For Swap Dealers (SD) and Major Swap Participants (MSP), Friday October 12, 2012 was the effective date for which compliance to the swap public and regulatory reporting rules of the Dodd-Frank Act is required (for interest rate and credit swaps). Many financial institutions have implemented solutions to support these requirements. We published a note (downloadable here) providing an overview of the technical complexities that a reporting solution would need to resolve. Some of these complexities emerge from the following:
“The storm starts, when the drops start dropping
When the drops stop dropping then the storm starts stopping.”
― Dr. Seuss, Oh Say Can You Say?
“Pray don’t talk to me about the weather, Mr. Worthing. Whenever people talk to me about the weather, I always feel quite certain that they mean something else. And that makes me so nervous.”
– Oscar Wilde, The Importance of Being Earnest, Act 1
We will talk about weathermen and the predictions they make. And we will mean something entirely different. By weathermen, we will mean the models in a bank and the predictions they make or the hypotheses they form. And for the realism of Dr. Seuss’ drops dropping, we will substitute the realism of P&L.. More specifically, we will talk about P&L attribution (PLA) and the role it plays in helping us use the realism of P&L to test the hypotheses posed by our various risk models – which actually is its primary purpose in life.
I. Change in the mark-to-market value of its positions are materially determined by changes to a specified set of variables and parameters (i.e. risk factors) and the expected change is quantified by the sensitivities obtained to these risk factors from its models;
II. There is a specified % probability that the value of its positions will lose more than its VAR number over any given interval equal to the VAR holding period;
III. The cost of insuring its aggregate positions against the risk of counterparty Z defaulting is not expected to exceed the cumulative sum of the CVA fees charged to its trading desks for originating exposure to counterparty Z.
One thing is for certain, they will have less secrets.
Regulatory oversight will ensure that, even if the current zeal lasts only 3 years (assuming a political shift in attitude 1 year out and 2 years of starvation budgets to thin out current muscular oversight).
Secrets are not necessarily the conspiracies of derivatives cabals in the shadows but the knowledge that we practitioners have about improvements that can be made in the technology infrastructure and business process that supports this complex activity.
With regulators not only focused on supervision against the backdrop of current and anticipated rules on the books, but also pushing for best practice as they have observed it on their journeys poking around the infrastructure of market leaders in the industry and also now sharing notes with other regulators; there is a lot of sunshine coming the way of regulated entities.
However, that sunshine is an opportunity to rethink and rebuild some of this infrastructure, process and the strategy around how these things will evolve.