Tag Archives: derivatives markets

Regulating Capital: the information challenge

stock market

During the financial crisis regulators discovered the hard way how little they knew about the risky derivatives portfolios built up by large financial institutions. Lehman Brothers, for example, was thought to have been a counterparty to about $5 trillion of credit default swaps. When they turned sour in 2008, it brought the financial system to its knees. In response leaders of the world’s main economies demanded in 2009 that derivatives deals should all be reported to “trade repositories”—vast central databases—to make it easier to identify and then reduce systemic risks.

On February 12th, 2014 European rules came into force requiring the reporting of all derivatives to one of six approved repositories. Similar rules have already been in place in America for about a year. But the effort, although concerted, is not consistent: the American and European reforms differ, making awkward transactions spanning the two jurisdictions. Moreover, even if these data can be reconciled, it is not clear what regulators will do with it.

The American regulations allow the reporting to be taken care of by one party to the trade. Yet Europe requires both parties to report. That means every fund manager or corporate treasurer trading derivatives has had to follow cumbersome rules, not just the banks that peddle most deals.  Getting both sides to report was originally seen as a means to ensure that every entity’s exposure could be rigorously monitored. But the complexities of obliging both parties to report trades, which then have to be reconciled with one another, have led many to question whether the additional burden is really worthwhile. “Dual reporting was required to avoid omissions in the data,” says Stewart Macbeth of the Depository Trust & Clearing Corporation, one of the approved repositories. But it “captures a lot of companies in the real economy that probably do not pose a systemic risk”.

The European rules differ from the American ones in other ways too. America staggered implementation of its rules over the course of several months as different sorts of contracts and counterparties were gradually brought within their scope. European regulators chose instead to have everyone start reporting everything on a single day. That created a bottleneck as participants rushed to put the necessary procedures and agreements in place.

Now that the deadline has passed, responsibility shifts to regulators, whose duty it will be to make sense of the torrents of data that are now flooding in. In America the Commodity Futures Trading Commission has openly acknowledged the problems it has already encountered coping with the deluge, with one commissioner blaming “inconsistencies and errors” in the rules. In Europe the problems are likely to be even worse as so many more counterparties are reporting data to multiple repositories. That will create an unfortunate opportunity for both omissions and duplications of data. In time the new reporting rules should reduce risks, but much work still needs to be done.

A paper published on February 4th by the Financial Stability Board (FSB) offers a solution. It proposes aggregating data from multiple repositories into one central one. That may iron out inconsistencies in the data—but it will not necessarily make it any more digestible.

Derivatives:  Data dump, Economist, Feb. 22, 2013, at 65

Fictitious Deals: Who Pays for the Unregulated Oil Market

futures market oil

The European Commission declared that it feared oil companies had “colluded” to distort benchmark prices for crude, oil products and biofuels. Royal Dutch Shell, BP, Norway’s Statoil and Italy’s ENI  all said that they were co-operating with the commission. The competition authorities also called on the London offices of Platts, a subsidiary of McGraw Hill, an American publisher and business-information firm, which sets reference prices for these commodities.

The volumes of oil and products linked to these benchmark prices are vast. Futures and derivatives markets are also built on the price of the underlying physical commodity. At least 200 billion barrels a year, worth in the order of $20 trillion, are priced off the Brent benchmark, the world’s biggest, according to Liz Bossley, chief executive of Consilience, an energy-markets consultancy. The commission has said that even small price distortions could have a “huge impact” on energy prices. Statoil has said that the commission’s interest goes all the way back to 2002. If it is right, then the sums involved could be huge, too.

The authorities are tight-lipped about their focus, but they seem to be examining the integrity of benchmark prices. Each day Platts’s reporters establish a reference price by following the value of public bids and offers during a half-hour “window” before a set time—4:30pm in London, for example. This “Market-on-Close” (MOC) method is based on the idea that using published, verifiable deals to set the price is more reliable than having reporters ring around their pals, who might be tempted to talk their own books.  Platts keenly defends the MOC method. It points out that it ignores bids, offers and deals that are anomalous or suspicious. “We are not aware of any evidence that our price assessments are not reflective of market value,” it says, before declaring that it stands behind its method.

Yet such price-setting mechanisms have come in for criticism. The International Organisation of Securities Commissions (IOSCO), a grouping of financial regulators, said last year that the potential for false reporting “is not mere conjecture.” Total, a French oil giant…told IOSCO that benchmark prices were out of line with the underlying market “several times a year”.

Nobody knows what, if anything, the present investigation will find. The authorities should be scouring firms’ books for trades within the half-hour window that are offset in the futures markets. Perhaps they will find deals used in Platts’s assessment that are quietly unwound by the oil companies in private. They should also check shipping registers to see that cargoes have actually changed hands, or whether deals are fictitious. If any of these tricks could distort the benchmark by even a few cents, it might create a handy profit on contracts that are priced off it.

Oil consumers have been quick to rage at news of this week’s raids. The belief that oil companies rip off consumers is as unshakable as the idea that Rockefeller was good with money. “Our members…will be incandescent if what many have long suspected—that is price fixing—proves to be true,” said Robert Downes, of the Forum of Private Business, a British group that backs small firms. In fact, if there have indeed been price distortions, then these could as well have nudged prices down as forced them up—because oil traders make money on price movements, not just rises.

It is a complicated picture and the EU’s competition authorities are likely to take months or years before deciding whether they suspect any oil companies of having committed a crime. Meanwhile, a reform of the oil markets is unlikely to come anytime soon. Despite IOSCO’s fears of price distortion, it backed away from recommending changes—after fierce lobbying from the industry.

Trading in oil: Libor in a barrel, Economist,, May 18, 2013, at 77