Monday, February 05, 2018

Giancarlo announces new paradigm for measuring swaps

By Brad Rosen, J.D.

CFTC Chairman J. Christopher Giancarlo called for the adoption of a bold new paradigm in the way the global interest rate swaps market is considered and how its size is measured in remarks before DerivCon 2018 in New York City, New York. A year ago, the chairman called upon the agency’s Chief Economist, Dr. Bruce Tuckman, to develop a more accurate measurement of the swaps market, with a specific focus on the market’s risk transfer functions. The roll out of this new paradigm and approach has significant regulatory implications with respect capital requirements, determining the swap dealer de minimis thresholds, as well as many other issues.

Giancarlo noted in his speech that the numbers typically describing of the size of the over-the-counter derivatives markets, where the notional figures are in the hundreds of trillions of dollars, have long been without meaning and barely comprehensible for many observers. Chief Economist Tuckman has addressed this problem straight on with the recent publication of his paper Introducing ENNs: A Measure of the Size of Interest Rate Swap Markets. The paper advances a new way of looking at this notional value problem, and breaks new ground with its development of Entity-Netted Notionals (ENN) concept. Dr. Tuckman provides further explanation of his paper and ENN on Episode 29 of the CFTC Talks podcast.

Historical background and a fog of confusion. In his remarks, Chairman Giancarlo observed that after ten years have passed since the financial crisis, we remain haunted by some of the decisions that were made, sometimes frantically, in an effort to save the financial system. While the swaps markets came under the regulatory umbrella with the enactment of the Dodd-Frank reforms, monumental decisions were made based on information and data available at the time, that in retrospect, was “vague, hard to understand, even inflated, bloated, or misunderstood.” In particular, Giancarlo noted, “sometimes the data may have been wrong, or, at least, wrongly used … [t]he worry is that there was a fog or distortion or myopia or fear that mis-framed the financial picture.”

Swaps have a large number problem. Giancarlo further stated plainly that swaps have a problem of large numbers, and asserted “that sizing the global swaps markets in hundreds of trillions of dollars has done nothing to bring clarity to newspaper accounts, policy discussions in Congress, or regulatory policy setting in the decade since the financial crisis.” He pointed out that notional amounts are frequently used to describe the size and risks of the global interest rate swap (IRS) markets. For instance, a recent headline provided, “the notional value of OTC derivatives contracts outstanding was $630 trillion.” The chairman observed this amount is eight times greater than global output and 6.5 times larger than outstanding debt securities, and leads to a misleading picture of the true size of markets for swaps and derivatives

ENN analysis in a nutshell. In his paper, Dr. Tuckman explained that notional amount is not a good measure of the size of the IRS market for two basic reasons. First, most swaps involve interest instruments that are based on overnight indexes or otherwise have very short terms. Accordingly, a focus on the notional value involved exaggerates the true extent of risk present. Consequently, Tuckman’s approach deals with the term of a given swap by expressing its risk on five-year risk equivalent basis.

Additionally, interest rate swap trading conventions do not recognize that a market participant may have positions with multiple counterparties involving risk-offsetting long and short positions. Without netting out these offsetting positions, the notional amounts may dramatically overstate the actual risk transfer among various counterparties.

Accordingly, Dr. Tuckman’s analysis introduces the concept of entity-netted notionals (ENNs), which are designed to more accurately measure the actual risk transfer in swaps markets. By netting longs and shorts among counterparties, ENNs capture the market risk transfer in IRS markets much more accurately than notional amounts. Moreover, empirical evidence of ENNs shows that there is, in fact, a tremendous amount of such netting in the IRS market.

The impact of the ENN approach can be appreciated with reference to the analysis that follows.
  • For all U.S. reporting entities as of December 15, 2017, the notional amount across all currencies and across the dominant IRS products is $179 trillion;
  • Expressed in 5-year risk equivalents, that notional amount falls to $109 trillion; and, 
  • Applying the netting conventions set forth in the ENNs analysis, the figure drops to $15 trillion, or just over 8 percent of original notional amount.
“Suddenly, at $15 trillion, the IRS market is more normalized and intelligible as part of the [U.S.] economy,” the chairman observed.

Regulatory implications. The chairman noted that the first step in the CFTC’s swaps Reg Reform 2.0 initiative will be to introduce a more accurate measure of swaps market size. He also indicated that these measures historically have been used in in important regulatory calculations, like capital requirements and various other thresholds. Chairman Giancarlo concluded, “Dr. Tuckman’s analysis is a necessary perspective, achieving much-needed clarity and accuracy. It is time we all agreed to look ahead with such clarity. The alternative is to continue to live with inexactitude, misinterpretation, and inaccuracy.”

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