What People Have to Say About OTC Derivatives

According to the Bank for International Settlements ("BIS"), the global market size for over-the-counter ("OTC") derivatives, as of June 2008, exceeded $683 trillion (yes trillion) or $683,725 billion. (These numbers reflect notional amounts outstanding.) Notably, an expanded use of interest rate swaps helped to push non-exchange traded interest rate derivative product outstandings above $450 trillion, a rise of 17% over the last half-year. It would be helpful to know whether, and to what extent, pensions' use of Liability-Driven Investing strategies influenced the numbers. Click to access "Table 1: The global OTC derivatives market."

Since June, a lot has happened in the global market place. Until BIS reports updated figures, it is hard to quantify how various players have responded to increased volatility with respect to their use of OTC instruments such as swaps, options and structured products. One might logically assume that valuation and liquidity concerns will reflect themselves in lower numbers for H2-2008. On the other hand, uncertainty could encourage hedging, in which case both OTC and exchange-traded activity might see a boost.

In the meantime, I asked a few financial market participants for their feedback. Here is what they had to say in answer to the following query.

Do You Think More Regulations Will Inhibit the Use of OTC Derivatives by Institutional Investors?

  • A director at a non-U.S. financial organization advises regulators not to throw the baby out with the bath water, adding that "Regulation should be framed to drive generic flows into more efficient 'plumbing' systems, while allowing custom-built trades to proceed when standardized terms don't make sense. Unless the market volunteers solutions, one must fear that knee jerk regulation will fail to differentiate, and therefore deprive end-users access to these undeniably valuable risk management tools."
  • Mr. Daniel Chertok, a quant by background, writes that "Any regulation inherently stifles innovation. However, it may deter those who should not be in this business from entering in the first place or encourage someone to rightly exit the market. There is likely to be a loss of liquidity but a drop in defaults should follow. What regulation will not do is eliminate the next bubble that occurs due to reckless derivative trading."
  • Mr. Luis Antonio Rangel, commodity derivatives professional and now President of Rockford Brownstone Rangel, thinks that regulation will inhibit use of OTC swaps and other kinds of derivatives by institutional investors. He adds that "the big downturn in this market recently has less to do with fear of regulation and more to do with counterparty risk. Regulators may help to repair the OTC market if their rules: (a) can improve market transparency as relates to how much leverage a particular manager employs (b) shed light on risk exposures to various counterparties across the spectrum For example, if Company DEF has a plain vanilla swap with Bank ABC but Bank ABC has a complex swap with Hedge Fund XYZ, how is Company DEF potentially hurt if Hedge Fund XYZ goes belly up? (c) improve investors' knowledge of liquidity, especially for instruments that have heretofore been deemed "low risk" and (d) mandate issuers of credit default swaps to reserve capital, in the same way that insurance companies must set aside monies. Too much regulation could push business offshore or impede transactions that, for viable economic reasons, should take place."
  • Mr. Patrick Rooney, Business Analyst at Trading Technologies, writes that "Initially, yes, more regulation will freeze OTC trading. As participants adjust to the new environment, the OTC market will flourish as new participants join. There are many misconceptions regarding the complexities and risks involved associated with OTC transactions. A centralized clearing environment is likely to vastly improve things."

Email us your comments. It would be great to get your feedback.

Public Pensions and Hedge Funds

In "States Double Down on Hedge Funds as Returns Slide," Bloomberg reporters Adam Cataldo and Michael McDonald (August 14, 2008) suggest that public pensions may get a double whammy if alternative investments go south. New York, New Jersey, South Carolina and Massachusetts are just a few of the large public plans now allocating monies to non-traditional investments such as hedge funds, real estate and private equity. This is not necessarily good or bad though one wonders about the timing. Will current market volatility help or hinder plans in search of higher returns? This blogger is quoted as follows:

"It doesn't come risk-free," said Susan Mangiero, president of Pension Governance, LLC, a research firm based in Trumbull, Connecticut. "You could end up having a worse performance and the chain of events is lower funding status and increased taxes."

Managing director Eileen Neill, with Wilshire Associates, states the need to "diversify some of the equity risk" and to attempt strategies that will help match the growth in liabilities. As I told the Bloomberg reporters (though not included in this article), how one measures diversification potential is key to understand. Correlation analysis only goes so far when markets are turbulent and bad news tends to adversely impact otherwise uncorrelated markets. Additionally, correlation assumes a linear relationship when comparing returns for a particular investment pair (hedge fund versus a large cap equity index for example). When the relationship is non-linear, correlation is less useful as a gauge of potential risk reduction.

Just as important, past is not prologue. Assessing historical returns can be misleading at best. Stan Rupnik, Chief Investment Officer at the Teachers' Retirement System of the State of Illinois, is quoted as saying that "Chasing performance, especially in a public fund, can be a dangerous thing." It is important for trustees to make sure that "what if" analysis is being done on a regular basis, taking into account relevant risk drivers. Consider private equity and venture capital. An accelerating credit crisis has made it extremely difficult for companies to go public or for potential suitors to finance their bid. As a result, returns suffer. No surprise that pension investors (and their plan participants) take a hit too.

Editor's Note:

Pensions and Liquidity Squeeze

More than a few people have declared the beginning of the end. A reference to halcyon market conditions, it looks like they are right (at least for now). A flurry of headlines address what this blog author has been saying all along. Watch the collateral, assess liquidity risk and take stress testing seriously. Where does one begin?

1. On March 5, a Pension Governance sponsored webinar (Fiduciary Risk, Trading Controls and External Asset Manager Selection) emphasized to need to be wary of the risks you don't know and manage the ones you can measure. In his remarks about global bank and pension regulation, Mr. Gavin Watson (Institutional Business Strategy Head, RiskMetrics Group) correctly pointed out that risk management is no longer a luxury. Basel II seeks to better link capital reserves with banks' economic risks. UCITS III (Undertakings for Collective Investments in Transferable Securities) requires asset managers to have a daily risk monitoring program that is easy to understand. Pension plans are not immune from new rules. Risk forecasting is a statutory reality for Dutch plans. UK plans must take underfunding risk into account or pay a punitive levy. The Pension Protection Act of 2006 in the US imposes a variety of rules that relate to fiduciary risk mitigation, including the selection of a proper advisor for 401(k) plan investment selection. Mr. Anthony Turner (Principal - Financial Tracking Technologies) talked about the need to examine managers' holdings and track deviations from approved limits.

2. In a separate webinar on March 6, I urged audience members to pay attention to the quality, quantity, price behavior and transferability restrictions attached to pledged collateral. Part of "Liquidity Risk Managemenft," hosted by Knowledge Congress and co-sponsored by Pension Governance, LLC, my presentation addressed liquidity red flags, including but not limited to the following:

• Undue Concentration in a Few Number of Holdings
• Low Trading Volume
• Infrequent Trading
• Limited Number of Market Participants
• Contractual Limitations on Whether, How and When Withdrawals Can be Made
• Volatile Market
• Form of Withdrawals, if Permitted
• Correlation Changes
• Contagion 

3. In today's paper, famed New York Times reporter Gretchen Morgenson refers to investors as guests in Hotel California since "they have checked into an investment they can never leave." Referring to auction rate notes (debt instruments with long or no maturities that reset weekly), author of "As Good as Cash Until It's Not" describes how this market has screeched to a halt in recent days. Finding few bidders, mostly municipal issuers worry about growing budget gaps. Investors, on the other hand, are left holding the bag after investing in what they perceived to be relatively "low risk" securities.

4. In "Hedge Funds Frozen Shut," Business Week journalist Matthew Goldstein reports that "Since November at least 24 hedge funds have barred or limited investors from taking their money out, tying up tens of billions of dollars for an indefinite period. Among them: GPS Partners, a $1 billion fund that bets mainly on natural gas pipelines; Pursuit Capital Partners, a $650 million portfolio with troubled debt; and Alcentra European Credit, a $500 million fund that owns slumping loans used to finance private equity buyouts. For those institutional investors who failed to read the fine print allowing managerial discretion, these lock-outs are bad news. Arguably, hedge funds want to prevent a mass exodus of their investors for several reasons. First, a drain on assets makes it harder to recover losses (if possible at all). Second, fees drop as the size of their portfolio falls due to redemptions and sub-par performance. Making matters worse, prime brokers are turning off the money tap, create illiquidity problems for hedge fund managers at the precise moment when they need cash to stay in the game. Goldstein suggests that redemption restrictions may be postponing an inevitable collapse for some hedge funds.

I'd say "take two aspirin and revisit the situation in the morning" but that solution fars short of what looks to be rough times ahead.

A Billion Here, A Billion There...

Though there is a question about whether former Illinois Senator Everett Dirksen ever said "A billion here, a billion there, and pretty soon you're talking real money," the statement is apt.

A quick read of the headlines suggests things are going to get ugly fast, and with little chance of a let-up anytime soon. Federal Reserve Chairman Ben S. Bernanke, in his October 15, 2007 address to members of the Economic Club of New York was no less sanguine. He offered that "Conditions in financial markets have shown some improvement since the worst of the storm in mid-August, but a full recovery of market functioning is likely to take time, and we may well see some setbacks." Click here to read the full text of his speech.

Billions of dollars in losses, due to sub-prime problems and related woes, pummeled recent earnings for more than a few organizations, sending the equity markets into a tailspin on October 19, 2007. Pundits report that the Dow had its worst day since early August, with worries about a looming recession being only one of several fears. Twenty years after Black Monday (October 19, 1987), the term "deja vu" comes to mind. At that time, this blog's author worked on a futures and options trading desk and well remembers the frenzy that ensued. Names then considered "too big to fail," no longer exist. Sobering lessons learned?


At a time of unprecedented technological advances in terms of analytical capabilities and information flow, why is it that risk management is still anathema to some? Arguably there will be times when "tail" events occur, despite the best intentions to create, implement and periodically review back-office, middle-office and trading desk activities. One possible silver lining is that organizations (for which this applies) go back to the drawing board to design a more effective set of checks and balances. Improved risk architecture could include any number of things, including the following:

  • Frequent and thorough testing of valuation models by independent third parties
  • Regular and more granular correlation analysis that (a) takes into consideration the reality that market convergence does sometime occur and (b) then tries to identify when it is most likely to present itself accordingly
  • Assessment of hedge effectiveness, and by extension, (a) what factors create "hedge leakage" and (b) thereby leave an organization exposed to adverse market conditions
  • Identification of risk drivers, along with both a quantitative and common sense ("smell test") assessment of their likely behavior and probability of occurrence
  • Identification as to how to improve collateral management
  • Better training for everyone involved in trading activity and oversight
  • Improved (or creation) risk budget that explicitly lays out how money is to be allocated on a risk capital basis.

Some will win as markets tremble but what about the losers? After today, equity-laden retirement portfolios won't look so good. Entire employee teams are shutting down as the credit crisis takes hold. Depressed times will certainly force plan sponsors to rethink their investment decisions.

How much money has to disappear before billions mean something other than zeros on a piece of paper?

Liquidity Crunch, Bonds and Pension Plans

Have the last few months of negative headlines scared you yet? If not, don't be too complacent. According to a recent survey conducted by Greenwich Associates, institutional investors have grown weary of structured financial products and fixed income securities. According to a summary provided by CFO.com writer Stephen Taub, a worldwide credit crisis "has caused a nearly complete disruption in the trading and use of many fixed-income products." Even trading in ordinarily liquid corporate bond markets has reportedly been difficult, leaving many scratching their heads as to whether the credit crisis is a short-term blip or a long-lived problem. Taub adds that the survey predates the Fed's recent rate cut. (Click here to read "Liquidity Crunch: How Long Will it Last?")

In his September 20, 2007 testimony before the House Committe on Financial Services, U.S. Treasury Secretary Henry Paulson describes the "interconnectedness" of global capital markets and the fallout from concerns over sub-prime mortgages - reduced investor confidence, reassessment of risk, and temporary diminution of liquidity. Describing self-correction tendencies of financial markets, Paulson's more sanguine take can be accessed by clicking here.

After a recent bridge game, I had a chance to ask my friend, Dr. Lucjan Orlowski, for his view of the world around us. As Senior Fellow at the Center for European Integration Studies (ZEI) at the University of Bonn; a Senior Fellow at the Center for Economic and Social Research (CASE) in Warsaw; a Research Fellow at the William Davidson Institute (WDI) at the University of Michigan School of Business, and a Research Professor at the German Institute for Economic Research (DIW) in Berlin, Orlowski's opinion counts in more ways than one. His prognosis? Not very good - In fact, he was downright gloomy with respect to jobs growth and continued ill-effects of this summer's incorrect pricing of default risk. Click here to read Lucjan's impressive bio.

So what does all of this mean for pension funds? Let us count the ways.

1. Diminished liquidity could imperil a plan's ability to meet its short-term obligations. This is especially serious for mature plans or in situations where labor contracts offer few opportunties to revise cash outflows. How should strategic asset allocations change to reflect a sustained credit crunch (if you accept that premise)?

2. Fewer companies are making their way to capital markets. Will a reduction in fixed income security issuance and/or a widening bid-ask spread make it more difficult for pensions to execute any type of liability-driven investing tactic that involves bonds or bond derivatives?

3. Will a weakening U.S. dollar, likely to experience even more downward pressure as oil producers switch to Euro invoicing, compel plans to seek out international assets? Will plan sponsors need to ask external asset managers more questions about risk controls, notably currency hedging techniques, as a result?

4. Could lower U.S. interest rates push some plans over the edge in terms of funding status and inevitable financial consequences?

5. Will changing correlation patterns, and the related reduction of diversification potential, leave defined benefit plan sponsors in a position of having to take on more risk? In the event that FASB requires additional pension investment risk disclosure, will corporate plan sponsors begin to feel pressure from shareholders as market volatility is more explicitly embedded in financial statements?

These are but a few possibilities for those who see the glass half empty and draining fast.

Give Us Our Money Back - Pitfalls of Lock Ups

In today's "Investors Mull How to Get Out Of Hedge Funds: Market Turmoil Highlights Notoriously Tricky Rules For Redeeming Shares." Wall Street Journal reporters Jeff D. Opdyke and Eleanor Laise paint a grim picture for investors in search of an exit. Besides the fact that many funds only permit redemptions at the end of a month or quarter, written notice is often required, sometimes as much as sixty to ninety days in advance. Even then, punitive fees may be imposed. Additionally, not all investors are equal if side letters exist that favor some over others.

For hedge funds already in crisis mode, redemptions may not come in time to stem further problems nor will they shield an investor from already realized losses. Moreover, fund managers may freeze redemptions, arguing that to do otherwise would imperil their ability to stay in business.

If that isn't gloomy enough, consider that investors who successfully withdraw money from a struggling hedge fund may have to give back. "If a hedge fund fails, in some cases a bankruptcy trustee or other investors may sue investors who have already redeemed money and try to force them to pay that money back into the fund, say Nixon Peabody's Mr. Mungovan and his co-chair of the firm's alternative investments litigation practice, Jonathan Sablone. The trustee could argue that the hedge fund didn't value its assets correctly and that investors withdrew more money than they were entitled to."

Valuation alarm bells are nothing new to this blog. We've been touting the need to assess a manager's valuation policies and procedures for months. As stated countless times before, we've asserted that valuation critically drives reported performance. Reported performance determines fees and fees drive risk management and asset allocation decisions. Now we see firsthand that valuation likewise drives the ability to liquidate.

Being locked up is no fun. For pension funds in desperate need of cash, the current state of affairs is agonizing.

Bad Trading Controls Could Lead to Blow Ups

Recent hedge fund blow ups and mutual fund woes related to market timing and valuation may be a harbinger of things to come. Part of the problem has to do with trading controls that are either weak or non-existent. For institutional investors such as pension funds, this could spell disaster. According to President of Pension Governance, LLC, Dr. Susan M. Mangiero, CFA and Accredited Investment Fiduciary Analyst, "Pension funds have oversight responsibilities with respect to external money managers. They would be remiss not to review their service providers' trading controls. We have only to look at recent headlines for examples of how bad things can get when rogue individuals or computer problems are left unchecked."

The process used to determine limits, authorized persons, style drift early warning signals and liquidity traps are a few of the many topics to be discussed during an August 8, 2007 webinar (noon to 1:15 p.m. EST).

Entitled "Fiduciary Risk, Trading Controls and External Asset Manager Selection," the webinar boasts practitioners with trading desk and risk control experience, including moderator Dr. Susan M. Mangiero and expert guests - Mr. W. Anthony Turner, Principal, Financial Tracking, LLC and Mr. Gavin W. Watson, Business Manager for Asset Managers, Pensions and Insurance, RiskMetrics Group, Inc.

Persons who attend this 75-minute webinar will learn the following:

  • What Constitutes "Must Have" Elements of Effective Risk Management System
  • Ways to Detect Deviation from Management Style and/or Excess Position Concentration
  • Red Flags Regarding Possible Rogue Trading
  • Industry Best Practices for Trading Controls and Lessons Learned About What to Avoid

Pension Governance, LLC is registered with CFA Institute as an Approved Provider of professional development programs. This program is eligible for 1.5 PD credit hours as granted by CFA Institute.

For more information about the webinar or to register for a modest fee, visit http://pensiongovernance.com/webinars.php?PageId=58&PageSubId=59.