Derivative Books at Banks Have Declared the Recovery Dead

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In the middle of August last year, a Swedish firm practically nobody has ever heard of issued a press release announcing that it had a primary hand in extinguishing half a quadrillion dollars in notional principal outstanding. That was, of course, a cumulative total dating back to the launch of TriOptima's "compression service" in 2003. Nonetheless, that the banking system globally might be shed of anything approaching a quadrillion is cause for notice.

Global banks are impressively complicated given both the spectrum of tasks they perform and the sheer numbers involved in trying to complete them without sending everything into a tailspin. While GDP's and even total debt counts remain, for now, in the tens of trillions and only threatening the order of magnitude into the hundreds of trillions, derivatives contracts long ago left 14 digits. It is entirely incomprehensible to fathom such figures, and even more so where all this "principal" intersects with itself and everything else out there in the real world.

That is what compression service offers, at least in one facet where computer management can efficiently process what human comprehension cannot. While we think of banking giants as rigidly-run bureaucracies, that, in fact, is quite the problem since it is and has become sometimes impossible to reconcile even stark redundancies. I'm not writing with respect to human resources as you might expect from government structures, for instance, but rather the nature of such global banking itself.

A eurodollar bank will have numerous operational systems, called "desks", that each have their own mandate and assigned tolerances, and thus in trading those parameters might duplicate what other desks are doing in fact if not in intent. In many cases, counterintuitively, different desks may make the exact opposite trade as each other at the same exact time. Thus is the nature of "dollar" money dealing where cross purposes for the whole are not in the individual circumstances.

By far the largest component of banking derivatives are interest rate swaps. Without stepping too far into that world, these swaps are an integral part of FICC (fixed income, currencies and commodities) and anyone paying real and close attention to eurodollar banking and the eurodollar system knows it is FICC and "bond trading" that actually rules finance and Wall Street. Stocks get all the attention, but it is FICC that runs things; it wasn't stocks that caused the Great Recession and 2008 panic, as billions upon billions in writedowns had nothing to do with equities - but a great deal to do with swaps.

TriOptima's great value is in finding derivative contract duplications that can be eliminated without any shift in the nature of the net position. You cannot, of course, simply eliminate a contract before maturity without ramifications in terms of risk parameters not to mention counterparty interests. Compression trades have the effect of matching characteristics, under defined tolerances, so that the net effect is to remove "unnecessary" contracts that provide no value or service either by "tear up" or offsetting. After the compression trading is done, by algorithm (which is why there is basically only one company in this business), the bank notices no effect on its book.

The benefits are more the kind of banking that modern banking has become in exclusivity. The compression service reduces, as TriOptima advertises, counterparty credit risk and operational risk and cost, but far more importantly balance sheet size and risk weighted assets (RWA). In all things that a wholesale bank does, this is very, very "valuable" mathematics.

To get this math magic to work, however, calls for some alterations to bank behavior and function. A big part is aggregation, not just inside the banks but amongst them. Various bank desk positions need to be combined so that the whole can be evaluated for compression submission and eligibility. And what is done for one bank needs to be offered by several others to create a compression "market" of sorts; a greater pool of existing contracts submitted for a "tear-up" trade, the greater the likelihood of finding just the right sort of offsetting positions.

Perhaps the greatest alteration to get this program working is to combine desks, or at least take desk positions and intra-book them (sort of double entry) to gather and organize disparate positions and trades. For example, Barclays has seemingly embraced the combination approach, as the ISDA reported in 2012:

Barclays has instilled trade life-cycle discipline not only in operations but also in trading, which helped create a consistent culture throughout Barclays that values compression. Barclays has a one-book approach in some currencies and currently has technology initiatives in place to expand its breadth. Barclays further maximizes the benefits of compression with specialist teams meeting before and after each cycle to apply custom risk tolerances designed to fit the currency and risk appetite at that time. The evaluations and risk impacts from previous completed cycles are documented and actioned which effectively create progressive improvements. In 2011, as a result of compression, Barclays Capital terminated $6.4 trillion of notional principal from SwapClear, doubling the amount from 2010 in both nominal and line item terms.

JP Morgan, on the other hand, at least as of 2012, takes to the double entry system to combine for firm-wide positions but with the same goal in mind:

J.P. Morgan has taken a comprehensive approach to counterparty and market risk by utilizing the one-book approach to IRS. The vast majority of transactions with third parties executed by any of J.P. Morgan's trading desks are rebooked into a central book. This means multiple desks may execute IRS but all the benefits from compression and risk offsetting can be managed centrally. It has taken some time and investment for the infrastructure to be established, but management firmly believes it is working.

Clearly, it is working as, again, gross notional eliminations have been absolutely astounding. If that creates a more efficient and less systemically-aligned and risky banking system, then the value of such an effort extends far beyond what each individual bank reaps in terms of internal cost savings and especially "capital" relief. But something has shifted in all this derivatives business, globally, as compression trading received massive new emphasis only more recently. As JP Morgan notes above, this shift has not been without significant cost and "investment."

As per usual, almost all commentary about such things is dedicated to Dodd-Frank, Basel or some other form of regulatory priority arising out of the last great problem. As I have documented too many times to recount, eurodollar banks and money dealers (mostly the same, but still) have been exiting that business dating back to the 2011 crisis flaring, and really to August 2007. Thus, compression trading is not so much an end to itself but rather the means to accomplish it.

Since the service began in 2003, in good partnership with LCH and its SwapClear on the domestic side, compression services had been available all through the eurodollar build up to August 2007. And it was used, too, as ICAP reports (TriOptima's current parent company) that there were $17.6 trillion in notional principal eliminated just in 2007; of that, $7.6 trillion were positions at clearinghouses and $10 trillion bilateral interest rate swaps; there were no compressions for credit default swaps. Just a year later, however, compression trading exploded to $45.0 trillion, with $12.3 trillion as clearinghouse positions, $30.2 trillion bilateral IRS, and all of a sudden $2.5 trillion in credit default swaps. It's as if "something" occurred that put great emphasis into banks for eliminations.

Before 2008, derivative books were exploding, compressions or not. While Alan Greenspan was busy thinking he had some financial control over such things by tinkering with quarter point changes in the largely irrelevant (and growing more so) federal funds rate, credit default swap notionals were just $400 billion when OCC first reported them in the first quarterly report for 2002. By the time Greenspan was gullibly starting his "tightening" in the middle of 2004, CDS notionals had nearly quadrupled to $1.5 trillion; by the time he finished, this "dark leverage" had more than quadrupled again to $7.9 trillion. At its peak, not coincidentally at the end of Q1 2008, there were reported to OCC $16.4 trillion in domestic CDS "principle." As I have written also many times before, the Federal Reserve had a far, far better chance (and still I doubt it would have actually worked) of averting panic then by absorbing and reissuing at least monolines' CDS portfolios and scrapping everything else they did including reducing interest rates.

The tale is less extreme on the interest rate swap side, but no less identical in pattern if on a different scale. There were regulatory burdens on "that" side of the panic, too, which proves that banks are not so burdened if they smell the great prospect of profit. We know that without fail because the largest source of revenue and profit for wholesale banks was FICC, particularly of the prop trade variety, and these massive and exploding derivative books unspoiled by compression in the pre-crisis era. There was no complaining or registration of concern over "unwieldy" positions and desks then, no heavy investment in, and serious alterations of, the entire investment bank structure, there was only the determined drive to get bigger as fast as inhumanly possible.

If there is one critical shift in financialization between the panic's demarcation, it is that point. Banking, eurodollar banking, pre-crisis was all about size, scale and expansion. Efficiency wasn't so much a priority except in that it might add to those three components. Now, quite contrarily, you often hear, to the point of universality, bank managements discuss their own operations often using that word, "unwieldy." Size and speed are no longer priorities, instead efficiency above all else. In other words, eurodollar growth has become as a mature business in the mythical life cycle status.

Not all banks embraced that approach; several refused the license and had been using the past few years of their peers' cumulative reductions as a potential entry into re-expansion. Credit Suisse and a few others, including Goldman Sachs in limited areas (interest rate swaps notably), aimed to rebuild their FICC, eurodollar business even in the aftermath of the QE/taper summer in 2013. In fact, they saw what Ben Bernanke described of a full and blooming recovery that would pay off anyone with the audacity to take it. That point was most enthusiastically attained by Deutsche Bank.

During that time, regulatory changes were well-known if not in exact specifics then at least in terms of general emphasis; yet these banks were willing to take on that extra "burden" of "capital" treatment and commit resources anyway. It is profit that overrides regulatory sense, even in situations of heightened sensitivity on both sides. If Bernanke was right, there was a lot of money to be made even under these highly different circumstances; it might not have been the Wild West of the pre-crisis days, taunting Greenspan's impotence in federal funds, but it could have been highly and richly rewarding.

That was what Deutsche Bank practically spelled out in May 2014 when it announced plans to use its new "capital." After having raised a huge chunk of change, and never truly explaining the amount or the timing, the bank was cocksure about riding straight into leveraged loans, emerging market debt and US junk corporates, as well as committing all the resources necessary to be a dominate player in money dealing capacity in those areas. Again, to reiterate, Deutsche knew full well at least the temperature of what regulatory changes would require should they be willing take this course. Given that it has taken years for many of these rules to be written and finalized, and the banks themselves given great input into doing so, it would be completely unreasonable to assume that they did not appreciate if not fully know the details.

One of those rules was the Fundamental Review of the Trading Book (FRTB). Since liquidity and leverage are primary concerns now, derivative books are being further refined and determined in separate liquidity buckets rather than the unassuming case that applied under Basel 2.5; which was that all derivative contracts were fully liquid, and thus could be sold in 10 days or less. Given the style of compression trading, such an assumption was obviously weak based just upon the complications of any trading desk, let alone a full book. Under the new rules, different flavors of derivatives are assigned different liquidity buckets, called liquidity horizons, which completely alters the derivative book's effects on risk-weighted assets and thus "capital."

Credit derivatives received, in part from the 2008 experience, the longest liquidity horizon, and thus have been handed essentially a death sentence. Back in June, Deutsche Bank estimated that such a regulatory change would increase its RWA profile from its credit trading book by 100%. The bank predicted it would be the end of at least single-name CDS.

It was, not coincidentally, at that same time the bank essentially fired its co-CEO's. Credit Suisse and those several other contrarian banks did the same. While allured by Bernanke's, now Yellen's, recovery opportunities they have not lived up to the hype and promise - by a long shot. Instead, not long after Deutsche was itself hyping leveraged loans and emerging market debt, each of these banks were furiously trying to undo the great damage as fast as they possibly could. The scale of their derivative book declines just in Q1 and Q2 2015 was unimaginable (again, compression trading as the primary means to accomplish it) except for all that has actually wrought.

Economists excuse the events of the past year as if some cosmic coincidence of unrelated timing and kind (such as October 15, 2014, being the whole task of computer trading rather than the unkind and dangerous illiquidity that betrays common conditional assessment) yet the steady drumbeat of dissonance is this very withdrawal of eurodollar FICC, the guts of the global "dollar." If the Swiss National Bank was forced off its peg to the euro, the "dollar" was at its very heart and Deutsche Bank's regrets undoubtedly a good part of the specific means. When the People's Bank of China was likewise forced to "devalue", it had nothing to do with actual devaluation and everything to do with the drastically unmanageable price of "dollars" Chinese banks were being forced to pay to maintain their wholesale short position. There was not enough FICC banking to maintain order, as the world was proved only two weeks thereafter.

Through all of this, commentary and "expert" opinion remained steadfastly blind to the internal mechanics tearing apart this global order - including the persistent if "unexpected" downward bend in the global economy this year. Interest rate swap spreads have been catastrophically decompressing, pushing spreads all over the maturity curve negative and often deeply and shockingly so, but the media insists in ascribing benignity with ideas about corporate issuance or trading calendars - until they can't maintain the charade any longer. It has become uncomfortably difficult in later 2015 not to notice the eurodollar's ransacking. From Bloomberg just this week:

In an unusual twist, the multitrillion-dollar interest-rate swaps market, which investors often turn to for protection against swings in Treasury yields, is sending just such a signal.

That obviously can't be right, so the more likely explanation is that an important market is malfunctioning. And it's more than just a curiosity.

To this point, even after 2008, there is almost no appreciation for the role these derivatives play in liquidity and really as modern money itself. Dark leverage isn't just some nice hedging tool to be applied in ease and comfort, it is vital to the turn of eurodollars and real economy. Just as CDS notionals skyrocketed into 2008, thus actually becoming a full part of eurodollar "money supply", they have been cratering ever since with a renewed and emphatic departure again this year (and not just for the reason stated above in the FRTB). Even the banking industry has finally noticed this absence, as rumors are swirling about "efforts" to try to revive CDS despite its popular revulsion (which wasn't fully wrong).
"We needed something that starts driving the market toward clearing, and that will help with liquidity," said Peter Tchir, head of macro strategy at Brean Capital LLC and a former credit-derivatives trader. "This is a step toward getting some more contracts cleared."

The moves by the dealers, which they are making separately, come amid a broader industry push to jump-start a market that's shrunk 59 percent since the 2008 financial crisis. Some of the biggest swaps investors, including BlackRock Inc., have been pushing for greater standardization after Deutsche Bank said stricter post-crisis regulations made the business less profitable. Net wagers using single-name swaps -- once the biggest part of the market -- have dropped to $646 billion from $1.59 trillion in October 2008, according to Depository Trust & Clearing Corp. data.

These plans, tenuous as they may be now, are simply recognition of what a financialized world looks like without all the deep finance behind it. Liquidity isn't just poor these days, it is dangerously so. There is more than negative swap spreads to suggest as much, but the fact that nobody is really embracing the challenge falls back on the unprofitability of the whole thing; this half-hearted approach is as a last ditch recognition that we have strayed too close to such a minimum level of function.

The appeal of compression trading and efficiency, especially with regard to the cost of time, money and structural alteration for each bank undertaking it, is truly the difference between 2007 and 2015, or more appropriately 2004 and 2015. These derivative books have already proclaimed the recovery dead; the last of them doing so around the end of last year, the bulk of them having already done so sometime in 2013, quite likely in and around November 20 of that year. The constant roll of deep financial inequality and irregularity is forcing even reluctant inquisitiveness from those still solidly connected to the recovery narrative, despite that this all appears quite impossible from that view.

If this "dollar" delivery has been signaling global economic turmoil ahead since June of last year, and that increasingly looks the case, this is the very method for it. China's problems are not dollars but "dollars." After all, a financialized economy cannot long survive without its finance. Nobody need wake Greenspan from his retirement reputation rehabilitation, the lack of profit potential, the end of recovery, is forcing the banks themselves to do what he never really could.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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