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OTC Derivatives

OTC Derivatives

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OTC Derivatives

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  1. OTC Derivatives – Product History and Regulation OTC Derivatives September 2009

  2. Introduction • What is a Derivative? • History, Purposes, Types • Common Types of Swaps • Swap Documentation • OTC Derivatives Regulatory

  3. History of Derivatives • Derivatives are not really “products” and they are not really “traded” • Simply views or bets on future price movements • Rice derivatives traded in Japan in 15th C • Stock options traded in the 1800’s • Corn and wheat futures traded on the CME today

  4. What is a Derivative? • Definition of a Derivative • a financial instrument (swap, put, call, cap, floor, collar, or similar option) for the purchase or sale of, or whose value is based on, one or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind • Definition of an Over-the-Counter (OTC) Derivative • a derivative that is not traded through an exchange or other regulated market but through a bilateral negotiation between two parties and thus executed off-exchange • The Securities Exchange Act and the Commodities Exchange Act regulate exchanges

  5. Purposes and uses of OTC Derivatives • Risk transfer • Hedging • Investment • Exposure to different markets • Change an asset’s balance sheet character • Speculation • Leverage

  6. Common Types of Derivatives • Options • Futures • Forwards • Warrants • Swaps • Other

  7. Options • Options • Holder can buy or sell a security/commodity at a set price on, or prior to, expiration of the option • calls or puts, caps or floors • European versus American Style • Exercise/Strike Price • Options on stocks; pork bellies • Options also are embedded, for example, in • Convertible Bonds • Holder can convert bond into shares of stock or other securities in the issuing company • Structured Notes • Holder can receive a return of principal greater than original investment if Note’s embedded option has adequately increased in value

  8. Futures • Futures • Futures contract obligates a person to buy or sell a commodity, security (equity) or financial instrument, or a basket of them (S&P 500 index), at a set price, on a set date (or dates) in the future • Standardized contracts only (i.e., exchange traded) • only trade specific contracts supported by the exchange • contracts are usually cash settled • Futures have only market risk due to daily re-margining through the exchange

  9. Forwards • Forwards • Like a futures contract, an agreement to buy or sell an asset at a specified future time and price • Customized between parties and not exchange traded • Can be for any underlier • Can be for any settlement date • Forwards are different from futures • Forwards entail credit risk exposure to your counterparty • Market risk on the trade unless negotiated re-margining

  10. Warrants • Warrants • Holder can buy securities of the issuing company at a specified price that is usually higher than the stock • Usually given as consideration of another transaction; sometimes purchased outright with a premium payment • Generally traded over the counter and have longer maturities than options

  11. Swaps • Swaps • A cash settled OTC derivative between two counterparties to exchange two streams of cash flows • Fundamental purpose is to change character of an asset or liability on one persons’ balance sheet without liquidating that asset or liability • Usually subject to ISDA documentation including master agreement, confirmation, and product definitions

  12. Exchange Traded vs. OTC Derivatives • Exchange Traded • exchange central clearing house (CCH) acts as counterparty on both sides of the transaction • credit risk exposure to CCH • margin as required by CCH rules • limited number of standardized products • Transparent end-of-day valuation • simple liquidation • OTC • private transaction between two parties • creates counterparty credit risk to be managed • collateral negotiated between the parties • valuation based on models using various and at times differing assumptions (witness AIGFP) • negotiated liquidation and early termination thus more complex outside of bankruptcy; sometimes skewed in bankruptcy

  13. Common Types of Swaps • Interest Rate Swaps • Currency (FX) Swaps • Commodity Swaps • Credit Default Swaps (CDS) • Equity Swaps • Total Return Swaps (TRS) • Other Types

  14. Interest Rate Swaps • Interest rate swaps developed in 1981 to alleviate mismatch on capital rates, investment returns and improve issuer balance sheet management • European companies could raise money with fixed rate Eurobonds, but European investments paid floating rates • US companies often used commercial paper and other floating rate capital markets while investments, such as Treasury, paid fixed returns.

  15. Interest Rate Swaps Use and Structure • Banks, funds and corporations use interest rate swaps to reduce mismatched interest exposure on other investments or speculate on interest rate movement • Interest rate swaps are standardized/very liquid Notional Amount= $500 million Fixed Interest Rate (e.g., 3%) A B Floating Interest Rate (e.g., LIBOR + 50 bps)

  16. Interest Rate Swap Payment Summary • Each payment is based on a notional amount, but the notional amount is not transferred • One party makes a stream of payments calculated like interest that would be paid on notional amount with a fixed (or floating) interest rate • Other party does the same but based on another interest index (typically a floating rate such as LIBOR, but can be based even on another fixed rate interest index) • Fixed and Floating payments • typically match on same day (otherwise credit risk) • can be made monthly, quarterly, semi-annually etc.

  17. Currency (FX) Swaps • Originally developed as back to back loans in the 1970s in the UK to avoid government charges on U.S. dollar based loans. • In 1981, Salomon Brothers created first direct currency swap between World Bank and IBM • IBM swapped U.S. dollars to the World Bank for Swiss francs and German deutschemarks

  18. FX Swaps Use and Structure • Banks, funds and other financial institutions use FX swaps to reduce currency risk on other investments or to speculate on currency fluctuations • Currency swaps are standardized and very liquid 5% on $10 Million USD A B LIBOR + 2% on $1.2 Billion JPY

  19. FX Swaps Payment Summary • Parties exchange streams of payments in different currencies to reduce exposure to currency risk • Multiple currency combinations are possible and some transactions have different currencies swapped based on exchange rate or other factors • Often used in conjunction with interest rate swaps where underlying liabilities are financing transactions

  20. Commodity Swaps • The Chase Manhattan Bank introduced commodity swaps in 1986 • Commodity futures were common for many years, but swaps provided advantages in products and maturity • The first swaps referenced oil, but the commodity swap market has expanded • natural gas, electricity, coal, other energy products, as well as metals, agriculture and other commodities

  21. Commodity Swaps Use and Structure • Commodity users use swaps to protect themselves from risk of price swings • Banks and financial institutions use commodity swaps to hedge market exposure to such commodities or to speculate on future price movement Depreciation on Referenced Commodity A B Appreciation on Referenced Commodity Fixed or Floating Payment or other Commodity returns

  22. Commodity Swap Payment Summary • Transaction relates to a certain amount of a particular commodity • Commodity amount may be for a one time settlement or multiple settlements at set time periods • One party pays an amount based on change in price of commodity • Other party pays a fixed/floating amount on each settlement date • These are cash settled and commodity is almost never transferred

  23. Credit Default Swaps (CDS) • Developed in 1994 by JPMorgan to overcome bank capital restrictions on outstanding Exxon loans • By transferring Exxon credit risk, JPM could reduce bank capital required to be held against Exxon loans • Credit derivatives expanded to reference loans, corporate, sovereign and fixed income notes, indices, etc. • How is it different from financial guaranty insurance? • CDS buyer need not have an insurable interest

  24. CDS Use and Structure • Banks, funds and other financial institutions use CDS • to hedge credit risk on investments • gain leveraged exposure to loans, debt etc. • engage in capital structure arbitrage • arbitrage credit markets Fixed Payments Reference Entity Buyer Seller DEFAULT Par Value of Reference Obligation

  25. Structure of Original 1994 JPM CDS (BISTrO) Loan portfolio($9.7 Bn) U.S.Treasuries • J.P. Morgan retains ownership of loans, but sheds credit risk • Credit default swap between MGT and SPV transfers risk • Investment proceeds invested in U.S. Treasuries, which collateralizecredit default swap (but not entire $9.7 Bn underlying amount) • BISTrO notes exposed to credit risk of larger reference portfolio • US $697 MM of BISTrO notes exposed to risk of $9.7 Bn portfolio Capitalmarket investors Return Par Credit default swap Fee (X bp p.a.) SpecialPurposeVehicle (SPV) Treas return + X MorganGuarantyTrust (MGT) Par Net losses Par (minus net losses) at maturity 0.3 % first loss (equity)

  26. CDS Payment Summary • CDS between Buyer and Seller of credit protection on a Reference Obligation • Buyer makes periodic payments (typically monthly or quarterly) to the Seller which terminate upon Credit Event • Upon the occurrence of a “Credit Event”, Seller pays Buyer’s loss resulting from Credit Event • Settled by physical delivery of a Deliverable Obligation or cash settled by difference between par (100%) and Final Price • Credit Events include Bankruptcy, Failure to Pay, Obligation Acceleration, Repudiation, Moratorium and, for some transactions, Restructuring

  27. Equity Swaps • Developed in late 1980s to avoid premium tax rates on investments in foreign securities • ISDA publishes Confirmations and Definitions for equities and equity indices (including variance indices) for most countries and exchanges

  28. Equity Swaps Use and Structure • Banks, funds and corporations use equity swaps • gain exposure to equities or indices • to avoid tax or transaction costs • gain exposure to illiquid markets • hedge investments Depreciation on Referenced Equity A B Appreciation on Referenced Equity Fixed or Floating Payment or other Equity returns

  29. Equity Swap Payment Summary • Transaction relates to a certain number of shares of a particular equity • Equity amounts may be for a one time settlement or multiple settlements at set time periods • One party pays an amount based on change in price of an equity security • Other party pays a fixed/floating amount on each settlement date • These are cash settled and equity security is almost never transferred

  30. Total Return Swaps (TRS) • TRS have been around since at least 1987, when Salomon Brothers offered the first Mortgage Swap Agreement • TRS allows Buyers to invest in otherwise unavailable markets, gain leveraged exposure to assets or arbitrage cost of funding expenses • TRS Sellers can hedge against investment exposure and profit from cost of funding differential between the parties • TRS’ used in many structured investment vehicles (SIVs) that collapsed at front-end of the Financial Crisis • SIVs were rated not on underlying asset quality but rather on Swap Counterparty credit rating

  31. TRS Use and Structure Increase in Value of Asset Interest payments from Asset TRS Buyer TRS Seller Interest Payment (LIBOR + Spread) Loss in Value of Asset Interest payments Reference Asset (e.g., bonds, indices, equities, etc.)

  32. TRS Payment Summary • TRS Buyer pays a rate of interest on notional amount of Reference Asset • Interest rate typically less than TRS Buyer’s cost of funding • TRS Seller can hedge exposure to asset and receive interest payments that are typically greater than TRS Seller’s cost of funding • Allows TRS Buyer to derive the benefit of owning an asset without having the asset on balance sheet, and gives TRS Seller protection from loss in value

  33. Other Swaps and Derivatives • Other common derivatives: • weather derivatives • electricity derivatives • life settlement indices • sovereign debt • There is no limit on products referenced • parties can create derivatives to precisely fit their investment needs and goals

  34. Exotic Derivatives • Parties can also combine derivative instruments to create new instruments • A Swaption is an option to enter into a swap and is a common derivative instrument • Parties also modify payment structure to fit investment goals • Swaps can be drafted to be effective only under certain conditions (interest rate, exchange rate, equity price triggers) or limit parties exposure to certain percentages of loss or gain

  35. Questions? Are there any questions?

  36. Swap Documentation • OTC Derivatives are traded under Master Agreements • Master Agreements by their terms: • net all transactions • Master Agreement nets all transactions for one aggregate liability or asset of a party • provide for representations, covenants, and events of default • methodology for terminating all transactions and calculating a final settlement amount

  37. Swap Documentation - Bankruptcy • Protected features under the Bankruptcy Code • Debtor generally has the ability to avoid • pre-petition “preferences” (S. 547) • fraudulent transfers (S. 548) • unperfected security interests (S. 547) • pre-petition set-offs (S. 553) and post-petition transfers (S. 549) • Trustee generally has the right to assume or reject executory contracts • Gives the trustee the power to “cherry-pick” • assume transactions favorable to debtor • reject transactions favorable to counterparty

  38. Swap Documentation - Bankruptcy • Master Agreements are “protected contracts” under Bankruptcy Code (S. 560) • ISDA was very active in lobbying for these changes to the US Bankruptcy Code and in some 50+ other countries • Other protected contracts include • securities contracts (S. 555) • commodities contracts (S. 556) • forward contracts (S. 556) • repurchase agreements (S. 559) • master netting agreements (S. 561) • These contracts protected to maintain integrity of financial markets • In Lehman bankruptcy there were 930,000 outstanding swaps • 918,000 terminated soon after the bankruptcy filings (September 2008)

  39. Swap Documentation - Bankruptcy • A party with a protected contract (including Swap Agreements (S. 362(b)(17)), notwithstanding the automatic stay, trustee’s powers, or any order of the Bankruptcy Court: • may terminate, liquidate, or accelerate the agreement • offset or net termination values, payment amounts or other transfer obligations • foreclose on collateral • Under a Swap Agreement, a party may be able to suspend performance under a transaction without terminating the agreement (Section 2(a)(iii)) • interest accrues

  40. Swap Documentation - Termination • Under 1992 ISDA Master Agreement, parties elect either “Market Quotation” or “Loss” • Market Quotation: based on (i) average of two middle bids obtained from 4 reference market makers or (ii) the middle bid of 3 bids so obtained – poses problems in times of market turmoil • Loss: cost of unwinding hedges related to the terminated transactions under the Swap Agreement – unilateral if “reasonable” determination of non-defaulting party • 2002 ISDA Agreement adopts single damages measurement defined as the “Close-out Amount” • requires a good faith determination, using commercially reasonable procedures, of the losses or gains that are or would be realized in providing for the economic equivalent of the material terms of and option rights of the parties under the terminated transactions

  41. Simplified ISDA Structure ISDA Master Agreement Long form Confirmation(s) Short form Confirmation(s) Definitions Definitions 41

  42. ISDA Agreement Structure (2009) 1992/2002 MasterAgreement Credit Support Documents: to reduce credit risk • 2001 Margin Supplement (incorporating 2001 Margin Provisions) • 1995 Credit Support Annex (Transfer-English law) • 1994 Credit Support Annex (New York law) Annexes • ISDA Global Physical Coal Annex • US Emissions Annex • EU Emissions Annex • North American Power Annex • North American Gas Annex • GTMA Annex (UK Power) • European Gas Annex • US Crude Oil and Refined Petroleum Products Annex Bridges • 2002 Energy Agreement Bridge • 2001 Cross-Agreement Bridge • 1996 FRABBA Bridge • 1996 BBAIRS Bridge Definitions: for use in documenting Transactions • 2007 Property Index Derivatives Definitions • 2006 Definitions • 2006 Inflation Derivatives Definitions • 2006 Fund Derivatives Definitions • 2005 Commodity Definitions • 2003 Credit Derivatives Definitions • 2002 Equity Derivatives Definitions • 1998 Euro Definitions • 1998 FX and Currency Option Definitions • 1997 Government Bond Option Definitions 1995 Credit Support Deed (Security Interest-English law) 1995 Credit Support Annex (Japanese law) Confirmations • Long form confirmations 2002 Master Agreement Protocol Confirmations • Short form confirmations • Master confirmation agreements 42

  43. OTC Derivatives Regulatory • History of OTC Derivatives Regulation • Discussion of Over-the-Counter Derivatives Markets Act of 2009

  44. Arguments for regulating OTC Derivatives • Speculative nature of the transactions cause market integrity issues • Lack of “transparency” or “opaqueness” • Precise nature of risk and scope unknown to regulators • Leads to potential increased systemic risk • Viewed as having exacerbated the Financial Crises

  45. Early Derivatives Regulation • Originally regulated in US and UK by common-law “rules against difference contracts” • could wager anything you wanted, but to go to court to enforce it had to demonstrate at least one party had a real economic interest in the underlying and was using the derivative to hedge against a risk to that interest • akin to insurance law concept of insurable interest

  46. Early Derivatives Regulation • Didn’t mean you couldn’t use derivatives to speculate, rather needed to come up with ways to make sure counterparts paid on their bets if they had no economic interest in the underlying • Private exchanges created with membership, margin, and netting requirements designed to make sure speculators would make good on their contracts • Control increased with imposition of government regulators • CFTC and SEC • ISDA Swap Agreements essentially created an OTC derivatives private exchange with netting benefits

  47. CFTC • In 1974 Congress created the Commodities Futures Trading Commission (CFTC) • Congress gave CFTC exclusive jurisdiction over all contracts having “the character of” futures contracts and mandated that such contracts, with certain exemptions, only be traded on CFTC-regulated exchanges • CFTC given exclusive jurisdiction over all futures and options on futures whether underlying was a physical or financial commodity

  48. 1974 Treasury Amendment • Treasury Amendment proposed over concerns of scope of CFTC’s jurisdiction • Amended CEA to exempt (so long as not conducted on a “board of trade”): • transactions in foreign currencies • government securities • mortgages • While these exemptions covered the exclusion of a number of private markets of concern to Treasury, a large number of derivative transactions would not fit into CEA/CFTC statutory exclusions or exemptions

  49. 1982 Shad/Johnson Accord • 1982 Shad/Johnson Accord attempted to clarify the regulatory jurisdiction over futures and options based on securities and stock indices between the CFTC and the SEC • Banned futures contracts on single stocks and narrow-based stock indices • thus viewed as a prohibition on equity derivatives

  50. 1982 Shad/Johnson Accord • CFTC retained authority over futures contracts and options on future contracts on • commodities (including exempt securities (other than munis)) • foreign currencies not traded on a national securities exchange • certificates of deposit • broad-based indices of securities • SEC retained authority over options on • securities (including certificates of deposit) • certain securities indices • foreign currencies traded on a national securities exchange