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By Richard Hill
The CFTC is exploring ways to better measure swaps-market risk as part of its effort under acting Chairman J. Christopher Giancarlo to improve its overall market-intelligence capability.
The information will help sharpen the agency’s oversight and surveillance capabilities, but isn’t going to inform rulemaking, Commodity Futures Trading Commission Chief Economist Sayee Srinivasan told Bloomberg BNA. One of the CFTC’s chief responsibilities is to monitor risk accumulation and step in when risk exposure or concentration becomes too great.
The aim of the project is to better account for the risk that any particular swaps instrument represents. Drilling down further into risk exposures will help the agency prioritize its oversight capabilities and not waste time chasing down false alarms.
More detailed risk information could be used in the future to better oversee swap dealer capital requirements, uncleared margin requirements, and trading thresholds that could trigger registration as a “major swap participant,” said Kathryn Trkla, a partner at Foley & Lardner LLP, Chicago, and a former Chicago Board of Trade senior vice president.
It’s too soon to tell whether more accurate risk insight might result in higher or lower margin and capital requirements, Trkla said.
“Hopefully, it’ll lead to the right margin and capital requirements,” said Micah Green, head of Steptoe & Johnson LLP’s cross disciplinary financial services practice in Washington. “That’ll be less in some cases and more in others.”
Position limits and the level of dealing activity triggering swap dealer registration are two areas that probably wouldn’t be affected by better risk monitoring since they are not typically measured by risk, Trkla said.
The area where it could have a significant impact is helping the CFTC respond to a crisis, Trkla said. “Having a more thoughtful approach” for assessing and understanding risk “can have real value if you’re dealing with a failed financial institution or clearinghouse,” she said.
Giancarlo told Senate appropriators in June there’s a “growing awareness” that the notional value of derivatives markets doesn’t provide an accurate representation of the risk exposure of market participants.
Notional measures of the marketplace over-simplify the risk profiles of market participants, derivatives experts told Bloomberg BNA. In a swaps transaction, the notional value includes the value of the asset that the swap is based on, which is never actually at risk. For instance, for an interest rate swap on a $100 million loan, perhaps one-tenth of a percent is potentially going to change hands based on the terms of the swap.
“When a bank is hedging a $1 billion notional interest rate transaction, it’s never really on the hook to write a check for $1 billion. That’s not its risk exposure,” Srinivasan said.
“Using notional makes the numbers somewhat scarier than they actually are,” Darrell Duffie, finance professor at Stanford University’s Graduate School of Business, told Bloomberg BNA. “More importantly, notional measures are less precise about risk.”Giancarlo told appropriators the CFTC’s project is a nascent effort that can be jeopardized if the agency isn’t fully funded at its $281.5 million request. If the project stalls, the CFTC “will continue to rely on outdated, anachronistic models and metrics of studying our markets,” he said.The project is an evolutionary effort that is beginning slowly, Srinivasan said, mostly because of resource constraints. For now, agency economists are analyzing “more plain-vanilla instruments” that are the most standardized and most frequently traded, he said.
One tool the CFTC is using in the project converts swaps contracts with different expirations into a “common-duration” instrument, so the risk profiles are more comparable. That was useful when the agency noticed a recent spike in total notional activity for interest rate swaps (IRSs), Srinivasan said. Digging into the details, the agency saw that much of the activity was in overnight indexed swaps (OISs). OISs tend to have short durations—three months—while other IRSs can last as long as 10 years. The shorter durations make OISs less risky, he said, and the spike in notional holdings less concerning. Using its duration-adjustment tool, the CFTC “converted” the OISs to see what they would look like as a more traditional 10-year notional value instrument. “It just becomes a very small number,” Srinivasan said. “While the risk looks really big in notional terms, in risk terms it’s a much smaller thing.” The focus on risk-exposure lets the CFTC better focus its market oversight efforts. Typically, if the regulator saw a bank with a buildup of notional risk, it would make a call to find out what the justification is. If it now sees that the bank is concentrating on OISs, and knowing that OISs are relatively less risky than a 10-year IRS with the same notional value, “We might not have to call the bank anymore,” Srinivasan said. “We do the analysis and see they’re doing the OIS structure and know why there was an increase in notional activity.”The initiative faces challenges. Mainly, the data the CFTC is receiving from swap data repositories isn’t conducive to making risk assessments, Srinivasan said, as CFTC rules don’t require reporting risk factors. At some point, the CFTC will start using the data to inform its weekly trading reports, “but we’re not there yet,” he said. Srinivasan also said it was too soon to speculate about how the data could be used to inform rulemakings or policy adjustments. “The simple thing we are trying to do here is bring more transparency to who’s doing what. Other questions are for the future,” he said.
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