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LONG TERM EFFECTS OF LONG TERM CAPITAL MANAGEMENT: RECENT DEVELOPMENTS IN THE REGULATION OF DERIVATIVES
Policymakers Weigh Options for Derivatives Regulation
The financial markets were in turmoil. Many prominent players had large, highly leveraged portfolios of illiquid investments. Rumors of serious liquidity problems possibly leading to the failure of a high-flying financial institution were all over the Street. There was a real danger panic selling would trigger a landslide of bankruptcies and cross defaults, with grave consequences for the economy. The question was, what could anyone do to put things right? In 1907, when the financial problems of Knickerbocker Trust precipitated a run on the banks, J.P. Morgans answer was to summon the leading financiers of his day to meet with him in his library, where they hammered out agreements for cash infusions to end the crisis. In September 1998, with neither J.P. Morgan nor his library readily available, and the hedge fund Long Term Capital Management (LTCM) facing imminent collapse, the Federal Reserve Bank of New York contacted a consortium of LTCMs counterparties to find an alternative to a fire-sale liquidation of LTCMs portfolio of swaps, options and other derivative instruments. They did, agreeing to provide $3.5 billion in new capital to LTCM, thereby avoiding a crisis. Even before the LTCM bailout, there was pressure for increased regulation of the derivatives market. The derivatives market has sometimes been viewed by the general public, and even by otherwise sophisticated regulators, policymakers and investors, with a mixture of curiosity and alarm. Twenty years ago, when the derivatives market was smaller and the community of end-users relatively limited, this did not present a problem. Since 1990, however, corporations, hedge funds, financial institutions and governmental entities have increasingly relied upon derivatives to help them unbundle risks, increase investment yields by leveraging their capital and hedge against fluctuations in interest and foreign exchange rates. As a result, the notional value of outstanding derivatives contracts reported by United States commercial banks has increased at a compound annual rate of approximately 20% since 1990, to a total of $33 trillion by the end of 1998. Of this $33 trillion, only $4 trillion were exchange-traded derivatives subject to regulation by the Commodity Futures Trading Commission (CFTC) under the Commodity Exchange Act (CEA). The remaining $29 trillion were over-the-counter (OTC) derivatives, which generally are exempt from all or almost all of the provisions of the CEA. Not only has the notional value of outstanding derivatives contracts increased, but new end-users such as pension funds, insurance companies, local municipalities and school districts have steadily entered the market, and derivatives have been used to perform an ever-widening variety of risk management functions. Chairman Greenspan has characterized the dramatic growth of the derivatives market as by far the most significant event in finance during the past decade. The LTCM crisis, however, has forced public and private policymakers to seek a better balance between the benefits provided by the derivatives market and the risks associated with derivatives trading lack of transparency, the high degree of leverage of many market participants and the potential for significant future credit exposures in the event of defaults. These efforts are ongoing, with many works in progress, but two things are already clear. First, no sector of the global economy stands in isolation from the derivatives market. Second, changes are occurring rapidly in the regulation of the derivatives market, best practice for disclosure of derivatives trading activities, and in other market practices and conventions. Though the full impact of these changes has not yet emerged, the process warrants close attention. This issue of Stroock Capital Markets focuses on the current status and policy implications of the debate. We examine proposals to close regulatory gaps by groups such -1-
as the Basel Committee on Banking Supervision (the Basel Committee) and the International Organization of Securities Commissions (IOSCO). These include proposals to improve regulatory disclosure and reporting and proposals to improve supervisory oversight of highly leveraged institutions active in the derivatives market. We also look at efforts to improve market practices and conventions to develop best practices by groups such as the Counterparty Risk Management Policy Group (CRMPG) and the Foreign Exchange Committee of the Federal Reserve Bank of New York. Our next issue of Stroock Capital Markets looks at other developments affecting the derivatives market, including FASB Statement No. 133 (Accounting for Derivatives Instruments and Hedging Activities), developing best practices for credit risk management and disclosure, and the continuing debate on reauthorization of the CFTC.
disclose information generated by their internal risk measurement and management systems concerning their risk exposures and their actual performance in managing those exposures (so that public disclosures are consistent with internal approaches used to measure and manage risk). The difficulty, of course, is determining what information would provide a clear picture of the risks associated with an institutions trading and derivatives activities. Balance sheet leverage alone does not fully reflect the fragility of an institutions portfolio. Off-balance sheet exposure information, such as market, credit and liquidity risks, is also important. The Presidents Working Group Report suggests using an alternative measurement, such as the ratio of potential gains and losses to net worth. Obviously, an important first step will be settling on a core set of data regarding the risk exposures of institutions, and agreeing on the manner in which off-balance sheet exposure information should be presented and the frequency with which information should be publicly disclosed in financial statements or otherwise. Disclosure to Regulators In addition to financial statement disclosure, several of the reports recommend voluntary disclosure by institutions to their primary regulators. However, the reports emphasize the need to tailor disclosure to the size and nature of the disclosing institutions trading and derivatives activities. As noted in the IOSCO/Basel Report, some institutions are wholesale market makers in a range of cash and derivative instruments, while others primarily use derivatives for their own risk management purposes. The extent of information disclosed about trading and derivatives activities should relate to the importance of these activities in the institutions overall business, earnings and risk profile. With that in mind, the CRMPG Report recommends voluntary disclosure by financial intermediaries to their primary regulators regarding significant counterparty credit and/or market exposure. The report acknowledges the importance of such financial intermediaries and regulators reaching agreement on permissible uses of such information and safeguards against its misuse. The CRMPG Report suggests disclosures be made on a consolidated basis, listing the ten largest exposures of such financial intermediaries in any of four categories: (1) current replacement cost (measured at market), including the benefit of netting agreements (if there is a high degree of confidence such agreements will be legally enforceable), but before consideration of any relevant collateral; -2-
(2) current net of collateral exposure, measured as replacement costs minus the market value of collateral, where there is a high degree of confidence about the enforceability of the security interest; (3) current liquidation exposure, measured as net of collateral exposure using estimated liquidation values of contracts and collateral, rather than current market values; and (4) potential exposure of OTC derivatives positions and non-regular way settlement trades (i.e., forward).
Disclosure of Market, Credit and Liquidity Risk and Risk Management Controls
The reports highlight the need for improved public disclosure by institutions of both qualitative and quantitative information about their trading and derivatives activities, including disclosure regarding market, credit and liquidity risk and risk management controls. Among their recommendations are the following: Risk Management Controls Institutions should provide (to regulators, in financial statements or otherwise) a general overview of their risk management and control structures and processes, including a description of how risks arise and how they are measured and managed. The overview should include, for example, discussion of limit policies for exposures to market and credit risk, and an explanation of how value-at-risk measures are used to manage credit risk. Market and Credit Risk The reports include many recommendations for improving disclosure of market and credit risk. Among other things, institutions are advised to summarize their policies for measuring and managing market and credit risk, and to supplement their quantitative disclosure of market risk with, for example, discussion of the material assumptions and parameters of their internal risk models and their method of aggregating risk, including the extent to which internal models assume less-than-perfect correlation among an institutions various risks. The reports also recommend disclosure of the procedures used for portfolio stress testing and the methodologies used to develop stress testing scenarios. Liquidity Risk - Exposure to Highly Leveraged Institutions Improved disclosure of liquidity risk is viewed as an important mechanism to limit what the Presidents Working Group Report describes as the potential
contagion effect of financial problems originating in one firm and spreading quickly, due to illiquidity problems and the interdependence of highly leveraged financial institutions in the global economy, to infect other firms. As noted in the report, neither SEC rules nor generally accepted accounting principles provide specific guidance for disclosure by companies with material exposures to significantly leveraged financial institutions. The Presidents Working Group Report proposes closing this regulatory gap by requiring public companies to disclose such exposures in the Managements Discussion and Analysis or Description of Business sections of their periodic disclosure reports on Form 10-K and 10-Q.
relationships, the investments they make and meaningful measures of future credit exposure. Both the CRMPG Report and the Presidents Working Group Report emphasize the responsibility of senior management and boards of directors for monitoring an institutions trading and derivatives activities. This responsibility includes: understanding the strengths and weaknesses of the institutions risk measurement systems, including model risk, liquidity risk, and risk of breakdown of historical correlations among different instruments and markets; and having a realistic assessment of the institutions tolerance for risk, including potential losses in adverse markets. The Presidents Working Group Report also notes the importance of senior management and boards of directors developing a clear understanding of legal risks, including contract enforceability and uncertainties concerning different legal regimes in different countries, and implementing procedures to ensure that such risks are controlled.
(g) valuation practices for derivatives and collateral; and (h) procedures for close-out and liquidation of contracts and collateral. The CRMPG Report reviews risk management market practices and conventions in a number of these areas, and sets forth the CRMPGs recommendations for improving them. Among these are recommendations to improve the quality of internal risk management tools for estimating counterparty exposure and risk, and for managing that exposure and risk. The intent is that these improvements lead to improved credit practices, risk analysis and senior management reporting. Among the specific recommendations in the CRMPG Report are the following:
reflect the cost of credit risks in internal risk or capital charges, procedures for proactive adjustment of counterparty credit limits, and tools for periodic evaluation of the adequacy of credit valuation adjustments to asset carrying values; and development and use by financial intermediaries and large trading counterparties of independent price verification procedures that include fair value adjustments to mid-market values which are assessed dynamically and consistently to account for, among other things, illiquidity characteristics of complex instruments or positions, any substantial specific repayment concerns, and operational and model risks associated with complex or large positions.
counterparty on all material terms to the trade and written evidence of their binding agreement. In addition, procedures should be in place to track unexecuted masters, unsent confirmations and unaffirmed trades. Finally, controls should be developed to ensure that senior management receives reports regarding material deviations from documentation policies.
To address these problems, the CRMPG Report recommends revising documentation to ensure a non-defaulting party has the flexibility to value transactions in a good faith and commercially reasonable manner as is already the case with the TBMA/GMRA and FEOMA standard form agreements and ISDAs Loss methodology. Because a commercially reasonable valuation contemplated by the Loss methodology will often involve use of market quotations, the report also recommends enhancing the effectiveness of a market quotation technique. Among other things, it recommends modifying the Standard ISDA Master Agreement and Schedule to provide that: Potential quotes provided by third parties may include not only price, but also yields, yield curves, volatilities, spreads or other relevant inputs. These inputs should be based on the size of the transaction, the liquidity of the market and other relevant factors. The number of third parties from whom inputs are sought may be reduced. Third parties from whom inputs may be sought may include not only dealers, but also major end-users, third party pricing sources or other relevant sources. Market quotations are but one means to achieve good faith valuations and may be by-passed when, in the judgment of the non-defaulting party, they are unlikely to produce a timely and commercially reasonable result.
regulatory requirements in a number of jurisdictions including the United States also interfere with the implementation of such mechanisms. The following is a summary of some current proposals to enhance payment netting, cross-product obligation and collateral netting and set-off: Payment Netting The CRMPG Report recommends revising documentation to provide for netting of all amounts (in a single currency) that are payable on the same day. At a minimum, the report notes, documentation should provide for payment netting across like kind transactions. A more effective approach, the report concludes, is to permit payment netting across multiple products using the mechanism of a master agreement or a master-master. Cross-Product Obligation and Collateral Netting Both the CRMPG Report and the ISDA 1999 Collateral Review recommend development of documentation permitting cross-product netting and cross-product collateralization of a wide range of products. The CRMPG Report recommends parties facilitate obligation netting and collateral netting across product lines by using, when possible, multiproduct master agreements, and master-masters. If the parties do not have the ability to net collateral, the report recommends modifying documentation (subject, of course, to applicable law) to permit the secured party to retain excess collateral to secure the pledgors other obligations to the secured party. Set-off The CRMPG Report recommends several modifications to standard documentation to permit non-defaulting parties to exercise broad rights of set-off. In addition to the right of the non-defaulting party to set off against obligations of the defaulting party, and the right of the non-defaulting secured party to transfer excess collateral to an affiliate to secure obligations of the pledgor to the affiliate, these include set-off rights with respect to the following: obligations of the non-defaulting party (or affiliates of the non-defaulting party) to the defaulting party
under other transactions or documentation; collateral or property of the defaulting party held by the non-defaulting party (or affiliates of the nondefaulting party) under other transactions or documentation; obligations of the non-defaulting party to affiliates of the defaulting party under other transactions or documentation; collateral or property of affiliates of the defaulting party held by the non-defaulting party under other transactions or documentation.
Coming Soon Stroock Online, a monthly newsletter about legal issues affecting business on the Internet. Whether your focus is online securities trading, or advertising and promotion on the Internet, or E-commerce generally, we think Stroock Online will be of interest to you.
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Stroock Capital Markets is a publication of Stroock & Stroock & Lavan LLP. 1999 Stroock & Stroock & Lavan LLP. All Rights Reserved. Quotation with attribution is permitted. This newsletter offers general information and should not be taken or used as legal advice for specific situations which depend on the evaluation of precise factual circumstances. For further information on the material contained in Stroock Capital Markets or other matters related to Stroocks practice, please contact Richard Fortmann (Editor) (212) 806-5522.
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