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To: Marty Rubin who wrote (106)	11/6/2001 6:50:29 PM
From: Marty Rubin	Respond to of 120

SURVEY - DERIVATIVES: All bets on hold as market waits out crisis: The US crisis has created turmoil for the equity and bond markets but that is what derivatives thrive on Financial Times, Sep 25, 2001 The financial markets have suffered a severe shock from the terrorist attacks on New York and Washington on September 11. Everything that was being planned - from mergers and acquisitions to the launch of cutting-edge derivatives instruments - is now under review, cancelled or postponed. The watchword now is risk. Already we have witnessed a big switch into the least risk-averse instruments - short-dated government bonds, for the most part. Yet derivatives markets should be beneficiaries of investor behaviour. By their nature they are creatures of risk, volatility and uncertainty. This year had been shaping up as a landmark year in the derivatives industry. The credit derivatives sector has seen the most spectacular growth, since credit risk has been rising in a weakening economic environment and protection against it was becoming a leading concern for investors and companies. The growth of the credit derivatives business has also proved a lure for insurance companies, looking to diversify their own risk portfolios outside their traditional business areas. One result of this, bankers say, was the prevalence of regulatory capital arbitrage deals, with banks, which are looking to utilise their own capital, happy to pass on chunks of their risk exposure to those such as insurance companies, seeking diversification. "The awareness of credit risk is very high in the corporate market," says a senior investment banker. "That creates opportunities for insurance companies to come in and take on that risk. They are looking for a diversified portfolio of risk - property, casualty, credit, etc. They are pretty active, especially at the low-value, plain-vanilla end of the market." Other investors are more interested in getting more yield on their portfolios. Given that before the terrorist attacks the outlook for interest rates was relatively favourable - that is to say that they were seen to be falling in both Europe and the US - yield investors were going outside their traditional areas of investment, in long-dated government bonds, in search of higher returns. The credit derivatives market is able to provide that. A bond issued by even a top-notch company is almost always going to yield less than a credit derivatives market product, according to fund managers. "There are huge capital markets volumes in the credit derivatives area," another banker says. "We've seen an increase this year in over-the-counter market activity, and there has been a lot more issuance, since liquidity is a key factor in building the market." There are three key factors to derivatives products - structuring and pricing, valuation, and risk management, including market risk, credit risk, liquidity risk, and settlement risk. As derivatives products became much more widely available, not just to sophisticated investors but to chief financial officers at companies, the industry has also been attracting the close attention of regulators. This is hardly surprising - the debate continues, for example, as to whether the use of credit derivatives by banks concentrates risk rather than dispersing it, which is what these instruments are supposed to do. Other developments this year have included the record growth in turnover in exchange-traded derivative products. Europe's two big exchanges, in Frankfurt and London, continued to slug it out for supremacy and have unveiled a wide range of new products to attract more volume and investors. The trading pits at the Chicago derivatives exchanges, meanwhile, have carried on echoing to the sound of thousands of traders, even though most of the rest of the world has moved completely into electronic trading. So, where are the markets heading? Some observers argue that the industry in Europe is in general more sophisticated and less commoditised than its US counterpart. This may be because it is of more recent development and banks have tended to specialise in over-the- counter solutions for clients rather than developing products that can be traded on an exchange. It has also been encouraged to spread by the advent of the euro, which has created a thriving cross-border business. Christophe Reech, chairman and chief executive of Reech Capital, a derivatives industry specialist, says the growth of the industry and its increased sophistication have a solid foundation. "Traditional solutions (to risk managment) are not good enough any more," he says. "You need to be a little bit creative. If you provide traditional solutions you solve the immediate problem but not the evolutionary one." One of the fastest-growing niche areas is the provision of weather derivatives. Demand began among natural gas companies in the US looking to hedge their exposure to extreme weather. Now many companies are in the market, with the most basic products designed to hedge against unusual temperature movements. Much of this business is also tailor-made for clients, with risks managed through secondary market trading. According to Paul Murray, director of weather risk management at Enron, possibly the largest trader of weather derivatives contracts, the market is growing at 40 to 50 per cent by number of transactions. "I'm pretty optimistic about the market - the weather isn't going to go away," he says. Whether the optimism that characterised much of this year will now evaporate in the wake of the terrorist attacks remains to be seen. With a new air of uncertainty gripping investors, and a sudden bout of risk aversion witnessed in the equity and bond markets in the aftermath of September 11, all bets are off. However, given that interest rates are certain to fall further - many analysts predict that the Federal Reserve will steadily lower US interest rates by at least another 50 basis points - yield enhancement and risk management are expected to continue to stay at the forefront of investor concerns. That could create the conditions for much more activity in both credit and equity derivatives. "It's far too early to predict anything, but derivatives are designed to minimise and control risk," says a leading derivatives industry banker. "I am pretty confident that there is a lot more growth to come in this industry." Copyright: The Financial Times Limited ______ URL: news.ft.com URL (print): globalarchive.ft.com

To: Marty Rubin who wrote (106)	11/6/2001 6:52:34 PM
From: Marty Rubin	Respond to of 120

SURVEY - DERIVATIVES: Exchanges trading on an uncertain future: COMMODITY DERIVATIVES by Adrienne Roberts: What will be the outcome of the rivalry between Nymex and London's IPE? The September 11 attack has added a brutal new twist to the ongoing contest Financial Times, Sep 25, 2001 By ADRIENNE ROBERTS After the devastation of New York's central business district, local commodity exchanges are still struggling to recover. The US trading floor for coffee, cocoa, sugar and orange juice was destroyed when the south tower of the World Trade Center collapsed, damaging the adjacent New York Board of Trade. The show goes on, however, this time relocated to cramped premises in a backup site in Queens. The world's largest energy exchange, the New York Mercantile Exchange (Nymex), based in the World Financial Center, was undamaged. But access to the building was made difficult by the surrounding carnage. It was almost a week before Nymex traders were able to return to the floor for abbreviated trading sessions. The attack completely eclipsed the recent rivalry between Nymex and its largest competitor, the International Petroleum Exchange. Some traders used to say that Nymex and the IPE each had one big worry. Nymex feared the IPE would develop serious electronic trading capacity and the IPE worried that Nymex would create a rival Brent oil contract. Both fears came true this year. First the IPE agreed to a takeover by the InterContinentalExchange (ICE), an internet market for over-the-counter energy and metal derivatives. For the IPE, this means ICE will develop the systems to take it fully electronic in 12-18 months. For ICE, it means access to clearing facilities. It recently announced that users would be able to clear ICE's West Texas Intermediate and Henry Hub natural gas swaps through the London Clearing House, alongside their IPE futures business. Then, in retaliation, Nymex launched a Brent contract this month and made it clear that, in New York at least, the future of open outcry trading would be preserved. Major incentives to trade the new Brent contract led several IPE floor traders to say they planned to relocate to New York. The terrorist attack abruptly interrupted the contest, at a time when it was important for Nymex to gather momentum. The US exchange has a limited window of opportunity to build up liquidity in its own Brent contract before the IPE's electronic platform is fully established. Some analysts think the contest will be won or lost even earlier, arguing that Brent must take off in the first few weeks of trade if it is to succeed at all. In the meantime, digital trading is still a contentious issue among IPE users. Some - not least the independent local traders - prefer open outcry. Others like the idea of a system where new products can be more cheaply and easily introduced. Where most of them do agree, however, is the advantages of real time risk management, and straight-through-processing which automates paperwork and reduces the risk of costly back-office errors. Other exchanges, too, are divided on the advantages of electronic trade. London International Financial Futures and Options Exchange (Liffe) commodity contracts went electronic late last year, but the London Metal Exchange is keeping open outcry. The LME launched a more sophisticated version of its electronic platform this month but Simon Heale, chief executive, has made it clear that open outcry will continue until LME members say otherwise. As competition between exchanges intensifies, there is pressure on managers to ensure that their market remains the market of choice. "You have to consistently review your contracts to ensure that they continue to be successful. You have to ask yourself: 'is this still what the market wants?'" said an IPE director. Liffe, for example, is planning on expanding its product range into weather derivatives, and has already started publishing three European weather indices. The exchange is also looking at expanding its portfolio of wheat products and is considering introducing an arabica coffee product to add to its existing robusta futures. Recent experience shows that some new products can take time to bed down, however. Weather derivatives - strictly speaking closer to an insurance contract than a typical commodity derivative - have a good following in the over-the-counter market, but the Chicago Mercantile Exchange is not yet seeing much call for its standardised weather derivatives, launched in 1999. Bandwidth futures, offered by anumber of online exchanges, also have yet to reach their full potential. Set up on the assumption that surplus network capacity would become a tradeable commodity, bandwidth exchanges have been hit hard by the decline in telecoms business. One of this year's latest products, Euronext's Bordeaux wine future, has yet to prove itself. Even computer memory is becoming commoditised. Enron has plans afoot for an over-the-counter DRAM market. Commodity exchange executives are not quite ready for DRAM futures. For the time being, they say, rapid technological change makes microchips too much of a moving target to form a standardised contract. Copyright: The Financial Times Limited _____ URL: news.ft.com URL (print): globalarchive.ft.com

To: Marty Rubin who wrote (106)	11/6/2001 6:54:12 PM
From: Marty Rubin	Respond to of 120

SURVEY - DERIVATIVES: Easy trades thrive on a complex platform: ELECTRONIC TRADING by Andrei Postelnicu: Europe, not the US, has taken the lead in new technology Financial Times, Sep 25, 2001 By ANDREI POSTELNICU While no one contests that electronic trading platforms have been transforming the derivatives universe, it is the magnitude, impact and pace of such changes that make the subject one of keen debate within the industry. In the financial markets, the impact of electronic trading platforms and the appetite for implementing them varies by geography and the culture and structure of the exchanges making the transitions, says Scott Shellady, chief operating officer at Patsystems, a provider of electronic trading platforms and services. He says Europe has been quicker to respond to the rise of electronic trading, citing Eurex as "an example to emulate" in terms to adopting electronic trading. On the other hand, he says it is understandable why the Chicago Board of Trade might take longer to replace open outcry trading with screens due to the membership structure of the CBOT. "Change has to happen at the pace of the market and successful changes have to come from within," says Michael Daymond-King of Garban Intercapital, the leading derivatives house. Merely implementing the platform and expecting traders to adopt it is not enough, he says. Increased efficiency, transparency and lower transaction costs are not the only attractive points of electronic trading platforms if these factors are not aiding liquidity in the market. "We have to have good and useful technology, along with liquidity, before such a shift in habits takes place and traders talk over the screen rather than over the phone," says Mr Daymond-King. In some markets, the increased transparency brought about by electronic trading can be a deterrent to liquidity, he says. On the other hand, if technology helps traders capitalise on opportunities they would not have otherwise seen, it is very likely that electronic trading platforms will catch on. "If a grain trader is seeing no activity for weeks in wheat contracts but catches a glimpse of high activity in the forex market, he will probably start trading some euro-dollar or euro-yen contracts and make his money there," says Mr Shellady. Industry insiders agree that the nature of the products traded plays a very important role in the way markets make the transition towards electronic trading. "Products that are currently traded electronically tend to be highly liquid, standardised and easily understood," says John Mooren, product manager at Front Capital Systems, a provider of electronic trading technologies. He cites straightforward vanilla (interest-rate) swaps as an example of a product lending itself more easily to electronic trading. At the other end of the spectrum are complex, structured deals where a great deal of negotiation and human contact is needed to bring the trade to fruition. "In the case of a risk hedge on a loan - by using a combination of, say, credit, currency and interest-rate contracts - the efficiency gained through technology is less important than knowing exactly what the other party is doing and talking with them directly," says Mr Mooren. Electronic trading leaves very little room for the kind of negotiating needed for concluding more complex deals, he says. The recent weakness of equity markets has helped volumes in the derivatives markets and has not forced exchanges to look at new ways of doing business, says Mr Shellady. In addition, he and others point out that weakness in the banking and financial industry has tempered both enthusiasm for and investment in new technologies. Beyond financial products, trading in the energy and utilities sector has experienced remarkable transformations in the last year due to the emergence and implementation of electronic trading platforms, says Mark Lillie, a partner at Accenture, the consultancy. A combination between a political environment that encouraged the deregulation of energy and utilities sectors in Europe on the one hand, and the 'internet boom' on the other hand, has made for a sweeping change in the way things like electricity and fuels are traded, says Mr Lillie. "As much as 50 per cent of the energy and utilities trades are done online, with brokers offering electronic trading as well as more traditional ways to trade." Technology enables traders to tame the traditionally volatile prices of commodities, and contributes to increased liquidity and transparency, which causes Mr Lillie to comment that "the internet was made for trading commodities". However, commodities markets encounter the same challenge as financial markets when it comes to adopting electronic trading: more sophisticated contracts that are harder to standardise continue to be traded in the traditional ways. The key question becomes how quickly will markets run along this spectrum of complexity of products and move them all towards electronic trading platforms? Specialists agree that timing will be key in implementing new technologies, but cannot forecast this 'electronic revolution'. Copyright: The Financial Times Limited _____ URL: news.ft.com URL (print): globalarchive.ft.com

To: Marty Rubin who wrote (106)	11/6/2001 6:55:33 PM
From: Marty Rubin	Respond to of 120

SURVEY - DERIVATIVES: Chicago traders stay entrenched in the bull-pit: SCREEN-BASED TRADING by Nikki Tait: Bold plans to transform the Chicago Board of Trade into a top-flight electronic platform by end 2000 have faltered, with less than one-fifth of overall volumes conducted by screen-trading Financial Times, Sep 25, 2001 By NIKKI TAIT A year may be a long time in politics. It has proved an equally lengthy and frustrating period for advocates of screen-based trading, who once hoped that the US's oldest futures exchange would follow European counterparts and quickly abandon its traditional open-outcry pits in favour of an electronic platform. The Chicago Board of Trade (CBOT), born in 1848 and traditionally the largest of the US futures exchanges, made its first serious foray into electronic trading in August last year when it launched the a/c/e platform. Up to that point, the Chicago exchange had operated a screen-based system, developed in-house, called Project A. While incorporating some attractive features, this was widely acknowledged to be less-than-robust and used primarily for after-hours or overnight business. The a/c/e system, by contrast, was based around the tried and tested technology employed at Eurex, the German-Swiss exchange which is now the world's largest futures market. The two exchanges collaborated, at some cost on the new platform, and it came into operation in late August 2000. However, although the new system has seen growing usage over the past 12 months, it is only now that some serious, consistent electronic volumes are beginning to emerge - and even then, only in a handful of financial contracts. In the final days of August this year, for example, about 36 per cent of the 30-year Treasury bond contract was handled by the a/c/e system. Similarly, screen-based volumes for the 10-year note contract accounted for approximately 37-38 per cent of the total business. For the exchange overall, by contrast, just over 30m contracts traded through a/ c/e in the first eight months of 2001. That compared with total CBOT volume of around 168.2m contracts - meaning that screen-based trades were less than one-fifth of the total activity. The agricultural pits, in particular, have seen little business divert to the electronic platform - and many of the wilder predictions, which suggested the Chicago pits could be closed by December 2000, have proved hopelessly awry. The reasons for this slow build-up of electronic volumes have been various. A good deal has to do with the relatively slow pace at which some of the big trading firms have been able to install satisfactory systems and bring their own customers online. Comfort levels over the reliability of the system and the ability of both traders and exchange officials to handle it smoothly have also taken months to build. Tales of erroneous trades, and issues over how and when these should be "busted", have been plentiful. These practical issues, moreover, have been grist to the mill of the traditional floor-based "local" traders, who are a powerful voice at the Chicago Board of Trade and once worried that screen-based trading would end their livelihoods. In reality, some have moved upstairs, to trade electronically. But others have also returned to the pits - including Tom Baldwin, a CBOT veteran and trading heavyweight, who told one local newspaper that floor trading was "more of a sport". So does the recent build-up of volumes in the 30-year bond and 10-year note contracts suggest that things are finally changing? Probably not - or at least only slowly. Traders say that the growth in screen-based volumes in the past few months does reflect the fact that some big investment firms are moving more of their operations off the floor, and now have clients hooked up online. But most also say that screen-based trading still has big limitations, with the a/c/ e platform unable to handle some of the more complex transactions. A good part of the recent volume increase on a/c/e has also been attributed to floor-traders themselves, arbitraging between the prices of contracts in the pits and on the screens. Hand-held trading devices have become increasingly visible on the CBOT floor, allowing traders operating there to play both markets. Indeed, some traders now wonder whether non-Eurex-based solutions may become an integral part of their trading life. For example, Brokertec, the bond trading system set up by some of the biggest investment banks, is due to launch a futures trading platform shortly. This could provide an opportunity to trade cash and futures products on the same system - a fairly attractive prospect, provided Brokertec can attract sufficient liquidity. Some bond traders even speculate whether CBOEdirect, the more sophisticated electronic trading platform being developed by the neighbouring Chicago Board Options Exchange, might ultimately better meet their requirements for complex trades. Relations between the CBOT and CBOE - sometimes frosty in the past - have improved dramatically in recent months, and talk of technical co-operation has been mooted. At the same time, the CBOT's relationship with Eurex has been strained over the past year - with the US institution unwilling to fund some future development work, as it attempts to repair its stretched finances. The two organisations have also disagreed on precisely what their original agreement anticipated on the joint product front. CBOT officials do not deny that running two trading platforms - electronic and open-outcry - adds cost. They do, however, tend to argue that customers want orders filled efficiently, with liquidity guaranteed, and that this is the overriding consideration. That contention seems unlikely to ameliorate pressures from the larger trading firms for cost-saving - which, in turn, suggests that an increasing proportion of the exchange's business will shift to the screens over time. But, with the past year's experience in mind, it would be a brave individual who chose to predict just when the pits' days will be come to be numbered. Copyright: The Financial Times Limited ___ URL: news.ft.com URL (print): globalarchive.ft.com

To: Marty Rubin who wrote (106)	11/6/2001 6:56:56 PM
From: Marty Rubin	Respond to of 120

<bSURVEY - DERIVATIVES: Demand for debt puts swaps at the cutting edge: NEW PRODUCTS by Sarah Laitner: Swaps appear to be the instrument of the future having rapidly become a hedging instrument, a benchmark for interest rates and a credible alternative to bond futures Financial Times, Sep 25, 2001 By SARAH LAITNER Swaps market activity has vastly increased in the past few years, and swaps have in many cases ousted government bonds as the reference against which other debt instruments are priced. Swaps, which were originally used to allow borrowers to exchange the type of debt they could easily raise for the type of debt they really wanted, are now traded by companies and investment banks alike. "Some time ago swaps were for corporate balance sheet management. Now there is a brave new world and they are the benchmark, a valuation tool and a hedging instrument," says Evan Kalimtgis, head of European credit strategy at Credit Suisse First Boston. "Swaps are the hedging instrument of choice for investors in the high grade credit market. They are now also a central bank reserve instrument, being employed to manage the maturity of central bank liabilities. "Additionally, they have become the primary hedging instrument in the US mortgage backed securities market," he adds. The growth in the swaps market globally has been rapid. At the end of last year, a notional amount of Dollars 48,768bn in interest rate swaps was outstanding, compared with Dollars 36,262bn at the end of 1998, according to data from the Bank for International Settlements. Interest rate swaps, where borrowers swap funds with fixed interest rates for floating-rate funding, are a big slice of the market, with the parties involved seeking to hedge their interest rate risks. One of the big attractions of swaps for investors and institutions is that they are very liquid, and available along the whole of the yield curve covering short and long term maturities, whereas diminishing issuance has meant that the supply of government bonds is sometimes not always assured across the yield curve. The availability of swaps contracts is also attractive to investors who have seen squeezes in bond futures contracts. Recently the lack of supply of German government paper has caused delivery problems for the Bobl contract, the five year German government future. "Every time there is a liquidity squeeze in the German Bobl future there is an increasing need to find an alternative, which draws people towards swaps," says Andre de Silva, bond strategist at HSBC. "In spite of the introduction of Eurex (the derivatives market) trading limits, the Bobl future is still prone to squeezes as it is the underlying cash, bond and repo markets that have led to imbalances," he adds. One of the most fundamental developments in the swaps universe in recent years has been the increasing use of swaps for pricing bonds in the primary market, with investors pricing new bond issues against the swaps curve rather than over the underlying government bonds. Strategists say this is because the method offers clarity and precision, making it easier to look at the relative value of different credits and different maturities than it is over the underlying government bond curve. Government bond curves are supposed to be a good predictor of future interest rates. However, government curves can be distorted, meaning that they do not always give a clear indication of interest rates. "Many people think that the swaps curve is a better predictor of interest rates than government curves, because government curves are sometimes distorted by technical factors," says Gary Jenkins, global head of investment grade credit research at Barclays Capital. Technical factors have recently distorted the UK government yield curve. Huge demand by pension funds and a lack of supply of government bonds led to prices of long-dated UK gilts rising, inverting the yield curve and not providing a true reflection of interest rate expectations. The precision and comprehensiveness of the swaps curve makes it attractive to those pricing bonds, according to Mr Jenkins. "The swaps curve does take out distortions in the yield curve and leads to easier analysis across currencies," he says. However, there are underlying concerns about the risks involved in using them. While many government bonds are seen among investors as being a risk free instrument, "swaps are inherently susceptible to systemic risk, counterparty risk, and shifts in market structure", says Mr Kalimtgis. Mr de Silva adds: "There are downside risks to swaps. One of these is the volatility of spread movements, which have been seen in extreme cases, such as the crisis in emerging markets in 1998." The swaps curve in particular is viewed by some as a reflection of banks' credit quality. "But this is not particularly true in the short term" says Mr Jenkins. "Swaps move quickly, and banks credit quality tends to move like an oil tanker - very slowly." Further derivatives products have been created. In March, the London International Financial Futures Exchange started trading two, five and 10-year futures on swaps - the swapnote contracts - with an average daily trading volume of 25,000. Copyright: The Financial Times Limited ____ URL: news.ft.com URL (print): globalarchive.ft.com

To: Marty Rubin who wrote (106)	11/6/2001 6:58:09 PM
From: Marty Rubin	Respond to of 120

SURVEY - DERIVATIVES: Synthetic deals take on natural growth curve: SECURITISATION by Claire Smith: Synthetic securities are becoming increasingly commonplace but the complexity of some deals adds in the possibility of operational and legal risks Financial Times, Sep 25, 2001 By CLAIRE SMITH The fastest growing sector of the ebullient credit derivatives market is synthetic securitisations, which accounted for over Dollars 200bn of the Dollars 800bn total global market size in 2000. Whereas default swaps continue to dominate the market in terms of notional amounts outstanding, synthetic securitisations, which use default swaps to supply the credits exposure which backs the securities issued, account for the biggest percentage of average dollar volumes traded. These, together with credit-linked notes - which are issued by banks and contain credit derivatives - account for 59 per cent of trading volumes. Credit default swaps arrived in 1999 and were first included in hybrid collateralised debt obligations (CDOs) that include both loans and credit default swaps. These days completely synthetic deals are commonplace, with the underlying credit assets being simply a collection of default swaps. Issues based on default swaps command a higher yield, as spreads on them are bid up due to demand for credit protection from banks, corporate treasurers and hedge funds. The involvement of investors is transforming the credit derivatives market by transferring risk through to the best marginal buyer, says Mike Connor, managing director of structured credit derivatives at UBS Warburg in Stamford, Connecticut. One industry initiative, aimed at satisfying the demand from money market funds for good quality short-dated paper, is to create notes of the required maturity and currency by incorporating interest rate and currency derivatives, linked to a longer dated exposure to a credit within a special purpose vehicle, which issues the securities. A danger arises from any inversion in either the yield curve or the credit spread curve, which will make the longer term assets more expensive to finance. Sourcing, parcelling up and selling on of credit exposure to suit investors' demands has taken the place of issues of bulky multi-tranche collective debt obligations, driven by a bank's desire to slim down its balance sheet. This is not to say that the deals are necessarily smaller. New entrants into the credit market are demanding sizeable ready-made portfolios, according to Jonathan Laredo, head of structured products at JP Morgan. "We have seen as much business this year driven by investors as wasdriven by issuers in 2000, as euro zone investors switched their attention from equities to credit in the aftermath of the stockmarket downturn," he says. With a typical notional amount of Euros 500m-Euros 1bn across a portfolio of 50 to 100 corporate entities, investors can achieve significant exposure to corporate credits without having to identify and deal in a single cash instrument. It is understood that some 20 deals of this type took place in the first half of this year, and thus a significant increase above the 2000 figure of Dollars 40bn can be anticipated in 2001. Lack of capacity among European corporate entities could limit future growth, however, with Mr Laredo citing just 300 liquid names. Antoine Chausson, head of credit derivatives structuring at BNP Paribas, remarks on the increasing flexibility provided by derivatives to the securitisation and repackaging market, whereby credit exposure can be warehoused or assets financed on a longer term basis by using a ring-fenced transaction issued by a vehicle which has no credit rating. One example of a fully synthesised securitisation programme is the BNP Paribas Riviera Finance One, an arbitrage CDO special purpose vehicle, which issued three tranches of five-year notes of varying degrees of seniority on Euros 1bn notional of credit default swaps on 52 different entities diversified by industry and geography. According to Mr Chausson, insurance companies typically take the most junior paper (the most risky element) for additional yield, whereas banks and finance companies take the more senior tranches. Credit derivatives could also supply a rather elegant solution to the change in the treatment of liquidity facilities which are usual in asset-backed commercial paper (ABCP) programmes that is flagged in the Basel 2 Capital Adequacy Accord. Rather than suffer a charge for capital usage for providing a liquidity facility, the ABCP issuer might offer a credit default swap to the holder of a portfolio of credits, with the swap providing the credit exposure on which commercial paper is subsequently issued. Inclusion of exotic features is increasing, for example, 'knock-in' or 'knock-out' of an interest rate or currency swap that is triggered by a credit default. This means that any default of the credit could either create or extinguish the swap transaction and adds further complexity to risk management, in what is still a fundamentally illiquid and developing market. Reserving of profits on open positions and using conservative assumptions in risk parameters minimises the risk of booking unexpected losses. This is a market where disputes over terminology and trigger events on the simplest default swap are frequent. Thus, creating back-to back credit derivatives deals, and adding in associated transactions in derivatives on other assets, might seem premature. Witness the lawsuit between Deutsche Bank and UBS when Deutsche Bank refused to pay up on a credit default swap because the name of the reference credit had changed following a transfer of ownership. Banks must be careful to ensure that the end product accurately reflects the features of all of the instruments underlying the transaction. Operational and legal risks occur when linking derivatives transactions together. Jeanne Bartlett, partner at legal firm Orrick Herrington and Sutcliffe, has worked with a number of banks to set up guidelines incorporating checklists and flow charts showing what approvals and which form of documentation are necessary. Copyright: The Financial Times Limited ____ URL: news.ft.com URL (print): globalarchive.ft.com

To: Marty Rubin who wrote (106)	11/6/2001 6:59:27 PM
From: Marty Rubin	Respond to of 120

SURVEY - DERIVATIVES: A form of protection for the rising risk of defaults: CREDIT DERIVATIVES by Rebecca Bream: Demand for hedging credit risk has boomed as the economy falters Financial Times, Sep 25, 2001 By REBECCA BREAM In the past 12 months credit risk has moved from being a secondary consideration for most companies and fund managers to an issue at the top of their agenda. The fall from grace of many companies in the telecoms and technology sectors has emphasised the increasing risks investors are faced with, as well as the ways in which many companies are exposed through vendor financing contracts and trade credit. Interest-rate, currency and commodity price risk have long been incorporated into business and investment strategy and often hedged through the derivatives markets. But when it comes to the risk that counterparties could go bankrupt, default on payments or pay late, most just hoped that they would be lucky. Since the mid-1990s larger investment and commercial banks had been developing credit derivative products to allow themselves to hedge their own credit risk, generated through their corporate lending books and proprietary bond trading desks. Banks were keen to reduce exposures to certain companies or industries without having to sell on loans and potentially damage valuable relationships with borrowers and by the start of 2000 a liquid over-the-counter market between banks in credit default swaps had developed. The most common product in the credit derivatives universe, default swaps are essentially a type of insurance contract used to protect the value of corporate bonds, loans or other credit contracts. The buyer of protection pays a premium to another party in return for a guarantee that if a negative credit event occurs it will recover the full value of the underlying debt instruments. Investment banks have now become adept at hedging their own risks and have moved into the business of structuring new types of bespoke credit risk products for investors. The lucrative credit derivative and structured product businesses are among the few areas where investment banks are still actively expanding. As there is a shortage of people with the right skills, the market value of credit derivative bankers has risen sharply. New products are emerging all the time. "The credit derivative market has inherited a lot of the creativity that was in the Eurobond market in the early 1980s," says Richard Williams, head of credit derivatives at Abbey National. "If there is demand, the market will find a product to satisfy it." The expansion in the credit derivatives market comes from the surge of new users. "A lot of the market's growth is coming from smaller banks starting to hedge their risks, as well as insurers and reinsurers using credit derivatives to achieve more diverse portfolios," says Sanjeev Gupta, head of developed markets credit derivatives at CSFB. UK retail bank Abbey National, for example, started dealing with the credit derivatives market at the start of last year when it set up a separate business group for financial products. The bank uses the market internationally to hedge its balance sheet and make some investments, but it keeps a risk-neutral position. "We do not take on extra risks through the market," says Mr Williams at Abbey National. "It makes sense for us to think of credit derivatives as a risk management or transfer tool." Fund managers are also buying credit exposure through derivatives, hoping to increase their returns or adjust their geographic or sectoral risks without having to buy or sell underlying securities. The fact that you can speculate on credits where the actual securities might be hard to get hold of is very attractive, as is derivatives' ability to isolate credit risk from currency and interest rate factors. Predictions on the market's growth show rapid expansion. Research by PricewaterhouseCoopers estimates that the global credit derivatives market will grow to a total size of almost Dollars 1.6 trn by the end of 2002, from a size of about Dollars 900bn at the end of last year. "Credit risk is ubiquitous," says Tim Frost, head of European credit derivatives at JP Morgan. "And the credit derivative market has not yet come anywhere near fulfilling the need for ways to hedge credit risk." The European market is thought to be more sophisticated than its US counterpart, mainly because its risk management and investment needs are more complicated and require more developed derivatives products. The US has a mature and liquid credit default swap market but there is said to be less demand for portfolio trades or synthetic transactions. One area of development is the growing use of credit derivatives by companies, many of which have great trade and vendor financing exposures currently left unhedged. A period of economic weakness and rising bankruptcies is expected to focus companies on this issue. "The downturn could actually prompt a boom in credit derivatives," says Arne Groes at ABN Amro. "Companies will get involved in credit derivatives but it is a slow process," says Mr Williams at Abbey National. "Companies that have seen their problems magnified as a result of having a large portfolio of credit risk will probably create liquidity for themselves by looking at them." Lack of understanding of the market and its untransparent nature, as well as companies' reluctance to incur extra costs that might reduce margins in the short-term, have been offered as reasons for the low level of corporate use in credit derivatives. Copyright: The Financial Times Limited ____ URL: news.ft.com URL (print): globalarchive.ft.com

To: Marty Rubin who wrote (106)	11/6/2001 7:00:46 PM
From: Marty Rubin	Respond to of 120

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 ____ URL: news.ft.com URL (print): globalarchive.ft.com