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#GDTRM15: Latest on derivatives markets' risk and regulation

First Published 20th May 2015

Delegates had optimistic views for a transatlantic agreement on clearing house regulation, even as derivatives markets grapple with systemic risk signals worldwide.

Global Derivatives Trading and Risk Management Conference

Global Derivatives Trading and Risk Management Conference

Delegates in Amsterdam, 18 to 22 May

Amsterdam - Ongoing negotiations between US and European regulators towards equivalent clearing house regimes seem to be moving forward in earnest, and are expected to wrap up favourably, according to an expert at the Global Derivatives Trading and Risk Management conference.

"At the end of the day there is distance between the two positions, but will they reconcile? I think they will," said Stuart Weinstein, professor and head of Coventry Law School.

Addressing delegates, he added: "Are you an optimist? You think by the summer? I think we are getting there."

Weinstein is commissioned by the SWIFT Institute to undertake research on regulation of OTC derivatives. The major hang-ups include items such as gross posting, meaning the clearing member must post for each customer, without any netting. The result is that US clearinghouses receive more, sometimes much more, collateral than under net posting.

The US wants it, Europe doesn't.

In an analysis, the CFTC calculated the margin requirements under both sets of rules for a defined set of accounts. In the US, that figure came out to some $58 billion, in Europe, it was more like $23 billion.

While acknowledging that there are caveats to this kind of hypothetical scenario, one delegate with knowledge of the CFTC analysis added that this issue overshadows the other items considerably.

Other roadblocks that regulators are sorting out include: mandatory collecting from all customers, reconciling the differences in the treatment of affiliates, and guaranteed default fund contributions.

If it doesn't get sorted, trading across the Atlantic could get cumbersome. The magic word, Weinstein said, is "equivalence".

Systemic risk

Clearing houses emerged as a darling of regulators seeking to safeguard the financial system against any future crash, since the last one vividly illustrated how the build-up of systemic risk gets ignored.

The warning for risk managers, said Hersh Shefrin, professor of finance at Santa Clara University, is "ignore sentiment at our peril".

Shefrin leans on theory and research from renowned economist Hyman Minsky, describing the 'Minsky dynamic' in behavioural finance; euphoria, followed by increase in leverage and shadow banking, a shift from debt financing to speculative and, ultimately, 'Ponzi finance'.

Ponzi finance occurs when expected cash flows from assets are not thought to be sufficient to cover even the required interest payments, Shefrin explained, let alone repayment of principal. That means doubling down on asset appreciation to do the job.

This then fuels an asset bubble, he added.

"As the bubble expands, it causes new era thinking. Some might say, 'This time is different'," he said. Bubbles get discounted and rationalised, while regulators lean towards "thinking that markets are rational enough to self-regulate", Shefrin added.

"The real lesson of behavioural finance is that sentiment isn't especially predictable and it adds to our risk more than it adds to our opportunities for higher expected returns," he said. "So when we seek to exploit mispricing in the market, there is a price to pay, and the rewards for that alpha is additional exposure to sentiment based risk."

Shefrin does not make predictions, but an area where Ponzi finance seems strong, he said, is in Chinese markets. "All the issues that Minsky was worried about, you see them playing up in Chinese markets."

China risk

There is no doubt that warning signs are coming from China's financial system, not known for its transparency. Margin trading too was hit earlier this year after it became frothy.

But those red flags are balanced by banking and market reforms in an economy that is only just starting to open and seems to have plenty of room to run, said Darrell Duffie, professor of finance at Stanford University.

"Concerns about shadow banking? Yes. Although I believe it's under control," he said.

Meanwhile the renminbi is increasingly convertible, there are fewer restriction on lending and borrowing rates by the central bank, and bail outs are being reduced. Regulatory hurdles are likely to be sped up - there are some 1,000 IPOs queued up in China, Duffie noted, and the Hong Kong-Shanghai Stock Connect link is doing well.

Alternative asset management is nascent. "It is a vibrant, active, growing, exciting period. But it's tiny," he said. That will start to change as derivatives markets continue to open up.

In May, Chinese stock index futures surpassed S&P500 futures in turnover, according to Reuters. The CSI300 index - composed of the 300 largest A-shares listed on the Shanghai and Shenzhen stock exchanges - is one of the most actively traded contracts in the world.

"(There will be an) increasing reliance on capital markets and capital markets pricing to allocate capital rather than state-directed," Duffie added.

The conference runs until Friday. Keep an eye out for more of our conference coverage of big data and machine learning, as well as the latest in algorithmic trading.

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