lunes, 16 de noviembre de 2015

lunes, noviembre 16, 2015

The $630 Trillion Derivatives Market: A Snowflake Away From Complete Meltdown?
              
 
- The over-the-counter derivative market is huge on a notional contract basis and is dominated by large cap universal banks. 
       
- Some investors perceive this as a "black swan" event risk that one day will potentially wipe out the capital of the whole banking system. 
       
- Are those fears grounded in reality or is it just misguided interpretation by not so well-informed investors? 
       
- In this article, I will endeavor to tackle this question heads on.
Albert Einstein once commented:

If the facts don't fit the theory. Change the facts.

When it comes to the OTC derivatives market, the headline size in excess of $600 Trillion dollar seems to downright frighten some investors. Perhaps it's the sheer size of the market coupled with somewhat fresh memories of Lehman Brothers collapse and AIG (NYSE:AIG) mishaps - it seems to me though, that some investors prefer to ignore the facts and readily believe that the derivatives market will be the culprit for the next financial crisis.

In a recent and popular editor's pick article named "Deutsche Bank: Just A Snowflake Away" - the author focused on the risks apparent with Deutsche Bank's (NYSE:DB) 52 Trillion euro notional derivative exposure as of the end of 2014. The author than explains that he is shorting the stock on that basis and as a hedge against a black swan event. For many unsophisticated investors (who are not banking experts), the article reads really well - in fact, if I didn't understand the facts either I might have joined the author in shorting the stock (as some other commenters seem to have done).

The issue with the article though, is that the author is not an expert on derivatives (self-admittedly so) and thus perhaps inadvertently, largely misinterpreted the facts and associated risks.

Additionally, in my most recent Citigroup (NYSE:C) article, one of the readers noted the followings:
I haven't looked at the Derivative pile in a while. Last I did it was about $750 Trillion of notional paper. We presume the vast majority of that is hedged/offset, although the credit side of it cannot be fully hedged ( the round robin argument, for example, is how do you assign a credit risk to Citi as a counter-party when you don't know what Citi is "worth"?). Even if we assume as little as 10% of the $750 Trillion is naked (no, nobody would EVER do that...would they?) and then we assume even that 10% of that 10% fails due to some unknown event, guess what? The entire bank industry capital is wiped out...and then some! 
That is the sort of risk thinking which you need to apply to these zombie banks in order to understand why they trade at "arguably" cheap valuations.
The views articulated above are not uncommon and even the pros seem to reinforce these - for example, in a 2013 Time magazine piece, the author suggested that "derivatives may be the biggest risk for the global economy" - essentially running similar arguments to above.

Clearly, many believe the risks of "big numbers" derivatives will come home to roost one day and that the banks that generate the lion share of notional derivatives contracts [including JP Morgan (NYSE:JPM), Citigroup, Bank of America (NYSE:BAC), DB, HSBC (NYSE:HSBC), Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS) and Barclays (NYSE:BCS)] are therefore not investable.

Are these fears grounded in reality or just a tempest in a tea cup?

Let's delve into the detail.

The Global OTC Derivatives market

The Bank for International Settlements (BIS) periodically releases OTC markets' statistics - as of the end of 2014, their report revealed the followings:

(click to enlarge)

A few explanations relating to above charts:
  • The left-most chart represents the 'scary' number of $630 Trillion of notional principal derivatives contracts.
  • The middle chart represents a snapshot of gross market values(in other words, gross sum of mark-to-market of existing derivatives contracts). This is a fraction of the notional exposure that people fear so much.
  • The right-most chart reflects the gross credit exposure post netting of legally-enforceable bilateral contracts
So the net exposure after netting is just over $3 Trillion (that is assuming all market counterparties one deals with actually default).

But what about collateral?

Most OTC derivatives contracts are governed by a master agreement published by the International Swaps and Derivatives Association (ISDA). In the majority of cases, ISDA also includes a Collateral Securities Agreement (CSA) that governs the posting of collateral by the parties to the contract. As such, if the mark-to-market of a contract moves adversely than the affected party must post collateral (typically in the form of cash or other marketable securities). Hedge funds for example, are typically required to provide a margin security upfront.

ISDA, in a June 2013 report, highlights the followings impact of collateralization:

(click to enlarge)

Considering December 2012, figures - the gross credit exposure (after netting) is estimated to be $3.6 Trillion. However, once collateral posted is included the gross credit exposure further reduces to 1.1 Trillion.

In the same report as above, ISDA highlights losses (Credit exposure only) made by U.S. banks in 2007-2011.

(click to enlarge)

Note that the Lehman exposure is reflected in the 2008 numbers whereas $1.6 billion exposure to monoline has been included in the 2011 figures - clearly, not material amount to the industry.

Explaining interest rate swaps

As can be seen from above, more than 80% of the notional derivatives contracts relate to interest rates derivatives. A simple example of that, is a plain vanilla interest rate swap - where counterparty A may be paying LIBOR + 1% to counterparty B, who in turn pays counterparty A a fixed 2% periodic payments. The agreement will be based on a notional amount, say $1 billion and typically, the parties may hedge their interest rate risk with another counterparty or simply seek to hedge an underlying exposure. Should there be a significant move up in interest rates, than it is probable that counterparty A will need to post collateral (given its variable payments over life of the contract will increase).

There is really nothing controversial with these type of OTC derivatives and are part and parcel of the efficient operations of capital markets. These form the lion share of the OTC derivatives markets (over 80%).

How about the regulators?

To think that in today's intrusive banking regulation environment - the powers to be would allow such a ticking bomb of an exposure (as some would have you think), sounds rather naive to me. In fact, Basel III specifically deals with counterparty risks (by increasing capital requirements) and further incentivizes the use of clearing houses for derivatives trading (by specifying lower capital charges compared with uncleared derivatives).

Finally, the banks themselves actively monitor and manage their market and counterparty risks - there are very large middle and back-office teams in banks that daily value these exposures and ensure any credit and market risks are within well-defined limits.

Final thoughts

Evidently the OTC derivatives market is not very well-understood by ordinary investors. It is important to note that the large reported notional exposures are just that (large notional numbers) and have very limited relational connection to actual risks.

In fact, when I consider the investment case in the large cap banking space - I am much more concerned with the good old credit cycle as opposed to losing sleep over notional derivatives numbers.

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