With my trusted tools of a large board and multi-coloured sticky notes I have made progress, well progress of sorts! I still come to a large ? at the end of the process.
While I was working for a Bank I attended several meetings trying to ascertain the impact of the first consultations seeking central clearing, transparency and collateral standards for the OTC derivative market places. As we worked through complex scenarios; parked controversial topics such as the need to build or buy new systems; clearly identify profit and loss (p&l) of each desk involved in a trade; and all of the divisional posturing and and denial that goes with such an exercise, I could only think about one thing, how do I explain this to a client?
I think it is therefore worth revisiting what went before the regulators started regulating, providing a tortured analogy and then concluding on the impact.
In the aftermath of the Lehman Brothers fall it became apparent that the Investment Banking dark arts had been very much in play in post-trade product management. Two plus two began life on the term sheets equaling four or near enough if you ignore amortizing p&l. Collateral would be posted and margin called within contractual parameters and established industry protocols. In the meantime all those otherwise redundant assets became inventory and indirect funding pools that could be re-hypothecated in the support of new contracts. All of a sudden two plus two became five, you could bet the p&l was being drip fed out of the price but it was far from certain that the assets were meeting the liabilities on the trading books and if they were, whether the internal trades between the exotic and security finance desks were booked correctly and stopping two plus two becoming three.
This may well be a jaundiced, generalised and simplistic view but for those of us involved in Investment Banking in the lead up to the Lehman's demise,whatever went on, the outcome is not a surprise. Structurers were constantly trying to identify efficiency to be competitive and maintain profit margins, in retrospect it is conceivable that the identified efficiency captured un-managed risks that so disastrously were realised to the detriment to all bank balance sheets. Whatever the truth and the intent the G20 mobilised quickly and the trusted regulatory weapons of transparency and regulation were brought into play and draft regulations were agreed in principle as early as 2009. In Europe we eventually ended up with the European Market Infrastructure Regulations (EMIR) and now have an established time line albeit with need for clarification on material definitions.
So how do we make sense of these dark arts, simply call on Paul and Barry the "Chuckle Brothers". Even if you are unfamiliar with Paul and Barry it becomes very easy to establish their brand of pre-teen targeted situation comedy and apply it analogically to securities finance and collateralisation! Without further ado imagine the following scenario. Paul Chuckle wants a new battery put in his watch and asks his brother Barry to do it as he as a very good tool kit. Barry looks in the toolbox, only to find that the required screwdriver is missing. Paul remembers that he lent it to the Vicar and as he wants his watch fixed undertakes to get it back. The following dialogue then ensues:
Paul C: "Hello Vicar, I was wondering if I could have the screwdriver that I lent you back, please"
Vicar: Paul, forgive me but I have sinned, I lent it to Police Constable Grossman who needs it to fix his torch!" Paul C: "No problem, Vicar I'm off to the police station anyway so I'll ask him directly"
Now to save you from reading several pages of dialogue, I can summarise as follows, PC Grossman has lent the screwdriver to Terry Dogood the probation officer, who has in turn lent it to Tommy Tempted a rehabilitating petty thief. Tommy however lent the screwdriver to Sam Slippery the local wheeler dealer. Sam sold it to Mrs Pickle the Chuckle Brothers' landlady, for a pound.
While Paul is desperately following the screwdriver through the various transactions, Barry decides to ask Mrs Pickle if she has a screwdriver fit for purpose, which of course she has and Barry borrows it, and fixes Paul's watch. Paul returns with a pound having asked PC Grossman to intervene and force Sam Slippery to pass over his ill gotten gains. Paul gives Barry the pound, Barry gives Paul the screwdriver. Paul gives the screwdriver to Slippery Sam, who gives it to Tommy T, who passes it to Terry D, who of course gives it to PC Grossman who lets the Vicar have it back who then returns it to Paul who give it to Barry who now has the pound and the screwdriver, so he offers the pound to Mrs Pickle who accepts it under the circumstances.
There is a lot of the catch phrase "from me to you, to me , to you"......hilarious? Now of course this last transaction could have been undertaken by Paul giving Mrs Pickle a pound and the explanation, in this scenario he would have been fulfilling in conjunction with PC Grossman the role of a central clearer. What this situation does not take into account is the scenario where Mrs Pickle wants the screwdriver and doesn't accept the pound, and the cost of a replacement screwdriver to Barry is £1.20. In this scenario we let Barry and Paul argue who should pay the he extra 20p. Really we all know it should be Slippery Sam but he has run off to Malaga! The regulators have of course decided that nobody can run off to Malaga without leaving 20p, simple.
However rediculaous this anlaogy may seem some of the transactional flows I have anecdotally been made aware of are not far off, some I am reliably informed are as yet still unravelled, ie no one has decided who owes the 20p although someone has lost the it!.
This brings me to the ?. How do I explain the requirements of EMIR to a client ? I'm not sure "it is collateralised" is going to help the Sales teams placate all those questions like, "what is the collateral, when is there a default, can collateral be re-hypothecated, is there margin in these transactions, can we have some of it off the price?
This is my point, the standard of transparency required for OTC transactions going forward, although laudable is significant. We do not expect a purchaser of a computer to understand how it works but what it does, with the safeguard that it will not kill you while it does it! I believe that the complexities of the back office are irrelevant if the safe guards are inherent in the products and the enforcement robust. I'm not sure the latter details are anywhere near being pinned down as we still await in scope instruments and thresholds.
Back to the drawing board!
HRP April 2nd 2013
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