Boomer candy could end in a derivatives sugar high
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Boomer candy could end in a derivatives sugar high

Derivatives structurers are thriving, but regulators aren’t convinced the biggest Wall Street banks have a firm grasp of their complex exposure.

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Derivatives structurers are having a day in the sun. Higher interest rates are helping these alchemists of Wall Street to put together profitable trades across asset classes that can be pitched to investors of diverse types.

The slow recovery of the market for credit risk transfer deals by banks to funds that shut down after the 2008 global financial crisis is now almost complete, as US banks join their European counterparts in embracing complex derivatives trades that generate juicy returns for structuring dealers.

And the latest upturn in the seemingly unstoppable US stock market is being accompanied by the sale of lightly structured equity derivatives products that have been dubbed “boomer candy”.

These products are generally structured as exchange-traded funds and sold with some protection against market downturns to retail investors who are often blissfully unaware of the value of the embedded options in their purchases.

Creating boomer-candy deals of this type must seem like easy work for bank structurers, who are used to pitting their wits against their peers at hedge funds and other institutional investors with a comparable understanding of option pricing and a tendency to push back over complex deal terms.

Regulatory complaints about the 2023 submissions represent criticism of their most recent plans for potential resolution in a crisis

What could possibly go wrong with this renaissance for derivatives structuring?

Plenty, according to US regulators.

The big US banks comfortably passed their annual stress test of overall health and the ability to withstand a market downturn, the Federal Reserve announced on June 26.

But a few days earlier, on June 21, the Fed combined with the Federal Deposit Insurance Corporation (FDIC) to highlight weaknesses in the resolution plans – or living wills – of four of the eight largest and most-complex US banks.

These faults included problems with their ability to model or unwind derivatives exposure in the event of material financial distress or failure.

The four firms – Bank of America, Citi, Goldman Sachs and JPMorgan – together account for the bulk of all derivatives exposure.

Of the big Wall Street derivatives traders, only Morgan Stanley avoided the censure of the Fed and FDIC.

Shortcomings

The weaknesses cited in feedback letters to the four banks were different in degree but similar in essence: regulators are not convinced that the big dealers have a firm grasp on their derivatives exposure and how trades might unwind in a crisis.

In a feedback letter to JPMorgan, regulators said that the bank’s 2023 living will submission had “a shortcoming related to the implementation of its derivatives unwind strategy”, adding that it “did not demonstrate the ability to model its derivatives portfolio unwind by counterparty for segmenting the portfolio in resolution”.

Big US banks must update their living wills every two years, so regulatory complaints about the 2023 submissions represent criticism of their most recent plans for potential resolution in a crisis.

The regulators said that Goldman needs to work on its derivatives portfolio segmentation analysis and assumptions about how trades might novate in a crisis. They identified a problem related to Goldmans’ “ability to segment its derivatives portfolio in a manner that accounts for trade-level characteristics, including the complexity and the granularity necessary to accurately measure exit timing, exit costs, and the difficulty of unwinding the portfolio in a resolution scenario. This raises questions about the reasonableness of the derivatives unwind related to liquidity and cost estimates, and consequently, the ability of the firm to implement this aspect of its preferred resolution strategy.”

At BofA, a crisis that arrives outside usual business hours could be a problem, apparently.

The charges levelled against the big derivatives trading banks for their living will preparations might seem like nit-picking by regulators

The regulators said that the bank “lacks the capability to use dates outside of the normal business-as-usual production process for spot derivatives and trading positions in estimating resource needs associated with unwinding its derivatives portfolio. This, in turn, raises questions about the firm’s ability to implement this aspect of its preferred resolution strategy in an actual resolution event.”

And Citi was written up by regulators for a number of issues. The bank “did not demonstrate the ability to model its derivatives portfolio unwind by counterparty for segmenting the portfolio in resolution”, regulators said, in a similar complaint to the ones addressed to Goldman and JPMorgan.

Citi suffered a more serious charge about the quality of its derivatives data in an issue that divided the two regulatory agencies.

The regulators agreed that Citi lacked the ability to incorporate updated stress scenarios and that ongoing data reliability problems contributed to inaccurate calculations of both capital and liquidity needs in the event of a crisis. The Fed judged that Citi’s derivatives data reliability and unwind calculation weaknesses were a “shortcoming”, but the FDIC took the view that they were a “deficiency” – which is a more serious charge in regulator-speak.

The big Wall Street derivatives dealers were not keen to discuss the details of the complaints by regulators.

BofA, Goldman and JPMorgan declined to comment, while Citi issued a statement that addressed its broader moves to tackle ongoing regulatory problems.

“We are fully committed to addressing the issues identified by our regulators,” the bank said. "While we’ve made substantial progress on our transformation, we’ve acknowledged that we have had to accelerate our work in certain areas, including improving data quality and regulatory processes such as resolution planning… More broadly, we continue to have confidence that Citi could be resolved without an adverse systemic impact or the need for taxpayer funds."

Rude health

The charges levelled against the big derivatives trading banks for their living will preparations might seem like nit-picking by regulators.

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Photo: iStock

Wall Street banks are in rude financial health, with capital ratios that are well over twice the levels seen when their derivatives exposure fuelled the GFC in 2008.

Advances in netting and clearing have also reduced the risk posed by derivatives exposure since then.

In its quarterly report on US bank trading and derivatives activity, released on June 25, the Office of the Comptroller of the Currency (OCC) noted that net credit exposure from derivatives – its preferred measure of risk – was $251 billion at the end of the first quarter. That is less than a third of the $804 billion peak seen at the end of 2008, and the OCC also noted that the banks under its supervision held collateral valued at 128% of the value of their net credit exposure from derivatives at the end of the first quarter.

It is tempting to speculate that the criticism of big dealers for their derivatives portfolio unwinding plans in the event of a market apocalypse represents regulatory payback for the recent successful rebellion by banks led by JPMorgan against the planned implementation of the Basel III capital framework in the US.

Senior regulators could be forgiven for succumbing to the temptation to remind Wall Street cheerleaders – at all executive levels – that their business is conditional on supervisory approval and market confidence in the results of independent assessments.

It is more likely that mid-level regulators – the infantry of bank supervision – are genuinely concerned about weaknesses in derivatives portfolio analysis, however.

And that should give bank executives and shareholders reason to question whether the current sugar high from derivatives structuring profits will end up delivering headaches in the future.

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