…Chatham Financial provided hedging advisory services to PGGM and Ampere for this Offshore Wind Project…Read More
Archive for 2012
The core responsibilities for this role are financial contract management and data management. Some of the key task include: To ensure the accuracy of all economic, financial, and legal terms of the contracts by comparing bank documentation with our transaction records, to facilitate the execution of our clients’ derivatives transactions under the most favorable terms, to coordinate with major investment banks to manage the life-cycle of these contracts, to capture and represent accurately a variety of complex financial transactions in our system, and to understand and mine data from client transactions and analyze them for valuable insights.
We have endeavored in this Ghostly little post, to raise the Ghost of an Idea, which we hope shall not put our readers out of humour with themselves, with each other, with the season, or with us.
Enduser Scrooge sat busy in his counting-house. It was cold, bleak, biting weather, but Enduser Scrooge would not put more coals upon the fire, for the price of coal had abruptly risen and he had not hedged his exposure with Newcastle Index swaps. “Bah! Humbug!” he muttered as he poured over the details of his risk management portfolio. At length the hour of shutting up the counting-house arrived, and with an ill will he dismounted from his stool and locked up the office with a growl. After taking his usual melancholy dinner in his usual melancholy tavern, Enduser Scrooge beguiled the rest of the evening with his ledger-book, and then went home to bed.
He awoke with a start to find a phantom standing before him. “Who are you?” he whispered.
“In life I was your partner, Unhedged Barley. You know that I untowardly managed all my agricultural price exposures in life. And now I’m come to tell you that three spirits will visit you; without their visits, you cannot hope to shun the path I tread. Expect the first tomorrow, when the bell tolls one.”
The Ghost of Derivatives Past
When Enduser Scrooge awoke, the clock chimed midnight and then three quarters more. He resolved to lie awake until the hour was past, and at length it broke his listening ear with a deep, dull, hollow One. The curtains of his bed were drawn aside by an unearthly visitor. “Are you the Spirit, sir, whose coming was foretold to me?” asked Scrooge.
“I am!” came the soft and gentle voice, as if from a distance. “I am the Ghost of Derivatives Past. Rise and walk with me! I am to show you the well-remembered time when you used derivatives without regard for diversifying counterparty risk.”
As the words were spoken, they passed through the wall and stood within the treasury department of the firm in which Scrooge and Barley had labored before the crisis. It was a large room, but one of broken fortunes, for the spacious offices were little used, and there was a lonely man talking on the telephone. Enduser Scrooge wept as he heard himself speak.
“Sure, let’s buy those options with Leanman Brothers. No, don’t worry about their risk of default! Every bank is much too big to fail. We can finance the purchases by selling CDS on a large diversified financial institution and insurer. Do I think the paper has any risk? Certainly not – if enough mortgages are packaged together, in the aggregate they lose all risk of default, no matter which tranche you own.”
The Ghost looked at him sagely. “So you see, do you not, that your choosing to disregard counterparty risk of default led you and many others to great sorrow?”
“Remove me from this place, Spirit!” said Enduser Scrooge in a broken voice. “I cannot bear it!” He was suddenly conscious of being exhausted and overcome by an irresistible drowsiness.
The Ghost of Derivatives Present
Awaking in the middle of a prodigious snore, and sitting up in bed to get his thoughts together, Enduser Scrooge had no occasion to be told that the bell was again upon the stroke of two. When no shape immediately appeared, he was taken with a violent fit of trembling, but then a strange voice called his name. He glanced up to see a jolly Giant, glorious to see, bearing a glowing torch not unlike Plenty’s horn, who held it high up to shed its light on Enduser Scrooge.
“Come forth!” exclaimed the Ghost. “Come forth, and know me better! I am the Ghost of Derivatives Present. Come forth, and let me show you the fruits of your current procrastination. Touch my robe!”
Scrooge did as he was told and held it fast. All the room vanished instantly, and they stood in the great hallway of the counting-house. It was a remarkable quality of the Ghost that notwithstanding his gigantic size, he could accommodate himself to any place with ease, and so they came inside the company’s file room to a huge stack of documents. One by one the Ghost lifted them up for Enduser Scrooge to behold.
“Observe,” said he, “no sign that you have prepared in any way for compliance with the Dodd-Frank Act. If you are a financial entity, where is the evidence that you have evaluated any potential FCMs, negotiated and signed Clearing Agreements or OTC Addenda with them, or obtained Cleared Derivative Execution Agreements with your dealers? Even if you are a non-financial entity qualifying for the end-user exception, I see no indication that you have amended your ISDAs to comply with Dodd-Frank, or gathered the fact pattern to demonstrate that you are an eligible contract participant.”
“No more, Spirit, no more!” Enduser Scrooge wailed. “I am woefully unprepared for the new regulatory regime; show me no more!” Just then the Ghost vanished, and the bell struck three.
The Ghost of Derivatives Future
The third Phantom slowly, gravely, silently approached. When it came, Scrooge bent down upon his knee; for in the very air through which this Spirit moved it seemed to scatter gloom and mystery. It was shrouded in a deep black garment, which concealed its head, its face, its form, and left nothing of it visible save one outstretched hand.
“Am I in the presence of the Ghost of Derivatives Yet to Come?” asked Enduser Scrooge.
The Spirit answered not, but pointed onward with his hand. They scarcely seemed to enter Scrooge’s office; for rather the office seemed to spring up about them, and encompass them of its own act. They passed through the walls into the executive boardroom, where Scrooge could see the two divisions of his company in desperate straits to justify their respective financial positions to the board.
One division head said: “Why are our earnings so volatile when they never were before? We looked at the regulatory burden and financial costs of hedging and just decided not to hedge our exposures. Our debits and credits rise and fall with the tide, and we cannot control their perturbations anymore. The FX gain and loss in our income statement twitches about like the tail of the black cat at the poultryman’s.”
The other division chief took a different approach: “Our risks are fully hedged, but our hedging costs are higher than they have ever been. We haven’t engaged an advisor to help us optimize our hedging plan, and to determine whether or not we should be trading our swaps over-the-counter, in a cleared environment, or on an exchange. Because our hedging plan is not optimal, our derivative costs erode our margins like rust upon the smithy’s tools.”
The Ghost pointed to the financially imperiled company, and then back at Scrooge.
Enduser Scrooge was undone. “No, Spirit! Oh no! From henceforth I will live in the Past, the Present, and the Future, and I will not shut out the risk management lessons that they teach.”
The kind hand appeared to shake.
“Starting today,” cried Enduser Scrooge, “I will ensure I am fully prepared for compliance with Dodd-Frank protocols! I will get all my ISDAs and required agreements in place! I will work with an advisor to ensure I am optimizing future hedging costs and benefits!”
And so the Phantom shrunk, collapsed, and dwindled down into a bedpost.
The End of It
When Enduser Scrooge awoke, he knew that his risk management strategy was now on firmer footing than it ever had theretofore been. He had no further intercourse with Spirits, and it was always said of him, that he knew how to manage risk well, if any man alive possessed the knowledge, for he lived upon the Principle: “My exposures – I’ll wisely hedge them, every one!”
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Chatham Financial’s Matt Hoffman and Michael Ashby assert that end users should explore some of the smaller terms of ISDA agreements when negotiating these agreements. The authors explore three terms included in ISDA agreements worthy of review to help all parties reach fair agreements.Read More
…”It is possible, if not even probable, that the futures world will make steady progress against making their products more and more customizable,” said Luke Zubrod at Chatham Financial, a consultancy firm…Read More
During this Thanksgiving holiday, we at Chatham got to thinking about the things for which we are thankful. Family, friends, health – the list contained the usual suspects. But this Thanksgiving, we had another reason to be thankful as we dug into the independent findings of Martin Wheatley, Managing Director of the Conduct Business Unit at the Financial Services Authority (FSA) and active Chief Executive of the newly created Financial Conduct Authority. In September, Mr. Wheatley released to the public “The Wheatley Review of LIBOR: Final Report,” a detailed, ten-step plan designed to give guidance for a policy response aimed at preventing future abuses of LIBOR and other financial benchmarks. After reading the Wheatley Review, we are thankful that the LIBOR calculation process is getting an apparently much-needed revamping.
In July, Chatham brought to your attention the economic impact of Barclays’ LIBOR manipulation. We reported that while it was most certainly scandalous, the economic impact for the hedger was marginal at most, as hedgers that both pay and receive LIBOR are indifferent to individual settings. The real loss was damaged market confidence resulting from a breach of public trust. The effects of such a breach weren’t to be fully understood until regulators, participating banks, and customers using financial contracts tied to LIBOR (futures, swaps, floating rate debt, etc.) determine what to do going forward. There was a general sense that LIBOR was the best we had, even if it was flawed… that is, until the Wheatley Review.
Pending Regulatory Changes
At a high level, Wheatley supports the continued existence of LIBOR. The Review’s findings confirm what we’ve experienced: there has been no recognizable market change in use or structure of LIBOR-based contracts. What will change is the institutional framework. Questions like, “What organization will be responsible for collecting and publishing LIBOR?” are the ones that will be answered in the immediate future.
Wheatley recommends that the British Bankers’ Association (BBA), under guidance from regulatory authorities, immediately begin to transfer to an independent party its administrative role in calculating LIBOR. The BBA has affirmed its support of Wheatley’s recommendations and will transfer its responsibility to a new sponsor. Those responsible for manipulating the rate in the future will face criminal charges and broader FSA investigative powers into LIBOR by amendment to Britain’s Financial Services and Markets Act 2000.
Wheatley recommends that LIBOR settings be corroborated with actual interbank lending data and use in financial contracts, suggesting that BBA member banks’ submissions are hypothetical and not necessarily reflective of the market for interbank lending. As an example, Wheatley notes that in the wake of the financial crisis and credit crunch of 2008, interbank lending had all but dried up except for the most short-dated maturities, especially in the Eurozone. If LIBOR is to be an accurate reflection of the banks’ unsecured lending, then it must be tied to transaction data. Where there isn’t supporting data, Wheatley recommends that these tenors not be reported. Specifically, Wheatley recommends that (a) the Australian, New Zealand and Canadian Dollars, Danish Kroner, and Swedish Kronor be discontinued; and (b) the remaining currencies have the four, five, seven, eight, ten, and eleven month tenors discontinued. Per Wheatley’s recommendations, the LIBOR benchmarks would be reduced from 150 to 20 rates over a 12-month transition period.
Currently, the daily submissions of each member bank are published daily as a mechanism to promote transparency and general accountability for the determined rate. Wheatley notes that this could provide incentives for each member bank to provide inappropriate rates because each submission can be perceived as an implicit signal of the individual bank’s creditworthiness. Wheatley recommends that individual submissions be made available after a period of at least three months. Additionally, he recommends greater bank participation, noting that larger panels discourage manipulative attempts and increase the representativeness of the LIBOR benchmark.
Wheatley’s findings include much to be thankful for: LIBOR will benefit from needed reform to discourage manipulation; rate settings will be made with greater fidelity; and LIBOR will continue to be used as a benchmark for financial products. But other market participants are looking into alternative benchmarks based on secured lending, which includes considerations of liquidity and collateral value and does not take into consideration bank credit risk. If market participants are to find a valid replacement, a large amount of research and ingenuity is required to develop an adequate replacement.
But post-Wheatley Review, questions remain. As a borrower, how do I anticipate the risk that the benchmark I’m using won’t change during the life of my financial contract? Is there a way to “hedge” that uncertainty by including language that addresses LIBOR’s going away or fundamentally changing? Lenders are asking themselves these questions too. As each party navigates the uncertainty with the best information available, that information is hard to unpack and often is nuanced, theoretical, and legalistic. Fortunately, we at Chatham have our fingers on the pulse of these and other issues, and we’re thankful that our clients trust us to keep them informed. As always, please don’t hesitate to reach out to us for an update!
…Rob Dornton-Duff at Chatham Financial said some market participants believed a full conversion to the CPI methodology was being priced in. “We assume under this scenario there will be some reduction in inflation breakeven swap rates, and at the other extreme of no change to the methodology break-evens will fall,” he said…Read More
…“Market participants need to assume that the current state of affairs will likely remain,” says Luke Zubrod, director at Chatham Financial…Read More