Maybe MTM isn’t exactly what is needed?

Everyone (except corporate boards and managers) seem to agree that short term incentive compensation is one of the key drivers for the excessive risk taking that led to the financial crisis. In an earlier post, it is suggested that one of the reasons is that accounting is less reliable in the short term.

Perhaps the problem is Mark-to-Market accounting. While it is an extremely important discipline to know the market value of positions, MTM has a misleading presumption. In effect, MTM treats a position that has been closed by sale on the day that the financials are set exactly the same as an open position.

Short term compensation based upon such accounting allows traders and managers to take credit for open positions AS IF THEY HAD CLOSED THEM. And I mean truly closed them by Risk Transfer, not simply Risk Offset. This means that the firm settles with the trader for something that the trader has not yet done and that there is no sure indication that the trader could actually accomplish.

That is because the MTM value may or may not be the amount of cash that the trader could get for their position, especially if you include the requirement that the risk is actually really and totally off the books, not simply offset. To know the actual cash equivalent and the difference between that cash equivalent and the MTM value, a firm would need to study each market to understand the trend and liquidity.

This issue is particularly important when valuing the custom non-exchange traded derivatives. Practice is to value those contracts by a replication process, using market traded instruments. There is no attempt to assign any illiquidity premium. This accounting practice is one of the fundamental supports to the practice of trading off market. During the height of the sub prime crisis, it was found that there was no market at all for some of these securities and the MTM process produced completely sham values. Sham because the real clearing value for the securities was much lower than the values that the holders wanted to report.

The difference between the next trade and especially a trade of the size of the position valued and the last trade regardless of the size of the trade is the issue here. And the problem is with treating completely closed positions exactly the same as open positions, by valuing them both as realistic cash equivalents.

Finally, there is the issue of continuing risk. A totally closed (transferred or expired) position has no capital requirement. An open position SHOULD have a capital requirement. Even an OFFSET position should have a capital requirement based upon the basis risk, the counterparty risk.

This discussion reveals an additional risk – the clearing risk.

So the value of the open position needs to reflect one level of clearing risk and the capital needs to reflect a much larger amount of clearing risk.

Explore posts in the same categories: Compensation, ERM, Hedging, Mark to Market, Reinsurance, Risk, Risk Management, risk transfer, Trading


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