Due to the great variety of types of structured products, there is no one definition. However, there are a number of traits that are common between them, including the use of a reference security or index and the use of derivatives. Here are four definitions:
- Finra NTM 05-59, Structured Products: "Structured products are securities derived from or based on a single security, a basket of securities, an index, a commodity, a debt issuance and/or a foreign currency."
- SEC Rule 434: "Securities whose cash flow characteristcs depend upon one or more indices or that have embedded forwards or options or securities where an investor's investment return and the issuer's paymet obligations are contingent on, or highly sensitive to, changes in the value of underlying assets, indicies, interest rates or cash flows."
- Structured Products in Wealth Management by Tolle, Hutter, Ruthemann, and Wohlwend: "The meaning of the term "structured products" as it is used in specialist literature is not the same everywhere. This book defines structured products as combindations of derivates and traditional financial instrments, such as stock and bonds. The various components are combined into a single financial instrument and securitized. The inclusion of derivative components gives the structured product itself the characteristics of a derivative."
- Wikipedia: "In finance, a structured product, also known as amarket linked investment, is generally a pre-packaged investment strategy based on derivatives, such as a single security, a basket of securities, options, indices, commodities, debt issuance and/or foreign currencies, and to a lesser extent, swaps.The variety of products just described is demonstrative of the fact that there is no single, uniform defnition of a structured product.."
SEC Rule 434,
This blog post continues our expert analysis of complex investments and their regulation.
The Telegraph is reporting on a story I have been following for some time. (Telegraph) Many UK banks sold complex interest rate swaps to small businesses to protect from rising interest rates. However, when rates continued to fall, the businesses were required to post more and more collateral forcing many into bankruptcy.
Martin Wheatley, chief executive designate of the Financial Conduct Authority, accused lenders of selling businesses “absurdly complex products” and said many customers could now expect compensation from their banks.
This blog post continues our expert analysis of complex investments and their regulation.
I just came across this CNBC discussion with Barry Ritholtz on global derivatives. The numbers are staggering:
- Global derivatives total $230 trillion;
- That represents 5X global GDP;
- 95% of the contracts are held at four US banks: JPM, BAC, C, GS
Here's the video:
Reuters reports that new Dodd-Frank Act rules could drive 30-50 percent of swap trades to exchanges, leaving brokerages looking for ways to replace billions of revenue. (Reuters)
See our previous coverage of Dodd-Frank Act regulations on the swap markets here and here.
Bloomberg has a fascinating article on the coming changes to swap collateral under the Dodd-Frank Act. (Bloomberg) I highly recommend you read this piece. Here are some key takeaways:
- Starting in March, as much as 79 percent of derivatives trades... must be backed by collateral and go through clearinghouses such as CME Group;
- Traders may have to post $927 billion;
- Currently, about 40 percent of swaps are cleared by clearinghouses;
- The collateral put up for swaps trades covered by Dodd-Frank typically equals only 0.5 percent of their notional value;
- At CME, the collateral... for a 10-year interest-rate swap ranges between 2.89 percent and 4.06 percent of the trade's notional value;
- (Collateral amounts are) based on "value-at-risk", and is calculated to cover the losses a trader might suffer with a 99 percent level of confidence. (I hope they're not still using normal distributions.);
- The Fed would backstop the clearinghouses in an emergency;
- The swaps market is 8X the futures market;
The Telegraph is reporting that 24 MPs are requesting the FSA to force UK banks into suspending interest rate payments on retail swaps. (Telegraph) Here's the basics:
Banks must be forced to offer a moratorium on payments that thousands of small businesses are still being forced to make on interest rate swaps, according to a group of MPs investigating the scandal.
The Financial Services Authority and Treasury have been told they must push banks to offer an immediate freeze on all swap payments, according to a letter signed by 24 MPs.
“There are many businesses who are continuing to enter administration as a direct result of their obligations under their swap contracts,” wrote Guto Bebb, a Conservative MP and chairman of the All-Party Parliamentary Group on swap mis-selling.
FYI, "administration" in the UK is bankruptcy.
The International Swaps and Derivatives Association has submitted a 39 page comment on the Dodd-Frank Act. (ISDA)
Here is the extract of their key points:
Initial Margin ("IM")
- Negative consequences of IM. As proposed, the IM requirement could severely challenge the resiliency of the financial system and will severely curtail the use of uncleared swaps for hedging, which would disrupt key financial services, such as those that provide for wider availability of home loans and domestic and international corporate finance.
- Proposed alternative. In lieu of IM, systemic risk can be effectively mitigated by: imposing VM requirements with daily collection (subject to limited exceptions) and zero thresholds; implementation of appropriate capital requirements, and mandatory clearing of liquid standardized swaps.
- Timing and Consistency. The Prudential Regulators' margin rules should be coordinated and consistent with the margin requirements of the CFTC, the SEC and regulators in other major financial jurisdictions. The Prudential Regulators should re-propose their rules on margin after they have had the opportunity to review and consider the final findings of the Basel/IOSCO Working Group and the SEC's proposed margin rules.
- Phase-In/Clearing: Compliance with the margin requirements should be phased- in over time and no earlier than the clearing requirements for the same asset class. The proposed time period of 180 days for implementation of the final rules is insufficient. The effective date for margin requirements for a given asset class should follow the implementation of mandatory clearing for that asset class.
Scope: Entities – We re-emphasize the recommendation that end-users, special purpose vehicles ("SPVs") and state and municipal government entities be excluded from the margin requirements. ISDA's position is that all sovereigns and central banks should post margin in order to achieve international comity. Unilateral action by a regulator in the U.S. or any other jurisdiction would be damaging to market participants and market liquidity.
Margin Calculation - We strongly recommend that the collection of IM not be required. While the Dodd-Frank Act provides for IM requirements for bank swap dealers, the Prudential Regulators have latitude in how they address that reference to IM and should consider the severe negative consequences of the proposed IM requirements. If the Prudential Regulators find it necessary to require the collection of IM, IM should be collected on a static basis, the amounts should be low and thresholds should be allowed as determined by the CSEs. In addition, calculation and posting of IM on or before execution date should not be required.
The proposed standardized tables would result in excessive IM requirements. Based on our review of aggregated QIS data from eight leading banks (which represent 45-50% of the total notional amount of the swap market), ISDA estimates that the amount of IM required using the standardized tables as proposed in the Study and the PR Proposal would be over $10.2 (in the Study)/7.6 (in the PR Proposal) trillion, over 6 times that required if an IM model were used.7 One way to address this issue would be to allow netting. The current proposal does not allow netting when the standardized table is used to calculate IM, whereas the Study and SEC proposals allow some netting with use of the standardized table.
- Netting – In general, netting that is legally enforceable should be permitted. The Prudential Regulators should also allow portfolio-based margining across cleared and uncleared swaps, other products and across legal structures. The Study allows netting within asset class when a model is used, and across comparable contracts with the schedule is used. The Prudential Regulators should also consider the approach proposed by the SEC, which allows broad netting for margin.
- Eligible collateral. Eligible collateral and applicable haircuts should be determined by the CSEs. At a minimum, the rules should adopt a broader range of eligible collateral as proposed by the Study. Alternatively, the Prudential Regulators' final rules may avoid specifying types of products and securities as eligible, as proposed by the SEC, subject to prescribed haircuts.
- Segregation. If IM is required, segregation and third party custody for IM should be at the agreement of the parties and not be required by regulation.8 CSEs should be allowed to offer asset protection mechanisms other than third party segregation that would provide that collateral be "immediately available" as recommended by the Study; e.g. segregation on the books of the CSE. The SEC proposal provides that SBSDs hold collateral in an account under the control of the SBSD and third party segregation is at the election of the counterparty that is not an SBSD. Parties posting collateral should have the option to allow the CSE to re-hypothecate the collateral.
- Inter-Affiliate Swaps - As stated in the prior letter to the Prudential Regulators, inter- affiliate trades should be excluded from margin requirements. Swaps between affiliates do not add systemic risk. Such trades are used to internally allocate risk and encourage centralized risk management. Imposition of margin requirements on inter-affiliate trades would add cost and inefficiency to internal risk management.
- Cross-Border Trades - Affiliates of U.S. persons should not be treated as U.S. persons under the margin rules, as proposed by the CFTC in its cross-border guidance. For swaps involving multiple jurisdictions, non-U.S. regulatory regimes should be recognized.
Reuters reports that Guardian Care Homes is suing Barclays over Libor-based interest rate swaps. (Reuters) Although it is a small claim of $59 million, it has big implications and will be watched carefully.
The article has one staggering fact:
Britain's financial regulator has estimated that about 44,000 interest rate swaps have been wrongly sold to UK companies since 2001.
Guardian Care Homes,
The latest liability estimate for the Libor scandal is in at $6 billion for municipal bonds, writes Darrell Preston of Bloomberg. (Bloomberg) The estimate comes from Swap Financial Group. The size of the muni swap market is estimated to be about $500 billion, so the $6 billion estimate comes in at 1.2 percent.
Swap Financial Group,
The Guardian has an article which estimates LIBOR-based swaps to be $250 trillion - which is a lot of illions. You can find the article here. Writer Alix Bailin does a nice job describing the LIBOR setting process, which is remarkably like the Keynesian beauty contest. Here you go:
The process for ascertaining Libor is really quite remarkable. It is not done by averaging the rates at which banks actually lend to one another for any given period of time. It is calculated by asking member banks (there are between eight and 20 for each currency) what rate they think they could borrow funds on the interbank market.
By the way, Bailin is a barrister at Matrix Chambers and used to trade swaps in the City.