2017-08-22

Settle-to-market: a quant perspective

Following recent regulatory guidance in the US, announcement by Barclays that it had reduced its regulatory assets by USD 113 billions, and last year switch by UBS that saved USD 300 millions in capital, I though it would be useful to give it a quant perspective to the settle-to-market question.

The centre of the question is to know if the VM mechanism in cleared derivatives is a “settle-to-market” or a “collateral” process. This is only a wording question, but what is the quantitative finance perspective? In both cases, the valuation fall in the generalised collateral framework. I use my “Multi-Curve Framework with Collateral” paper from 2013 as a representative example of that framework (also described in my multi-curve framework book). It’s starting point is, in all cases,


The price process is constant at 0. That is a perfect example of settle-to-market. The continuous dividend/pay-off is a mixture of change of value dVt and payment linked to a benchmark ct Vt dt. The number is called rate, but in all generality it is a reference number, nothing else. In some cases it is a rate (like overnight) it some case it is a conventional number (0 for futures).

Citing the great Poincaré, as I did just below the above definition in the paper,
La mathématique est l'art de donner le même nom à des choses différentes. 
Henri Poincaré.

Most derivatives,  cleared or uncleared, are now traded under mandatory daily VM process. If we ignore the wording and concentrate on the content, all of them fall in the settle-to-market category in the above sense. If you thing that names are more important than substance, just rewrite your contracts. Instead of a vanilla interest rate swap, call it ‘path dependent multi-index contingent claim with daily pay-off’, write the above formula in the term sheet, make sure that you write explicitly in the contract that the value is settled-to-market on a daily basis and the residual value is exactly 0 on a daily basis, settle the daily pay-off in cash and you are done. You can use the settled-to-market term for all your derivatives.

Obviously, this is a quant perspective, not an accounting or regulatory one. But hopefully there is only one reality. Hopefully also the common sense perspective that two assets that have exactly the same pay-offs in all circumstances are equals is true not only from a quant perspective, but also an accounting or regulatory one.
Who would you give different names at the same concept?

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