SURVEY - DERIVATIVES: Market participants react to regulatory straitjacket: REGULATION by Rebecca Bream: Markets fear too much regulatory scrutiny will hamper product innovation
Financial Times, Sep 25, 2001
By REBECCA BREAM
As afast-growing and little-understood market, derivatives have attracted much attention from regulators and prompted discussion about how investors can be protected. Derivative products generate concerns that as well as individual buyers, whole banks or even the financial system could be at risk in some way from irresponsible and undisclosed leveraged speculations.
The debate between marketeers and regulators and other concerned parties has been particularly fierce in the credit derivatives market. Earlier this year Bank of England deputy governor David Clementi warned in a speech about credit derivatives that "these instruments might equally be used to concentrate risk as to disperse it".
Bankers have been eager to rehabilitate the reputation of their business. "The premise has been that banks would use credit default swaps to take large exposures to single name credits, and that this would be able to be hidden," says Sanjeev Gupta, head of developed markets credit derivatives at CSFB. "This has not happened; in fact, banks already take larger exposures through the loan market."
The derivatives market has been affected by several new regulatory decisions in recent years. In the US the Financial Accounting Standards Board several years ago introduced FAS 133, a rule that requires companies to disclose all their derivative market positions when they publish their results.
FAS 133 was greeted with much trepidation by most US companies, and some bankers predicted that there could be less corporate use of derivatives because of the extra accounting work involved or the fear that losses in the markets would be revealed.
However, now that FAS 133 is accepted as a standard, the impact is less clear and there has not been a marked drop in companies' use of derivatives. Some maintain that FAS 133 is leading to greater confidence in derivative products precisely because of the stricter regulation, making the market easier to understand.
The Basle Accord on banking regulation is also set to affect the market, especially in credit derivatives. While credit derivatives can reduce the amount of bank capital that must be set aside for each debt holding, the Basle recommendations include a formula known as the 'W' factor to determine how much capital a bank must reserve.
The Basle committee contends that credit derivatives are riskier than other risk management tools and so more bank capital should be required. But bankers accuse the regulators of trying to stifle innovation in the market. The International Swaps and Derivatives Association (ISDA), is currently consulting market participants and hopes that the issue will be resolved by the end of the year.
But the biggest issue in the credit default swap market, contracts that are written on individual, mainly investment grade corporate debtors, is that of standardising documentation. Default swaps are rarely triggered, although default and debt restructurings are becoming more common as the world economy weakens. However, recent cases have ended in dispute about whether contracts should be triggered by restructurings as well as defaults, and how contracts should be settled in the event of a pay-out.
"In 1999, ISDA introduced a default swap contract which became the market standard. Prior to that, contracts were agreed on a bilateral basis and so there were often differences in the terms," says Robert Heathcote, European head of credit derivatives at Goldman Sachs. "Since then, there have been refinements in the contract and it is an ongoing process."
ISDA has now introduced revised definitions of what constitutes a negative credit event, and has restricted the sort of debt that can be delivered to the protection seller at par. Protection buyers now choose what level of protection they want to pay for, with default swaps offering features trading at different prices in the secondary market.
"It is inevitable that not all products traded will carry the same level of protection," says Richard Williams, head of credit derivatives at Abbey National. "If you try to force everyone to trade everything in the same way, there would be very few opportunities in the market."
The next issue for the credit derivative market to iron out is the so-called 'successor issue', regarding what happens to the value of credit derivatives when the company they refer to is broken up or restructured.
ISDA expects to reach a conclusion later this year. "No matter how much ISDA refines the contracts, there will always be situations where credit derivative traders will require intensive legal support to interpret credit derivative contracts," says Tim Frost, head of European credit derivatives at JP Morgan.
Although differences of opinions may be natural, bankers are keen to avoid ugly lawsuits between banks or flat refusals to pay-out.
"It is in the market's interests to agree a standard practice so it does not get caught in a gridlock," says Arne Groes, head of credit derivatives at ABN Amro.
Copyright: The Financial Times Limited
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