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ISDA PRESS REPORT - MAY 30, 2001
Credit Derivatives * ISDA tackles default swap successor definition - IFR Risk Management * Basel 2 comment period ends, work for banks begins - Reuters * Hedge funds drive risk tool boom - IFR Regulatory * New U.K. Financial Regulator Draws Fire From Institutions - The Wall Street Journal Other * US Equity Derivatives - FOW ISDA tackles default swap successor definition IFR - May 26, 2001 The International Swaps and Derivatives Association's credit derivatives market practice committee last week moved to tackle the question of reference entity for credit default swaps in the event of a de-merger. With the dismantling of AT&T looming, the need to resolve the "successor" issue is heightened, say industry officials, who note that resolution would enhance legal certainty for the product. AT&T's restructuring plan calls for splitting the company into four different units and assigning the bulk of the firm's massive debt burden to two of the entities. Under the ISDA 1999 credit derivatives definitions, the entity that assumes "all or substantially all" of a firm's debt responsibility after a break-up should be used as the reference entity for outstanding credit default swap contracts. The AT&T example highlights the need for clarification because no one entity stands to assume the majority of the company's debt obligations. Also, AT&T is one of the most heavily traded names in the credit default swap market. One potential answer may be to allocate a de-merging company's default protection among the newly formed companies according to the percentage of debt that each entity is allocated, said credit derivatives officials in New York. No historical guidance exists currently. The issue first rose to prominence last year with the question of the reference entity for credit default swaps on the UK's National Power following the company's de-merger. International Power was eventually agreed to be the reference entity because it had to take on new debt at the time of the de-merger. Many end users of default swaps were unhappy with the way major dealers spun out the debate over this case, however. Firms representing the key participants in the credit derivatives market on June 5 will report back to the credit derivatives market practice committee. The firms consulting the marketplace include a credit derivatives dealing firm, a bank portfolio manager and an end user of credit derivatives. Each group has European and US representation. It is unclear whether the clarification on the successor issue, which will probably be released, as a supplement later this summer, will apply retroactively, one market official said. Basel 2 comment period ends, work for banks begins Reuters - May 30, 2001 By Alice Ratcliffe ZURICH, May 30 (Reuters) - An industry comment period on new global capital rules dubbed " Basel 2" ends on Thursday, but the work will just be starting for banks calculating how the sweeping changes will affect their businesses. The new rules are due to be enforced in various legal jurisdictions starting in 2004. They will apply to most of the world's banks now subject to the outmoded Basel Accord dating from 1988. Basel 2, once adopted, will also set standards for securities and brokerage firms in the European Union. Despite outcry from some industry participants that the new rules were formulated too quickly, supervisors appear set to complete Basel 2 by year-end, in time to implement it by 2004, according to industry sources. One reason for the haste is that the Basel Committee on Banking Supervision drafting the new rules worries an industry stalemate could delay adoption of the badly-needed new rules in some key jurisdictions. The 2004 implementation date is already seen as a sop to the lengthy EU legislative process. "Time (Basel 2) uses up eats into time for the EU directive," said a source familiar with the issues, adding the Basel Committee is "between the devil and the deep blue sea". SWEATING OVER CALIBRATION Of course, that doesn't make the process any smoother. Officially, banks are to have all comments submitted by May 31. Unofficial dialogues will likely continue for a long while. One area of concern is Basel 2's approach to capital needed to cover lending exposure. It allows for banks, which meet certain qualifications, to measure the risk of a borrower defaulting using an internal system, in a way similar to an earlier advance adopted in the 1990s is used to measure market risk. In the approach to market risk, banks deemed eligible by supervisors can use their own internal "Value-at-Risk" (VAR) models to assess market risk to assess capital requirements. Basel 2 foresees letting eligible banks use an "internal ratings based" (IRB) approach to measure credit risk. But unlike market risk, banks are not allowed to use their own models to calculate the capital needed to cover credit risk, at least not yet, as such models are not deemed advanced enough for this. Instead, banks will compute their regulatory capital using their own internal ratings. But they must then plug internal numbers into formulae spelled out by Basel 2, computed on an indexed or "calibrated" basis. This is where problems arise. "The first thing we said was that the calibration of the whole proposal has to be re-worked," said one banker. Banks complain Basel 2's calibration formulae, as spelled out in a draft published in January, penalise the IRB approach, saying set-asides for risky corporates, for example, could be higher than what is called for by a standardised approach applied for less sophisticated banks. One fear is that this could lead small and mid-sized banks using the standardised approach to wind up with a disproportionately larger exposure to riskier borrowers. Supervisors are expected to work out the kinks, however, and are expected to take into account data collected by the Basel Committee under a Quantitative Impact Study (www.bis.org). "I have the strong impression there are going to be substantial changes to the document...," said one banker whose own institution had run simulations which took into account its profile including a large amount of emerging market loans. He said the simulations showed his bank "would have been seriously penalised" by the earlier proposal. "But now it looks as though it will be changed. The Basel Committee seems to be open to our point of view," he said. Banks are to submit findings on such technical issues to country regulators by June 1. The Basel Committee could finish analysing these by October, and is likely to incorporate them into the finished version of Basel 2. OPERATIONAL RISK PALPITATIONS Operational risk is a new category foreseen by Basel 2 alongside credit and market risk. No one doubts that such risk exists. But requiring banks to quantify it and set aside enough capital to satisfy regulators is proving another headache. Some private bankers worry that asking banks to set aside capital for such risk could adversely affect the burgeoning business of wealth management which in theory requires a low capital base compared to lending or trading activities. "A lot of banks have gone into private banking and asset management and have paid a fortune to do so. The message is they want these glamorous purchases because they need low capital and offer good returns," said one European banker, adding the original proposed changes "move the goalposts". The Basel Committee raised a storm when it suggested a capital set aside of 20 percent - a provisional figure - for operational risk. The final figure has not yet been set. Basel 2 defines operational risk as "the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events" and refers to "an average of 20 percent of economic capital". Alongside smaller banks, big ones are irked that the calculation ignores what one banker said was big banks' more diversified income, and hence reduced risk of failure. Some banks would also like included in the calculation the "hit absorption" of a bank, meaning that a bank making losses would first use income, not capital, as a cushion. Hedge funds drive risk tool boom IFR - May 26, 2001 By Kathleen Fitzpatrick Dubbed virtual portfolios, risk measurement services that include a 'what-if' scenario along with the more traditional kind of risk analysis are gaining in importance. The hypothetical feature allows for a more customised and flexible approach to the management of risk and answers situational hedging questions about a portfolio. "What would happen if I added a hedge into the portfolio? What if I buy or sell futures?" are questions that Deutsche Bank's dbRiskOffice scenario analysis can now address, said Michelle McCarthy, managing director, risk analytics at Deutsche Bank. Deutsche's 'What-if Positions Change' enhancement, released to clients in mid-May, includes features to determine changes in value at risk (VAR), tracking error and surplus-at-risk resulting from a variety of hypothetical situations. Deutsche's client risk reporting system, available via an internet browser, specifically targets risk managers who outsource their risk measurement, instead of building up an entire department to monitor their VAR. Deutsche's customers are keen on obtaining cross-asset class VAR coverage, according to McCarthy. Managers who incorporate the use of the client risk reporting enhancement would have a better handle on whether a particular position will better correlate a fund to an index, for example. The current VAR analysis tools have already been mastered by the fund community, which is now looking for better predictors of risk. VAR is tied to a particular probability at present and fails to capture an exceptional move in an index, for example, said Guillaume Blacher, senior managing director, pricing advisory and risk management. at Reech Capital in London. "Risk managers have been consistently going for greater flexibility.' added Deutsche's McCarthy. "More managers want to work with the numbers, rather than have a single number that comes out once a day," she said, referring to the benefits of scenario analysis over traditional risk measurement practices. The hypothetical scenario tools, along with the traditional VAR risk measurement systems, are needed by fund managers in a complementary way, stated Reech Capital's Blacher. However, the hypothetical tools give more flexibility to analyse potentially substantial losses. "VAR has shown its limitations . . . it tends to capture bad days, not the extremes," according to Blacher. Hypothetical analysis tools will assist the risk manager in deciphering what positions are needed to get back within a fund manager's limit, he added. Option competition The need for faster and more reliable scenario hedging for managers investing in equity options has been a key driver of demand for 'what-if' scenario analysis lately. "The stock option market has become tighter, more competitive," noted Ravi lain, chief executive officer of Egar Technology, a New York and Moscow-based firm that launched its own real-time equity options trading and risk management platform (Equity Trading System) last week. "We have already seen an incredible amount of interest from market-makers moving upstairs and the hedge fund community," lain said. He also credits the more educated investor who may be prompting the fund manager to install better risk management and reporting systems, particularly for option based funds, as fuelling the current demand for hypothetical risk analysis. "Aside from the trading and risk management systems, there is a lot of need for decision support tools," he added. Michael Gannon, sales and marketing associate at Imagine Software, the software maker that powers the Derivatives.com trading site, agreed that more sophisticated investors are a force behind fund manager demand for this kind of system. Banks such as Deutsche Bank and Citigroup use Derivatives.com risk measurement tools in their sell-side operations, according to Gannon. And it is precisely the use by these banks that smaller Imagine Software clients like. However, the current risk measurement systems can be expensive for all but the largest trading organisations, and especially for start-up funds. "Hedge funds are not going to spend US$1m on buying a big system," said Egar's lain. Instead, he said, they will investigate the more customisable decision analysis tools. Imagine Software implemented its hypothetical 'what-if' position analysis last year. Its Derivatives.com website features a 'hedge as you re-hedge' component that allows funds to rehedge during the simulation to give the portfolio a two-dimensional real-time projection of a trade. MicroHedge, a web-based platform that caters to option traders, also offers 'what-if' scenario analysis in its Micro-Hedge Portfolio Risk product. That platform, however, targets the needs of active market-makers, rather than hedge fund derivatives users. The fact that these virtual portfolio hypothetical analysis tools are now available is beginning to make it easier for hedge funds to start up, according to Imagine's Cannon. With the right risk analysis tools, a hedge fund could be up and running in a week, instead of hiring an entire IT staff, he said. Certainly, the growth of hedge fund start-ups continues at rapid pace. Hedge funds are expected to expand with a compound annual growth of 27%, according to a study by Freeman & Co. New U.K. Financial Regulator Draws Fire From Institutions The Wall Street Journal - May 30, 2001 By Silvia Ascarelli LONDON -- Will too much bureaucracy cause a logjam in the City? A think tank warned of growing discontent among major financial institutions with the Financial Services Authority, which this year will take over the duties of all of the financial regulatory agencies in the United Kingdom, and said the FSA's style eventually could undermine the international competitiveness of the City, as London's financial district is known. The FSA is seen as "bureaucratic, intrusive and insensitive," and its regulatory style risks becoming a rules-based system for the benefit of lawyers and compliance officials, according to the Centre for the Study of Financial Innovation, in London. The conclusions, which are based on interviews with officials at about 70 financial institutions, including foreign banks with large operations in the U.K., come as the FSA nears a still-unnamed date when it will officially replace 10 regulators and 14 different rule books. During the past four years, the FSA has been a virtual regulator that contracted some of its duties to the agencies that it will replace. The FSA said the think tank -- which admits it began with negative preconceptions -- ended up with some positive conclusions. For instance, the study found little evidence, despite many complaints, that the FSA's approach has cost the London's financial center any business. Rather, it found that the FSA is seen as more sophisticated than other European regulators and that new banks and companies are setting up shop in the U.K. at an unprecedented pace. The think tank itself acknowledged that some of the institutions may be grumbling because they prefer the old regime and because the FSA isn't completely formed. The think tank also warned of "inexorable forces" driving the City toward rule-bound regulation, rather than a more flexible, individual approach. Some respondents said they feared that the FSA may be less hospitable to innovation and start-up companies. The CSFI also claimed that regulatory costs are rising in most parts of the City because of higher compliance costs. An FSA spokesman said the report didn't back that claim up with hard analysis and that indirect costs are included in the cost-benefit analysis that the agency performs on policy proposals. US Equity Derivatives FOW - May 2001 By Anuszka Ranslev The economic slowdown of global markets has had a dramatic effect on the US equity derivatives market. Although the underlying market is proving to be quite uncertain, traders report a remarkable time for equity derivatives. One trader describes this as "probably the single best I environment for equity derivatives that we've seen in the last decade". Compressed levels of volatility at the beginning of the year, combined with uncertainty in the market, has lead to an increased usage of equity y derivatives. While volatility levels dropped in the first few months of the year due to supply and demand factors, the past month has seen volatilities begin to move up again. However, one US-based broker warns that volatilities have not moved up as much as the market would expect. "We would predict, with the current supply and demand imbalance, that vols would rise more significantly than they have," he says. "The fact that vols have not risen in this way creates good value for those looking to use equity derivatives." Meanwhile, there are reports of a diversity of business being traded across the board, with no significant markets being favoured. While February saw no signs -of a herd mentality since March there has been much copycat trading going on. This has lead to reports of the US leading the market with Europe and Asia following. However, at the beginning of April, traders report some diversions from this copycat trading, particularly with the Nikkei rising by several per cent. Convertibles remain the core of activity in the market. A dealer comments: "If you can get the premium high enough, although people aren't crazy about selling their stock at this level, convertible financing is pretty viable." The demand in the convertible market has lead to a significant growth of convertible arbitrage. This sector has become the best performing alternative investment hedge fund strategy, rising from last year, with a total return of approximately 350/0. The dealer warns: "There is a lot of new money that has moved into this arena, but there are just not that many new funds, and now, as funds come on, there aren't that many convertibles available." The convertible market continues to offer zeros with many large over night deals being witnessed. One trader comments that: "The big buyers of convertibles believe that the arbitrage funds are very material to the market, although they would prefer them on a hedge basis with more attractive volatility." However, he warns: "In this market of convertibles you need to be aware of where you can get stock off, where the credit should be trading and where you can distribute that credit." Traders report a record year, so far, in equity derivatives and speculate that the market is the one area in investment banking, other than fixed income, that is really having a good year. A head of desk concludes: "This is a period of divergence where there is so much uncertainty in the market that it is hard to trade and hard to take direction. Yet, this is often when derivatives have the best opportunities and can provide the best solution." **End of ISDA Press Report for May 30, 2001** 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 & Media Relations ISDA 600 Fifth Avenue Rockefeller Center - 27th floor New York, NY 10020 Phone: (212) 332-2578 Fax: (212) 332-1212 Email: smarra@isda.org
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