propose
it should be noted that the bank’s risk management
department can easily use this information to decide
tradable fixings in a meeting with Lee McGinty of JP
the size of any credit default swap hedge against the
end-user defaulting it may need in future.
27 The cause of the stigmatization has been the fact
Morgan in January 2004 which implemented in 2005
that going long CDS referenced to a company is
see http://www.creditex.com/press/credit-fixings.pdf.
17 With an end-user supplying some or all of their own
related to going short in that company’s stock – It has
margin (but perhaps less frequently than daily) the
been argued that unregulated CDS trading contributed
33 Hopefully the reader knows enough about the often
relationship would be analogous to derivatives prime
to the severity of the recent bear market in stocks.
poorly understood and rarely explained relationship
between OTC-forwards and futures to see this is not a
broking in the existing OTC model.
28 Presumably the reader will know where to get
trivial point. Just as there cannot be a futures contract
18 The “bid” is the price/quotation at which banks
basic information on CDS for themselves or perhaps is
without a hosting futures exchange so there cannot
are willing to take a long exposure (i.e. buy) whilst the
already familiar with the basics of these products.
be an x-swap without a hosting exchange. Hopefully
the reader will also appreciate that giving x-swaps a
“ask” is the price/quotation at which banks are willing
29 The “credit spread” is the term given to the relative
distinct name is not just a gimmick: x-CDS are not
yield that a debt instrument must offer in the market to
simply cleared OTC CDS which are made available on
19 This is of course an issue for the CCPC-house and
attract bidders i.e. relative to another benchmark yield,
a trading platform. They are constructed ab initio for
it may be imagined that keeping on top of this issue
typically government debt yield. Most corporate bonds
the sole purpose of being listed on exchange, whether
would require a very significant overhead of staff trained
for example trade at a yield higher than government
that be under an EET model or a more sophisticated
in quantitative finance.
debt of comparable maturity yields. An appropriate
hybrid exchange model as proposed here. Feel free to
way to view a corporate bond is therefore that it carries
contact me if you require further explanation.
to take a short exposure (i.e. sell).
20 The emergence of so called “free-riding” behavior
the risk of its benchmark government debt (known as
is prevented in the EET model by setting a “tic size”
interest rate risk) plus the risk of its credit spread. The
34 Since this property of “original deal price
because this sets a threshold beyond which “fronting”
former can be hedged with government bond and other
independence” is a defining feature of best-of-breed
is not possible by creating a minimum bid/ask spread.
interest rate derivatives. The latter can be hedged with
exchange traded products it is interesting to notice
CDS. Should its credit spread widen the corporate
how the hybrid model creates OTC-like products
21 Under point iii in the proposal below, “free-
bond will sell off relative to govies but the CDS hedge
precisely by reversing deal price independence in a
riders” holding positions overnight would (as well as
will appreciate in value to compensate.
deliberately controlled manner. As discussed in the
previous chapter this is achieved under my proposals
having to post initial margin) suffer a mark to market
variation margin loss equal to the cost of closing
30 The details of the relationship between market
via the introduction of guaranteed accounts and
out their position with the real (i.e. guaranteeing full
quotations in terms of par coupon rate and equivalent
the requirement that accumulated daily variation
member) liquidity providers. Thus “free-riding” would
trade settlements in terms of pairs of actual deal
margin balances must be recorded for each element
no longer be free!
coupon plus fair upfront payment need not concern
separately. Again, I would be happy to expand on this
us here: All we need to know is that a market standard
observation if contacted.
22 To be clear, the derivative provider’s cost of doing
formula for making this transformation exists and is
business is their cost of hedging. Setting a fair bid/ask
available on systems such as Bloomberg.
35 This is because due to the coupon cancellation
feature following a credit event, a notionally higher
spread is just as important to a liquidity providing bank
as the difference between wholesale and retail prices is
31 The designs describe how the trading and clearing
OTC CDS coupon would, all else remaining equal, lead
to a retailer. It is true that the valuation methodologies
process under an electronic futures market can be
to lower payments in practice as compared with the
used within banks are often based on academic work
adapted to handle derivatives such as interest rate
lower x-CDS quote, so the two formats would in fact
that imagines a simplified world with no hedging costs.
swaps (x-IRS) and credit default swaps (x-CDS).
be equivalent.
However using these artificial models is only a first step
Unfortunately ownership of my x-swaps inventions was
and the theoretical values they generate only serve as
wrested from me. The inventive moments for x-swaps
36 The recovery rate is the price of the defaulted
a starting point, over which a bias such as the volatility
occurred independently of my employment in July
debt after a credit event as determined by the credit
smile, and around which bid/ask spreads, must be
2004. However I naively tried to share my x-CDS idea
event auction.
added to cover the hedging costs dealers expect might
with my employer, LIFFE (The London International
be incurred in the real world.
Financial Futures & Options Exchange), because I
37 I have based the calculations in this example on the
knew they were an ideal venue to implement my ideas.
simplifying assumption that credit events occur only
23 The net effect of these ideas together with the
Once I had finally got management’s attention the
at the end of whole periods. It would not be hard to
guaranteed account concept is that the guaranteeing
issue of ownership quickly arose. In early 2005, whilst
lift this assumption but it would make the over- hedge
banks would initially have to fund the bid/ask spreads
on leave because of bullying from a senior manager, I
more complex (and dynamic) as I would need to hedge
that their clients’ guaranteed accounts had paid away
applied for US patents on both kinds of x-swaps (the
the cancelled un-accrued portion of the effective OTC
as variation margin losses. Therefore banks could
applications were published in 2006 as 20060224491
CDS coupon – Presenting the full detail would make
not claim bid/ask spreads as upfront profits, since
and 20060224492). My ex-employer then spent in
the example unnecessarily complicated.
these would not be realized until variation margin
the region of six hundred and fifty thousand pounds
was returned under 3)b). Such a novel set up is
convincing the UK courts that I had been “employed
38 There is an overspend because the par coupon
clearly music to the ears of regulators who have been
to invent” in order to gain control of x-swaps (and was
rate market quoted in x-CDS format will be below
concerned about distortions caused by profits being
even granted the other two of my patent applications
the 0.60% per annum quoted in traditional OTC CDS
recognised too early.
that concerning cash products and which I had
format – see note 35 for an explanation of why.
actually developed in early 2005 whilst on leave). The
inventions were described as “ground breaking” in
court and they undoubtedly constituted an enormous
business opportunity at the time, especially in light of
17
Epilogue
I hope you have enjoyed reading this guide and that it will serve its intended purpose in
stimulating a paradigm shift in the way (formerly) OTC derivatives are handled. The hybrid
model can cover any exchange tradable instruments and my former work (which is now
owned by LIFFE) covers interest rate swaps (x-IRS and x-OIS) as well as x-CDS. Since forex
futures and options already exist these too can be included.
By the way, last year I also further developed my ideas on reforming another OTC market,
namely, the global money markets (the original ideas are also owned by LIFFE) and would be
happy to share my thoughts on improving the global economy by improving transparency
and yet controlling capital flows in an open capital account in a manner which also prevents
financial necrosis from spreading between banks both domestically and internationally – If
anyone wants me to contribute on this other topic please also get in touch.
Chi pò, non vò;
chi vò, non pò;
chi sà, non fà;
chi fà, non sà;
e cosi, male il mondo và
Italian proverb
translation:
“Who can do, does not want to;
Who wants to, cannot do it;
Who knows how, will not do it;
Who does it, knows not how;
and, so, badly goes the world.”