ISDA PRESS REPORT - MAY 22, 2001

ISDA PRESS REPORT - MAY 22, 2001

Bankers question Basle proposals - Financial Times
KfW seeks Basle II changes - IFR
Creditors Must Better Measure Hedge Fund Exposures - BIS - Dow Jones
Banks warned on exposure - Financial Times
Banks say bill `too tough' on disclosure - South China Morning Post
US bankruptcy bill aids derivatives - Risk
Securities Trade Groups Argue Against Firm's Liability To Sophisticated
Investors for Certain Trades - BNA
The limits of ingenuity - Financial Times
Airlines and food and beverage firms targeted - IFR
UK building societies' use of credit derivatives limited - IFR
West coast blues - Risk
European settlement systems under fire - Financial Times

Bankers question Basle proposals
Financial Times - May 22, 2001
By Colin Cameron and Deborah Hargreaves

Leading European and US banks want more information on how new rules on
capital adequacy will operate, raising the possibility that final proposals
from the Basle committee could be delayed.

In a letter to William McDonough, chairman of the Basle committee of
international financial regulators, banks yesterday asked for more detailed
information on seven key areas. The letter was signed by heads of the US,
European and Japanese banking associations.

"We are keen to implement the new accord in 2004, but we see no absolute
reason why the end-of-the-year timetable has to be kept," said Maurizio
Sella, president of the European Banking Federation. "It's much better to
get out a proposal that's right even if it is a few months' late."

The committee published its latest draft of the proposed Basle 2 accord in
January and set a deadline for consultation with the industry to be
completed by the end of May. But many financial operators believe this is
now unrealistic.

The banking associations are asking for detailed papers to be sent to them
by August so that they could respond by October.

"The Basle committee has bitten off more than it can chew," said Ian
Linnell, banking analyst at credit rating agency Fitch. "The accord in its
draft form is incredibly aggressive and a contains a number of black holes
that require further work."

Banks want detailed papers on the treatment of retail, equity and project
finance portfolios. They are also asking for more information on the way
operational risk - unexpected losses - will be treated, and for details on
aspects of securitisation, counterparty risk and disclosure.

The letter points out that in a number of important areas the Basle
committee's second consultation document has either come up with new
proposals or indicated that final proposals are to come.

"Taken together these greener areas will have a critical impact on the
outcome of the proposals for individual firms and the industry as a whole,"
the letter says.

The banks are particularly concerned about the levels of capital that would
have to be carried by some institutions to cover operational risk.

"The misapplication of the operational risk charge could cause serious
distortions in competition between institutions," Mr. Sella said.

They are also worried about the calculation of the level of capital banks
must hold, which in an economic downturn could lead to a credit crunch. "We
have been assured the level of capital in the system will not increase. We
are very concerned that if the calibration is not done properly, that will
go up and it could have a serious effect on the economy," the European
banking federation said.

The Basle committee last night welcomed the banks' feedback but expressed
confidence that the year-end timetable would be maintained.

KfW seeks Basle II changes
IFR - May 19, 2001

Kreditanstalt fuer Wiederaufbau (KfW), Germany's largest promotional bank,
intends to bring four items into the discussion surrounding the revised
Basle Capital Accord (Basle II). Hans Reich, the agency's managing board
chairman, said that modifications were necessary to ensure the supply of
credit to small and medium-sized enterprises in the future.

In particular, KfW wants the customary collateral categories to be
recognised equally and fully in all risk rating approaches. It also wants
Basle II to allow small loans, such as those to small businesses, to be
combined into so-called retail portfolios in all ratings approaches.

Referring to the advanced IRB approach and the Basle II paper's requirement
of higher equity being held for loans with long maturity, KfW considers this
to be a discrimination against the customary long-term lending relations
that are long established in the German banking system.

KfW also considers the Basle II proposals on the subject of securitisation
to be unclear. It argues that care needs to be taken to ensure that the new
requirements do not run counter to those of SME loans securitisation, which
reduce the risk for banks.

Reich expressed satisfaction at his firm's "intensive and constructive"
talks with the German finance ministry on these points. "We are pleased that
our politicians are dealing so intensively with the topic of SME finance and
the necessary changes required by Basle II," he said.

Creditors Must Better Measure Hedge Fund Exposures - BIS
Dow Jones - May 21, 2001
By Tyler Lifton

NEW YORK -(Dow Jones)- While good progress is being made towards
strengthening the counterparty credit risk management and regulatory
oversight of highly leveraged institutions (HLI), credit providers need to
make further improvements in the measurement of credit exposures, a global
banking watchdog said Friday.

Disclosure of information by HLIs to banks and other credit providers has
improved in terms of both quality and quantity, nonetheless "progress
remains inconsistent, with confidentiality concerns and competitive
pressures sometimes limiting information flows," according to a press
release from the Bank For International Settlements. HLI is a description
generally reserved for hedge funds and other investment vehicles that use
leverage, or borrowing, as a fundamental strategic tool.

The press release outlined a report by the Financial Stability Forum, which
works to promote international financial stability and is affiliated with
the Basel, Switzerland-based BIS, on progress made toward implementing
recommendations it has endorsed.
"Supervisors remain concerned about the ability of regulated firms to resist
market pressures, in particular on initial margin," according to the
release.

Although a separate study that looks to set out a basis for improvements in
public disclosure of financial risks has been completed, actual progress
toward introducing mandatory public disclosure requirements for HLIs and
hedge funds has been limited, the FSF report said.

At the same time, improvements have been made by senior management in terms
of reporting on HLI exposures, general standards of credit analysis, due
diligence and documentation, the FSF reported.

And foreign exchange market participants have agreed to a set of so-called
Good Practice Guidelines for Foreign Exchange Trading. This would help
address concerns that large and concentrated HLI positions could have the
potential to materially influence market dynamics in small and medium-sized
open economies, according to the FSF report.

While progress is being made in addressing weaknesses in legal documentation
practices, it has proven difficult to achieve improvements in the
consistency, where appropriate, between different industry standards, the
report added. Legal documentation underlying financial contracts is "a
crucial building block in the stability of the financial system," the FSF
said.

Banks warned on exposure
Financial Times - May 22, 2001
By Dow Jones Agency Material

Banks warned on exposure

The Bank for International Settlements believes that banks are still not
doing enough to monitor their exposure to hedge funds.

The central banks' central bank set up a group to study the systemic risk
posed by hedge funds after Long-Term Capital Management's collapse in 1998.
So far it is only partially satisfied.

While good progress is being made towards strengthening the counterparty
credit risk, management and regulatory oversight of so-called highly
leveraged institutions (HLIs), credit providers need to make further
improvements in the measurement of credit exposures, the global banking
watchdog said.

Disclosure of information by HLIs to banks and other credit providers has
improved in terms of both quality and quantity, the Bank for International
Settlements said last week. Nonetheless, "progress remains inconsistent,
with confidentiality concerns and competitive pressures sometimes limiting
information flows", it said.

HLI is a description generally reserved for hedge funds and other investment
vehicles that use leverage, or borrowing, as a fundamental strategic tool.

BIS outlined a report by the Financial Stability Forum, which works to
promote international financial stability, on progress made in the area.

"Supervisors remain concerned about the ability of regulated firms to resist
market pressures, in particular on initial margin," BIS said.

Banks say bill `too tough' on disclosure
South China Morning Post - May 22, 2001
By Enoch Yiu

Nine investment banks have voiced opposition to the proposed Securities and
Futures Bill, saying the proposals for derivative trading disclosure are
tougher than elsewhere in the world.

They have asked the Government to amend the bill to exclude disclosure on
some derivatives and ensure the disclosure regime "reflected more closely
the existing laws in Hong Kong and other markets".

The banks said they feared the legislation would discourage international
investors from trading in Hong Kong shares, undermining the SAR's position
as an international market.

The investment banks involved are Credit Suisse First Boston, Deutsche Bank,
Dresdner Kleinwort Wasserstein, Goldman Sachs (Asia), J P Morgan, Merrill
Lynch (Asia Pacific), Morgan Stanley Asia, Salomon Smith Barney Hong Kong,
and UBS Warburg.

They are concerned about disclosure on so-called cash-settled derivatives.
Under existing law the banks need make no disclosure. However, they will
need to do so under the new law as it expands the disclosure requirement
from shares to include derivatives.

In a paper submitted by their law firm, Linklaters, to legislators
yesterday, the group of banks warned the bill would impose a stricter
disclosure regulation on the local financial market than on those of
overseas competitors.

But the Government rejected this saying the smaller local market would
require tougher restrictions to avoid market manipulation.

The Government's refusal to make changes could endanger the implementation
of the bill. It has already been delayed from July to the year-end because
legislators feared a rush to pass the bill would repeat the mess of the
copyright law.

The Securities and Futures Bill, when it becomes law, replaces all 10
existing securities ordinance and adds new regulations on Internet trading.
It will also tighten securities business in banks and make insider dealing a
criminal offence.

The banks said the main reason the bill was tougher than those of its
overseas competitors was that it required anyone to disclose interests in
shares which had not yet been issued - referring to newly issued shares held
if options were exercised.

Also, it required disclosure of their interests in listed companies arising
under cash-settled derivatives. In addition, it required banks to report on
short positions.

However, the government refused to make any alterations.

"Locally listed companies are smaller than their overseas counterparts,
making it easier for them to be manipulated by speculators," said Au
King-chi, Deputy Secretary for Financial Services.

"The stricter disclosure requirement [in the bill compared with]
international practices would be needed for Hong Kong to reduce manipulation
activities," she said.

Ms Au said the Hong Kong General Chamber of Commerce supported the bill to
require disclosure in the derivative markets.

"The government will not just hear the opinions of the large investment
banks, but we also need to listen to the ideas of the listed companies and
the local investors who have demanded more transparency."

The Pan Asian Securities Lending Association - a group of 33 companies which
conduct stock lending and borrowing activities, also complained that the
bill was too tough.

Its concern is that the bill is drafted too widely resulting in lender
agents being required to make the disclosure.

"None of the other global financial markets that have a formal securities
lending market treat securities lending as a disclosable event," the
association said in a paper given to legislators yesterday.

US bankruptcy bill aids derivatives
Risk - May 15, 2001
By Alexandra Ness

A US bankruptcy bill now in the last stages of congressional approval
contains cross-product netting provisions that should enhance the legal
status of credit, equity and weather derivatives, The hill updates the US's
10-year-old netting laws, which have been outstripped by the rapid
development of new types of over-the-counter derivatives markets.
Updating the netting provisions to include a wider range of OTC products has
been a priority for the International Swaps and Derivatives Association and
the Bond Market Association (BMA) since the mid1990s. In two high-profile
reports in 1999 by the President's Working Group - one on Long-Term Capital
Management and one on OTC derivatives regulation - US regulators
acknowledged that updating the netting law would reduce systemic risk.

Even so, Congress and the Bush administration do not see quick passage of
the bill as particularly urgent, and observers estimate it may take until
the third quarter for it to become law.

Cross-netting or mutual offset of obligations and liabilities is standard
for many transactions, including swaps, under current US law. The definition
of swaps has been stretched to cover forward rate agreements, forward
foreign exchange contracts and other instruments. But the current law does
not include equity and credit derivative contracts in its definition of
swaps. They fall under the nebulous term "other similar agreements' in the
code.

The current cross-netting provisions for derivatives were passed under the
Federal Deposit Insurance Corporation
Improvement Act (FDICJA) in 1991, and are reflected in ISDA's master
agreements. Since the passage of the FDICIA legislation, the derivatives
market has grown significantly. 'Friction developed between the swaps and
securities contracts with regard to netting across them," says Dan
Cunningham, a partner at Allen & Overy in New York and ISDA's legal counsel.

ISDA and the BMA have worked on this issue since 1995. Nearly all the
provisions requested by them have been included in the legislation. The
House of Representatives and Senate versions of the bill are currently being
reconciled, and there is little doubt that the netting provisions will be
included in the bill eventually sent to President Bush for his signature.

Among these provisions is the expanded definition of a swap agreement. At
present, swap agreements do not encompass any security agreements, credit
enhancements, guarantees or reimbursement obligations related to swap
agreements. By eliminating the non-specific phrase other similar agreements"
and expanding the definition of swap agreements to include equity, credit
and weather derivatives the new provisions allow for nearly all swap related
securities contracts to have the right of transfer and set-off. Currently,
security arrangements not specifically defined as swap agreements are
rejected as unqualified transfers and not netted.

"This bill will provide substantial legal certainties regarding securities
lending and will promote liquidity," says Seth Grosshandler, partner at
Cleary, Gottlieb, Steen & Hamilton, an adviser to the BMA in bankruptcy
legislation. 'Contracts will have expanded collateral and an array of
products to provide for safe harbour" Netting and settlement will be much
faster and more efficient under the new bill, he adds.

One area the new hill does not address his cross-affiliate netting. All
provisions in -the bill pertain to bilateral netting. Provisions for
cross-affiliate netting were deemed too complex to be included. The I BMA is
expected to propose an addition to the bankruptcy provisions to deal with
cross-affiliate netting in the third or fourth I' quarter of this year. U

Securities Trade Groups Argue Against Firm's Liability To Sophisticated
Investors for Certain Trades
BNA - May 22, 2001

The Bond Market Association, Futures Industry Association, and Foreign
Exchange Committee of the Federal Reserve Bank of New York told the U.S.
Court of Appeals for the Second Circuit May 21 that sophisticated investors
should not be permitted to sue financial institutions for carrying out their
"nondiscretionary" transactions in the credit markets, BMA said that day (de
Kwiatkowski v. Bear Stearns & Co., 2d Cir., No. 01-7112, 5/21/01).

In an amicus curiae brief, the groups urged that allowing such suits would
only lead to a '"heads I win, tails I sue' liability framework that would
'undermine the integrity and efficiency of the financial markets,'" BMA said
in a news release.

"This is a critically important case for the fixed-income industry," BMA
General Counsel Paul Saltzman said in the release. "If the appeals court
upholds the legal reasoning underlying the district court's decision,
counterparties will want juries to second guess every good faith action of
financial institutions and seek reimbursement for every losing trade," he
predicted.

The organizations sought the overturn of a decision rendered late last year
in the U.S. District Court for the Southern District of New York. Henryk
deKwiatkowski, a wealthy Canadian investor, had engaged in a series of
currency futures contracts and currency forward contracts that were
purchased on the Chicago Mercantile Exchange and the over-the-counter
markets. The contracts were carried out by Bear Stearns & Co. as a futures
commission merchant (FCM) and as principal, BMA recounted.

Responsibility With Customer

The district court decided that "special circumstances" supported a jury
verdict for Kwiatkowski and against Bear Stearns. However, the brief argued
that the responsibility for trading decisions in "nondiscretionary" accounts
rests with the customer and precluded liability in this instance for Bear
Stearns. '"Customers who suffer market losses should not be able to effect
an 'end run' around the carefully defined limitations on the duties of a
broker by alleging violations of some general duty of care," the groups
wrote.

The three groups contended that because a wide range of factors can affect
the market price of a futures contract, the imposition of '"any continuing
duty to furnish all price information and information of all facts likely to
affect the market price would be so burdensome as to be unreasonable."' In
this case, they said, deKwiatkowski's financial losses were brought about by
market factors.

"'De Kwiatkowski speculated that the dollar would appreciate--and he would
have profited handsomely if it had--but the Mexican debt crisis intervened,
the dollar fell, and he incurred losses,'" the brief said. "'Those are the
only 'special circumstances' of this case--yet they are precisely the sort
of circumstances that participants face in these markets day in and day
out,'" it said.

Reliance on Contracts

Because of the need for legal certainty, the credit markets must rely
heavily on contracts to permit market intermediaries and their customers and
counterparties to identify the precise nature of the products, services, or
functions being purchased, the brief observed. "'Market participants need to
be able to expect that other participants will be held to their contractual
allocations of risk for the markets to perform effectively and efficiently,
especially in the futures and OTC derivatives markets, where risk of loss
inheres in every trade.'" the three organizations urged. The absence of
certainty introduces risk, which can hurt market efficiency, liquidity, and
costs.

By disregarding precedents and New York law, the district court's opinion
runs counter to the legal certainty the markets require, the brief said.
"The district court in effect created a broad new 'malpractice' cause of
action against brokers regarding the 'handling' of accounts--which is
plainly at odds with New York law," the brief maintained.

The narrow scope of a broker's duty to a nondiscretionary account under New
York law applies fully to a futures broker, the groups wrote. Under
long-standing legal precedent, the duty owed by a futures broker to a
nondiscretionary account is an "exceedingly narrow one," relating to
properly carrying out transactions ordered by the customer, the brief noted.
Dealers have similarly narrow responsibilities, it argued. Market
intermediaries may agree to perform additional services, such as
discretionary trading and investment advisory services, but in the absence
of an explicit agreement, "'the risk of the venture is upon the customer,
who profits if it succeeds and loses if it fails,'" the brief summed up.

The limits of ingenuity
Financial Times - May 16, 2001

Is the pace of financial innovation slowing? To pose the question, when
global financial markets appear trapped in a perpetual maelstrom, may seem
quixotic. Yet the markets in swaps, options, futures and other derivative
instruments that emerged from the economic upheavals of the 1970s are now
relatively mature. Innovative dynamism is less evident.

That fact in no way belies the radical nature of the changes of the past
quarter-century. The balance of the global financial system has tilted away
from conventional tasks - raising capital and matching the needs of savers
and borrowers - towards the management of risk.

According to Alfred Steinherr, chief economist of the European Investment
Bank, the impact bears comparison with the creation of stock exchanges in
previous centuries. Some even argue that this financial revolution will
become self-sustaining, generating constant improvements in economic
efficiency. But what will drive that innovation in future?
The late Merton Miller, Nobel Prize winner and supporter of derivatives
markets, emphasised the facilitating role of new technology and the desire
to mitigate the costs of regulation and taxation. That was certainly the
pattern in the immediate postwar period.

Development in the 1960s of the eurodollar deposit market arose from the
regulatory ceiling on interest rates imposed on US commercial banks. The
eurobond market was a response to a new withholding tax on interest payments
to overseas investors in dollar bonds.

Yet the explosive growth of derivatives markets from the 1970s was driven by
something more akin to deregulation. The collapse of the Bretton Woods
exchange rate system shifted the task of managing currency volatility from
the public to the private sector. The resulting huge demand for insurance
against fluctuations in exchange rates and interest rates was met by swaps,
forwards, futures, options and so forth.

Computing and telecommunications power, developments in financial theory
such as the Black-Scholes option pricing formula and the profit-maximising
instincts of bankers and traders did the rest. Instruments originally used
for hedging in commodity markets became a large-scale financial phenomenon.

That said, regulation did encourage important innovations in the 1980s and
1990s that shifted financial business from one part of the system to
another. Increased capital requirements encouraged banks to push business
off-balance-sheet via derivatives trading and securitisation of loans. Hence
the phenomenal growth of the mortgage-backed securities market alongside the
derivatives markets.

A measure of the transformation can be seen in the market value of
outstanding over-the-counter derivatives, which are growing at the expense
of exchange-traded derivatives. At the start of 2000, outstanding OTC
derivatives amounted to $2,800bn according to the Bank for International
Settlements, or just over half the value of all outstanding international
debt securities.

That is up from $2,600bn in June 1998 but down from $3,200bn at the end of
1998, when after-shocks from the Asian crisis, the Russian default and the
near-collapse of the Long-Term Capital Management (LTCM) hedge fund
increased the need for hedges against volatility.

The picture is one of unspectacular growth. And, as Professor Richard
Brealey of London Business School points out, the academic world's
contribution in this area, though still prolific, has become less productive
in terms of innovation.
So it seems we are close to a hiatus in developing new markets, while new
products no longer proliferate at the same pace. Could there be a limit to
the efficiency gains that can be wrung from the global financial system
through innovation?

Robert Merton, the Nobel laureate, has argued that growing familiarity with
the use of derivatives and their capacity to reduce transaction costs will
continue to underpin a rapid pace of innovation. Certainly there is scope
for diffusion of derivatives around the world's less efficient markets.

Existing trends such as the transfer of business from banks to the markets
will, says LBS's Prof Brealey, continue. Newer instruments such as credit
derivatives are growing fast, although central bankers worry about their
robustness in a downturn.

Yet transaction costs remain stubbornly high in some markets where there is
an obvious job to be done - witness the thinness of the market in long-term
swaps. Moreover, there is a paradox in the way risk management acts on the
efficiency of the system.

Before the growth in derivatives, the cushion against unforeseen losses was
equity capital. It was a useful, if often expensive, protection against all
kinds of risk.

Hedging with derivatives removes the need for an all-purpose cushion because
it targets specific risks. The implication ought to be that this is an
efficient and cheap substitute for equity.

Yet, partly because bank supervisors remain sceptical about banks' ability
to control risks with derivatives, bank capital has in fact increased over
the past decade at the regulators' behest. So capital is probably being used
less efficiently in the financial system in spite of innovation.

A more fundamental critique of hedging comes from Daniel Ben-Ami who argues,
in a new book*, that the systemic tilt towards risk management is both a
consequence of, and an encouragement to, excessive risk- aversion.
The argument is provocative, coming so soon after the technology stock
bubble. But it coincides with the hedge funds retreating from big betting,
investment banks withdrawing capital from market-making and a dearth of
stabilising speculation in currency markets.

A more plausible case can nonetheless be made that increased risk-aversion
is happening mainly in central banks. The speed and complexity of
derivatives trading have completely outstripped their supervisory
capability. This has fuelled a tendency among central bankers to see every
financial tremor as a systemic threat that calls for last-resort lending;
or, in the case of LTCM, for broking a bank rescue.

Meanwhile, the enthusiasm with which financial institutions have shoveled
assets and liabilities off the balance sheet suggests a robust appetite for
risk in the face of unwelcome regulatory constraints. That appetite may have
been enhanced by moral hazard, whereby the existence of a safety net - the
central bank lender of last resort - encourages less prudent behaviour.

Either way, there will always be scope for increasing efficiency in the
financial system. More difficult is to forecast new customer demands of the
kind that arose after the end of Bretton Woods.

One might be the shift of social security and pension arrangements from the
public to the private sector. But this is a slow- burn affair, not an
explosion. While portfolio regulations for private pensions will encourage
regulatory arbitrage via derivatives, the scope for innovation is less
obvious than in responding to floating exchange rates and financial
liberalisation.

In retail financial markets, innovation has to cope with less sophisticated
users. It also operates more slowly. Maybe private individuals will hedge
more, in future, against reduced earnings, unemployment or fluctuations in
mortgage outgoings. But politics militates against a "big bang" removal of
the state safety net.

Perhaps the most interesting potential lies in a reversion from pure
financial hedging to tradeable insurance against real-world uncertainty. The
fledgling weather derivatives market, for example, holds promise.

But only a visceral optimist could assume that financial innovation will
continue at the pace of the past quarter-century. The coincidence of market
liberalisation, advances in computing and new financial theory in the 1970s
has had a truly explosive impact. But it is, by the same token, the kind of
rare historical event that does not repeat itself in a hurry.

Airlines and food and beverage firms targeted
IFR - May 19, 2001

As a true commodity, weather derivatives still have a long way to go. But
power and weather derivative officials at FOW's third annual Derivatives
Expo last week were encouraged by the new breed of end-users they expect to
see using weather derivatives, particularly airlines, food and beverage
firms, agricultural/fertiliser firms, and construction firms.

Airlines, especially those concentrated in a particular hub, could use
weather derivatives more actively since inclement weather can prompt many
more delays than they are used to, notes Claudio Ribeiro, head of new
products development, weather risk management group, Enron.

Food and beverage firms are also viewed as prime targets that could use
weather derivatives to manage their cashflows better. These companies are in
need of hedges since weather can increase or decrease a firm's sales
dramatically. Food and beverage firms typically benefit from warm weather,
but on occasion, a food chain, for example, can enjoy increased sales in
cold spells if the weather is extreme enough to keep customers indoors.

More firms are beginning to ask questions such as "If there's going to be a
really hot summer, how does that affect my bottom-line? What is my
systematic weather risk going to cost this summer?" adds Cameron Rookley,
financial economist at Caminus.

Use of weather derivatives by agricultural sector companies is also a
logical step, according to people in the industry, especially to hedge a
guaranteed sale. Though no underlying market exists, power and weather
derivatives providers have pinned their hopes on the growth of this market
in the supply and demand for derivatives.

"No one can buy a sunny day. What you can buy is just the cost of the risk
associated with that sunny day," says Ribeiro. The way to do that is by
entering into swaps and options with limits. The transactions are capped to
reduce aggregate exposure up to US$100m. The structures are mostly seasonal
and feature multi-year terms.

"Weather hasn't presented itself to-date to be sufficiently fungible for us
to build a broad market on, yet it's a pretty big market nonetheless," adds
Robert Levin, senior vice-president, planning and control development, at
the New York Mercantile Exchange.

Since September 1997, when the first weather derivatives trade occurred, the
market has experienced an estimated 4,500 weather transactions worth more
than US$6bn. Much weather derivatives use is occurring in the natural gas,
propane and electricity markets.

Markets are currently made in heating degree days (HDD), cooling degree days
(CDD) and variations such as collars, forwards and swaps. "Through the OTC
market, we can create any kind of structure," Ribeiro says.

One brake on faster growth of weather derivatives is the lack of historical
data. To compensate, a realistic hourly weather simulation engine is needed
that could replicate thousands of multi-regional weather scenarios, said
Rookley.

Such a model could capture seasonal and hourly patterns for normal
temperatures, the extent to which temperatures deviate from their normal
level, and the speed at which temperatures tend to return to the norm. It
would also handle a correlation across weather station pairings.

UK building societies' use of credit derivatives limited
IFR - May 19, 2001
By Jean Haggerty

The UK Treasury's legislation allowing building societies to use credit
derivatives to protect assets against borrower default may fail to bring the
societies into the credit derivatives market. Initial hopes were that the
Treasury's move a fortnight ago would prompt the societies to embrace
synthetic securitisations - and thus help fuel credit derivative market
growth. On closer examination, those hopes seem to be fading.

"It is unlikely to be a very big market. There are few building societies
remaining. Also, the assets suitable for synthetic securitisation are
relatively small," said Chris Carman, a vice-president within JP Morgan's
structured products group in London. Building societies' mortgage assets are
predominantly owner-occupied residential mortgages, and as such, they have a
50% capital weighting for Bank for International Settlement purposes.

"This weighting means that they have to hold at least 4% capital against the
asset. So, as a synthetic securitisation would only take the capital
weighting to 20%. A deal would produce limited capital savings," Carman
said.

It also means that, unlike banks with a large proportion of 100% weighted
assets, building societies have limited incentive to seek regulatory capital
relief via the transaction, said Simon Gleeson, partner at solicitors Allen
& Overy in London. As mutual societies, they are also not under pressure to
improve their return on equity, he noted.

While some smaller building societies may be candidates for synthetic
securitisations because they are cheaper and require less documentation than
traditional securitisations, others may not have concentrations large enough
to warrant the use of synthetic securitisations.

The smaller building societies that may be viable candidates for synthetic
securitisations, may not be able to build the infrastructure required to
otherwise actively trade credit derivatives, noted Janet Tavakoli, executive
director and head of structuring and engineering for credit derivatives at
WestLB in London.

Building societies would need to be securitising an asset pool of more than
E500m to warrant entering into the transaction because the cost of putting
together these transactions is quite sizeable, other industry officials
said.

Regulatory barriers

The Building Societies Commission (BSC), the industry's regulator, last week
sent letters to all 67 UK building societies, saying that only building
societies deemed to have sophisticated treasury departments will be able to
use credit derivatives products without asking for regulatory permission
ahead of execution. Only about 12 of the societies fall into that category.

A building society's ability to use credit derivatives hinges on where it
fits on a BSC-created spectrum that assigns eligibility based on criteria
such as sufficient experience in using derivatives and adequate systems to
capture and handle credit derivatives business. An institution ranked in the
middle of the five-tier spectrum will have to apply and to make a strong
case for why it should be able to use credit derivatives. Building societies
ranked in the last two categories will not be allowed to participate in the
credit derivatives market.

Even those building societies that have large mortgage books may reject the
idea of using synthetic securitisations, said Nick Rice, associate director
at Royal Bank of Scotland in London. "The top-tier building societies are
better rated. Therefore, issuing vanilla debt is easier than doing synthetic
securitisations," he said.

The rapid growth of the credit derivatives market has been spurred by an
increase in synthetic securitisations. The British Bankers Association (BBA)
last summer projected that the credit derivatives market would reach
US$1.5trn (notional outstanding) by 2002. In 1997, before synthetic
securitisations were used as a method for mitigating risks, the BBA
estimated the credit derivatives market at roughly US$180bn.

Building societies are most likely to use synthetic securitisations in new
product areas as a way to transfer out the risk related to a new product or
for transferring the risk of higher-weighted assets, industry officials
said. Buy-to-let mortgages might prove to be an area that is ripe for
synthetic securitisation as they are 100% weighted in the UK, said JP
Morgan's Carman. "Building societies could also look to [synthetically]
securitise some of their commercial lending," he added. For this, too, they
would need to hold 8% regulatory capital, he said.

The changes enabling building societies to use credit derivatives occurred
because the BSC's regulatory jurisdiction over building societies is being
transferred to the FSA in November. "When the new Basle Accord comes in,
building societies will be subject to the FSA's bank rules. They will be
forced to look at their credit risk management," said Simon Firth, partner
and head of the derivatives practice at Linklaters in London. Under the new
Basle proposal, building societies will have the option of using a 50%
capital weighting against residential mortgage assets or using an internal
risk-based approach.

Mortgage guarantees

According to some industry officials, building societies' current practice
of using insurance to reduce borrower risk may turn out to be what prompts
them to enter the credit derivatives market.

"Theoretically, credit derivatives could take the place of mortgage
guarantees. You could say, 'Instead of getting an insurance policy each time
someone takes out a loan, why not do a portfolio trade?'," said Firth.
Unlike credit derivatives, mortgage guarantees carry an insurance premium
tax. It is unclear how the cost of using mortgage guarantees compares with
credit derivatives, however.

The ban on UK building societies' use of credit derivatives dates back to
the 1986 Building Societies Act, and subsequent amendments to it, that
preceded the development of the credit derivatives market. The societies
have been able to use only interest rate and foreign exchange derivatives.
The order allowing them to use credit derivatives comes into force on July
1.

West coast blues
Risk - May 2001

It has been a good quarter for the big US energy trading firms. Enron and
Dynegy, two of the largest, posted exceptional first-quarter results last
month, buoyed by their wholesale energy trading businesses. Enrons revenues
increased by 281% over the corresponding period of 2000, while Dynegys more
than doubled. But the news out of California - the country's largest
electricity market and an area where Enron, Dynegy and a host of other
energy marketers are active - is unremittingly bad. California utilities and
state agencies owe the energy trading firms billions of dollars, and their
credit is deteriorating fast.

Pacific Gas & Electric (PG&E), California's largest utility, filed for
bankruptcy protection early last month, and there are mounting concerns
about the creditworthiness of Southern California Edison and even the state
government, the energy buyer of last resort. California officials have yet
to devise a way to extricate the region's utilities from the quagmire caused
by its mid-1990s electricity market deregulation plan - which disastrously
combined retail price caps, a prohibition on hedging and unlimited wholesale
price exposure.

The energy marketers say the California crisis will have little effect on
their results. Jeff Skilling, president and chief executive officer at Enron
in Houston, said in an April 17 conference call held to discuss its
first-quarter earnings that the California crisis had no material impact on
earnings to date, and would have no adverse impact for the rest of the year.
Dynegy officials, in a conference call the same day, echoed the sentiment,
saying they had sufficient reserves and "expect to get paid every cent they
are owed" from California's energy buyers.

Some observers are less sanguine. "The energy marketers say earnings are
good, but these big P&Ls [profit and loss statements] are not cash - so much
cash is being absorbed by collateral," says Jean-Paul St Germain, principal
consultant at Risk Capital Management (RCM) in New York. "And these firms
are owed boatloads of money."

Most energy trading firms claim to have hedged their books against market
risk. But St Germain argues that their re
cent performance indicates otherwise. The high earnings the trading firms
are reporting show that they take a strong view on the market. "These firms
made a lot more money than expected - that means they're not hedging
correctly," St Germain says. "They weren't gamma hedged," he says. "Gamma
will kill them if the market goes the other way."

The energy trading firms will not discuss the methods and extent of their
market risk hedging. But Skilling said that, for each trade, "when it closes
we have the position hedged". Part of this is a function of Enron's own
capacity. "We continue to develop new generating capacity, which provides an
inventory of future capacity sales and low-cost, high-value optionality in a
highly volatile market-place," Skilling said.

The real danger for energy traders is not market risk, but - as PG&E's
bankruptcy illustrates - counterparty credit risk. This has focused the
minds of traders on proper documentation, collateral management, termination
provisions and related issues.

"For credit and trading organisations, it has always been a huge issue,"
says Blake Herndon, director of risk management at the Williams Companies in
Tulsa, Oklahoma. "The volatility has highlighted it throughout the
industry," he says.

Audit
David Yeres, a partner specialising in derivatives law at Clifford Chance
Rogers & Wells in New York, says: "A number of our clients have asked us to
do a contract audit in response to the scrutiny management is giving to
these exposures and the adequacy of the documentation."

Mark Haedicke, managing director and general counsel at Enron Capital and
Trade Resources in Houston, says: "It is the credit-related provisions that
are most important: the termination provisions, netting, collateral
thresholds." He adds:
"We work very hard at upgrading our contracts, We're analysing our contracts
in light of market changes and our experience in California."

Haedicke says there is currently a wide spectrum of contracts in use in
California, from very basic short-term sale tariffs to very sophisticated
master agreements. The standard contract for California power trading is
sponsored by the Western Systems Coordinating Council (WSCC), an industry
group that monitors power generation and distribution in the western US.
This contract, while widely used, does not have state-of-the-art termination
and set-off netting provisions.

A new master agreement published last year by the Edison Electric Institute
(EEl), a Washington-based electric industry group, contains many
cutting-edge provisions. It has a structure similar to the International
Swaps and Derivatives Association's master agreements. Although it is not
yet widely used in California, it is gaining adherents.
"We love the EEl master; it's an excel-lent form," Haedicke says. "Prior to
starting to use the EEl about nine months ago we had our own form, which
basically took all the financial trading provisions out of the ISDA master
and put it into a power trading context."

Clifford Chance's Yeres expects that I the California crisis will accelerate
acceptance of more-sophisticated master agreements. Counterparties are eager
to do business on a single counterparty to single counterparty basis,
governed by a master that allows netting, he says.

The EEl master is designed so counterparties can adjust its provisions to
suit their credit risk management policies. "There is a lot of optionality
built into the master," says Andy Katz, director of industry legal affairs
at the EEl. 'For instance, you can set up any kind of structure using
collateral threshold amounts or guarantees, or any type of credit support
mechanism. I know a lot of the suppliers have added quite a bit of
additional language for transactions with the California Department of
Water, Resources [CD~I'R - the state agency that now purchases power on
behalf of the utilities]," he says. Concerns over the state's own credit
quality are affecting the CDWR's level of credit risk.

Some traders believe the WSCC's document is adequate, as long as
counterparties keep counterparty risk standards tight. "The WSCC has done
well for us over the last five years," says Kevin Fox, senior vice-president
and general manager of the commodity service division at Aquila in Kansas
City. Fox says Aquila's main response to the California crisis has been to
keep a close eye on its counterparty risk. "If we had a lot of positions
with one counterparty we would put on countervailing positions to flatten it
out," he says.
Despite the conflicts between counterparties in the California energy
market, the EEl master has not, itself, been tested in court. However, the
concepts contained in the EEl master that are similar to those in the ISDA
master agreement. which has stood the test of time and been proven in court.

ISDA itself has an initiative under way that, when complete, could benefit
energy marketers operating in California. It is looking at ways to expand
its master agreement to cover both physical and financial transactions.
Haedicke, who is an ISDA board member and chair of the energy and developing
products committee looking into this, says: "It would be a much more
efficient world if we could find a way to use the ISDA master for both
physically and financially settled transactions, and find a way to net
across physical and financial

Collateral
Collateral is another area being scrutinised in the wake of the California
crisis. "The energy trading firms will, not only look harder at
creditworthiness, but also, more importantly, they will reconsider their
policies on collateral," Clifford Chance's Yeres says. "Traditionally,
energy firms have not been as collateral conscious," he says, but they are
now becoming much more so.

An important part of this, especially when price volatility is high, is the
need to tighten-up mark-to-market requirements for collateral, Yeres says.
Counterparties are eager for more frequent and accurate mark-to-market
provisions, and for terms that give the party with the net exposure the
right to receive collateral promptly.

For contracts that are not written with adequate, or even any, collateral
provisions, there is still a way for counterparties to manage their credit
risk, if they have written their contracts under New York law, Yeres says.
Under the concept of "adequate assurances" in New York law, a party to a
forward contract with "reasonable" grounds to be insecure about the ability
of its counterparty to fulfill its responsibilities may demand performance
assurance such as collateral. If the demand is denied, it may be able to
terminate the contract. Market participants say this is not standard
practice, although many contracts are written under New York law because the
courts have a strong understanding of, and long track record with,
derivatives litigation.

Termination and settlement provisions are also vital. "Depending on
documentation, some energy traders [have] been able to terminate and
close-out transactions at an earlier stage than others using the so-called
'early termination events'" Yeres says. These include cross-default
provisions, not only with the counterparty's other credit agreements, but
also increasingly with the credit agreements of its affiliates.

Settlement provisions are also important. If a party terminates a contract
early for failure to deliver or some other reason, the contract must specify
how the compensation will be calculated. "From the early days of this
market, it has been apparent that the old terms like force majeure don't
work unless there is a price attached," RCM's St Germain says.

There is a debate over whether compensation should be based on a market
quote or on liquidated damages. This is a controversy typical of new
markets; participants in the bandwidth trading market are trying to reach a
durable accord on the same topic (Risk November 2000, page 28). Generally,
the market's preference depends on liquidity, Yeres says. Where the market
is not fully liquid and quotes are not reliable, participants use liquidated
damages.

A final area where contracts are being scrutinized in dispute resolution.
There is currently no consensus on this topic. Different market
participants reflect their institutional preferences. For example,
financial institutions highly value the predictability of litigation, while
trading companies have been satisfied with arbitration, which is faster,
Yeres says. He predicts that, as transaction sizes grow, the trading
companies will begin to value litigation's predictability over arbitration's
speed.

Strategies
To survive the California crisis intact, trading and power supply firms must
have -sound credit risk hedging strategies. For -example, before PG&E's
bankruptcy, Dynegy, Reliant Energy, Duke Energy and Mirant all set aside
reserves against their exposure to the utility. Calpine, a San Jose,
California independent power producer, did not, and its stock has suffered
since PG&E's bankruptcy filing. The utility owed Calpine $297 million as of
March 9.

Some energy marketers are rumoured to have sold short PG&E and Edison
International, the parent company of Southern California Edison, in the
second half of 2000. Others have sought protection in the credit derivatives
market, but default -swap spreads on PG&E and Edison widened rapidly last
summer after the ex- -tent of the energy crisis became apparent, and
protection quickly became unavailable. In either case there is substantial
basis risk, but the hedges should have provided some protection nonetheless.

Traders say that, above all, aggressive counterparty credit risk management
is crucial. In his earnings conference call, Enron's Skilling said his firm
calculates the credit quality of each of the more than 5,000 counterparties
in its portfolio. "At
the end of the day, we run our credit exposures against that and it kicks
out what we need to reserve. We have done this for a decade. Our credit
reserves are significant and totally a function of what's -happening in the
market-place every day." Aquila's Fox agrees: "Basically, we have been
setting our credit exposure limit to each counterparty based on the high
prices we began to see last June."

Despite this, many trading companies still have to endure long and uncertain
workout processes. Enron and other trading firms have been appointed to
PG&E's creditors' committee. The PG&E bankruptcy process promises to be long
and contentious - not least because the company will find it hard to form a
business plan until Californian politicians and regulators agree on a
solution to its energy crisis. The costs and opportunity costs of working
through this debacle should ensure that the lessons of the California crisis
are long remembered.

European settlement systems under fire
Financial Times - May 22, 2001
By Vincent Boland

Central securities depositories and futures exchanges need to co-operate on
the "recurring problem" of unsuccessful transactions in the European
securities markets, according to the International Securities Markets
Association.

ISMA said yesterday representatives of its European repo committee had held
"a frank and open discussion" with CSDs to address the issue of settlement
failures - transactions where one or other party to a deal fails to settle
its end of the bargain on time, or at all.

While allowances would be made for the nature of the market, a "major factor
contributing to the relatively high level of settlement failures in the
European securities markets is the fragmentation of settlement systems, the
large number of clearing and settlement depositories, and the different
time-frames within which each custodian operates".

ISMA said these bodies needed to work together in a constructive way to
provide a more harmonised security settlement environment in Europe to
"substantially reduce" the number of failed transactions.

The organisation's intervention will increase pressure on Europe's 26
different clearing and settlement systems to speed up co-operation so costs
can also be reduced.

US banks and investors claim processing transactions in Europe costs up to
seven times as much as in the US, where most clearing and settlement is
handled by the Depository Trust & Clearing Corporation.

**End of ISDA Press Report for May 22, 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