Monthly Archives: April 2015

Inhibiting Derivatives

The array and complexity of new financial regulation in response to the financial crisis can have unforeseen impacts. A reduction in the liquidity of the bond markets today compared to before the crisis is commonly explained as a result of increased regulation of the banking sector.

A report by International Organization of Securities Commissions (IOSCO) in 2013 highlighted the impact of the regulatory push, following a G20 direction in 2009, for the OTC derivatives markets to be cleared through central counterparties (CCPs), thereby creating a potential for systemic counterparty risk (as per this post). The idea was to provide a centralised clearing point per asset class with the goal of increasing transparency and providing regulators with consistent data across borders to monitor.

The reality today is somewhat different that the theory. Many competing repositories have sprung up with the commercial intend of leveraging the valuable data. David Wright, the Secretary General of IOSCO, recently stated “we’ve got 25 of these beasts today and they don’t talk to each other, so a basic fundamental trawl of transparency is actually missing”. Regulators are stressing the need for further reform so that data can be aggregated to improve monitoring and, in February, issued requirements on CCPs to disclose information on topics such as the size of their credit risk, liquidity risk, collateral, margins, business risk, custody, and investment risks

Benoît Cœuré, a member of the Executive Board of the ECB, said in a speech this month that “the gross notional outstanding amount of centrally cleared positions was estimated at $169 trillion for OTC interest rate derivatives, and at $14 trillion for credit derivatives. The sheer magnitude of these figures (around ten times the GDP of the United States or European Union) gives us an idea of the severity of the potential consequences from a stress event at a major global CCP”.

Cœuré outlined a number of options for strengthening the financial resilience of CCPs including increased regulatory capital, initial margin haircutting, setting up cross-CCP resolution funds or a central resolution fund. Any such measures would have to be consistently applied across jurisdictions to ensure fairness and designed so as not to provide a disincentive to using CCPs.

In March, the Bank of International Settlements (BIS) and IOSCO announced a delay until September 2016 for the introduction of margin requirements for non-centrally cleared derivatives (above certain thresholds and subject to exemptions). The proposed margin requirements are split between initial and variable, with the initial margin phased in from September 2016 to September 2020 and the variation margin phased in from September 2016 to March 2017.

The amount of initial margin reflects the size of the potential future exposure calculated “to reflect an extreme but plausible estimate of an increase in the value of the instrument that is consistent with a one-tailed 99 per cent confidence interval over a 10-day horizon, based on historical data that incorporates a period of significant financial stress”. The required amount of initial margin is calculated by reference to either a quantitative portfolio margin model or a standardised margin schedule (as per the schedule below). The requirements also prohibit the re-hypothecation of initial margin required to be collected and posted under the rules.

click to enlargeInitial Margin for Derivatives

The amount of variation margin reflects the size of this current exposure dependent on the mark-to-market value of the derivatives at any point in time. As such, the volatility of this requirement may be significant in stressed cases, particularly for illiquid derivatives.

The proposals, as set out by the BIS and IOSCO, are ambitious and it will be interesting to see how they are enforced across jurisdictions and the impact they will have on market behaviour, both within and outside CCPs. I suspect there will be a few twists in this tale yet, particularly in relation to unintended consequences of trying to tame the derivative monster.

Converts on a comeback

My initial reaction, from a shareholder view-point, when a firm issues a convertible bond is negative and I suspect that many other investors feel the same. My experience as a shareholder of firms that relied on such hybrid instruments has been varied in the past. Whether it’s a sign that a growing firm has limited options and may have put the shareholder at the mercy of some manipulative financier, or the prospect that arbitrage quants will randomly buy or sell the stock at the whim of some dynamic hedging model chasing the “greeks”, my initial reaction is one of discomfort at the uncertainty of how, by whom, and when my shareholding may be diluted.

In today’s low risk premia environment, it’s interesting to see a pick-up in convertible issuances and, in the on-going search for yield environment, investors are again keen on foregoing some coupon for the upside which the embedded call option that convertibles may offer. Names like Tesla, AOL, RedHat, Priceline and Twitter have all been active in recent times with conversion premiums averaging over 30%. The following graph shows the pick-up in issuances according to UBS.

click to enlargeConvertible Bond Market Issuances 2004 to 2014

Convertible bonds have been around since the days of the railroad boom in the US and, in theory, combining the certainty of a regular corporate bond with an equity call option which offers the issuer a source of low debt cost at a acceptable dilution rate to shareholders whilst offering an investor the relative safety of a bond with a potential for equity upside. The following graphic illustrates the return characteristics.

click to enlargeConvertible Bond Illustration

The problem for the asset class in the recent past came when the masters of the universe embraced convertible arbitrage strategies of long/short the debt/equity combined with heavy doses of leverage and no risk capital. The holy grail of an asymmetric trade without any risk was assumed to be at hand [and why not, given their preordained godness…or whatever…]! Despite the warning shot to the strategy that debt and equity pricing can diverge when Kirk Kerborian’s increased his stake in General Motors in 2005 just after the debt was downgraded, many convertible arb hedge funds continued to operate at leverage multiples of well in excess of 4.

The 2008 financial crisis and the unwinding of dubious lending practises to facilitate hedge fund leverage, such as the beautifully named rehypothecation lending by banks and brokers (unfortunately the actual explanation sounds more like a ponzi scheme), caused the arbitrage crash not only across convertibles but across many other asset classes mixed up in so called relative value strategies. This 2010 paper, entitled “Arbitrage Crashes and the Speed of Capital”, by Mark Mitchell and Todd Pulvino is widely cited and goes into the gory detail. There were other factors that exacerbated the impact of the 2008 financial crisis on the convertible debt market such as market segmentation whereby investors in other asset classes were slow to move into the convertible debt market to correct mis-pricing following the forced withdrawal of the hedge funds (more detail on this impact in this paper from 2013).

Prior to the crisis, convertible arb hedge funds dominated the convertible bond market responsible for up-to 80% of activity. Today, the market is dominated by long only investors with hedge funds only reported to be responsible for 25% of activity with those hedge funds operating at much lower leverage levels (prime brokers are restricted to leverage of less than 1.5 times these days with recent talk of an outright rehypothecation ban for certain intermediaries on the cards). One of the funds that made it through the crash, Ferox Capital, stated in an article that convertible bonds have “become the play thing of long only investors” and that the “lack of technically-driven capital (hedge funds and proprietary trading desks) should leave plenty of alpha to be collected in a relatively low-risk manner” (well they would say that wouldn’t they!).

The reason for my interest in this topic is that one of the firms I follow just announced a convertible issue and I wanted to find out if my initial negative reaction is still justified. [I will be posting an update on my thoughts concerning the firm in question, Trinity Biotech, after their Q1 results due this week].

Indeed, the potential rehabilitation of convertible bonds to today’s investors is highlighted by the marketing push from people like EY and Credit Suisse on the benefits of convertible bonds as an asset class to insurers (as per their recent reports here and here). EY highlight the benefit of equity participation with downside protection, the ability to de-risk portfolios, and the use of convertible bonds to hedge equity risk. Credit Suisse, bless their little hearts, go into more technical detail about how convertibles can be used to lower the solvency requirement under Solvency II and/or for the Swiss Solvency Test.

With outstanding issuances estimated at $500 billion, the market has survived its turbulent past and it looks like there is life left in the old convertible bond magic dog yet.

The Float Game Goes Into Overdrive

The IMF today warned about rising global financial stability risks. Amongst the risks, the IMF highlighted the “continued financial risk taking and search for yield keep stretching some asset valuations” and that “the low interest rate environment also poses challenges for long term investors, particularly for weaker life insurance companies in Europe”. The report states that “the roles and adequacy of existing risk-management tools should be re-examined to take into account the asset management industry’s role in systemic risk and the diversity of its products”.

In late March, Swiss Re issued a report which screamed that the “current high levels of financial repression create significant costs and lower long-term investors’ ability to channel funds into the real economy”. The financial repression, as Swiss Re calls it, has resulted in an estimated loss of $470 billion of interest income to US savers since the financial crisis which impacts both households and long-term investors such as insurance companies and pension funds.

Many market pundits, Stanley Druckenmiller for example, have warned of the destabilizing impacts of long term low interest rates. I have posted before on the trend of hedge funds using specialist insurance portfolios as a means to take on more risk on the asset side of the balance sheet in an attempt to copy the Warren Buffet insurance “float” investment model. My previous post highlighted Richard Brindle’s entry into this business model with a claim that they can dynamically adjust risk from one side of the balance sheet to the other. Besides the influx of hedge fund reinsurers, there are the established models of Fairfax and Markel who have successfully followed the “Buffet alpha” model in the past. A newer entry into this fold is the Chinese firm Fosun with their “insurance + investment twin-driver core strategy”.

The surprise entry by the Agnelli family’s investment firm EXOR into the Partner/AXIS marriage yesterday may be driven by a desire to use the reinsurer as a source of float for its investments according to this Artemis article on the analyst KBW’s reaction to the new offer. In the presentation on the offer from EXOR’s website, the firm cites as a rationale for a deal the “opportunity to exploit know-how synergies between EXOR investment activities” and the reinsurer’s investment portfolio.

Perhaps one of the most interesting articles on the current market in recent weeks is this one from the New York Times. The article cites the case of how the private equity firm Apollo Global Management purchased Aviva’s US life insurance portfolio, ran it through some legit regulatory and tax arbitrage structures with Goldman Sachs help, and ended up using some of the assets behind the insurance liabilities to prop up the struggling casino company behind Caesars and Harrah’s casinos. Now that’s a story that speaks volumes to me about where we are in the risk appetite spectrum today.