Manufacturing and Managing Customer-Driven Derivatives. Qu Dong

credit crunch in 2007/08 and European sovereign-debt crisis in 2012/13. Both crises led to the freezing of the global credit market. Derivatives were certainly not the cause of the crises, although in some cases they were misused. Many lessons can be learnt from the analysis of how the crises happened, as can be seen in Table 1.4.

Table 1.4 Financial crises and their causes

      Direct financial losses incurred by the financial institutions were massive during the crises. The losses in many large banks were running into tens of billions each. Ironically, the losses due to traditional banking activities such as (bad or excessive) lending were many magnitudes higher than the derivative losses if compared like-for-like, even though derivatives are perceived as more risky by the general public.

      In the aftermath of the financial crises, financial institutions started fundamental changes and repositioning to de-risk and de-leverage. For example, one bank's leverage ratio (total assets exceeding tier 1 capital) was reduced from 68 times in December 2007 to 44 times in December 11. High leverage means high volatility in P&L, resembling derivatives. Leverage itself is a derivative on society, and too much of it will expose the economy.

      Regulations Affecting Derivative Business

      The financial regulatory landscapes have evolved dramatically during and after the crises. Banks have been under increasingly tighter regulatory regimes, at various levels, from capital to liquidity to operational details. Financial regulations have become an extremely important part of the derivative business. Both the USA and the EU have been introducing various laws and directives that will affect the business profoundly. All of these have implications on the day-to-day management of the business, and knock-on impact on derivative models and infrastructures.

      Dodd–Frank and EMIR

      No one can have a sound and prosperous derivatives business without embedding the relevant financial regulations into its operation framework and reporting infrastructures. Regulatory requirements can in fact affect the viability of certain trading and products distribution activities. The recent wide-ranging regulations affecting derivatives include:

      • Dodd–Frank (the Dodd–Frank Wall Street Reform and Consumer Protection Act);

      • EMIR (European Market Infrastructure Regulation).

      Dodd–Frank has been written into law in 2010 in the USA. It covers areas of monitoring systemic risks, limiting/banning banks' proprietary trading (the “Volcker rule”) and new regulations on derivatives and consumers protection. All the major aspects of the banking activities, from trading to customer/consumer services, have been under intensive regulatory analysis and scrutiny. The “Volcker rule” effectively bans banks' proprietary trading activities, although trading activities of “market making” are exempt. Clearly, the definition of “market making” is very important in this context. As for customer/consumer services, transparency and accountability together with investor protections are specifically mentioned and emphasized, which have profound implications for how financial institutions should be run and managed.

      EMIR was brought into force in 2012 by the European Parliament, putting strict regulations on OTC derivatives, central counterparties (CCPs) and trade repositories (TRs), with a view to controlling systemic risks and reducing counterparty credit risks associated with OTC derivatives. Under EMIR, the relevant financial institutions must observe the following obligations: central clearing for certain categories of OTC derivatives; risk mitigation techniques for non-centrally cleared OTC derivatives, such as using collateral and having adequate capital coverage; trade reporting to TRs; organizational and prudential requirements for CCPs and TRs.

      The regulatorily required CCP clearing of certain OTC derivatives (such as IRS, OIS) can also bring about real capital and operational efficiency. Some clearing houses have already introduced trade compression for IRS, OIS, Basis, FRA etc. to reduce the line items and net notional. For example, a trade compression for a portfolio of fixed legs of the same counterparty will net the cash flows of the fixed rates having the same coupon dates. In essence, it generates a synthetic fixed leg with a weighted average blended fixed rate. By replacing those fixed legs with one synthetic fixed leg, compression can greatly reduce the number of line items. As a result, it can achieve much enhanced operational efficiency and reduced capital requirements for all counterparties. It is conceivable that the trade compression technique can be further extended to cover all linear instruments to achieve greater business efficiency.

      Both Dodd–Frank and EMIR are designed with a view to preventing another financial crisis and promoting financial stability. Their scopes are wide-ranging, and their effectiveness clearly depends on how effectively they are implemented in the financial systems by the relevant financial institutions.

      European Markets and Structured Products Governance

      The European Securities and Markets Authority (ESMA) governance paper on structured retail products maps out the expected good practices for issuers and providers when manufacturing and distributing the products. The expected good practices are aimed at improving product providers' ability to protect investors, in particular in relation to the complex structured retail products, the nature and range of investment services and activities undertaken in the course of business, and the type of investors they target. The good practices guidelines cover a wide range of topics, including product design and testing, target market and distributing strategy, value at the date of issuance and transparency of costs, secondary market and redemption, and the review process.

      It is conceivable that other types of financial instruments such as asset-backed securities or contingent convertible bonds being sold to professional clients will be under increasingly tighter governance. The regulator insists that sound product governance arrangements are fundamental for investor protection purposes. When properly implemented, it can reduce the need for product intervention actions by competent authorities.

      The European Parliament has also approved MiFID II, the full implementation of which ESMA will oversee by 2017. MiFID II will directly impact on the product manufacturing and customer value chain with to the following two aspects:

      • Much enhanced market transparency: The scope and scale of the financial instruments covered by MiFID II have been much widened, to include equity and fixed income markets, derivatives, bonds, commodity, etc. It requires transparency and accountability in both manufacturing and distributing process. Trading venues must be transparent and adequately controlled to provide level-playing fields. Institutions must ensure pre- and post-trade transparency, timely reposting etc.

      • Much-increased investors' protections: The requirements will govern how financial firms should design, advise on or distribute MiFID instruments. MiFID II makes clear that complex products, including complex structured deposits, cannot be sold to investors on an execution-only basis. The requirements will promote greater price transparency, allowing retail investors to see more clearly the actual prices of various financial instruments, enabling them to compare prices and find the most competitive offer available.

Table 1.5 summarizes some key MiFID II features and coverage, and the relevant regulations derived from it relating to structured products.

Table 1.5 Regulations and key features

      EU-11 Financial Transaction Tax

      The EU-11 Financial Transaction Tax (FTT) will be introduced in 11 EU countries: Austria, Belgium, Estonia, France, Germany, Greece, Italy, Portugal, Slovakia, Slovenia and Spain. It will levy tax on financial transactions involving EU-11 counterparties. The financial instruments covered by FTT include cash management products, securities, derivatives and repos. FTT will impact the financial markets in a variety of ways and it will also impact derivatives pricing. The affected derivative instruments can impact end products pricing, either directly or via hedging.

      Corporate and retail customers will be exempted from FTT. Market-making activities will also be excluded from FTT,