With the 10-year anniversary of the Lehman Brothers bankruptcy just passed, the financial industry has been reflecting on what was the largest bankruptcy in history.
It is well documented that the collapse triggered the economic recession, eroding USD 10 trillion in market cap from global equity markets along the way. But it also created a series of unexpected events, among which is the very limited recourse that hedge funds and asset managers have on the upfront cash required by banks when entering OTC swaps, options and other derivatives.
The reversal of situation, where banks are considered riskier and of lesser credit quality than hedge funds themselves, prompted the need for the Initial Margin discussion. Initial Margin will need to be posted for non-cleared derivatives trades starting from 1 September 2020 for a large group of market participants.
As we look at the markets this September, little has changed in effect. Even if the Initial Margin is rolled out gradually, smaller players with AANA (aggregate average notional amount) lower than USD 8 billion still need to use the pre-financial crisis Independent Amount approach, where an asset is put forward by the counterparty and is commingled with the banks’ assets. The issue of limited recourse is still raised frequently in today’s discussions, and the one-way approach continues to reign, even as more balance is required in the markets.
In addition, recent discussions among key market participants and lobbying groups such as ISDA (the International Swaps and Derivatives Association) have given way for an AANA up to USD 50 billion to trigger Initial Margin, leaving a potentially larger number of market players to continue using the Independent Amount approach.
Despite the shock Bear Stearns and Lehman Brothers brought, the overall market still exhibits a questionable underlying structure with limited changes and room for increased risks, exemplified by an August 2018 Financial Times report showing a ‘boom’ in leveraged loans in some global markets once again.
Staggering statistics show that almost nothing has changed. It is estimated that over 90 percent of all current security interest-based OTC derivative collateral agreements are completed using non-segregation and without any restrictions on rehypothecation. Direct Dealer holdings, without any restrictions such as a segregation requirement or a limitation on rehypothecation, is the most common market practice currently used in the US and Asia Pacific. On the other hand, Europe operates mainly using TTCAs (title transfer collateral arrangements).
In these one-way agreements, the bank benefits from additional collateral, but the counterparty assumes added risk of loss in the event the bank becomes insolvent. Without restrictions on rehypothecation or non-segregation, Independent Amounts are freely used. Since most of agreements do not include asset protections, counterparties are given the same priority of claims as general creditors, and in the case of an insolvency, rarely recover the full Independent Amount that was initially provided. As we saw with the Lehman collapse 10 years ago, this is no longer a hypothetical risk for counterparties, but a real threat.
For hedge funds, asset managers and some broker-dealers, the real risk lies in the framework of the agreements. Under current market conditions, counterparties are exposing themselves to very material amounts of downside risk, in the billions of dollars, by following agreements with major banks that were constructed well before the 2008 Global Financial Crisis.
To mitigate these risks, alternative holding agreements should be designed. For example, a Segregated Direct Dealer holding arrangement would allow banks to directly hold the collateral but disallow it from comingling or rehypothecating the provided amount.
Another alternative is to initiate a Third-Party Custodian Agreement. In this case, the Independent Amount is sent to a custodian account that is chosen by the bank and specified in a bilateral agreement. The bilateral agreement gives the bank the right to choose the custodian account, and the counterparty is relieved of the risk of non-segregation and rehypothecation. But this bears a cost, which custodians are debating over today, as this is a transfer of real assets.
Finally, the parties could construct a Three-Way Collateral Agent Agreement, where the Independent Amount is transmitted to a third-party agent, generally another bank under a syndicated asset agreement. In this case, the independent third party is in control of the asset, and the above stated risks are considered relieved, so long the risk of the holding agent is considered limited.
The liquidity of the assets parked in custodian or agent accounts may become a key element of the equation, as Libor-based products may soon require a revision of haircuts. Meanwhile, room to post SOFR or SONIA-based products as collateral may have limitations due to the unavailability of products and limits in their overall liquidity given they are newly created markets.
On a separate point, the liquidity of the new reference rates is developing via various means, including through futures trading – SOFR Futures have been available on CME since April 2018, and have since reportedly outpaced by 28 times the cumulative notional volume of Bitcoin Futures, which opened for trading more than eight months ago (USD 711bn vs 25bn).
The Lehman Brothers collapse was the true definition of a black swan, as stigmatised by Nassim Taleb; a far-tail risk event or occurrence quite difficult to predict and for which the impacts are often not even considered. However, not many individuals expected a company that was founded in 1858 and, at the time, the fourth largest bank, to become insolvent so quickly.
So the question is: given the potential for another crisis in the next two years, if Bridgewater Associates founder Ray Dalio is to be believed, will the financial industry take the appropriate steps early on to ensure it is protected for the next black swan event?
This article was written by Matthieu Sachot, a director at Chappuis Halder & Co., Asia-Pacific, with contributions from Samir Aljabar at the firm’s Hong Kong office.