FSB Updates FX Benchmark Progress

The Financial Stability Board (FSB), created in 2009 by the G20 to reform international financial regulation, includes as part of its mandate a role in standard setting and in promoting members’ implementation of international standards. In September 2014 it issued a report highlighting recommended solutions to prevent a repeat of the FX benchmark scandal. Today it released an update to look at progress made since that report.

The update is fairly positive ("having moved the market in a favourable direction"), highlighting improvements, but also mentioning areas where it believes that more work needs to be done.

The points made include:
1) There have been useful reforms in the methodology used in the WM Reuters (WMR) fix but that more can do done, and mentions certain central banks adjusting their fix methodologies as well. The FSB reiterates that all fixes need to be reviewed, not just the WMR fix.

2) "Recommendations suggested to increase transparency in pricing for fix transactions have seen good implementation among the largest market participants and for the most used benchmarks, but that elsewhere there is scope for further improvement".

3) "Steps to separate dealers’ fixings business from other activities are being taken by the larger participants and in the most active markets, but again there is room for further implementation in other areas of the FX market. For the execution of benchmark transactions, industry-led initiatives to promote greater use of independent netting and execution facilities are seeing welcome progress".

4) "Work is underway to improve market conduct practices, both within individual firms and through market-wide initiatives, including the global effort underway to develop a single code of conduct for the foreign exchange market through the Bank for International Settlements (BIS) Markets Committee working group on FX markets".

5) "While many index providers and end-users have increased their focus on the due diligence around FX benchmark use, there is scope for greater follow-through on this on the part of some market participants".

All in all, it appears that while some additional fix changes may be seen, for the most part fix reform will primarily involve broadening the changes already made to cover additional fixes and additional market participants. The probable exception will be the new international code of conduct being created by the BIS. This will replace the many different codes currently in force in markets around the world and will impact bank behavior.

A Bank Bailout Plan to INCREASE Systemic Risk ?!

Eighteen global banks agree not to terminate derivative contracts when regulators seize their failing bank counterparty.  Is that a bad idea?

(Adapted from A Bailout Plan that Could Actually Increase Systemic Risk, a Quant Perspectives column published by the Global Association of Risk Professionals)

ISDA (the International Swaps and Derivatives Association) reports that eighteen large global banks have agreed not to terminate derivatives transactions when regulators seize the bank counterparty with the goal of “resolving” the failing institution.  Both the ISDA announcement and another news article claim that this agreement will “reduce systemic risk.”  The FSB (Financial Stability Board) had requested this accommodation in the September Consultative Document “Cross-border recognition of resolution action.”

What about the healthy banks?

But what about derivatives risk management for the healthy banks that are counterparties to the failing bank?!  Termination of derivative trades before failure has been a standard tenet of risk management for decades.  See, for example, this BIS (Bank for International Settlements) 1994 document “Risk management guidelines for derivatives” that explicitly discusses early termination.  On its face, this new FSB-ISDA opposition to early termination drastically increases risk to the healthy banks in the name of assisting resolution of the failing bank.

The risk to a healthy bank in a derivative trade with the failing bank is that the former cannot know if the latter will ultimately perform on the derivative hedge or not.  If the failing bank does default on the trade, the healthy bank will have an unhedged risk position and will lose some or all of the positive value of the trade.  The healthy bank cannot hedge its risk with another derivative counterparty as long as the original trade remains in place.  Given the critical importance of hedging to bank operations and stability, this hedge uncertainty to a large global counterparty is a huge threat to safety and soundness.  Systemic risk increases due to this hobbling of risk management at healthy banks.

One may sympathize with the dilemma of the regulators

If one believes that a proper role of regulators and governments is to control the resolution or liquidation of large financial institutions, then the FSB-ISDA initiative has its merits.  It would likely be easier to “save” a failing bank if it has all hedge (derivative) agreements in place.  Just as we noted above for healthy banks, evaporation of derivative trades would leave the failing bank with ruinous open risk positions.

The FSB resolution plan appears to be to transfer some debt, some assets, and all derivatives to a “good bank” and leave distressed assets, shareholders, and bailed-in creditors in the “bad bank.”  In this positive scenario, the healthy bank derivative counterparties would find themselves facing the “good bank” such that, in the end, they would have suffered no harm.  But there are too many assumptions here.  First, the bank resolution may fail.  Second, it is unreasonable to project that all derivative trades should go to the “good bank.”  Since some assets and debt will remain in the “bad bank,” there should certainly be “bad bank” derivatives as well.

Perhaps the goal is to guarantee the derivative trades?

The FSB and ISDA do not state or hint that governments will guarantee the performance of the derivative trades as the quid pro quo for the agreement of the healthy banks not to terminate upon regulator seizure.  But this is our conjecture.  Otherwise, it is all too clear that the FSB-ISDA removal of early termination merely aids one weak bank – which likely deserves to fail – at the risk to and expense of the entire banking system.  Surely the FSB would be averse to increasing systemic risk.  Thus, our ansatz that governments will guarantee derivative performance rings true.  Perhaps the regulators will simply squeeze bailed-in creditors to whatever degree is necessary to honor derivative contracts.

The irony splashes all around us!  Once again, we find ourselves witnesses to governments bailing out and protecting the banks!  The plan appears to be that regulators will protect the bank counterparties.  At risk of raising a past controversy without room to dissect the details, this is AIG all over again!  AIG the insurance company would have withstood the failure of AIG FP (the “financial products” affiliated entity).  The true AIG FP bailout beneficiaries were the bank counterparties.

Returning to more sober considerations, our conjecture implies that the FSB-ISDA plan gives higher priority of repayment to derivative liabilities than to senior debt liabilities.  Derivatives and senior debt are currently pari passu.  We remain unconvinced that derivatives merit such super-priority.

What about CCPs?

We wonder how the FSB-ISDA gutting of early termination impacts CCPs (central counterparty clearing facilities).  The failing bank subject to regulatory resolution might be a counterparty to the CCP or a member of the CCP or even the CCP itself.  In any of these cases, forcing a prolonged period of hedge uncertainty on all other presumably healthy parties would be chaotic.

(The author acknowledges numerous helpful conversations with Ce Shi, a graduate of the Quantitative Finance and Risk Analytics Master’s program at the Lally School of Management of the Rensselaer Polytechnic Institute.  Mr. Shi is now a candidate for a Master’s in Applied Mathematics at Rensselaer.)