TURNING the TIDE Canada’S Stand Against Financial Crises
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TURNING THE TIDE Canada’s stand against financial crises TABLE OF CONTENTS NEW METHODOLOGY for establishing bond futures position limits 12 MX REVIEWS the October 15th Treasury « Mini-Flash Crash » 14 NEW! The CGF Incentive Program 20 News on PRE-TRADE VALIDATION 24 New LIVE approved participants 25 2014 Trading VOLUMES and Open INTEREST 26 2014 RECORDS 28 Upcoming 2015 EVENTS 31 m-x.ca/twitter m-x.ca/facebook m-x.ca/linkedin CADerivatives 2015 / Vol. 1 That very system would serve as the a stop to the convertibility of the US impetus for the Great Depression of dollar into gold, rendering the dollar TURNING THE TIDE the 1930’s, which became worldwide a flat currency and signaling the end news with the US stock market crash of the Bretton Woods system. Known of October 29, 1929. In the preceding as the Nixon Shock, this led to the US Canada’s stand against decade, interest rates had been low and dollar becoming a reserve currency for money in ample supply. The middle many nations, and drove a mass global class had begun investing in the stock transition from fixed to floating rate financial crises market for the first time. Margins weren’t currencies. regulated, so they were at the discretion of the brokers. To ease pressure on In 1973, an oil embargo was called by was escalated by unrestrained issuance speculators, margins were dropped to the Arab members of the Organization of paper money by state banks, over just 25% by October of 1929, exacerbating of the Petroleum Exporting Companies, MICHELLE MACADAM whom regulatory influence had ceased an already volatile situation. The Dow plus Egypt, Syria and Tunisia. It lasted Editor in Chief in 1811 with the fall of the Bank of the Jones Industrial Average fell from 381.17 five months, during which time the price 514 871-7894 [email protected] United States. The Second Bank of the in September of 1929 to just 41.22 in of oil quadrupled to $12 per barrel. The United States was formed in 1816 to get July of 1932. While some countries had First Oil Shock had widespread effects on state banks back under control. Loans started to recover by the mid-1930s, politics and the global economy. While When you’re in a pit, the first were issued sparingly and defaulters others struggled until the end of WWII in oil producing countries benefited greatly, thing to do is to stop digging. zealously pursued. State bank failures 1945. The US stock market wouldn’t fully both financially and geopolitically, — James Ellman and mortgage foreclosures became recover until 1955. oil importing countries were hit with commonplace; unemployment soared. drastic spikes in fuel costs and financial The crisis signaled the transition of recessions. Financial crises are nothing new. The the US from a European offshoot to a world has suffered through them for dynamic economic system that would millennia, as with the Crisis of the Third come to dominate the world. Century which lasted from 234 to 285 AD and nearly wiped out the Roman Empire. They have, however, become increasingly complex over time. In 1944, 730 delegates of all 44 allied The Panic of 1819 arose in the US nations collaborated to develop the from the financial burdens of the Bretton Woods exchange rate system, Napoleonic Wars and the War of 1812. It establishing rules for commercial and financial relations. In 1971, the US put P / 2 P / 3 CADerivatives 2015 / Vol. 1 It’s a crisis if everybody calls it borrowers defaulted on their loans, the headings: Macroeconomic Policy and The report comprises key principles for a crisis. — Morgan Downey value of the loan investments dissipated. Data Transparency, Financial Regulation Financial Market Infrastructures (FMIs): Over 2007, US home sales dropped more and Supervision, and Institutional and systematically important payment In the wake of the Nixon and First Oil than they had in 25 years. Market Infrastructure. systems, central securities depositories, Shocks, France, Germany, Italy, Japan, securities settlement systems, central the United Kingdom and the United clearing counterparties and trade States formed the Group of Six in 1975, to THE PFMI STANDARDS REPORT repositories. The report also covers the facilitate economic cooperation. A year Falling under Institutional and Market responsibilities of those who regulate, later Canada was welcomed into the fold Infrastructure are the Principles for supervise and oversee FMIs. and the organization became the Group Financial Market Infrastructure (PFMI), of Seven (G7). published in April 2012. Requirements under PFMI are more stringent and specific than those In 1999, the G7 Finance Ministers and At the Pittsburgh Summit in September under the previous standards reports Central Bank Governors founded the 2009, G20 leaders had agreed to (Core principles for systemically Financial Stability Forum (FSF) to enhance By the fall of 2008, banks and insurance reform over the counter markets to important payment systems - CPSS, global financial stability through the companies could no longer cover improve transparency, protect against 2001, Recommendations for securities cooperation of the world’s supervisory the financial commitments they had market abuse and mitigate systemic settlement systems - CPSS-IOSCO, bodies and financial institutions. Later undertaken to be able to finance these risk. As a key tactic, it was agreed that 2001 and Recommendations for central that year, to further promote global subprime mortgages. As the news spread, non-centrally cleared contracts should counterparties - CPSS-IOSCO, 2004). PFMI financial stability, the Group of 20 (G20) the Global Financial Crisis erupted, be subject to higher capital requirements also covers new risk management areas international forum was created by the corroding investor confidence and and that minimum margining and types of FMIs. G7 member countries plus Argentina, sparking a major decline in stock markets requirements should be developed. The Australia, Brazil, China, India, Indonesia, industry wide push for mandatory central worldwide. The crisis revealed significant CCPS Mexico, Russia, Saudi Arabia, South deficiencies in industry practices and in clearing led to the creation of the PFMI Africa, South Korea and Turkey, as well as regulatory and supervisory systems. standards report. One notable enhancement under PFMI the European Union. is the increased emphasis on Central Early in the crisis, G20 leaders called for Clearing Counterparties (CCPs), which act From 1998 to 2006, the price of the the FSF to expand into a mechanism as the counterparty to both buyers and average US house increased by 124%. through which authorities, regulators sellers through the process of novation. The bubble burst in 2006 and the value and financial institutions could heighten As such, CCPs are designed to eliminate of US real estate tumbled. Home loans financial stability. The FSF became the the financial risk of a counterparty were freely given to borrowers who Financial Stability Board (FSB). The FSB defaulting on a transaction. couldn’t afford them, then those loans identified twelve key standards for sound were bundled, overvalued and sold off financial systems, classified under three to unsuspecting investors. When the P / 4 P / 5 CADerivatives 2015 / Vol. 1 In order to have sufficient assurance that HOW CDCC IS ADDRESSING PFMI 2. Procyclicality 3. Collateral policy they can bear this responsibility, CCPs: The CCP for Canadian derivatives is In this context, procyclicality refers to risk To reflect price movement volatility off the Canadian Derivatives Clearing management processes that are positively the mark-to-market value of securities • enforce minimum standards for Corporation (CDCC). The implementation correlated with market, business or credit being pledged, CDCC uses haircut participation and actively monitor of the first round of CDCC rule changes in cycles, and so may impede financial percentages. A haircut is a percentage by the financial and operational respect of PFMI will take place in March stability. which the value of pledged collateral is health of their members, 2015. reduced for margining purposes. CDCC’s new margining framework • collect and hold sufficient margins incorporates an Exponentially Weighted The enhanced collateral framework will in their accounts to ensure that Read on to learn about some of the specific Moving Average (EWMA) volatility assess the initial haircut for eligible the potential losses of a defaulting CDCC rule changes being enacted. estimator with a 0.99 decay rate and a non-cash collateral on a quarterly basis, member do not cause losses margin floor calibrated with ten years considering market risk, liquidity risk to other members in extreme 1. Concentration risk of data. EWMA estimates next-day and clustering of eligible instruments. but plausible scenarios, and Should a clearing member default, their positions might need to be liquidated. If volatility and measures volatility as For market risk, the procyclicality of • maintain effective, transparent default the positions are relatively large, it may it changes. This replaces the previous haircuts will be limited with an EWMA management processes to manage not be possible to liquidate them within model which considered 20, 90 and volatility estimator, also with a 0.99 exposures and minimize losses. the default close-out periods without 260 day standard deviations. Spikes decay rate and a margin floor calibrated unduly influencing the market. in margin requirements will be greatly with ten years of data. Liquidity risk will CCPs are subject to global performance lessened during stress periods, and the be managed though an EWMA approach standards and must continually prove To limit concentration risk, CDCC will margin floor will inhibit disproportionate for volatility estimation of the bid ask that they comply with PFMI standards. add a set number of liquidation days to leverage during times of low volatility. spread. The clustering approach will use Otherwise, participants using their default close out periods, applicable to up to six buckets for each type of eligible systems will be subject to higher capital incremental positions above a certain collateral.