The LCH CME swap basis another consequence of regulatory pressures
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Transcript of The LCH CME swap basis another consequence of regulatory pressures
© 2015 - Proprietary and Confidential Information of FINCAD
How FINCAD can help navigate Swap Strategies in the new
Regulatory Environment
Subbu Loganathan, Kramerica Consulting
Richard Weeks, Quantitative Analyst, FINCAD
© 2015 - Proprietary and Confidential Information of FINCAD
Agenda • Introduction – How it all came to this
– Dodd Frank and EMIR Clearing and Margin – Good intentions, unintended impact
– Basel III Capital Rules and Credit Risk – Consequences for the buy side
– Increase in complexity post financial crisis • Hedging Interest Rate Risk in the new environment
– Using cleared Interest Rate Swaps – Collateralisation considerations – Margin considerations – LCH and CME – too big to fail?
• Managing Complexity using FINCAD F3 – Multiple curves – Risk Reprojection – Demo
• Q&A
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How it all came to this
• The financial crisis of 2007/08 was in part due to the lack of transparency in the trading and processing of OTC derivatives It highlighted the need for data standards and management of counterparty risk for OTC instruments
“All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.” September 2009
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© 2015 - Proprietary and Confidential Information of FINCAD
The Regulatory Landscape now
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Man
dat
ory
Cle
arin
g
Structural Reform AIFMD Volcker Rule Ring fencing Solvency II Basel III
Record Keeping (BCBS 239), (FSA49), CASS, MiFiD II
Ris
k M
itig
atio
n f
or
Un
clea
red
OTC
–
Var
iati
on
Mar
gin
an
d
Init
ial M
argi
n
Ap
pro
pri
ate
Cap
ital
St
and
ard
s fo
r fi
nan
cial
in
stru
me
nts
Reg
ula
tory
Tra
nsp
aren
cy
– Tr
ade
Rep
ort
ing
and
D
aily
Val
uat
ion
s
© 2015 - Proprietary and Confidential Information of FINCAD
Evolution of the Market post regulation
Source - http://www.bis.org/publ/qtrpdf/r_qt1312b.pdf
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Impact – Mandatory Clearing & Collateral
• Vanilla swaps cleared through CCPs
– IRS : LCH, CME, …
– CDS : ICE, …
– Mandatory clearing for vanilla swaps
– Variation margins + initial margins
• Specific to CCP, time varying rules,…
– Different supervisory bodies : CFTC, SEC, FCA, PRA, EBA, …
• Non mandatory cleared swaps
– Current ISDA + CSA
– Variation margins + bilateral IM
• Exemptions
– Sovereigns (unilateral CSAs), FX, covered bond swaps, structured product swaps (no VM)
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© 2015 - Proprietary and Confidential Information of FINCAD
Central Clearing Counterparties – A new Risk?
• Systemic Risk implications – Market fragmentation, interoperability, waterfalls and pooling of
counterparty risks – Initial margin vs. capital protection – CCP Governance
• Rehypothecation of posted securities (and credit risk) • Clearing membership • Data processing and model risk when computing clearing
prices • Product Scope • Implication of competition among CCPs
– Initial Margin procyclicality • Volatility Scaling • Haircut dynamics • Eligible collateral, thresholds
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Hedging Interest Rate Risk in the new landscape
• Buy-side clients with interest rate risk due to fixed income exposure
• look to swap the fixed coupons on their bond holdings into floating coupons via swaps - Meaning they generally pay fixed on swaps
• O/N LIBOR rate vs LIBOR + OIS + CCP specific curve + collateralisation
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0.6
0.65
0.7
0.75
0.8
0.85
0.9
0.95
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0 2 4 6 8 10
Pre-Crisis Discount Curve
0
0.005
0.01
0.015
0.02
0.025
0.03
0.035
0 2 4 6 8 10
Pre-Crisis Forward Curve
© 2015 - Proprietary and Confidential Information of FINCAD
The CCP landscape for IRS today
• Increased complexity and fragmentation – CCP interoperability
– ICE single name and index CDS, CFTC ruling
– Client clearing
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LCH and CME – The origin of Swap basis spread
• Not all IRS can be cleared. If only a subset is centrally cleared, this can result in increased margin costs and increased counterparty risk exposure – “Roughly half of IRS are out of scope of central clearing“– ISDA, 2012
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© 2015 - Proprietary and Confidential Information of FINCAD
The case for FVA
• Funding books of swaps – For fully collateralised contracts
• With no slippage risk at default • Discount rates are tied to the (expected) rate of return of posted
collateral (EONIA or Fed funds rates in the most common cases) • Calibration can be done on market observables with little
adaptation and thus little model risk - Collateralised OIS and Libor swaps, possibly futures’ rates
– Uncollateralised contracts • Generally a funding spread is used but may not be adequate • We miss out-of-the money swap prices to calibrate discount
factors – The funding rate
• Default-free : Funding/Lending rates essentially acts as the usual short-term rate
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How F3 framework can help
1) Flexible Curve Modeling
1) Curve with OIS discounting
2) Curve with OIS discounting + CCP curves
3) Curve with OIS discounting + CCP curves + collateralisation – CVA/DVA/FVA
2) Risk Reprojection
1) Optimal Hedging of Interest Rate Risk based on Fixed Income Portfolios
2) Accounting for offsetting products like Futures
3) Scenario Analysis – Useful in Stress Testing for AIFMD/ Solvency II/Basel III
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© 2015 - Proprietary and Confidential Information of FINCAD
Flexible Curve Construction
Richard Weeks, Quantitative Analyst, FINCAD
© 2015 - Proprietary and Confidential Information of FINCAD 15
Lazy Evaluation
Generic Calibration
Analytic risk
Scenario Analysis
Topical Example
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Lazy Evaluation
Generic Calibration
Analytic risk
Scenario Analysis
Topical Example
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Lazy Evaluation / Auto Calibration
Product Model Valuation Method
input Δ?
request output
observe
Δ
no Δ
Cache
Output
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Lazy Evaluation
Generic Calibration
Analytic risk
Scenario Analysis
Topical Example
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Model Calibration
Valuation approach
A
Valuation Approach
B
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Abstraction
- Comparing instrument(s) value under different valuation approaches - Adjusting the value of model parameters to optimize some metric based on the difference in instrument(s) value under the two approaches.
Model Calibration
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Generic Framework Par
Closed Form
Closed Form Closed Form
Closed Form
Closed Form
Target Valuation
Source Valuation
Optimizer
Instrument Strategy
Calibration Target
Model
© 2015 - Proprietary and Confidential Information of FINCAD 22
Hybrid modeling challenges
Generic Calibration
Analytic risk
Scenario Analysis
Conclusion
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• How can we calculate the risk numbers?
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Risk Calculation Primer
- At least one bump per market data point, with hundreds or more market data points, and can be inaccurate
Bumping
- When calculating the value, calculate its first order derivatives as well & use the Chain Rule from Calculus to propagate them across all market data points
Analytic risk
© 2015 - Proprietary and Confidential Information of FINCAD 25
Simple Example
sum w y
ratio
square
z
u
v
x
© 2015 - Proprietary and Confidential Information of FINCAD 26
Simple Example
sum w y
ratio
square
z
u
v
x
© 2015 - Proprietary and Confidential Information of FINCAD 27
Simple Example
sum w y
ratio
square
z
u
v
x
© 2015 - Proprietary and Confidential Information of FINCAD 28
Simple Example
sum w y
ratio
square
z
u
v
x
© 2015 - Proprietary and Confidential Information of FINCAD 29
Simple Example
sum w y
ratio
square
z
u
v
x
© 2015 - Proprietary and Confidential Information of FINCAD 30
Simple Example
sum w y
ratio
square
z
u
v
x
© 2015 - Proprietary and Confidential Information of FINCAD
• Universal Algorithmic Differentiation (UAD) ™ – Automatically calculates the 1st order partial
derivatives without bumping
– Minimal incremental computing cost
– Numerical stability
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Analytic Risk
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Analytic Risk - benefit
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CU
MU
LATI
VE
TIM
E (S
ECO
ND
S)
NUMBER OF RISK EXPOSURES CALCULATED
CURVE BUMPING VS. F3 UAD
Curve Bumping Cumulative Time (seconds) F3 Risk Report Cumulative Time (seconds)
© 2015 - Proprietary and Confidential Information of FINCAD 33
Lazy Evaluation
Generic Calibration
Analytic risk
Scenario Analysis
Topical Example
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• Generic scenario framework that enables: – Creation of simple and complex hybrid scenarios
– Global scenarios spanning asset classes & stress factors
– Run stress-tests on entire portfolio
• Store definitions and output results – Defensible audit trail & granular risk analysis
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Scenario Generation
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UAD risk computation efficiency with Risk Reprojection. An example, If you want to hedge multiple term-structure exposures using zero-coupon bonds for the respective term structures. • How F3 constructs a reprojected model from the original model,
extracting the risk -report that will give exposures, reprojecting the risk to a new set of instruments that were specified in the reprojected model
• Result No need to re-define market data in this new reprojected
model since it is built from the original model, which contains the market data.
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F3 Risk Reprojection