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Enron Mail |
ISDA PRESS REPORT - TUESDAY, NOVEMBER 28, 2000
* Uneven Progress * German Derivatives Legislation: A Need For Change Now * Rate Derivatives Is Top Performer * Capital Concerns * Enron To Expand Weather Derivatives Cover Uneven Progress Asia Risk - November 2000 By Quentin Hills The derivatives markets across Asia continue to develop in terms of maturity and complexity. However, as has been the case over the past five years, this development has been neither homogeneous or consistent. Before considering the future landscape, it is worth reviewing the various phases of the market during the last few years. During the early to mid 1990s, the main activity comprised currency and interest rate transactions in the major currencies. The market was dominated by a handful of foreign financial institutions, while local currency business was limited and activity was for the most part evenly distributed throughout the region. The regulatory environment was mixed and generally not well defined or comprehensive. Increasingly during this period, the transactions became more speculative (in line with global trends)and the inevitable occurred in the first quarter of 1994. As interest rates quickly reversed (de, rose) in February 1994, there were several well-publicised losses both in the region and globally. There were quick and adverse consequences on the derivatives markets. Activity abruptly slowed, speculative transactions ceased and financial institutions that had been active pulled back - at least temporarily. Globally, the focus turned towards discipline and control and there was a flurry of new derivatives guidelines and regulations. Asian regulators responded with new guidelines, which largely followed international practice. During this period the industry, represented by the International Swaps and Derivatives Association and regulators from all countries, developed strong relationships. These relationships continue to this day and result in increasing industry comments during the drafting of new regulations. As derivatives markets began to recover, players returned and new entrants emerged, local currency markets developed strongly and end-users focused on risk management processes. Nevertheless, despite the lack of highly leveraged structures, companies throughout the region continued to fund long-term local currency investments with shorter term foreign currency ("cheaper") liabilities, both in the cash markets and synthetic derivatives. When the Asian Crisis struck, the impact was severe and the toll heavy. Apart from deals being unwound, activity ceased and liquidity disappeared. Since the crisis, derivatives markets have recovered with a marked increase in activity (although not to pre-crisis levels), the return of market makers and the introduction of new products, such as credit derivatives. Going forward, the market seems poised to resume strong growth as Asia emerges from this difficult period. Breadth and depth of participants A consequence of the crisis was a sharp and significant fall in counterparty creditworthiness across the region and the withdrawal of many market makers. This was particularly acute during the height of the crisis, but is reversing as foreign banks once again become more active and local banks build their derivatives capabilities. Corporate credit quality is slowly improving and a recent trend has been the increasing use of derivatives by financial institutions - particularly local banks and fund managers. This is expected to continue as more active portfolio management leads to a focus on yield enhancement and credit risk management. Additionally, there has been an ongoing mend among end-users of markedly improved understanding and use of derivatives in risk management. Also noticeable is the broader application of new products. For example, local financial institutions are using credit derivatives to manage balance sheet risk strategically, both for liabilities and assets. This reflects the efficiencies available through the correct use of derivatives and increasing sophistication of end-users. Domestic bond markets The emergence of domestic bond markets is having a positive impact on market development, both directly and indirectly. There is a direct impact where bond issues are swapped into a different currency (in the case of foreign issuers accessing a market), or interest rate (where issuers wish to alter the interest rate basis). Additionally, the increased availability of instruments in the market and greater demand for product from investors is leading to new local currency products, such as options on domestic interest rates and securities. Regulatory convergence Finally, derivatives regulation in the region has generally been somewhat mixed, with some countries adopting a prescriptive approach and others a risk-based approach. Prior to the Asian Crisis, there was a trend towards convergence and harmonization with respect to regulation. During the crisis, however, new regulatory initiatives were put on hold as countries managed larger and more pressing issues. The response to the economic turmoil elicited different responses concerning currency convertibility. Naturally, where currency controls were imposed either in part or in full, there was a direct adverse impact on the local derivatives market. However, in those countries where the response has been to keep markets open, or even to restructure the local financial markets, derivatives usage has rebounded quickly. This in turn requires further regulatory consideration, which has generally been in line with international standards. Going forward, it is reasonable to expect a mend towards regulatory harmonization and increasing adoption of international regulatory standards. The derivatives markets in Asia have undergone dramatic changes over the last few years. The markets themselves are far from homogeneous and significant progress has been made from a low base. There has been continual progress as the number of users increases, more products become available and regulations put in place to allow healthy market development. Development has not been uniform across the region, nor has it been consistent over time as evidenced by the setbacks brought about by the Asian Crisis. Nevertheless, the derivatives markets in Asia will continue to develop and mature as end-users grow in number and sophistication, while the range of products continues to expand. German Derivatives Legislation: A Need For Change Now Derivatives Week - November 26, 2000 In a global economy it is essential that each country establish a transparent and efficient regulatory system for financial products. To ensure market stability, governments must also instill a high degree of confidence m the legal system. In relation to over-the-counter derivatives transactions, these goals have not yet been fully achieved in Germany. But with the forthcoming Fourth Financial Markets Enhancement Act (4.Finanzmarktf~rderungsgesetz) there might be light at the end of the tunnel. In this context, it makes sense to look at a much-needed change in the legal regulation of the so called Borsentermingeschaft. ENFORCEABILITY Generally, a party to a derivatives contract under German law could attempt to challenge the validity of the agreement by raising a statutory defense: the gaming or betting defense (sec. 762 of the Civil Code, Burgerliches Gesetzbuch), the margin defense (sec. 764 of the Civil Code), or the futures defense (sec. 52 of the Exchange Act, Borsengesetz). However, there are two ways to possibly avoid the threat of such defenses: (i) the contract in question could qualify as a hedging transaction, or (ii) as a so called exchange traded futures agreement (Borsentermingeschaft). HEDGING Under the hedging exception, a derivatives transaction is valid, enforceable, and not subject to the gaming, betting or margin defense either if it constitutes a hedge for both parties or if the transaction is a hedge for one party and if this party believes, without negligence, that the transaction constitutes a hedge for the other party as well. The term hedge in this context covers micro-hedging strategies. Whether this exception is also true with respect to macro-hedging strategies is not entirely dear. Modern legal authors tend not to use the term "hedging exception" anymore, but more broadly refer to economically justified transactions. BORSENTERMINGESCHAFTE According to the Exchange Act (sec. 53 pare. 1) Borsentermingeschafte are binding on both parties if each party is a merchant, and is either registered or not subject to registration because he/it is a foreign resident or a public law entity, or a professional (defined as a person who, at the time of the transaction or prior thereto, traded in futures commercially or professionally, or is permanently admitted to engage in exchange-trading). If only one party qualifies under the relevant provision of the Exchange Act, a futures transaction is enforceable only if one party is subject to statutory banking or exchange supervision, be it in Germany or abroad, and informs the other party in writing of the risks inherent in the derivatives transactions in question (standardized information papers which, pursuant to German Supreme Court (Bundesterichtshof ) case law, satisfy the requirements under the Exchange Act and were created by the industry federations of the German banks). This technique of entering a valid agreement is commonly referred to as the "information model" and is subject to strict and ongoing form requirements. In addition, the transaction in question must qualify as a Borsentermingeschaft. Unfortunately, this term has never been statutorily defined, but is intended to cover new types of transactions and has, thus, to be interpreted in a broad sense. Moreover, the Exchange Act was amended in 1989 to extend the privilege of its sec. 53 to transactions with a similar financial purpose as exchange-traded futures transactions. Therefore, today most types of financial, commodity, energy and credit derivatives, whether stock exchange traded or OTC products, are generally eligible for falling under sec. 53 of the Exchange Act. Despite the vast amount of case law (almost exclusively in the context of warrants) on this matter, there is still some uncertainty as to whether certain OTC derivatives qualify as Borsenter7ningeschdffe within the meaning of this provision. RELIEF: THE FOURTH FINANCIAL MARKETS ENHANCEMENT ACT It is, however, widely expected-or at least hoped - that the forthcoming Fourth Financial Markets Enhancement Act will include the introduction of a statutory definition of Borsentermingeschafte. A legislative initiative to define Borsentermingeschafte in concrete terms would be helpful, not least because the German Supreme Court seems in its more recent judgments to have entirely given up the attempt to bring such transactions within its own traditional definition attempts and now lays emphasis only on the financial purpose necessary for qualification as a Borsentermingeschafte. The term also requires clarification in light of recent amendments to the Securities Trading Act (Wertpapierhandelsgesetz) and the Banking Act (Kreditwesengesetz), implementing into German law the EC Investment Services Directive (ISD) and the EC Capital Adequacy Directive (CAD), which introduced the distinguishable supervisory law term "derivative," narrowly defined, into the two acts. The term "Borsentermingeschaft" is not used internationally - it is specific to Germany. Its conceptual scope is controvasial3 and the continuous development of new types of transactions requires a provision which is as comprehensive as possible. For this reason, it makes sense to find a legal definition which includes existing derivatives and can accommodate new developments. Moreover, the essential point of a derivative is the dependence of its price upon the development of its underlying(s). Securities, money-market instruments, currencies, units of account, interest rates or other yields as well as commodities, power, and precious metals may all be assets underlying derivatives transactions as defined in, for example, the Securities Trading Act and the Banking Act. In addition, the inclusion of other underlyings such as credit events, weather developments, traffic flows and environmental emissions would be desirable in order to ensure that here too validity defenses are essentially eliminated. A broad definition of a Borsentermingeschafte would remedy the existing lack of public confidence in the law - especially with regard to future developments-and thus would enhance the status of Finanzplatz Deutschland. The German banking associations and the International Swaps and Derivatives Association should be supported by all market participants in air attempts to convince the German legislator to make a broad definition of Borsentermingeschafte a reality as soon as possible. Rate Derivatives Is Top Performer Australian Financial Review - November 28, 2000 By Bill McConnell An explosion in the use of interest rate derivatives, particularly forward rate agreements and swaps has been the standout feature of Australian financial markets this year alongside strong growth in non-government debt securities. However, a slump in foreign exchange transactions resulted in an overall decline in total financial markets turnover. The Australian Financial Markets Association, in conjunction with the Securities Industry Research Centre of Asia-Pacific released the results of its annual report on trading in Australian financial instruments yesterday. The report detailed statistical results of Australian over-the-counter, and exchange traded market activity. Traded contracts in Australian financial instruments totaled $38.3 trillion with the bulk of trading taking place on over-the-counter markets which contributed 72 per cent of total market turnover. The two markets to show substantial declines in trading activity were foreign exchange and options on futures, with yearly volumes down 16.7 per cent in FX markets and 26.1 per cent in SFE traded options. The fall in activity in currency trading the first since 1994-95 led to an overall decline in market turnover of 1.5 per cent. The total turnover on the Australian Stock Exchange options and direct equities was $466 billion, or a little over 1 percent of total market volume. But the meager contribution provided by equity markets masked an impressive 28 per cent increase on volumes from levels last year, and a 14 per cent increase in exchange traded options. Market capitalisation in the Australian sharemarket also increased by 20 per cent to $682 billion. The report identified not only a growth in share trading, but also a changing investor profile. ``This growth in investor participation in the market does not mean larger volumes. It also means there is a growing number of more experienced investors, seeking a broader range of investment products. In addition, the growth in superannuation funds in Australia is placing greater demand on investment products. The challenge for exchanges is to meet these growing demands.'' But the top performer in Australian financial markets this year was interest rate derivatives . Use of forward rate agreements more than doubled during the year to $1 trillion making it the fastest growing market segment for the year. Non-government debt securities, repurchase agreements and swaps experienced growth in turnover between 36 and 50 percent. Swap turnover has increased every year since data was first collected in 1992-93. ``Turnover in swap markets has increased each year for four years, and that has been happening irrelevant of economic circumstances,'' said Mr. Gordon Axford, chairman of the Swaps Committee. ``This has been a function of greater use of capital markets, and an increased borrowing requirement by the corporate sector requiring the use of swaps to hedge exposure.'' Mr. Ken Farrow, chief executive officer of AFMA, said it had been ``an astonishing turnaround'' by interest rate markets after FRA markets appeared to be in decline in 1994. ``The interest rate market was more volatile this year than last and that means there was greater underlying customer demand for interest rate hedging,'' said Mr. Farrow. Trading in government debt securities fell for the fourth consecutive year, and while the traded volumes fell by only 1.1 per cent, the trend suggests a creeping supply gap between government and corporate markets. ``Corporate issuance has really come into its own,'' said Mr. Phil Coates, AFMA debt capital markets committee chairman. ``The market has advanced considerably. People are very much in tune with what is on offer and we have seen the expansion of the corporate floating rate note market.'' But Mr. Brad Scott, vice-president, head of fixed income credit research at Salomon Smith Barney, said while the corporate bond market was of equal size to the semi-government sector, the liquidity of the government bond market still far outstripped the corporate market by a factor of more than three. ``As funds inflow continues to outstrip demand, deal sizes particularly in the triple B land will need to continue to increase to attract offshore demand and encourage broad-based turnover growth. ``Similarly, greater issue diversity and liquidity provided by global credit markets will continue to attract more interest from funds who have money to place and can't wait for the market to grow.'' KEY POINTS * Australian financial markets' turnover was $38.3 trillion for the year. * Turnover in forward rate agreements increased by 101 percent, the fastest growing market segment. * Foreign exchange trading fell 16.7 per cent, the first fall since 1994. * Trading in government debt securities fell for the fourth consecutive year, down 1 per cent. Capital Concerns Risk - November 2000 By Oliver Bennett There are plenty of people who believed it would or should - never happen. But early next year, regulators are expected to announce a tier one capital charge for operational risk. Bankers who have worked closely with the Basle Committee on Banking Supervision say it is likely to recommend three different options for banking supervisors: basic indicators (that is, a single proxy for the entire bank, such as trading volumes); a business line approach using Committee-imposed capital ratio; or thirdly, internal measurement using a bank's own loss data within a supervisory specified framework. The implication is that further and more detailed work on the internal measurement approach may result an the development of appropriate models and a fourth regulatory option, based on internal modelling. There has been intense criticism from banks about an operational risk capital charge through industry groups such as the International Swaps and Derivatives Association (ISDA) and the British Bankers Association (BBA). However, the Committee's consistent position on a capital charge for "other risks" is encouraging initiatives to develop methodologies and coiled data related to managing operational risk. Standardisation is some way off, although there is growing industry agreement on a core operational risk definition, the collection and sharing of internal loss data and the importance of qualitative criteria. The proposal took banks by surprise the absence of a standard methodology led to fears of an arbitrary operational risk charge, supplementary to existing capital charges for credit and market risk, based on size and volume. Allen Wheat, chief executive officer and chairman of Credit Suisse First Boston, speaking at Risk's annual European congress in Paris last April, described the proposal for an operational risk capital charge as "the dopiest thing I've ever seen". Other leading banks like JP Morgan also expressed concern that an operational risk capital charge was premature when the industry had not come to an agreement on how important the issue was, or how to measure it. A rule-of-thumb measurement would not accurately reflect different levels of risk in various banks and could result in overcharging some banks for risk and undercharging others. Similarly, operational risk capital charges could penalise banks competing against non-banking organisations not subject to the charge. The principal message to regulators is that larger banks with good operational risk measurement and management should achieve lower capital charges. However, without a standardised methodology, proposed operational risk capital charge criteria need to be progressive, flexible and include a risk-based option. Joseph Sabitini, managing director in the corporate risk management group at JP Morgan in New York, recognises that a new regulatory framework for operational risk must accommodate banks at all levels of sophistication in terms of risk measurement and management, but that it also includes a risk-based option for "those with the appropriate capability". Sabitini, who has been working closely with the Risk Management Group of the Committee, goes on to say that to avoid the shortcomings of the previous Accord, the capital rules must also be transparent, uniform and consistency applied. A recent report by Meridien Research, the Massachusetts-based technology and advisory service, concludes that in two to three years only one-third of financial institutions will have the technology to measure and manage their operational risks. The report examines how financial institutions measure up in a four-stage progression of addressing and implementing an operational risk management strategy. In the first stage, firms concentrate on the identification of key risk Indicators and data collection. Stage two involves developing metrics and tracking for the identified risks from stage one. Stages three and four move on to using technology for the measurement and management of those risks within a firm. The report gods on to say that most firms are working in stages one and two of the operational risk management process. With the regulatory option to focus on specific business lines such as investment banking, retail banking or asset management, banks are concentrating on internal definitions and management strategies. But how are they preparing for a capital charge? For most banks this includes loss-gathering initiatives, key indicator information, risk assessment and in some cases calculation However, unlike market risk and credit risk, a purely quantitative approach to measure operational risk is not the current focus. Chris Rachlin, head of group operational risk at Royal Bank of Scotland (RBS), details the main initiatives his group have been focusing on: "We have been identifying and implementing tools and techniques to help our businesses identify, manage and monitor operational risks better. As part of this we have been collecting data on loss events. We have also looked at a number of quantification techniques, but believe their effectiveness will depend on the quality and quantity of the data available." The current challenge is to find a way around the lack of data on big loss experiences. Due to the rarity of these large losses, banks lack extensive data on operational catastrophes such as Nick Leeson-style fraud or a complete systems breakdown. According to Tony Peccia, vice-president in the operational risk management division at CIBC World Markets in Toronto, most banks would want to be at the internal measurement stage of the proposed capital charge when implemented - which is dependent on internal data. This has led to the establishment of a number of operational loss databases - in particular, introduction consortia of internal loss data-bases. The two principal consortia are the Multinational Operational Risk Exchange managed by NetRisk, and the Global Operational Loss Database (Gold), managed by the BBA, which both provide a mechanism to share loss data in a secure environment. The consortium members supply operational loss data, business and risk characteristics to the managing agents. The data is sanitised, secured and scaled then returned to the consortium members As well as assisting banks to manage their operational risks, the data can be used to compare their performance against their competitors and highlight vulnerable areas. The More consortium has agreed to begin sharing data from November 1 2000 and receive the first batch of scrubbed, anonymous data by the end of the year. There are a number of concerns regarding data standards. According to Richard Metcalfe, ISDA Assistant Director of European Policy: "There is concern that, while the proposed Basle Committee rules incentivise data gathering, that is not the only issued if banks record their losses in general categories when submitting internal data but do not associate losses with enough contextual information, it we be difficult to understand the finer gradations of risk later on - or indeed to reclassify the database to an agreed industry or regulatory standard. Matt Kimber, a director with Arthur Andersen's financial practice, welcomes initiatives to collect internal loss data to increase the breadth of information available. However, he goes on to say that users of the information "will have to be mindful of the parameters as to how the information is "gathered and prepared." Similar criticisms are also levelled at publicly disclosed external loss databases, where issues of caring and cleansing must be considered. Last month, ISDA issued a discussion paper, Operational Risk Regulatory Approach Discussion, on operational risk capital charges. The paper highlights concerns that a purely quantitative approach could enable institutions with poor operational risk management processes and controls, but with access to internal loss event data, to achieve a lower capital charge that institutions with stronger risk management processes but no access to internal loss event data. The paper also highlights fears over the method of calculation of operational risk capital for an institution that has recently experienced serious loss, but where management has reacted and strengthened the control environment in that area, and consequently reduced the likelihood of reoccurrence. The paper, produced with the active support of over 20 ISDA member firms and facilitated by PriceWaterhouseCoopers, sets out a series of structured and transparent qualitative assessment criteria - with particular reference to quantitative criteria - to complement the operational risk data requirements currency proposed by regulators. The paper argues blat there is strong support in the industry for a regulatory capital assessment model that allows institutions managing operational risk to effectively access a more precise means of Calculating an operational risk capital charge - institutions should benefit from more sophisticated controls and the regulatory regime should establish incentives to improve risk management and controls. This is consistent with proposed quantative techniques once internal loss data is incorporated into the operational risk capital charge calculation, as any institution with an effective control environment would normally expect to have a lower loss experience, and thus a lower capital charge. According to Arthur Andersen's Kimber, there is another option - insurance. "Insurance and risk transfer will become an important and sophisticated component in an operational risk manager's tool-box over the next few years. "There are definitely challenges for insurance providers in offering operational risk cover, but there has been some recent headway in the last year or two" In fact, regulators have made it clear that, in principle, mechanisms such as insurance might be an acceptable way for banks to mitigate risk and reduce their capital charges. Depending on the stance of regulators, the Committee might insist that policies that mitigate the capital charge pay out immediately after any operational disaster, or that these polices only cover certain classes of operational risk. It may also stipulate a specified credit rating of the insurance company, or the percentage of risk that the primary insurer can sell into the wider insurance market. Possibly the most well-known operational risk insurance product is Swiss Re's Financial Institutions Operational Risk Insurance (Fiord). With Fidelity Investments as the first client for the re-insurance firm's product, it is designed for the top 400 financial institutions in the world. FIORI would have covered most of the devastating losses that have hit the headlines over the last few years - 68% of them according to the insurer's own analysis. Lars Schmidt-Ott, head of global banking practice at Swiss Re New Markets, sees insurance as a good alternative to capital charges. "Holding Capital on the balance sheet is not good for shareholder value - if you can keep it off the balance sheet at an efficient price you only pay the downside premium." But according to RBS's Rachlin, there are a number of problems with the insurance option - principally the speed of payment and potential lack of capacity for meaningful levels of rover from financially secure insurers. Although some products on the market will provide immediate liquidity to a bank following a disaster, there may be certain arguments after the event. Policies with catastrophe levels of cover would also need to be scheduled or layered, and it is not always possible to secure acceptance for finely worded polices from differed underwriters. Rachlin also highlights reputational issues: "While insurance may cover the short-term financial impact for some events the longer term reputation impact can be of greater concern." Although Schmidt-Ott does not agree that there are any reputational issues using insurance products, he recognises that it may be some time before gaining relief from operational risk charges becomes a real incentive to take out insurance. "Insurance will play a role as an instrument for managing operational risk, but not in its current form....we are waiting for the regulators." Insurance aside, the Basle Committee's capital charge announcement for operational risk is not eagerly awaited. If the regulators make their announcements in the first quarter of 2001 they probably would not become effective until at least 2002. Depending on the flexibility of the proposals, research into internal modelling approaches to operational risk is likely to intensify. Victor Dowd, an associate involved with operational risk capital charge discussion at the UK's Financial Services Authority agrees that further and more detailed work on the internal measurement approach may result in the development of appropriate models. However, for the present, he says," modelling is not an option" for the regulators to consider. Enron To Expand Weather Derivatives Cover Derivatives Week - November 27, 2000 Enron Europe is set to start quoting weather derivatives on an additional 15 cities in Europe in the next two weeks. Thor Lien, v.p. and head of weather risk management-Europe in Oslo, said Enron is adding the cities in the U.K., the Netherlands, Germany and France. Enron has since the beginning of the year been offering weather coverage via its website (www.enrononline.com) and voice brokers on London, Paris, Oslo and Stockholm, as well as some U.S and Asian cities. Lien predicts the European weather derivatives market will double in size to approximately EURO-8 billion (USD5.1-6.8 billion) (total outstanding notional) within a year. Fund managers and risk managers are growing more interested in the product as liquidity and transparency increase. Although customers will also be able to trade weather derivatives through Enron's voice brokers, the company is putting the contracts on its web site to entice players worldwide and increase liquidity, Lien said. End of ISDA Press Report for Tuesday, November 28, 2000. THE ISDA PRESS REPORT IS PREPARED FOR THE LIMITED USE OF ISDA STAFF, ISDA'S BOARD OF DIRECTORS AND SPECIFIED CONSULTANTS TO ISDA. THIS PRESS REPORT IS NOT FOR DISTRIBUTION (EITHER WITHIN OR WITHOUT AN ORGANIZATION), AND ISDA IS NOT RESPONSIBLE FOR ANY USE TO WHICH THESE MATERIALS MAY BE PUT Scott Marra Administrator for Policy and Media Relations ISDA 600 Fifth Avenue Rockefeller Center - 27th floor New York, NY 10020 Phone: (212) 332-2578 Facsimile: (212) 332-1212
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