Fed Calls in Banks on Derivatives Paperwork Backlog (Update2)
Sept. 13 (Bloomberg) -- The Federal Reserve Bank of New York called in representatives from 14 of the world's largest banks because their failure to erase a backlog of paperwork in the $8.4 trillion market for credit derivatives.
The meeting, announced by the Fed on Aug. 24, will be at the central bank's New York office on Sept. 15. It will bring bank representatives and risk managers together with U.S. and European regulators to discuss ``market practices,'' New York Fed spokesman Peter Bakstansky said in an interview.
Banks and securities firms are struggling to keep up with administration as the credit derivatives market grows. They risk being overwhelmed by investors seeking settlement of contracts if there is a corporate default, an industry group led by E. Gerald Corrigan, managing director at Goldman Sachs Group Inc. and a former New York Fed president, said in a report in July.
``Banks have been too focused on their own profit interests and in grabbing a share of the rapidly expanding market and haven't focused on operational issues,'' said Alistair Milne, senior lecturer on credit risk and settlement systems at Cass Business School in London. ``Systems, controls and accounting haven't kept pace with the growth in the market.''
JPMorgan Chase & Co., Deutsche Bank AG, Goldman, Morgan Stanley and Merrill Lynch & Co. are the five most-cited trading partners in credit derivatives, according to Fitch Ratings.
Like Insurance
JPMorgan will send Donald McCree, deputy head of risk management, and Eric Rosen, head of credit trading, to the meeting, said spokesman Michael Dorfsman in New York. McCree and Rosen, both based in New York, declined to be interviewed.
Goldman spokesman Michael DuVally and Morgan Stanley spokesman Mark Lake, both in New York, declined to comment. Merrill Lynch spokeswoman Terez Hanhan and Deutsche Bank spokeswoman Michelle Agostinho, also in New York, didn't return calls.
The banks didn't break down earnings from credit derivatives in their quarterly reports.
Credit derivatives are the fastest growing part of the $248 trillion derivatives market, based on the so-called notional value of the debts that underlie the contracts.
Credit-default swaps allow investors to bet on a company's creditworthiness or protect against a default. Like insurance, buyers pay an annual fee similar to a premium to protect a certain amount of debt against default for a specified number of years. In the event of a default, they are paid the face value of the bonds or loans.
13-Day Wait
The global credit-derivatives market more than doubled last year, mostly on demand for credit-default swaps, according to the International Swaps and Derivatives Association, or ISDA. The credit derivatives market wasn't even tracked until 1997.
A derivative is a financial obligation whose value is derived from interest rates, the outcome of specific events, or the price of underlying assets such as debt, equities and commodities.
ISDA, a New York-based trade group representing more than 600 securities firms, said credit-default swap trades went unconfirmed for 13 days on average last year, and for 18 days in 2003. ISDA Chief Executive Robert Pickel didn't provide an estimate for the total amount of default swaps that are currently unconfirmed.
LTCM
Corrigan's committee, which first met in 1999 after the collapse of hedge fund Long-Term Capital Management, called on banks to process more of their trades by computer and to consider cutting trading until the backlog is reduced. The report, released July 27 in New York, didn't provide an estimate of the dollar value of the backlog or the number of contracts awaiting confirmation.
The New York Fed brought together 14 banks and securities firms in 1998 to orchestrate the rescue of LTCM to avert a mass sell-off in financial markets. Banks and securities firms had loaned the collapsed hedge fund about $120 billion to make its bets.
``Having the attention of regulators gives the industry a push in the right direction,'' ISDA's Pickel said in an interview. ``It provides further impetus to address the issue sooner rather than later.''
About 40 percent of trades were sent out using automated systems last year, compared with 24 percent in 2003, ISDA data show.
`Inadequate Resources'
The U.K.'s Financial Services Authority in February said some transactions were left for months without being signed, and called for banks to work urgently to reduce the backlog before a crisis occurs. A number of firms are ``failing to resource their back-office functions adequately,'' the FSA said, without identifying any companies.
The FSA has since asked banks for an update on the delays, spokesman David Cliffe said.
``We're attending the meeting; we see this as a good opportunity to discuss the main issues in the industry,'' Cliffe said today, declining to comment further.
The settlement process for default swaps typically requires faxed signatures.
Confirmation delays are compounded when a seller of a credit- default swap transfers the contract to another firm, which then becomes responsible for payments in the event of a default. Sellers ``routinely'' reassign contracts in this way without seeking the consent of the original dealer, Corrigan's group said.
Assignments
The paperwork for these transactions, known as assignments, takes three times as long to complete, raising concern that the contracts might not hold up in the event of a default, Corrigan's group said.
``The trades that are done on automated systems are being confirmed on a timely basis,'' said Janet Wynn, general manager at Deriv/SERV, a computer-based processing system managed by the New York-based Depository Trust & Clearing Corp. ``The backlog has occurred in the paper world.''
Some transactions are more difficult to automate than others, Wynn said. Default swaps on a benchmark index can't be automated as easily as contracts on individual companies.
New York Fed President Timothy Geithner, who also serves as chairman of the Committee on Payment and Settlement Systems for the Bank for International Settlements, warned in a speech to the Securities Industry Association's national conference in New York in November 2004 of risks to the global financial system from the use of derivatives by hedge funds.
GM, Ford
The price of credit-default swaps jumped as much as 35 percent in May after Standard & Poor's stripped General Motors Corp. and Ford Motor Co. of their investment-grade ratings, causing a surge in demand for debt insurance from hedge funds and other investors.
JPMorgan in a June 9 report estimated about 90 companies worldwide, mostly investment banks and hedge funds, lost a total of $3.3 billion in the second quarter from trading so-called collateralized-debt obligations that group credit-default swaps.
Geithner urged the banks to send both ``a senior business representative and a senior risk management person'' to the meeting.
Regulators attending include the U.S. Securities and Exchange Commission, the Office of the Comptroller of the Currency, the New York State Banking Department, the U.K.'s FSA, Germany's Federal Financial Supervisory Authority and the Swiss Federal Banking Commission, said New York Fed spokeswoman Linda Ricci.
The New York Stock Exchange, Chicago Mercantile Exchange, the Chicago Board of Trade and the Chicago Board Options Exchange will also attend, Ricci said.
The NYSE will send Grace Vogel, executive vice president of member-firm regulation, said exchange spokesman Brendan Intindola. David Prosperi, spokesman at the Chicago Mercantile Exchange, and Maria Gemskie, spokeswoman at the Chicago Board of Trade, weren't immediately available to comment.
To contact the reporter on this story:
John Dooley in New York at jdooley@bloomberg.net.
Last Updated: September 13, 2005 06:21 EDT |
