Credit Derivatives And Their Risks Are on the Table
By HENNY SENDER
Staff Reporter of THE WALL STREET JOURNAL
September 15, 2005; Page C1
The New York Federal Reserve Bank is gathering the big Wall Street players today. The topic: rising concerns about risk in what is known as the credit-derivatives markets.
The talks come amid frustration about the failure of the structure of the market to keep pace with the explosive growth in the trading of these complex securities.
"People have the best intentions, but there are resource issues," says Donna Parisi, head of the derivatives practice at the law firm of Shearman & Sterling. Credit derivatives, which allow investors to take positions on the risk of default of both companies and countries, have been one of the most rapidly growing financial products on Wall Street.
Infrastructure issues that have bedeviled the market involve processing and settling trades, or what some experts such as Thomas Russo, vice chairman of Lehman Brothers Holdings Inc., refer to as the "plumbing of the market." Such descriptions sound boring and technical. But the credit-derivatives arena has become increasingly important in terms of managing investment risk, which means regulators are eager to ensure that these complex and often opaque markets operate smoothly.
Thus far, their proddings have largely gone unheeded, leading to the unusual summit at the New York Fed.
The love-hate relationship between Wall Street firms and their hedge-fund clients has grown more acrimonious when it comes to credit derivatives. Hedge funds claim that Wall Street firms are reluctant to move to more efficient electronic trading and processing systems, because such a move would crimp the Street's margins. The dealers in turn say that hedge funds have been reluctant to invest sufficient funds in their back offices, and that it is the hedge funds, not Wall Street firms, that are the problem.
In any case, the result is stacks of paper at both hedge funds and at Wall Street firms. And the paper load is growing, as the labor-intensive review of documents and agreements confirming trades falls increasingly behind the growing volume of new trades.
"The burden gets bigger and bigger," says Robert Pickel, head of the International Swaps & Derivatives Association. ISDA provides master agreements for trades in the credit-derivatives market, but there is often a lot of debate about basic definitions of the trades, especially on what constitutes a default. The agreements "are only a partially completed canvas," adds Mr. Pickel.
The spotty record of confirmations can become a risk-management issue in times of turbulence. Such conditions occurred in May, when the gap between safer Treasurys and less-safe corporate bonds widened sharply. The trading turmoil that month has prompted several reviews of the market, with regulators trying to get a stronger handle on how best to ensure smoothness in the credit-derivatives market.
Valuations are another issue of contention. Since credit derivatives can be illiquid, hedge funds can garner a wide range of estimates on what a given position might be worth. Indeed, two different areas within a single investment bank have been known to give widely differing quotes on a given credit derivative, hedge-fund managers say. Who gets to say what a position is worth in times of volatility is an even more troubling issue, especially since it is such a critical element in assessing hedge-fund performance and the risk exposure of firms dealing with the hedge fund.
The Fed is also tackling the related, highly arcane issue of assignment. Hedge funds sometimes move out of trades -- "assign" them -- without telling the bank that sold them the credit-derivative contract. This practice makes it harder for other market participants to know whether their positions are properly hedged.
While the purpose of the meeting is simply "to discuss how best to address a range of important issues," according to the letter sent to 14 industry participants and a variety of international regulators, there is always the implicit threat of regulatory action.
"When things get relegated to the support areas, they sometimes often do not get the attention they deserve," says Mr. Russo, who was part of a private-sector group led by former New York Fed Chief Gerald Corrigan that looked at such risk issues. "Meetings such as those sponsored by the New York Fed are sometimes necessary to shine a light on a problem, mobilize people and bring about positive action."
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