In the last week alone, we’ve read half a dozen articles on how technological innovation can improve outcomes in diverse fields. Investors can look to Twitter updates and search engine queries to characterize investor sentiment accurately. The military will be able to decide and deploy much more rapidly through the use of robotic forces. Psychiatrists might start using phone data to track depressive symptoms.
Yet each of these innovations will not come without its own inherent risks. Among the perils to be navigated will include:
(1) Over-prediction: The European Central Bank published an intriguing study this month on how online bullishness (expressed in Twitter updates and Google searches) positively correlated with investment sentiment and led established sentiment surveys. But while high Twitter bullishness predicted increases in stock returns, the stock returns then retreated to their fundamental values. Social feedback emerges with stunning speed, but it can often exaggerate the true magnitude and longevity of sentiment, financial or otherwise. In the study, stock returns didn’t permanently hold to social sentiments, but retreated to the fundamentals.
(2) Loss of control: Military thought leaders report that emergent technologies will transform warfare over the next decades. For instance, when the future of battle is comprised of autonomous robotic units, or at least a hybrid of robots and human partners, battle rhythm may eventually render tactical human decision making far too slow to be viable. What will happen when robots autonomously decide when and how to use lethal force, with human beings only as passive observers rather than proactive deciders?
(3) The illusion of expertise: Earlier this year we wrote about the benefits of tracking personal caloric intake, exercise regimes, and budgetary adherence. But what happens when a smartphone app starts to diagnose — with 86% accuracy, by noting increased phone usage, fewer trips from home, and lack of routine — that its user is depressed? Will said user self-prescribe medicines without visiting a psychiatrist, or stop taking prescribed medicines in the face of a false negative from the smartphone test?
Citizens of the 21st century understand that sweeping, irreversible change accompanies any technological enhancement – each enhancement arrives with great fanfare about its benefits, but subtle risks follow in its train. Like their contemporaries in other fields, finance professionals must consider carefully how to benefit from each innovation without misapplying it.
(1) Accurate Projection: Multinational corporations trying to quantify their financial risks across asset classes run risks of under-prediction and over-prediction alike. It’s vital to employ simulation or shock analysis to understand negative impacts to financial results that could ensue, but these pictures are incomplete. To be as robust as possible, risk analysis has to contemplate the often highly correlated nature of financial asset classes (e.g. the Australian dollar and the price of copper), the risk of contagion from one region to another, and extreme event risks. A reliance on simpler shock analysis alone would be like assessing equity valuations solely by Twitter updates.
(2) Control: It can be very beneficial to set up a rules-based, programmatic approach to hedging budgeted cashflows in other currencies. However, it’s important to re-assess periodically to ensure that a long-established hedging program still fits current business realities. A hedging program set up in one subsidiary with PLN costs may no longer be required based on a newly acquired unit’s high level of PLN sales. Setting up programmatic hedging to run indefinitely without review would be like irrevocably handing over decisions on combat engagement to machines.
(3) Expertise: Our clients’ finance organizations find it useful to see at a glance the current valuations of their debt and derivative portfolios, along with current counterparty exposures. But unparalleled tracking and transparency on portfolio composition and current valuations alone does not necessarily provide true clarity on suitable actions. For instance, overall exposure to Bank A may be much higher than exposure to Bank B, but Bank A may still be a more desirable counterparty for the next trade because of better pricing or less stringent collateral requirements. Making hedging decisions based on a valuations dashboard alone would be like self-diagnosing depression based on a smartphone app.
At Chatham, we’ve invested heavily in technologies that price derivative and loan instruments accurately, enable consolidation and tracking of all debt positions across a worldwide company, and apply the abstruse rules of hedge accounting correctly. However, we’ve also invested in expert advisory teams that understand derivatives structuring, execution, valuation, and accounting. In our experience, the best results don’t come from just a black-box software solution, or just a team of bright finance professionals armed with Excel, but in the marriage of expert advisory and robust technology.
VIDEO: Portfolio Reconciliation Requirements
Heather Fritzinger of Chatham Financial discusses the advantages of reconciling a portfolio of derivatives transactions with bank counterparties on a periodic basis. In addition, she explains which parties are required to reconcile trade portfolios under Dodd-Frank and EMIR, and describes how this reconciliation must be properly documented according to protocols published by the International Swaps and Derivatives Association (ISDA). A full transcription of the video is available below.
Heather Fritzinger: The frequency of portfolio reconciliation varies by jurisdiction, and depends on two factors; entity classification and the number of trades between the counter parties. Under Dodd-Frank, swap dealers must make reasonable efforts to engage in portfolio reconciliation with their end-user counter parties. If those counter parties have less than 100 trades with each other, the frequency is annual, and if they have more than 100 trades, it goes to quarterly. It’s important to keep in mind that end-users do not have to engage in portfolio reconciliation with their swap dealers. They can decline to do so. It’s a bit different under EMIR. Any entity that is domiciled in the EU, or an entity that faces a bank that’s domiciled in the EU must engage in portfolio reconciliation. Again, that’s based on entity classification. Under EMIR, there are FCs, NFC pluses, and NFC minuses. NFC minuses only have to engage in portfolio reconciliation once per year if they have less than 100 trades. If they have more than 100 trades, it goes to quarterly. For NFC pluses and FCs, the requirement is at a minimum quarterly, and then increases in frequency the more trades there are.
The portfolio reconciliation requirement under EMIR is different than that of EMIR reporting, but there is an obligation for FCs to report information to their national regulator if a dispute remains outstanding on a trade for more than 15 business days, and if that dispute is greater than 15 million Euros. Under both Dodd-Frank and EMIR, counter parties have the option of either exchanging data with each other, or simply reviewing data that they receive from one party. It’s important to keep in mind that under EMIR, if you elect to be a data-receiving entity and review the information that is sent from your bank, you have five business days within which to respond, otherwise, the information is deemed affirmed. Dodd-Frank and EMIR regulations require that the parties put in place documentation to govern the portfolio reconciliation process and dispute resolution procedures. An efficient way to satisfy those documentation requirements are via the protocols published by ISDA. Under Dodd-Frank, this could be satisfied using the ISDA March 2013 Dodd- Frank protocol, and under EMIR, that protocol is the ISDA 2013 EMIR port-rec and dispute resolution protocol. In general, portfolio reconciliation can be a good exercise, especially if you have a large portfolio of trades. Despite having correct trade documentation in place at the time of execution, minor discrepancies may arise in the portfolio reconciliation process. This can help you avoid surprises in the event you wish to modify a trade or unwind it early.
Accountancy Live: Accounting for floating rate loans under IFRS, FRS 102
June 22, 2015, Accountancy Live
By Zwi Sacho, Chatham Financial
“Preparers and auditors should should carefully consider the accounting consequences when encountering floors in floating rate loans under IFRS and FRS 102, says Zwi Sacho ACA, director of the corporate accounting advisory practice at Chatham Financial Europe”
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VIDEO: Michael Bontrager Wins EY Entrepreneur Of The Year® 2015 Greater Philadelphia Award
EY Speaker: Michael Bontrager, Chatham Financial. With Michael Bontrager, you’re in good hands. Michael founded Chatham Financial in 1991 on principles of transparency and unbiased expertise in the derivative and debt markets. Chatham is now a global success, providing risk management and investment solutions to over 1,600 companies.
Michael Bontrager: The most valuable service that we provide to our clients is a peace of mind that they’re doing the right thing, they’re paying a fair price, they’re not going to have any blowups, and their workflow is far more efficient.
VIDEO: Internal Compliance Under Dodd-Frank and EMIR
Matt Hoffman of Chatham Financial answers your questions such as “What regulatory compliance obligations might my banks not help me with?”, and others regarding Dodd-Frank, EMIR regulations, and, in particular, the ISDA Dodd-Frank Protocols. Thanks for watching!
Matthew Hoffman: When Dodd-Frank and EMIR first came online, we found that the buy-side of the over the counter market was concerned with continued access to that market asking us questions like, “What do I have to do for my banks to continue to trade with me?” This question really amounts to what do my banks need me to do so they are compliant with Dodd-Frank and EMIR and while these indirect compliance obligations are important in terms of continued access to the OTC market, we focused on ensuring that our end-user clients are meeting their own internal compliance obligations under Dodd-Frank and EMIR, internal compliance obligations that banks cannot handle for them.
While banks simply require these companies to make certain representations typically through ISDA’s Dodd-Frank Protocol 2.0, SEC filers boards were required to authorize a committee to review and approve the decision to enter into derivatives as well as to put a risk management policy in place and review it annually or more often upon a triggering event.
More generally, both Dodd-Frank and EMIR require derivatives end-users to have certain policies and procedures in place. And while banks simply are required to receive certain representations to that effect, internal auditors or even national derivatives regulators may look more closely to ensure that end users are complying with regulations in related representations. For example, on the Dodd-Frank side, US swap dealers typically require end-user parties to adhere to ISDA’s Dodd-Frank Protocol 1.0 and in so doing to make institutional suitability representations by electing schedule 3 from the DF supplement. But many end-users fail to realize that this election amounts to a representation, that certain written policies and procedures are in place.
On the EMIR side, end-users are required to have policies and procedures in place on account of direct risk mitigation compliance obligations including timely confirmations, portfolio reconciliation, dispute resolution and valuations. But banks typically only focus on portfolio reconciliation documentation rather than ensuring that end-user’s policies are drafted appropriately or even exist.
Another often overlooked element of internal compliance relates to record keeping. While banks typically report transaction data under Dodd-Frank, the regulations actually require end-users to keep full, complete and systematic records together with all pertinent data and memoranda with respect to each swap in which they’re a counterparty. As the system of record for many of our clients, we’re confident that our clients can meet the regulatory requirement that such data be accessible within 5 days at any time during the life of the trade and for 5 years thereafter.
The human ear can only simultaneously comprehend two, or at most three, distinct melodies. Even renowned classical composers generally don’t aspire to create pieces that exceed this number of tunes played concurrently – the sheer volume of melodic combinations renders it unthinkable to write coherent music.
The single glorious exception in history is the final movement of Wolfgang Amadeus Mozart’s final symphony, popularly called the Jupiter symphony. In this stunning tour de force of musical composition, Mozart introduces five separate musical themes, then closes with a fugato counterpoint in which all five play simultaneously. The result is not discordant but stirring and sonorous, even as themes frolic about from strings to horns to woodwinds at a pace the human mind cannot possibly focus on or comprehend.
Harvard musicologist Robert Levin told NPR about the symphony’s finale: “At the very end, [Mozart] does something absolutely unimaginable, which is that he combines all five of these tunes simultaneously, tossing them about from one instrument to the other in a display of intellectual fireworks that remains unprecedented in the symphonic domain.” No composer had ever reached this pinnacle before Mozart – a literal quintessence of symphonic development – nor has any composer that followed him.
We thrill to hear Mozart’s soaring finale, marveling at the super-human genius from whence it sprang – a sharp contrast from our all-too-human inability to “focus on five melodies at once.” Yet while doing so, we can’t help but think of the challenges faced by the contemporary finance or treasury officer. In a world where risk and its management has become exceedingly complex and inter-woven, it’s no longer sufficient – if indeed it ever was – to isolate each risk management discipline and optimize it before turning to the next. Rather, senior finance executives need to make decisions that contemplate interactions among many connected disciplines, such as economics, contracts, accounting, and regulatory. Only an inter-disciplinary approach, expert in all topics, permits the formulation of a risk management strategy that optimizes across them simultaneously.
Here are a few examples of how we’ve helped clients adopt more holistic thinking in their risk management practices:
(1) Symphonic Risk Policy: A multinational corporation asked Chatham for a total re-assessment of its risk management across its worldwide businesses; we were requested to leave no policy, governance, regulatory, or economic stone unturned. Because multi-asset and multi-business risk management drives its organizational performance, the corporation requested that we study how each business unit manages risk and what best practices could be codified in global policy. Again, thinking about currencies but not fuel, or thinking only about Europe but ignoring North America, would lead to a discordant risk management approach, unfit for the complexity of the risks it faces.
(2) Symphonic Hedging Strategy: For publicly traded regional banks, it is essential to deploy hedging strategies that minimize accounting noise. Often, a bank’s economic need is clear, but there are multiple ways of addressing that need, each yielding better or worse accounting outcomes. For example, a bank needing to reduce its sensitivity to rising rates can swap floating rate debt to fixed or fixed rate assets to floating. The key question becomes how to achieve the desired hedge in a way that minimize accounting burdens. The integration of hedging and accounting strategy is thus essential to ensuring a sweet-sounding outcome that deftly blends economics and accounting.
(3) Symphonic Transaction Management: We recently alerted a client to a 0% floor that was contained within its loan agreement. That initial finding led to a broader discussion with numerous implications, including economic, accounting, and regulatory. Such a conversation could not merely focus on financial considerations, then think about accounting, and finally cover regulatory – it needed to harmonize all of them simultaneously into a coherent solution.
Mozart was a one-of-a-kind intellect who could master five themes simultaneously. Rather than recruit the next Mozart, corporate finance executives must tackle their risks holistically, taking pains to avoid the kind of silos that produce discordant risk management outcomes.
Chatham has been wrestling with this challenge since our founding more than two decades ago, and we’ve learned that the job is never finished. It takes vigilance across all aspects of an organization, from team composition to floor plan design to compensation strategy. Our approach has been to build collaborating teams of experts in structuring, trading, accounting, documenting, and complying with regulations for financial risk instruments. And when you call us, you may sometimes be distracted by the whir of activity in the background – a function of our open floor plan with no offices. Our approach to compensation also strives to remove obstacles that might otherwise discourage collaboration. In other words, every decision we make is about creating a beautiful risk management symphony that thrills and delights.
Whether you play the conductor or ask us to do so, we think this kind of interdisciplinary approach is the cornerstone of effective risk management in today’s complex world. It is our earnest hope to see your organizations experience the beauty of well-harmonized risk management, so that your boards and investors say like Diana Ross and the Supremes, “Whenever you’re near, I hear a symphony.”
VIDEO: Pre-trade Documentation
Christina Norland of Chatham Financial discusses the documentation requirements under current Dodd-Frank regulation that must be met prior to trading. Thanks for watching!
Christina Norland: So, for all transactions that involve U.S. swap dealers or registered, non-U.S. swap dealers, many clients have to complete pre-trade documentation, that’s required by their banks. This is because the banks have specific requirements that they have to fulfill under Dodd-Frank to, ensure that they have complied with various business conduct standards as well as swap-trading relationship documentation standards. This often involves a little bit of pre-trade work that needs to be done that can kind of delay trading if it’s not completed, prior to the day of execution.
Hedging Deposits to Reduce Liability Sensitivity
A Chatham Financial White Paper – April 2015
Chatham has long espoused POLAR (the Path Of Least Accounting Resistance) when it comes to balance sheet risk management. There is a bias towards simplicity and operating in the cash flow hedge accounting model whenever possible, in order to minimize or even eliminate hedge ineffectiveness and P&L volatility. For a liability sensitive FI, reducing asset duration or extending liability duration, or both, can have the desired impact on the FI’s interest rate risk position. Once a financial institution decides it will use derivatives to make these adjustments, the question of what to hedge takes center stage.
This white paper focuses on increasing liability duration (and thus reducing liability sensitivity) by hedging deposit accounts. Of course we apply our POLAR methodology to determine the simplest and most effective economic and accounting solution.
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Exactly seventy years ago today, in the small but strategic Belgian town of Bastogne, the 101st Airborne Division and elements of the 10th Armored Division of the United States Army were completely surrounded. Lacking proper winter uniforms and equipment, the American troops slept in foxholes during the bitingly coldest European winter of perhaps the entire century. They bravely bore incessant artillery shelling, constant snowfall which prevented supply drops of food and ammunition, and uncertain hope of reinforcement, without any auspicious military or meteorological signs.
And so it was that on December 22nd, 1944, the German commanding general wrote to General McAuliffe of the 101st Airborne, urging him to surrender within two hours or face annihilation by artillery barrage. Famously, General McAuliffe initially responded “NUTS!” – and his emphatic rejection of the German general’s surrender offer concluded with this sentence: “We are giving our Country and our loved ones at home a worthy Christmas present and being privileged to take part in this gallant feat of arms are truly making for ourselves a Merry Christmas.”
General McAuliffe and the troops’ courage and determination paid off. One day later, the immoderate weather cleared to permit the drop of food, medicine, ammunition, and even volunteer surgeons on a glider. Four days later, General Patton’s army broke through to Bastogne, and the German offensive would be doomed to fail, leading Prime Minister Churchill to declare: “This is undoubtedly the greatest American battle of the war and will, I believe, be regarded as an ever-famous American victory.”
Throughout that December, the American troops and their families at home took nostalgic comfort from a song recorded by Bing Crosby and released by the War Department. Although Crosby began the song by crooning “I’ll be home for Christmas, you can count on me,” he ended wistfully: “I’ll be home for Christmas, if only in my dreams.” Capturing the emotional ethos of millions of families separated by distance and history’s costliest war, this song entered the American pantheons of both wartime music and Christmas music.
As we reflect back on that harshest of winters in 1944, after which freedom from Nazism’s scourge became certain, we acknowledge with great thankfulness how vastly different our lives are seventy years later, thanks in no small measure to the brave troops of the Battle of the Bulge. We’re working in heated offices and sleeping in heated homes. We can purchase ample food and medicine in nearby stores. Artillery shells aren’t exploding all around us. And we still get to enjoy Bing Crosby’s crooning while spending this holiday season with loved ones, not merely in wistful dreams.
Of course, around here we can’t resist changing the words slightly to say: “I’ll be hedged for Christmas, not only in my dreams.” It may just have a nicer ring to it. But either way, we are deeply grateful for you our friends and clients, wishing you a wonderful holiday season and a prosperous New Year, hoping you’ll be hedged for both.
In 1973, the Arab Oil Embargo and ensuing oil crisis in the US prompted Congress to react with new regulation. The Corporate Average Fuel Economy (CAFE) Standards introduced fuel efficiency benchmarks that were intended to “reduce energy consumption by increasing fuel economy.” Now more than 40 years later, the unpredictable outcomes of fuel economy regulations are instructive, especially as we embark on a similarly ambitious regulatory scheme for OTC derivatives. They teach that regulations are likely to have unexpected and undesirable effects, even while achieving their broad objectives.
The current fleet-wide fuel efficiency standard in the U.S. of 27.5 miles per gallon will increase to 54.5 mpg by 2025. These ever-growing standards have forced automakers to rethink their entire line-ups, generally emphasizing economy over other factors like performance, safety, size and comfort. But performance is not something auto enthusiasts are eager to sacrifice, so automakers are innovating to overcome the performance loss. McLaren, Ferrari and Porsche now offer road-ready hybrid supercars that pack nearly 1,000 horsepower, 200+ mph top speeds and kinetic handling. Formula 1 race cars employ a Kinetic Energy Recovery System that collects otherwise wasted energy created during braking and offers it to the driver in bursts of power. Such innovations will trickle into consumer automobiles over time.
The quest for efficiency is also naturally leading to smaller engines and lighter weight vehicles. The V8 is becoming an endangered species as full-size sedans and even half-ton pickups are increasingly dropping them from their base models, if not their entire engine portfolios. Automakers are also shaving weight by innovating with lightweight materials. While these kinds of innovations will reduce fuel bills, this benefit comes at a cost – estimated at $5,000-6,000 for each new vehicle. Also, smaller vehicles tend be less safe. For example, a 2009 crash-test study comparing the Honda Accord and Fit showed that the smaller vehicle was more likely to result in leg and head injuries.
Just as Congress reacted to the ’73 Arab Oil Embargo with CAFE regulation, the 2008 financial crisis prompted financial regulation in the form of Dodd-Frank. Like the CAFE standards, Dodd-Frank’s reforms will force changes that are beneficial to some market participants and to the market as a whole. One early example is a tightening of bid-offer spreads for certain trades executed on swap execution facilities – new electronic platforms mandated by Dodd-Frank for financial entities.
The new requirements will also create outcomes unforeseen by the Act’s architects and that are costly for market participants. Indeed, some of these are already apparent. Central clearing – Dodd-Frank’s signature derivatives reform – is prohibitively expensive for financial entities that transact infrequently. Swap reformers were likely not aware when they designed this requirement that clearing members would charge minimum annual transaction fees of $60,000+ per year. Rather than reducing risk, the universal application of this requirement to all financial entities will cause some market participants to stop risk-mitigating hedging behavior that is socially beneficial.
Additionally, some foreign swap providers – fearful of becoming subject to US regulations – have determined not to transact with US companies. Transacting in excess of $8 bn with US entities will subject these entities to tens of millions in cost associated with registering as a US swap dealer. An odd result of this regulatory incentive is thus that US companies can effectively be encouraged to concentrate their counterparty risk amongst a small set of US financial institutions. This exacerbates a challenge precipitated by the financial crisis, wherein important financial institutions including Lehman Brothers, Bear Stearns, Wachovia and Merrill Lynch all disappeared as swap counterparties.
These examples show that it can be difficult to predict what will come from regulation. Certainly markets will maximize efficiencies where they can. But the regulations themselves will create new risks and difficulties not all of which will have been intended. No one can say for sure what a 54.5 mpg auto industry will look like in 2025, or even whether any of us will be driving by then, or if automated cars will have made passengers of us all. The same goes for regulation; while the market has become acquainted with the look and feel of Dodd-Frank, there are still many issues and processes that are far from crystallized, not to mention the uncertainty around ongoing regulations in Europe, Canada, Asia, and Switzerland. At Chatham we are thinking hard about what regulatory developments mean for the markets and our clients, so if you want to talk through the impacts of regulation on your business, give us a call.
Call 610.925.3120 or email us.