Goldman and the OIS gold rush

7/22/2019 Goldman and the OIS gold rush

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RISK MANAGEMENTl DERIVATIVESl REGULATION RISK.NETJUNE 201

Goldman and theOIS gold rushHow fortunes were made from a discounting change

Client clearing

Exclusive survey of early adopters

SecuritisationPolicy-makers versus regulators

Proprietary indexesDefining debt

Cutting edgePolishing SABR


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risk.net/risk-magazine 1

COMMENT

that swaps traders atGoldman Sachs and a

handful of other dealers made a lot ofmoney in 2008 and 2009 as a result ofthe industrys switch to collateral-basedvaluation is an open secret. Exactly howthey did it, and how much they made,has never previously been revealed.

Tanks to a host of interviews withcurrent and former traders on thebuy- and sell-side, this months coverstory sheds some light on what wasarguably the most dramatic change inthe history of the over-the-counterderivatives market, during a time when

the nancial system itself was comingapart at the seams.

It had a Wild West-type feel, and itwas breaking new ground, one swapstrader says. With hindsight, they werefantastic times. I learned more in thosetwo years than in the previous 10 yearsof my career.

What everyone learned was thattrades should be discounted at the ratepaid on the accompanying collateral the overnight indexed swap (OIS) ratefor cash-collateralised trades and thatswaps portfolios across the Street werevalued incorrectly. What made itinteresting was that everyone learnedthis at different times, with GoldmanSachs a couple of years or more ahead ofthe pack.

It meant Goldman could pre-positionits books to benet the switch to OIS

from Libor meant the value of derivativesassets and liabilities would grow, so thebank tried to boost the former andconstrain the latter. From what littlepublic information is available, that seemsto have been hugely successful. In 2008,the banks annual report shows it received$137 billion in cash collateral a 132%increase on the previous year while theamount of cash it posted grew only 22%.

It also meant the bank had more timeto comb through its collateral agreementsand amend them so counterparties

when they woke up to the new pricingorthodoxy would not be able to take

advantage. A former Goldman trader saysthe bank had a team of 10 lawyersdevoted full-time to the task. Otherbanks soon started to use the same tactics.

We dont know exactly how muchGoldman Sachs made as a result, buttraders at other banks claim to haveearned up to $600 million over athree-year period specically fromOIS-driven trades and they are con-vinced Goldman made more possiblyas much as $1 billion.

Tat is an extraordinary sum toextract from the minutiae of creditsupport annexes, and it explains why oneof the traders that agreed to speak reluctantly only did so out of a sense ofhistoric duty: Before all of this getscompletely lost in the myth-making thatfollows this kind of stuff, someoneshould sit and write it all down.

TheWildWestThe fact

Editor Duncan Wood

Read it rst online

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20Proprietaryindexes

Dening debt

by Lukas Becker

Proprietary indexes are one of the few remaining

hot spots for product structuring, but with banks

churning out new investments from one week

to the next, lawyers are increasingly worried that

some product tweaks could inadvertently expose

issuers to harsher regulation.

23Bankresolution

Hinging on trust

by Michael Watt

Work to develop a cross-border recovery and

resolution regime is progressing, but the need

for individual regulators to sign co-operation

agreements is seen as a potential problem. It

boils down to trust and that worries some

participants.

25CCPresolution

The end of the waterfall

by Michael Watt

Policy-makers say they will not bail out a stricken

clearing house, which means the industry needs

explicit recovery and resolution plans. It also

means member firms will get a better picture of

exactly how much risk they face.

30

Securitisation

Insecuritisation

by Laurie Carver

The European Central Bank wants to promote

securitisation, but critics of the Basel Committees

proposed new capital rules fear the extra burden

will snuff out the European market altogether.

The stage is set for the latest clash between

policy and regulation.

6 New angles

CFTC approves Sef rules and eyes block trade

controversy

Eurex may copy CME swap futures

'No panic' as Nikkei vol spikes, dealers say

US to revise CVA capital charge

SEC combats cross-border rule critics

12 People

REGULARS

14Goldman and the OIS gold rush

by Matt Cameron

Its the untold story of the switch toovernight indexed swap discounting.

As the Street haltingly adjusted to the

new reality, some desks are said to have

booked profits running into the hundreds

of millions of dollars earning grudging

praise, or just grudges, from their peers.

COVER STORY

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71

Introduction

Continuity error

by Laurie CarverSome quants discarded the continuous time

model when it got in the way of arbitrage-free

pricing but others see a chance to fix the

traditional ideal.

72Interest rate derivatives

SABR goes normal

by Philippe Balland

and Quan Tran

The benchmark stochastic alpha beta rho

model for interest rate derivatives was

designed for an environment of 5% base rates,

but its traditional implementation method

based on a lognormal volatility expansion

breaks down in todays low-rate and high-

volatility environment, returning nonsensical

negative probabilities and arbitrage. The

authors present a new method based on anormal volatility expansion with absorption

at zero, which calibrates while eliminating

arbitrage in the lower strike wing.

78Interest rate risk

Lois: credit and liquidity

by Stphane Crpey

and Raphal Douady

The spread between Libor and overnight

index swap rates used to be negligible until

the crisis. Its behaviour since can be explained

theoretically and empirically by a model

driven by typical lenders liquidity and typical

borrowers credit risk.

33Futures

Stick or twist

by Tom Osborn

Clearing rules for over-the-counter derivatives

are prompting buy-side firms to revisit long-

standing futures clearing relationships, withsome customers choosing to house both sets

of business in the same place. Big swaps players

say this hands them the advantage but their

futures rivals are not so sure.

36Libor

Votes for quotes

by Lukas Becker

The Wheatley Review decided to stick with a

patched-up Libor submission methodology,

but some regulators want it replaced with a

mechanism based entirely on transactions. The

compromise may be to use committed quotes.

51Swaps push-outWill the Fed x 716?

by Peter Madigan

Since it was signedinto law three yearsago,

banksand lawyershave been expectinga fix

to the Dodd-Frank Acts swaps push-out rule.

But with six weeks until it comes into effect,

expectation is turning to hope and banks are

warning they may not be able to comply.

54Risk institutional investor

rankings 2013

All mixed up

by Tom Newton,

with research by Max Chambers

Dealers have been cheered by the return of

volatility to Japans slumbering markets, but

ongoing global reforms to bank supervision

and derivatives markets are the backdrop to

this years rankings and have shaken up some

categories. Deutsche Bank retains top spot, with

JP Morgan again second.

70Risk analysis

Tipping point?

by David Rowe

Electoral advances by anti-European parties and

vocal criticism by influential voices represent the

most serious challenge to the European project

in a generation. While a rapid restructuring of the

eurozone, or of the union itself, may feel unlikely,

risk managers ignore the possibility at their peril.

RISKCONTENTS V.26 N.6

CUTTING EDGE

84Prole

First-mover disadvantage

by Nick Sawyer

Elbert Pattijn of DBS.


6/22

RISKCONTENTS V.26 N.6

4 Risk June 2013

39 Introduction

40Client clearing

Into the unknown

by Joe Rennison,

withresearch by MaxChambers

Client clearing is a new business for the over-the-

counter derivatives market, with untested rules

and so far largely unproven services. To shed

some light on pricing and practices as the first

clearing mandates take effect, Risksurveyed 21early adopters.

46Client clearing

The need for non-cash

byTom Osborn

Pensionfunds tend notto have a lot of cash

lying around, making it difficult for them to

meet clearing house margin calls. Specialistasset manager Insight Investment is pressing for

a solution.

47Client clearing

Cutting costs of clearing

by Tom Osborn

Early adopters of over-the-counter derivatives

clearing tended to be the big beasts of the buy-

side universe, but smaller firms such as Frances

OFI Asset Management are coming on board

as well.

48Client clearing

Small banks, big needs

byJoe RennisonIn the US, banks with more than $10 billion

in assets will be required to clear from June

10, and the smallest of these institutions may

not be attractive as clearing clients. Some are

struggling to be readyin time, but others have

shown it can be done.

IN DEPTHCLIENT CLEARING

THE TOP 5 ONLINEONLY STORIES LAST MONTH:

1 CFTC misusing Dodd-Frank to expand its role, says CME's

Duffy: www.risk.net/2269641

2 Europe should consult on Emir equivalency SEC official:www.risk.net/2268415

3 Sef rules continue to raise questions:

www.risk.net/2271380

4 BIS nds no evidence of persistent collateral scarcity:


5 Mandatory clearing in Hong Kong postponed until January


THE5 MOST RECENTVIDEOS ANDAUDIOON RISK.NET:

1 Flexible technology needed to respond to regulatory

change, says Fincad: www.risk.net/2266443

2 Falling correlations could give hedge funds bumper returns:www.risk.net/2264546

3 Skylar's Perkins sees potential for volatility in US natural gas:


4 Cern Pension chief urges others to think like global macro

hedge funds: www.risk.net/2271052

5 Extraterritoriality, uncleared margin and futurisation Isda

on OTC derivatives: www.risk.net/2255763

THERES MORETO RISKTHAN RISKMAGAZINEAreyoumissingoutonexclusiveonline-onlystories?


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8/22

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6 RiskJune 2013

NEW ANGLES

Te US Commodity Futuresrading Commission (CFC)may even-up block trade rulesfor swaps and swap futures, itannounced on May 16, aslong-awaited requirements forswap execution facilities (Sefs)

were approved at an openmeeting in Washington, DC.

As things stand, swaps are sub-ject to CFC-set block thresh-olds which allow big trades

to avoid real-time reportingrequirements but exchangescan set their own thresholdsfor futures contracts.

Critics have argued thisdisparity hands the exchanges forma lly known as de sig-nated contract markets(DCMs) an unfa ir advan-tage in ca ses where they aretrading products that are eco-nomically equivalent to over-the-counter swaps (RiskApri l2013, pages 4850, www.risk.net/2257576). Te CFCappears to be listening.

Te staff as a team is look-ing at issues relating to the set-ting of block sizes on DCMsand is contemplating some sortof potential commissionaction, regulation or rule-mak-ing that would address issuesrelated to the setting of blocksizes on DCMs in particular,

with respect to the so-calledfuturisation of swaps that hap-pened last year. Tats some-thing were looking at, said

Richard Shilts, acting directorin the division of market over-sight at the CFC.

Tis was immediately wel-comed by Lee Olesky, chiefexecutive of New York-basedelectronic execution platformradeweb. Te different treat-ment between the ability ofDCMs to set their own blocksizes and the CFC-mandatedblock sizes for Sefs is a serious

inconsistency, especially as itrelates to the goal of transpar-ency. Our view has long beenthat economically equivalentinstruments, whether tradedon a DCM in the form of aswap future or over the counteras a swap contract, should havethe same block standards. Tefact that the commission men-tioned the issue and its willing-ness to investigate it is a posi-tive step in equalising thesetwo types of provision.

Te block rules for swapswere nalised during the May16 meeting, establishing a 67%notional size threshold. Anytrades above this point in agiven products range ofnotional sizes can be executedbilaterally (Risk April 2012,

pages 2629,www.risk.

net/2163871), away from a Sef,and will be subject to a report-ing delay of at least 30 minutes meant to give liquidity pro-viders time to hedge them-selves before the market isnotied of a large transaction.Te CFC has ca lculated thatroughly 6% of swaps will qual-ify as blocks under the nalstandard but, during the rst

year of the new regime, theblock threshold will initially beset at 50%.

Under the nal block rules,the threshold applies to allswaps, regardless of whetherthey are traded on a Sef or aDCM. Market participantscould sidestep this rule, how-ever, by electing to insteadtrade a swap futures contractthat is economically equivalent

to the swap the fear ofradewebs Olesky and othercritics thereby becomingsubject to the DCMs ownblock threshold rather thanadhering to federal limits (Risk

April 2013, pages 3841, www.risk.net/2257042).

Beyond the CFC staff sdecision to review this dispar-ity, trading platforms gener-a lly lauded the na l form ofboth the block trade and Sefcore principles. Proposals forboth sets of rules had beenhugely contentious.

I think the commissionhas come up with a great rule,notwithstanding the argu-ments and delays that led upto it, says James Cawley,chief executive of JavelinCapital Markets, a New York-based Sef. I think the blockru le is the most signicantmeasure passed, becauserequiring Sef execution for alltrades larger than 67% ofnotional swaps size translates

into 94% of all swaps traded,and thats a big win for trans-parency and for competition.Combine that with the made-available-to-trade rules,

which give autonomy to Sefsto list products and self-cer-tif y, and this is a big step ingetting this market rolling.

Te nal design of the Sefcore principles provided littlein the way of surprises. Te

proposal that requests for aquote would need to be sent toa minimum of ve market-makers potentially making itmore difficult for these rms tomanage their risks, criticsclaimed has been watereddown. During a one-year tran-sition period, quote requestscan go to two participants, andthree thereafter.

As expected, voice broking is

permitted to continue as anexecution method and the15-second crossing rule delay isalso retained. Te latter meansa customer order has to be dis-played for a minimum of 15seconds and cannot beinstantly lled, giving otherparticipants a chance to pro-vide a better price.

Sefs will be allowed to startoperating as soon as theyreceive a temporary Sef regis-tration from the CFC, ratherthan being required to wait fora full registration. And in adeparture from the normal90-day waiting period, the Sefrules go into effect just 60 daysafter they are published in theFederal Register a move someplatforms have interpreted asan apology from the CFC forthe lengthy period of regula-tory limbo that precededtodays vote.

Tat 60-day approvalcould be interpreted as a tip ofthe hat by the CFC to the

long delay the market hasendured and toward movingthings a long a litt le faster.

What these rules have pro-vided is clarit y, and we cannow get down to the businessof submitting our applicationsand beginning to ser ve cli-ents, says Christian Martin,chief executive at New Jersey-based DCM, eraExchange.

Peter Madigan

CFTC approves Sef rules and

eyes block trade controversy

Lee Olesky, Tradeweb


10/22


Eurex is consulting with deal-

ers and buy-side rms on thepotential launch of a euro-denominated interest rate swapfuture contract that maymimic the design of contractstraded on US rival CMEGroup, Risk has learned. TeCME product begins life as afuture, but users can opt to bedelivered a cleared over-the-counter swap at the contractsquarterly settlement dates.

Te German exchange isunderstood to be seeking legaladvice on whether the US pat-

ent behind the CME product which is held by GoldmanSachs and is used by CMEunder licence (Risk October2012, page 6, www.risk.net/2206844) applies only toproducts traded in the US,according to two people famil-iar with the matter.

Eurex declined to com-ment on its specic plans.However, a spokesperson forthe bourse in Frankfurt sayssufficient market demand isa key prerequisite for any

successful product launch.

Te patent used by CME,Method and apparatus for list-ing and trading a futures con-tract that physically settles into aswap, was led by Oliver Fran-kel, a managing director inGoldmans securities divisionin New York on June 12, 2007and granted in 2011.

CME launched its dollar-denominated deliverable swapfutures in December, supportedby four dealer market-makers,including Goldman Sachs. Tecontracts have enjoyed steady

growth since their launch, gen-erating notional turnover ofmore than $33 billion so farthis year, according to a CMEspokesman.

But whether the patent i senforceable in Europe and

where responsibility lies forensuring it is not infringed is unclear. Tey do not needto license the patent if no USperson is going to trade orclear it. Te patent is a USone, not a global one. Tatsaid, it would be very hard for

them to know no US person

was trading the contract , saysone industry source.

According to one seniorintellectual property lawyer:A patent grants the holder amonopoly right over a productor a method claim only withinthe jurisdiction in which it wasgranted. In order for a party toinfringe on a US patent forexample, by a developing abusiness method based on themethod claim that patent pro-tects the infringing act wouldhave to take place in the US.

If the patent is deemed notto apply in Europe, then itcould pave the way for Eurexto develop a contract with asimilar delivery model, whileavoiding the need for a poten-tially costly licensing deal ofthe kind struck by CME in theUS (RiskOctober 2012, pages3438, www.risk.net/2208967).Under the terms of that deal,Goldman stands to collect1520% of the revenues gener-ated by CMEs contract,sources in the exchange indus-

try have estimated. A Gold-

man Sachs spokeswoman inLondon declined to commenton whether the bank hadreceived enquiries from Eurexregarding the patent.

CME is planning to offer asuite of xed-income futuresgeared towards European mar-ket participants on its soon-to-be-launched Europeanexchange, a move that couldcome in the second half of thisyear. Te exchange is also con-sidering the launch of a euro-denominated deliverable swap

future, initially to be traded inthe US.

But while Eurex has beenconsulting on specications fora swap futures contract since

January and, it is understood,could be operationally ready tolaunch andclear such a contractthis year the exchange is saidto be in norush. Its rst priorityis a revamp of its Euriborfutures contract a market cur-rently dominated by rivalNYSE Liffe.

Tom Osborn

Eurex may copy CME swap futures

Equity derivatives desks inJapan claim to have copedwith a large spike in volatilityafter the Nikkei 225 indexexperienced its biggest dailyfall since the devastating tsu-nami that hit the country inMarch 2011. Short-end volatil-

ity on the index leapt morethan 16 points on May 23,according to the Nikkei Stock

Average Volatility Index, asspot plunged from the previousdays close of 15,627.26 to14,483.98, a drop of 7.32%.

Despite that spike in volatil-ity, equity derivatives dealersbelieve the industry emergedfrom the days trading rela-tively unscathed, and claim

there was little sign of desksscrambling to hedge short vol-atility positions.

When you look at the skewthe day before for an at-the-money option at strike 15,600,the implied vol was around 26,

while for the 14,500 strike, vol

was 29. oday, the vol for the14,500 strike is around 34.5 so thats a jump of 8.5 points.But three points of that wasmerely riding the skew, so re-marking of vol was around 5.5points, which is not huge,given what spot did today. Tissuggests there werent anypanic buyers of volatility, saysone equity derivatives trader ata European bank.

Another head of equityderivatives trading at a Euro-pean bank agrees. Te move

was driven much more by spotthan short covering there waspanic in the move, but notpanic in the market, he says.

Te trader adds that volumes

of options traded did notchange radically from thoseseen in previous months. Tere

was also no spike in theamount of puts traded, he says.

However, some dealers claimto have seen a small number ofdesks buying large amounts ofvolatility on the way up, andcaution losses cant be ruledout. Tere were a couple ofdealers that were buying vola-

tility in a big way but we dontknow whether it was on theback of client ow or to covershort positions it was verydifficult to tell because themarket was gapping massivelyintraday. But assuming thedealers were long delta, it is

difficult to tell much about theStreets positioning on vega. Itwill be varied in terms of theimpact, says one index volatil-ity trader at a US bank inHong Kong. Delta measuresthe change in an options pricefor a change in the underlying,

while vega measures a changein an options price for achange in volatility.

Matt Cameron

No panic as Nikkei vol spikes, dealers say


11/22

8 RiskJune 2013

NEW ANGLES

US regulators are said to havedismissed the idea of copying

Europes exemptions to thecredit valuation adjustment(CVA) capital charge, and areinstead planning to change the

way hedges are recognisedwhen they publish their ownversion of Basel III, possiblybefore the end of June.

I understand perfectly whyEuropes exemptions are there,but exemptions are the lastresort of a legislative processand the US has no intention ofmirroring them. Tey are moreinclined to make different

changes, says one industrysource who has spoken withUS bank supervisors.

If correct, that would createthree versions of the charge andleave other jurisdictions in a dif-cult position. Canadas Officeof the Superintendent of Finan-cial Institutions (Os) decidedlate last year to defer imple-menting the CVA charge until

January 2014 the start-date forEurope and the US to avoidputting its banks at a disadvan-tage. A common start date maystill be possible, but its not clear

whether Canada would adoptthe official CVA charge, or copythe European or US approaches Os declined to comment onits plans. Other jurisdictions arealso keeping a keen eye ondevelopments.

We see benet in consistentBasel III implementationacross jurisdictions and arenaturally cautious with regardto exemptions that represent arelaxation of the standard for

reasons of regulatory arbitrageand any potential to concen-

trate risk geographically in theexempting jurisdiction, says aspokesman for the Hong KongMonetary Authority.

In March, European politi-cians agreed to exempt tradescovering corporates, sovereignsand pension funds from theCVA charge (RiskApril 2013,page 8, www.risk.net/2252629).Proponents of the exemptionargued the CVA capital chargedoesnt make sense givenEuropes clearing exemption forthe same rms. Te clearing

exemption was granted becausecorporates lack the large stocksof liquid assets needed to satisfyclearing house demands for ini-tial and variation margin. Butuncleared, uncollateralisedtrades attract a big CVA capitalcharge unless the exposure canbe hedged with credit defaultswaps (CDSs), meaning corpo-rates would escape the margindemands associated with clear-ing only to face a hike in trad-ing costs.

Te exemptions haveangered US dealers, whichargue they will be disadvan-taged when competing withEuropean banks for derivativesbusiness.

While market participantsglobally have raised legitimateconcerns about the CVA cali-bration, and we believe theBasel Committee should revisethe calibration, the Europeanexemption is troubling in thatit is a diversion from a uniformapplication of capital standards

incongruous with G-20 princi-ples and will result in an un-

level playing eld for non-EUdealers, said Kenneth Bent-sen, acting president and chiefexecutive of the SecuritiesIndustry and Financial Mar-kets Association at a HouseFinancial Services Committeehearing on April 11.

Industry sources that havespoken to US regulators inrecent weeks say the FederalReserve opposes copycatexemptions, but is insteadplanning to modify the treat-ment of CVA hedges and isalso reviewing the role of mar-ket risk hedges. Te FederalReserve declined to comment.

While banks typically hedgemarket risk incurred in clienttrades by entering into offset-ting transactions, those hedgesare not taken into account

when calcu lating exposure forthe purpose of the CVA charge which is designed to capturecounterparty risk and thehedges themselves becomesubject to trading book capital

requirements. Te only way tomitigate the charge is to collat-

eralise or clear the trade, or topurchase a CDS hedge, withthe available hedges alsostrictly curtailed.

We understand the US reg-ulators are examining inclusionof market risk hedges for theCVA charge, which is driven byvolatility in credit risk and thevolatility in underlying marketrisk components. In the Baselframework, the credit risk isincluded and the market risk isexcluded but these marketrisk factors can be very signi-

cant, effective CVA hedges,says one regulatory policyexpert at a European bank.

Risk also understands theBaselCommittee has instructedits trading book group to con-sider the implications of theCVA charge for market risk inits fundamental review of thetrading book an about turn,after last Mays consultationpaper for the fundamentalreview made it clear the CVAcharge was out of scope.

When Europe created apotential un-level playing eldby exempting trades with cor-porates and sovereigns fromthe CVA capital charge

which the US regulators didnot agree with there was a lotof pressure to revisit the chargeand this is why it has shot rightto the top of the agenda at theBasel Committee and hence

why its back in the tradingbook review, says one capitalexpert at a European bank.

Matt Cameron

US regulators to revise CVA capital charge

Kenneth Bentsen, Sifma

Former Fed chairman Volcker vents anger at US regulatorsTe fragmented US regulatory frameworkis a recipe for indecision, for neglect andfor stalemate, according to former Fed-eral Reserve chairman Paul Volcker, whovented his frustration with the slow paceof Dodd-Frank Act reforms during anevent at the Economic Club of New Yorkon May 29.

It was recognised that the FederalReserve was ineffective in the run-up to thenancial crash. Nonetheless, the Dodd-Frank Act implicitly reinforced the FederalReserves supervisory authority. I think itsclear now that the regulatory landscape hasbeen little changed and the result is that wehave been left with a half-dozen regulatory

agencies involved in banking and nance.Tey all have their own mandate, their owninstitutional loyalties, their own supportnetworks in the Congress a long with anever-growing cadre of lobbyists equipped

with the capacity to provide campaignnance, said Volcker.

Peter Madigan


12/22


13/22

10 RiskJune 2013

NEW ANGLES

A US Securities and ExchangeCommission (SEC) official hasrejected crit icisms that theagency capitulated in the faceof bank lobbying and watereddown its cross-border rules,

which include a narrower de-nition of US person than inguidance issued la st year bythe Commodity Futures rad-ing Commission (CFC).Crit ics saw that as evidencethe SEC had succumbed to

outside pressure.Te suggestion that in try-

ing to address internationalregulatory concerns we some-how sacriced robust regula-tion is simply a reection of alack of understanding of theregulatory system that we areputting in place, full stop,said Brian Bussey, associatedirector for derivatives policyin the division of trading andmarkets at the SEC, speakingat an industry brieng organ-ised by the Futures andOptions Association (FOA) inLondon on May 15.

Te 650-page proposal oncross-border security-basedswaps activity was votedthrough unanimously at anopen meeting held at the SECsheadquarters in Washington,DC on May 1. A key part ofthe proposal was the denitionof US person vital because itessentially determines who or

what will be subject to Dodd-Frank entity-level and transac-

tion-level requirements.Under the proposal, a USperson is dened as any naturalperson resident in the US; anypartnership, corporation, trustor other legal person organisedor incorporated under the lawsof the US, or having its princi-pal place of business in the US;and any account (whether dis-cretionary or non-discretion-ary) of a US person.

Tis is fairly similar to thecurrent denition of US per-son under a CFC nalexemptive order, which cameinto effect on December 21 lastyear the third denition ofUS person since the CFCpublished its original interpre-tative guidance on the cross-border application of Dodd-Frank on July 12, 2012.However, the exemptive reliefruns out on July 12 this year,and the CFC is currentlyconsidering a much broaderdenition of US person thatlawyers say will extend Dodd-Frank to cover a large numberof entities also likely to be sub-

ject to overseas rules (www.risk.net/2255184).

Tat proposal sparked a

storm of protest from marketparticipants, who claimed theCFC rules were extremelycomplex and would meanoverseas rms are subject tomultiple, potentially conict-ing regulations. Te SEC hastaken note of these concerns,says Bussey.

On the denition of USperson, the staff is recom-mending a narrow territorial

approach to the denition. Justas importantly, we have triedto make the denition easy tounderstand and to follow, hesaid, speaking when the pro-posal was published.

Another important aspect ofthe SEC rules is the concept ofsubstituted compliance aterm introduced in the CFCsoriginal interpretative guid-ance last July. Te frameworkis broadly similar to the

CFCs, in that non-US swapdealers, non-US major swapparticipants and foreignbranches of US banks will beable to apply foreign regulatoryrequirements in certain cir-cumstances, as long as thelocal rules are comparable toDodd-Frank. However, theSEC is basing its determina-tion of equivalency on out-comes, rather than requiring arule-by-rule comparison of theregulations, as stipulated bythe CFC.

More controversially, theSEC proposal covers businessconducted within the US.Both the CFC and the SECrequire non-US rms to regis-ter as swap dealers or security-based swap dealers if theyexceed a de minimis notionalvalue of swap transactions withUS persons over the prior12-month period set at $8billion. Under the SEC rules,however, non-US rms wouldhave to count any transactions

solicited or negotiated in theUS, even if the trade is con-ducted with a non-US counter-party and is booked overseas.Tat means a foreign bankcould come under the over-sight of the SEC, even if itdoesnt execute any trades withUS persons.

Tis requirement notincluded in the CFC pro-posa l has been quest ioned

by foreign regulators. Tis istricky because there are differ-ent approaches across a ll themajor regu lators on this , sothere are real r isks of overlapor underlap, said omSpringbett , manager in theover-the-counter derivativesand post-trade policy team atthe Financial Conduct

Authorit y (FCA), also speak-ing at the FOA event. Tebasis of the European

approach on branches is tofocus very much on the legalentity, because what we inEurope really care about is therobustness of the entit ies for

which our taxpayers could beon the hook. Tat is not thecase for a European branch ofa foreign parent.

Bussey argued the rule wasaimed at creating a level play-ing eld for domestic and for-eign dealers within the US,and ensuring all customers aresubject to the same levels ofconsumer protection andtransparency.

Overall, the rules have beenwelcomed by lawyers, who saythe agency appears to be takinga more co-operative approach

with foreign regulators.Te SEC approach recog-

nises that it is going to have toregulate the swaps markets byobtaining co-operation withnon-US regulators. Tis isfundamentally different fromthe CFC approach, which

was to go it alone and tobelieve that if it put out itsrule s, then non-US ent it ie s

would have no choice but tocomply. Ultimately, I thinkthis approach is impractical,says Steven Lofchie, co-chair-man of the nancia l servicesdepartment at law rm Cad-

walader, Wickersham & aftin New York.

Peter Madigan and Nick Sawyer

Securities and Exchange Commission

combats cross-border rule critics

Steven Lofchie,

Cadwalader, Wickersham & Taft


14/22

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15/22

12 RiskJune 2013

HSBC has named Dariush Mirfendere-ski as global head of ination trading forthe US, the UK, Europe and Asia, effec-tive immediately. He wil l be based inLondon and will report to ChristopheRivoire, head of North Amer ica ratestrading, and Pasquale Cataldi, head ofEuropean rates trading.

Mirfendereski returned to HSBC asmanaging director of rates trading strat-egy in March this year after an 18-monthsabbatical from the industry. Prior to thishe was head of ination-linked trading atUBS from March 2004 to July 2011, cov-ering the US, UK, European, Japaneseand Australian markets. Before his time atUBS, Mirfendereski helped build theination derivatives trading business at

Barclays Capital from March 1996.According to an HSBC spokesperson,

Mirfendereskis appointment is part of thecreation of a unied ination trading deskat HSBC, which was previously run sepa-rately in the UK, US, Europe and Asia.More focus will be put on expanding theUK and Asia franchises into other regions.

Credit Suisse has appointed Brian Chanas head of equity derivative sales for Asia-Pacic, replacing Min Park, whose four-year stint at the Swiss bank ended in April.

In addition to his existing sales manage-ment responsibilities for Hong Kong,

Japan and Korea, Chan, who was previ-ously head of equity derivatives retailproducts for Asia-Pacic, will be responsi-ble for all structuring and distribution ofequity derivatives products to private andretail investor clients in the region.

Chan will continue to be based in Hong

Kong and will report to Ken Pang, head ofequity derivatives for Asia-Pacic, a CreditSuisse spokeswoman conrmed.

Chan has been with Credit Suisse since2009 and has worked in various leadershiproles within the regional and global equityderivatives management team. Prior to join-ing Credit Suisse, he spent ve years at UBSin trading and platform development roles.

Bank of Montreal Capital Markets hasexpanded its foreign exchange business

globally, with four appointments in Lon-don, New York and Shanghai.

Greg Anderson, previously NorthAmerican head of G-10 currencies strategyat Citi, becomes global head of forex strat-egy at the Canadian bank in New York.He will report to Ed Solari, managingdirector for forex sales. Anderson had beenat Citi for just over two years, and beforethat was a currency strategist at SocitGnrale. He has held forex strategy rolesat ABN Amro and Bank Boston, and ownsa part-time forex consulting businesscalled Harmonics FX.

Te bank has also added to its forexstrategy team in London, hiring StephenGallo as head of forex strategy for Europe.Gallo, who will report to Simon Watkins,managing director, forex and China capi-tal markets, was previously a forex strate-gist at Crdit Agricole.

In Shanghai, Angela Wen joins as

head of China forex sales, reportingjointly to David Mu, senior manager inthe treasury function, and Lisa Xia, man-aging director for trading products.

Wens career spans more than 20 yearsand includes senior sales roles at CreditSuisse and ANZ.

Matthew Van Dyckhoff also joins therm in forex sales. Based in London, he

will cover the real-money sector. He mostrecently worked in forex sales at BrownBrothers Harriman.

Joe Regan has parted ways with JP Mor-ganjust three months after being unveiled

as the rms new chief risk officer (CRO)for the Asia-Pacic region. He was pro-moted in March alongside Joe Holderness,

who became CRO for Europe, the MiddleEast and Africa as the bank adopted a new,regional risk management structure.

A spokesperson at the bank dec lined tocomment on the departure, but did indi-cate that a search for Regans replacementis under way. It is understood that Regan

was offered another opportunity in thenancial sector.

Regans career at JP Morgan stretchesback to 1984, encompassing a period asthe chief nancial officer for the banks

asset management business. Prior to hisbrief nal role at the rm, he was chief ofstaff for JP Morgans Asian operations.

Te creation of regional CRO roles was

the latest in a string of management andrisk function changes that followed the

London Whale trading losses in early2012, when the banks chief investmentoffice (CIO) tried to reduce risk-weightedassets (RWAs) accumulated, in part,through the Basel 2.5 comprehensive riskmeasure. CIO traders engaged in a com-plex synthetic trading strategy that wassupposed to cut RWAs and keep the unitsrevenue intact. Instead, it led to an esti-mated loss of $6.2 billion.

As a re sult, Ina Drew quit her positionas head of the CIO. Matt Zames, therms co-head of global xed income andhead of capital markets, was promoted inher stead more recently taking on the

role of chief operating officer for the bank and Marie Nourie became the CIOschief nancial officer. Chetan Bhargiri

was named as the units new chief risk

officer. Barry Zubrow, group CRO in theyears prior to the losses, retired from theindustry in October last year, to be

replaced by John Hogan, who has been onsabbatical since January. In his absence,

Ashley Bacon, the banks former marketrisk head, is acting CRO.

PEOPLE

Othermoves

Regan quits Asia chief risk officer role at JP Morgan

Dariush Mirfendereski: promoted at HSBC


16/22


Nomura has hired Eric Miller as head ofinterest rates sales for the Americas. He joinsfrom Credit Suisse, where he took on anumberof senior roles during a 12-year stint,most recently co-head of US dollar rates sales

and US dollar swaps product manager.Miller will be based in New York and

will report to Henson Orser, head of glo-bal markets sales for the Americas.

Antti Suhonen has left his position asmanaging director of origination in equityand funds structured markets at Barclays.He had been with the bank for 15 years,and previously worked as a senior dealerfor the Union Bank of Finland from 1993to 1997. As of press time, no information

was available regarding his plans.

Lloyds Banking Group has recruited

Matthew Eldereld to be group directorof conduct and compliance, a newly cre-ated position. He will start work in Octo-ber this year, reporting to the chief riskofficer, Juan Colombas.

Eldereld is the deputy governor of theCentral Bank of Ireland, and previously

worked as alternate chairman of the Euro-pean Banking Authority and chief execu-tive of the Bermuda Monetary Authorityfrom 2007 to 2009.

With a strong and diverse backgroundin nancial regulation and business con-duct, Matthew brings a wealth of experi-ence to the group. I look forward to himbuilding on the work already being donethrough our compliance and conductteam, says Columbas.

In a speech last month at the EuropeanInsurance Forum, Eldereld pointed to anumber of aws in the Solvency II frame-

work for insurance regulation solvencybuffers could be left too low by overlyoptimistic internal models, while com-plexity has clearly gone too far in someareas and looks set to worsen. He alsoindicated that the lengthy negotiationperiod on the new standards has led tofatigue and exasperation from market

participants.However, Eldereld stressed that thebenets outweighed the costs. o be blunt:it is unacceptable that the common regula-tory framework for insurance in Europe inthe twenty-rst century is not risk-basedand only takes account, very crudely, of oneside of the balance sheet, he said.

Coutts has announced the appointmentof Nigel Drury as chief risk officer. Basedin London, Drury will cover Coutts risk

management functions across all geogra-phies of the wealth division at Royal Bankof Scotland (RBS), the private banksowner. He will report to Rory apner,chief executive of Coutts and David

Stephen, RBS group deputy chief riskofficer. He will also continue to sit on thegroup risk committee and will join Couttsexecutive committee.

Drury moves across from his position asgroup head of operational risk at RBS,

which he has held since 2010. His careerin nancial services spans two decades,and he has previously worked in seniorroles at ABN Amro and JP Morgan.

Commerzbank has appointed FarzanaNanji to its corporates and markets divisionas a director in foreign exchange bank sales.

Nanji started in her new role, which is

based in London, in early May. She reportsto Steffen Berner, head of forex bank salesfor Europe, the Middle East and Africa,and is responsible for banks in the MiddleEast and Africa.

Nanji joins from Credit Suisse, whereshe most recently worked in the forexstructuring group. She had been at therm for seven years.

Te German bank has also added JuliaWestcott-Hutton to its forex hedge fundsales team in London. She reports to MarkCudmore, head of forex hedge fund sales,and covers European real-money accounts,focusing on the UK and Benelux regions.

Westcott-Hutton, who has been in thenancial industry for more than 25 years,recently left Socit Gnrale Corporate &Investment Banking, where she was respon-sible for German real-money forex sales.She had been with the bank for 15 years.Prior to that, she was at Barclays in a similarrole, focusing on the Swiss market. She hasalso worked at UBS in London and Zurichas a forex specialist to the Benelux region.

Lona Nallengara has been named chief ofstaff at the US Securities and ExchangeCommission (SEC). He replaces Didem

Nisanci, who left the SEC last December.Nisancis departure was one of a series oftop-level resignations after former SECchair Mary Schapiro decided to step downin November 2012. Schapiro has sincebeen replaced by Mary Jo White, who wassworn in on April 10 this year.

Nallengara joined the SEC in March2011 and served as deputy director forlegal and regulatory policy in the divisionof corporation nance. In December2012, he was named its acting director.

Previously, Nallengara worked as a part-ner in the capital markets practice group atShearman & Sterling in New York. He

also served as the rms co-hiring partner,co-chair of its associate development com-mittee and international associates andtrainees committee, and as a member ofthe rms diversity committee.

Prior to joining Shearman & Sterling in1998, Nallengara practised in the corpo-rate group at law rm Osler, Hoskin &Harcourt in oronto.

Icap has named Dean Berry as its newchief executive officer of global brokinge-commerce. Berry moves up from his roleas Icaps regional chief operating officer forglobal broking in Asia-Pacic, and willnow be responsible for dening and imple-menting the rms global broking e-com-merce strategy. He will report to DavidCasterton, head of global broking.

Credit Suisse has promoted Joerg Schm-uecker, previously head of forex optionselectronic commerce and structuring forEurope, the Middle East and Africa, to glo-bal head of forex options in the privatebanking and wealth management division.

He began his new role, which is based inZurich, on April 1, and reports to Urs Bee-ler, head of forex trading in Switzerland.

Schmuecker joined Credit Suisse in 2007as a director in forex options structuringand trading, and was promoted to his mostrecent role in 2009. Before joining theSwiss bank, he was a managing partner atnancial consultancy rm Ekkono. He hasalso worked at Dresdner Kleinwort.

Matthew Elderfield: joining Lloyds

Please let us know about your new appointments.

T. +44 (0)20 7968 4624

F.+44 (0)20 7930 2238

[email protected]


17/22


18/22


everyone on the Street with this one, says one head of swaps trading at an Asianbank, recalling how his rm was repeatedly asked by Goldman Sachs to step

into a package of swap trades in 2008. Te trades in question were two cross-currency swapsin the same currency pair one would be out of the money for the new counterparty, whilethe other was at. Goldman was offering to pay around $200 million to the bank to step in money that would immediately be posted back to the US bank as collateral.

But it was not as straightforward as it seemed. Unknown to its prospective counterpar-ties, Goldman Sachs had come to the conclusion that cash-collateralised trades should bediscounted using an overnight indexed swap (OIS) rate the rate paid on the collateral rather than Libor, as was the practice at the time (RiskMarch 2010, pages 1822, www.risk.net/1594823). Using the lower OIS rate to discount the trade would produce a biggerliability and ought to mean a bigger upfront payment but a counterparty discounting atLibor would not twig.

Te problem was that everyone was valuing trades at Libor at the time, so we wouldhave effectively been underpaid to assume the liability. It was sneaky, says the swapstrading head.

Everyone who is anyone in the over-the-counter market has a story like this. From oneday to the next, the rules of the game changed but only a few dealers knew it. Suddenly,fortunes could be won or lost on the minutiae of the credit support annex (CSA) thatgoverns collateral posting between two counterparties. Banks that were in the knowemployed teams of lawyers to comb through those documents, and set up desks dedicatedto trading on the information they gathered.

Was that sneaky, or was it smart? raders, by and large, say it was smart. Some clients particularly insurers that were asked to pay for the collateral-posting rights Goldman

would lose on a trade unwind say it was underhand. Whatever the ethics, it wasmassively protable. One European bank made more than $500 million over a three-yearperiod, according to a former trader; another ex-trader at a different European bank putsits OIS-related prots at $600 million over a similar period of time.

We ensured we were the right way round and a market leader. We may not have madeas much as Goldman but they started earlier, had the systems, and were able to be moreaggressive, says the second swaps trader.

Riskspoke to six former Goldman Sachs traders to tell the story, for the rst time, ofhow the bank and a handful of clued-up peers made fortunes from the switch to OISdiscounting. But how much Goldman itself earned is still shrouded in mystery and thebank declined to provide any official comment for this article. Te banks former tradersalso refuse to provide any numbers, but its rivals put it at around $1 billion. One of the

Its the untold story of the switch to overnight indexed swap discounting. As the Street

haltingly adjusted to the new reality, some desks are said to have booked profits running

into the hundreds of millions of dollars earning grudging praise, or just grudges, from theirpeers. ByMatt Cameron

They rang

COVER STORY

Illustration:EoinCoveney,nbillustration

Goldman and theOIS gold rush


19/22

16 Risk June 2013

COVER STORY

Goldman traders, asked about that gure,only says he wouldnt want to understatethe protability of this enterprise.

Like any gold rush, the early monthswere the most lucrative. As the rest of the

market gradually realised what washappening, opportunities disappeared when everyone else was armed with thesame knowledge, the gold eld became amineeld. Collateral disputes multiplied,simple trade novations became a source ofintense paranoia and dealers stoppedbackloading portfolios into clearinghouses, where collateralisation practiceschange (RiskSeptember 2011, pages2427, www.risk.net/2105032).

It was chaotic, unforgiving, bewilder-ing. raders had the time of their lives.Everyone was re-ghting. It was a verytense few years, and there was an awfullot of stuff going on. It had a Wild

West-type feel, and it was breaking newground. With hindsight, they werefantastic times. I learned more in thosetwo years than in the previous 10 years ofmy career, says one swaps trader at aninternational bank.

So, how did it all play out? Put simply,Goldman and other dealers were able toprot in two ways. First, as the basisbetween Libor and OIS started to widen,it meant anyone using the higher Libor

rate was working with valuations thatwere too low the spread blew out from6 basis points on January 3, 2007, to acrisis-era peak of 344bp on October2008 (see gure 1). As a result, Goldman

and others started positioning theirportfolios to benet when they made theswitch from Libor to OIS discounting they built in-the-money positions that

would be magnied by the change, andtried to minimise trades with a largenegative present value (PV).

Tis added up rapidly when appliedacross a whole portfolio. One ex-deriva-tives trader says using Libor rather thanOIS to discount a $100 million notional

ve-year interest rate swap could result ina difference of around $2 million on atrade with a PV of around $10 million.

At a more complex level, dealers beganto recognise the complexities associated

with CSAs in which a variety of differentcurrencies could be posted (RiskMarch2011, pages 1823, www.risk.net/2027812).Each currency requires a differentdiscount rate to be used the federalfunds rate is paid on dollar cash collateral,

while the euro overnight index average(Eonia) is paid on euro collateral, forexample which results in a differentvalue for the swap. In order to optimisecollateral usage, and swap valuations, a

dealer should theoretically post whichevercurrency is cheapest for it to deliver at anypoint in time, an embedded option thathad been completely ignored up to thispoint, but which suddenly became

valuable especially as the cross-currencybasis between dollars and euros blew outduring the crisis. As a result of that basismove, it became hugely advantageous toreceive dollars and post euros in CSAs aposition many banks sought to engineer.

While most dea lers only started wakingup to the new orthodoxy in 2008 and2009, Goldman is believed to haveidentied OIS as the correct rate and tohave recognised the need for CSA-specicvaluation as far back as the early 2000s.It started building systems to deal withthis new world in 2005.

It took a lot of work to get the systems

in place. But what was difficult was thatbecause each counterparty had a differentCSA, we had to read all of those agree-ments and build an infrastructure thatcould develop an individual curve forevery CSA. It was essential in being ableto price the cheapest-to-deliver collateraland create CSA-based discounting. Tis

was a massive undertaking, and we had10 lawyers who spent all their time goingthrough CSAs, says a second ex-Gold-man trader.

Once that work was complete, the bankanalysed what would happen to itsvarious portfolios in terms of prot andloss if it were to switch to OIS discount-ing, and then started a painstakingprocess of optimising and pre-positioningits portfolio to benet from the move.

We started to take an in-depth look atthe portfolios and model what wouldhappen if we were to ip the switch.

Where that would result in losses, welooked to optimise the trades so as toprotect the book, says the rst formerGoldman trader.

Te pre-positioning of portfolios wassimple in concept, and four other bankssay they did something similar. Because

many banks and clients were stilldiscounting trades using Libor, whichsurged away from OIS rates during thesecond half of 2007, the present value oftheir positions would be a lot smaller thanif the correct OIS rate was used. Tere-fore, a bank with a position that wassignicantly out-of-the-money could payabove market prices to unwind the trade,but still make money because it had paidless than the true value of the trade whenseen through an OIS lens.

The idea is to shift money along the curve and monetise as much

negative PV as possible at the right price by trying to unwind

positions at Libor flat, or Libor plus a little, and build up as many

collateralised positive replacement values as you can

SatyaPemmaraju,Droit Financial Technologies

150

100

50

0

50

100

150

200

250300

350

400

Basispoints

2007 2008 2009 2010 2011 2012 2013

1 Federal funds and three-month dollar Libor basis

Source:Bloomberg


20/22

For example, if a bank owed a pensionfund $100 million in 10 years time, andthe PV discounted at Libor was $80million, the PV at OIS might be $84million. Te bank could then pay theclient $82 million to unwind the trade abetter price than its peers would be

willing to pay to step into the trade, butless than the true value of the swap.

Te idea is to shift money along thecurve and monetise as much negative PV

as possible at the right price by tryingto unwind positions at Libor at, or Liborplus a little, and build upas manycollateralised positive replacement values asyou can. When you are able to switch,those values become real and you recognisea substantial gain, says Satya Pemmaraju,founding partner of Droit Financialechnologies, and former managingdirector in xed-income, currencies andcommodities trading at UBS. Swaps withpension funds and life insurers providedfertile ground for this strategy tradition-ally large xed-rate receivers, falling ratesleft swap positions for many of these rmsheavily in-the-money.

Most dealers eventually picked up onthe arbitrage, says a swaps trader at a USbank in London. ake a lot of theEuropean pension funds they hadmassive in-the-money positions, and some

wanted to liquidate those swaps becauseof counterparty risk concerns during thecrisis. So if you were smart and dis-counted using Eonia rather than Euribor,you could lock in signicant gains byunwinding or stepping into trades. Teearly movers were paying out muchsmaller values than they should have

been, and that alerted other banks as towhy they were losing trades.Riskspoke to six insurers and pensions

funds that say they received requests fromGoldman and other banks to unwind ornovate the trades away.

Tere were denitely banks that weremarketing the fact they could pay youmore to unwind the trade or to re-couponthe swaps. Te only question was whetherthat would be full OIS or not, which Isuspect it wasnt. But we saw many bids

better than Libor, says one head ofderivatives at a US insurer.

Some dealers accuse rivals of takingadvantage of clients by paying less thanthe true value of the swaps with most ofthe criticism directed at Goldman. Itsformer traders defend the way the bankhandled these transactions.

We did a lot of education on this andpresented papers not only to clients butalso to regulators. We were offering better

prices to unwind the trades than most onthe Street and our clients knew why that

was the case. Tis wasnt something wewere trying to hide. Clients could alsotake advantage of the differential indiscounting between different dealers andrecognise some decent value, says thesecond former Goldman trader.

Tat is backed up by some swapend-users. Tey gave us a presentationand explained the math behind it, so weknew fully what we were going into. Andby the same token we were looking foropportunities too if certain banks, likeGoldman, were paying above marketprices, then it made sense for us to do thetrade with them. Others were signi-cantly mispricing, says another swapstrader at a different US insurer.

Max Verheijen, head of trading atCardano, a risk management and advisoryrm that trades on behalf of institutionalinvestors, agrees: We denitely made useof the differences in pricing models usedby banks. Often, it proved protablenovating swaps to other parties insteadof unwinding a trade with the existingparty because different models werebeing used for the same CSAs. We really

have been able to make an opportunityprot on these transactions.However, when Goldman did ip the

switch to full OIS discounting some-time in 2008, and two years before manyof its competitors it had a tougher timemaking it stick.

Essentially, we present-valued theprot and loss that would have accruedover the life of the swaps trades, and whenthat switch was made and the valuationsof the trades changed, we needed to

receive the collateral to match those newvaluations. Tis meant making calls toclients. Tere were a lot of hard conversa-tions and upset counterparties. It took along time and a lot of effort to educateclients and to explain how we werevaluing trades and why we were callingfor more collateral. It was really tough,says the fourth ex-Goldman trader.

According to Goldmans 2008 annualreport, the bank received cash collateralof $137 billion that year, a 132% increaseon the $59 billion received in 2007.Meanwhile, the amount of cash collateralposted in 2008 was $34 billion, only a22% increase on the $27 billion posted in2007. Essentially, the banks derivativeassets ballooned massively in size, whileits liabilities barely changed whichhints at the furious behind-the-sceneseffort to optimise its book ahead of thevaluation switch.

Another problem for the bank was thatit became harder to compete against rmsthat were still discounting with Libor andproducing too-low swaps prices. Tis

was another headache. Essential ly, wewould end up pricing ourselves out of themarket on certain trades, and it required alot of client education to get them tounderstand why our prices were moreexpensive, the trader adds.

As a result, there were fears within therm that the rest of the market might notembrace the new valuation regime. It

was by no means certain that the rest ofthe market was going to follow us on this.Te OIS-Libor basis might never have

Some banks were charging for the optionality in unwinds,

and I think that was very disingenuous. Essentially, these were

documents signed 10 or 15 years previously to help increase

business between us and the banks, and nobody back thenvalued the optionalityTerry Leitch, ex-Aegon


21/22

spiked, and the market conventions mighthave stayed as they were. We were

condent we were right, but the truth iswe could not predict whether the marketwould move to this convention that wasdenitely a risk, says the rst formerGoldman trader.

Apart from the high-level shift fromLibor to OIS discounting, banks alsofound other ways of optimising theircollateral posting specically, takingadvantage of the widening cross-currencybasis. During the crisis, this marketbecame stressed as many European banksturned to cross-currency swaps to raisedollar funding when other avenues startedto dry up in turn, causing the basis toblow out. It became very expensive toraise dollars, but cheap to borrow euros.For savvy swap desks, this presented anopportunity (see gure 2).

As a simple example, take a swap deskwith two offsetting trades, one under aeuro-only CSA and the other under a dollarCSA. If the desk was in-the-money on thedollar CSA, it could in theory take thedollars it received and lend them out in thecross-currency swap market, being paid alarge basis to borrow euros, which it wouldthen post under its euro CSA. Once yourealised that euro was the cheapest-to-

deliver collateral, it became completelyobvious that you could optimise collateralposting so as to lock in the funding bases,and start moving your collateral aroundenmasse, says Droits Pemmaraju.

Te one-year euro-US dollar cross-cur-rency basis had generally oated around12bp prior to the crisis, but widened to21bp on June 2, 2008, and eventuallypeaked at 132.5bp on October 10. It hasremained between 20bp and 60bp eversince, breaking out of that range a few

times in late 2011 as the eurozone debtcrisis again caused US dollar funding to

dry up for European banks.Prior to the currency bases blowing out,

Goldman had tried to insulate itself fromthe risk that other counterparties would

wake up to collatera l-based valuation andwould recognise the value of the optionsembedded in multi-currency CSAs. It didthis by asking clients to ditch the optionto post euros. Many agreed.

A lot of counterparties were posting usdollars anyway, and we didnt want to getstuffed by being posted the worst fundingcollateral. For example, if you allow bothdollars and euros, you are short a switchoption changing that to dollars is inyour favour. We were protecting ourselvesby not being short that option. And we

were able to get a lot of those agreementschanged with rms that may haveprotested if they thought about it thesame way we did, says the rst ex-Gold-man trader.

He says the rm also used novation asan additional safeguard, giving ahypothetical example: If I had a trade on

with Bank A, which had a CSA thatallowed both dollars and euros, but gotBank B with which I had a dollar-onlyCSA to intermediate the trade, I would

no longer be short that switch option.Tere was a sneakier variant of this anoffensive, rather than defensive, move in

which one dealer would ask a client toapproach its existing bank counterparty toarrange an assignment of the trade. Teresult would be that the new dealer couldinterpose itself between the two and hooverup valuable collateral from one side, whileposting less valuable assets on the other.

It was a simple mechanism approachclients that had trades on with other dealer

counterparties with which you hadadvantageous CSAs, and try and get thoseclients to agree to theassignments. Forexample, if you had a euro CSA with theclient that was in-the-money, but a dollar

CSA with its counterparty, you could stepin between and extract value, says oneswaps trader at a European bank in London.

When the bases between currency pairsstarted to widen, other banks saw thehidden value in multi-currency CSAs. Asthey did so, the practices used by Goldmanbecame commonplace every dealer wastrying to arbitrage every other, either byexercising the switch option in a CSA or,in its more sophisticated form, by playingthe novation game. And while traders mayhave understood and recognised what wasgoing on, back-office and operations staffoften did not. Frequently, traders were

frustrated that their bank was agreeing tocollateral substitution requests that couldturn a prot into loss. But, sometimes,there was a way out.

Tere was one really special day, saysthe international banks swap trader,recalling a standoff his former rm alarge European dealer had withGoldman in 2009.

Somehow, someone in the rm agreedto the novation of a large out-of-the-money swap portfolio from a client,leaving us facing Goldman and posting aload of US dollars, which was an awfulposition to be in. Tis was at a time whendollars were really expensive to post,especially if you had to fund through thecross-currency swap market where thebasis blew out, he says.

Te bank decided it was going to ghtre with re. It combed through thedetails of its CSA with Goldman and, toits delight, found it could also post USreasury ination protected securities(ips), which had little value as collateral.

No-one would touch ips, so wepromptly pulled all the cash back andposted them linkers, as we had fullsubstitution rights. Tey werent pleased at

all, and it threatened the relationship for afair while, escalating to just below boardlevel. Butit was in the terms ofthe CSA, so

we told them they would have to live withit. Everyone knew everyone else was playingthese games back then. Tey got us, but wegot them back, the trader chuckles.

Most of the early action was in theinterest rate swap market, but it migratedto other asset classes later on, wheretraders were unaware of the implications.I remember being asked to step into a

COVER STORY

18 RiskJune 2013

140

120

100

80

60

40

20

0

20

Basispoints

2007 2008 2009 2010 2011 2012 2013

2 Euro/dollar one-year cross-currency swap basis

Source:Bloomberg


22/22

large out-of-the-money options portfolio,says one equity derivatives trader at aEuropean bank in London. Te bankasking for the novation said its creditlimits with the other bank counterparty

had been breached and it needed toreduce its exposure. But the deal didntseem right to me, there was somethingshy about it. So I stalled. I was reviewingthe transaction for two weeks, andeventually gured out the trick thebank asking us to step into the trade hada euro CSA with us, and a dollar CSA

with the original counterparty. But wealso had a dollar CSA with the counter-party. If we had stepped into the trade, we

would have received euros, posted dollars,and bled around $15 million on thecross-currency basis.

But one of the biggest arbitrage

mechanisms was carried out by backload-ing trades into SwapClear, the interestrate swap clearing service at LCH.Clearnet. Te clearing house only acceptscash collateral in the currency of theunderlying trade so, for example, adollar interest rate swap would have to becollateralised with US dollars. Terefore,banks could persuade unsuspecting dealercounterparties with which they hadin-the-money dollar swaps under a euroCSA to backload those trades intoSwapClear. Te bank would haveeffectively performed a collateral switchfrom euros to dollars.

While most traders bear no grudgesabout all of this, some clients see itdifferently. In one case, an insurer thatsought to unwind a trade with GoldmanSachs was toldit would have to pay thebank for the loss of the option in the CSA.

It became a relationship-ending dispute.We certainly had some issues with

Goldman. When we were trying tounwind, we were seeing a much lowervalue from them, and they told us they

were charging for the optionality. But thiswas no small amount to them it wasextremely valuable, they were essentiallytrying to add a bid-offer spread to theunwind. In the end, we didnt unwind theswap, and instead did an offsettingtransaction. o this day, we dont trade

with them, says one derivatives trader ata US insurer.

Others have similar complaints. Somebanks were charging for the optionality inunwinds, and I think that was verydisingenuous. Essentially, these weredocuments signed 10 or 15 years previ-ously to help increase business between us

and the banks, and nobody back thenvalued the optionality. Everyone wasblind to it, so for banks to start chargingfor it out of the blue when it goes their

way just doesnt seem fair, says erryLeitch, former head of derivatives tradingat insurer Aegon in New York.

Te third ex-Goldman trader says thebank always explained to clients why it

was charging them, and was consistentacross the board. We tried to communi-cate the pricing as early as possible, andmost of the insurers said they understoodit intellectually, but they said most of ourcompetitors didnt price it, and that we

were being a pain in the neck. But wewere doing the right thing; we werepricing the trade, to the best of ourknowledge, in the correct way.

Some clients agree, but were no lessunhappy in these cases, it was simply

the age-old story of a dispute betweenbuyer and seller. I hold no hostilitytowards them. I understand their businessdecision and the math behind it itmakes sense. But were talking about

millions of dollars here on large portfo-lios, and its not something I want to pay,says the head of derivatives trading atanother US insurer.

Other dealers, though, argue that whilethe maths might make sense, banksshould not charge clients for optionalityin multi-currency CSAs because the valueis impossible to realise. In order to hedgethe optionality, you need cross-currencybasis options, which dont trade at all and if they did, the bid-offer spread wouldbe as wide as Kansas. Essentially,Goldman has marked stuff it cannottrade, and if that is the case, then it is

questionable whether it should be chargedto clients, says another swaps trader at aEuropean bank in London.

For the same reason, any bank that hasmarked the value of those options on itsbooks and Goldman is believed to bethe only one to have done so will see thevalue bleeding away over the life of thetrades. But the third ex-Goldman tradersays the bank was extremely conservative

when marking gains on what it callscheapest-to-deliver valuation adjustment.

Yes, its very tough to monetise. Whileyou can relatively easily price the intrinsicvalue by looking at the cross-currencyforwards, there is no market for cross-currency forward options. So when youprice the option, you have to be extremelyconservative. Tere would be no pointmarking something we would then bleedover the next few years, he says.

Trading is a dog-eat-dog profession and, in the interdealer market, there is

widespread if occasionally grudging admiration that Goldman Sachs was

first to spot the opportunities in the new valuation regime. A different stand-

ard applies to trades between dealers and clients, of course, and Goldman

has been widely criticised for ignoring this distinction in recent years, treating

customers as counterparties. Its a claim some of the banks rivals make in the

context of the switch to overnight indexed swap discounting, and is one that

former Goldman Sachs traders de ny.

Here, three different takes on the behaviour expected of a swap dealer:

I applaud them. I really do. They were the smartest guys on the Street. They

thought about the issues before anyone else, built the systems to take advan-

tage of the situation and implemented it before anyone else knew what was

happening. Every other bank I know wishes they could have done exactly the

same. I have the utmost respect for them. And they did us all a favour in the

end you just had to make sure you werent lunch the head of fixed income

at an international bank in London.

Between dealers, all bets are off. If they dont get it, then thats tough. If two

dealers fundamentally are valuing the same instrument differently, then there

are trades to be done. If someone thinks the price is X and the other thinks it

is Y, then that is what creates markets. But when dealing with clients, you have

to sit down with them and explain why prices are different, and why you are

asking to novate or unwind trades. And sometimes, you need to waive certain

charges where it is disingenuous to levy clients. Otherwise it disincentivises

clients to use the product the head of swap trading at a US bank in London.

We werent trying to profit unknowingly off people. This was a modelling is-

sue. We valuedswaps differently and it could have gone either way.And before

this was made public, we had dialogues with our customers for years,becauseif

someone comes to unwind and they get charged a lotmore, they will ask why.

So in no way was there any type of unsavoury behaviour. It wasnt our intent to

go out and fool people.The price didall thetalking anex-Goldmantrader

The morals and manners of the OIS gold rush

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Goldman and the OIS gold rush

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