Introduction
This chapter focuses on the risks of derivatives, which center on the possibility of a default of one of the counterparties. Netting is absolutely critical in this analysis.
There are seven risks associated with derivatives:
legal risk;
credit risk;
market risk;
liquidity risk;
operational risk;
reputation risk; and
systemic risk.
These risks were identified in the Group of Thirty report on financial derivatives.1 One of the most important findings of this report is that, at one level and, indeed, at many levels, the risks of derivatives are fundamentally no different from the types of risks associated with traditional instruments, including loans, securities, and deposits. Considering the above list of risks in the context of a product, such as a fixed-rate mortgage with a prepayment option (which is an extremely popular product for homeowners in the United States), one realizes that the same risks associated with derivatives are present for a bank lending fixed-rate mortgages. In fact, it was the inability to manage that fixed-rate mortgage portfolio that was at the core of the failures of so many savings and loans in the United States. It is also important to recognize—and this is the focus of the U.S. Congress, regulatory bodies, and others around the world—that the complexities associated with derivatives give rise to issues of transparency and questions of legal and market linkages that require a higher level of attention.
A point worth making in connection with derivatives is that these products are not new. One of the earlier derivatives products was born of necessity: a bond offered by the Confederate States of America in 1863, during the Civil War. This was one of the more complicated derivatives that one could imagine. A dual-currency bond, it paid either in British pounds or in French francs. It had a commodity convertible element: the holder had the option of taking 40,000 pounds of cotton, delivered on the Gulf of Mexico. In 1863, that was not a good option for many of the market participants. This bond offering reflected a situation in which the Confederacy was having serious difficulty raising money and Confederate currency had no value in the world market. Consequently, the Confederate Government designed a product paying in recognized currencies and with a commodity element as a way to raise funds. Although the complexity of this product is important and interesting, it had the same core problem that all such products have: complex payout structures do not mean anything if the creditworthiness of the issuer is a cause for concern. In this historical example, of course, the Confederacy lost the war and defaulted on the bonds.
Failure of Management
Senior management of any institution—central bank, corporation, or pension fund—needs to set the standards by which that entity will engage in derivatives and to manage the program that the company then implements.2 Recommendation 1 of the report of the Group of Thirty provides that
[d]ealers and end-users should use derivatives in a manner consistent with the overall risk management and capital policies approved by their boards of directors. These policies should be reviewed as business and market circ*mstances change. Policies governing derivatives use should be clearly defined, including the purposes for which these transactions are to be undertaken. Senior management should approve procedures and controls to implement these policies, and management at all levels should enforce them.3
The failure to implement this recommendation has been and will continue to be the cause of the vast bulk of derivatives problems. The key is that the hierarchy of the organization should be familiar with derivatives; otherwise, the institution should not be involved with them. Senior management should not be surprised by any one investment or overall investment strategy that is undertaken by its treasurer’s office or any other unit in the institution. For example, one large U.S. corporation identified a substantial loss in derivatives and ended up writing down over $100 million as a result of its investment. Its senior management indicated in a notice to shareholders that it was surprised by the risk and did not understand the impact of that investment. The position of the Group of Thirty would be that this was not a responsible investment for the corporation to make, as senior management did not know what it was doing. Until senior management understands these kinds of investments, the organization should not undertake them. This issue has been identified as “intellectual risk,” the risk generated by an organization’s lack of intellectual capacity or know-how to manage a derivatives portfolio. It is also connected with the issue of internal controls, that is, the failure to set the right policies. This derivatives risk often can also be stated simply as a basic failure of management.
Legal Risk
The fundamental aspect of legal risk is the risk that a transaction is not valid and enforceable under applicable law. The law could be that of the home country, that chosen by the parties, or that of the jurisdiction where a bankruptcy filing takes place.
Most countries’ legal systems have not kept pace with financial development. This general comment applies not just to derivatives but to all means of financial innovation. Very few cases anywhere have dealt with the issue of the legal enforceability of derivatives. Market participants end up having to work with legal opinions. The ISDA has done a splendid job of collecting these opinions; however, reading them makes one realize that they are not as good as an affirmative statement from a country’s legislative body. For this reason, the ISDA and others are pursuing such legislation in order to make sure that an isolated case does not threaten a whole category of derivatives.
Four issues arise under the heading of legal risk:
bankruptcy and insolvency (netting);
documentation;
capacity and authority; and
legality and enforceability.
The first issue, bankruptcy and insolvency, bears on the enforceability of netting and the critical elements addressed in the previous chapter.
Second, documentation and the use of master agreements are also a key part of the netting process. At its inception, any agreement in the derivatives or any other contract area needs to be put in writing in most jurisdictions to be enforceable. Even in those jurisdictions where all agreements are enforceable, a written agreement helps in a court or other legal context to solidify the parties’ rights and obligations.
Third, the capacity or authority of a counterparty to enter into a transaction is absolutely critical to ensure that the transaction is enforceable. Unfortunately, a British case involving the London councils, which are municipalities in and around the city of London, Hazell v. Hammersmith and Fulham London Borough Council4 resulted in a decision by the U.K. House of Lords, the highest court, that the councils did not have authority under their enabling statutes to enter into swaps of any kind. This decision surprised many observers, who felt that swaps entered into by the councils to manage risk should be enforceable. The ISDA conducted a ten-year study of defaults and losses in swaps and found that about half of those losses—$500 million out of approximately $1 billion in total losses—were the result of having to unwind all of the swaps with the councils. This issue involves the authority of not just a London council but also that of all municipalities, pension funds, insurance companies, building societies, and other organizations. Obviously, a wrong assumption in this area could be devastating to an institution that has entered into a transaction, particularly if the result is an unwind and a return to the first position. A dealer in a swap market who has a position between two parties always assumes that the position is matched up; however, if one party defaults and has to unwind, the consequence for the other party is very serious.
Fourth, the issue of legality and enforceability raises the question of whether the derivatives transaction can or will be enforced in court. The Group of Thirty found in its examination that two general areas of law were problematic in many jurisdictions. First, derivatives may in many cases be subject to laws applicable to futures contracts. For example, in the United States, all futures contracts must be traded on a designated exchange, such as the Chicago Board of Trade or the Chicago Mercantile Exchange. There was a concern that, if a swap were deemed to be a futures contract, it would be illegal because it was not trading on a designated exchange. The law in the United States was changed in 1992,5 and regulations were implemented in early 1993 to largely settle this issue,6 but the same problem exists in other countries. An unfortunate case in Australia highlights this issue.7
The second problematic point on legality and enforceability is the possibility that in many countries derivatives may be seen to violate a gambling statute or a statute that requires that such trading occur on a licensed exchange. These statutes, which have been on the books for a long time, concern a bet of some kind on a future event whose outcome is not controlled by one or the other party. In the United States, this problem has largely been solved by legislation. However, the examination by the Group of Thirty indicates that, in countries such as Australia, Brazil, Canada, and Singapore, there are uncertainties as to whether derivatives violate relevant statutory provisions.8
This issue is evolving, and significant new developments and changes can be expected. The Group of Thirty focused on making recommendations to deal with legal and regulatory uncertainties. They have recommended that
[l]egislators, regulators, and supervisors, including central banks, should work with dealers and end-users to identify and remove legal uncertainties with respect to:
The form of documentation required to create legally enforceable agreements (statute of frauds).
The capacity of parties, such as governmental entities, insurance companies, pension funds, and building societies, to enter into transactions (ultra vires).
The enforceability of bilateral close-out netting and collateral arrangements in bankruptcy.
The enforceability of multibranch netting arrangements in bankruptcy.
The legality/enforceability of derivatives transactions.9
Credit Risk
Credit risk is the risk of loss if a counterparty defaults. The key point from the standpoint of a company’s internal controls is that the company should measure the associated costs of replacing a derivatives transaction, in addition to the potential replacement cost itself. Thus, in evaluating its overall exposure to credit, a company must take into account the possibility that the market may move between the time of default and the time that it is able to replace the particular transaction.
The other key element in the credit risk recommendations of the Group of Thirty is that credit risk management has to be independent from the trader who put together the original transaction.10 The incentive of the trader to do the transaction may make it difficult to take into account fully the extent of the credit exposure. An independent credit risk manager is the correct person to evaluate whether it is the right kind of transaction for the company.
In this regard, two additional points should be made. First, greater use is being made of collateral, and the 1994 ISDA Credit Support Annex will be a big help in this regard. Institutions such as the World Bank have made public their interest in moving more generally to collateralizing their swap portfolio as a way of substantially reducing and managing this risk. Second, there is talk in the press—more than in corporations and other institutions—about developing a clearinghouse for swaps and-other kinds of derivatives transactions. This undertaking would be very difficult, but a number of people are looking into it.
Market Risk
Market risk is the risk associated with a decline in the value of a derivatives instrument. An example of this kind of stress situation would be the U.S. stock market crash of October 1987. Market participants need to calculate their market risk when evaluating their potential credit and other risk exposure by marking their positions to market at least daily. Participants may assume that the market will move within historic limits in making these calculations. Dealers should also mark positions to market at least daily.
Liquidity Risk
Liquidity risk is the risk that, because of market movement, a counterparty will be unable to meet its net funding requirements. More specifically, it is the risk that, because of liquidity strains in the market, there will not be a fair price, that is, the price between the bid and the offer will be so wide that there may be no real market in which the participant can sell or buy the position that it is trying to replace. Liquidity risk has been a problem with more complex derivatives instruments. In the United States, for example, one organization saw its portfolio value drop from $600 million to near zero overnight when trying to sell it. Although the company thought that it had made reasonable assumptions about the portfolio’s value, the absence of liquidity in the market meant that there was no buying market for its interests.11 This risk is obviously something that needs to be evaluated.
Operational Risk
Operational risks are the risks associated with human error, systems failures, or inadequate procedures and controls. It is the responsibility of senior management to set the parameters and design and implement proper back-office procedures and other technological programs to counteract this risk. The absence of these internal controls, as well as the resulting operational risk, are unacceptable for any derivatives participant. Prospective participants should not enter the business until such systems are in place.
Reputation Risk
Reputation risk, a sort of summary risk, is a risk that market participants deal with every day. A market participant might lose clients or general reputation in the market if it does not deal fairly with them or does not properly manage its business. This risk might also be characterized as the risk of professional embarrassment.
Systemic Risk
Systemic risk is very difficult to define; it is the risk on which legislators, central bankers, and regulators have been focusing. There is no real evidence to support the scope that has been attributed to this risk, but it is a valid issue at the theoretical level. It is based on the “domino theory,” that is, the idea that the failure of one institution will cause failures in a series of other institutions or create a marketwide disruption in the financial system. This would be the catastrophic event that nobody looks forward to or anticipates but is always a possibility. Systemic risk is the focus, in fact, of the U.S. General Accounting Office’s report on financial derivatives.12
The elements of systemic risk are hard to identify. First there is the question of the size and complexity of the market. The press reports notional amount exposures; however, those amounts of $12–14 trillion do not reflect the real risks in the market. A smaller number, $68 billion, has been calculated as the percentage of the overall exposure that banks have in their loan and other portfolios. Second, there is a concern about concentration, based on the limited number of dealers in the market. However, statistics show that no one dealer has more than 10 percent of the market.13 There is, in fact, a wide dispersion of involvement among both dealers and end users. Third, the lack of transparency in the market is a cause for concern. In this respect, the accountants have not kept up with financial innovation. It is to be hoped that progress will be made in providing more information. Fourth, there is a somewhat vague concern that certain entities in this market are unregulated. The authors of the General Accounting Office report, for instance, have identified this as a problem. Fifth, there are concerns that the products are unusual and therefore illiquid—a point that has previously been addressed. Finally, there is the concern that the markets are linked and that, because of technology and innovation, a negative impact on one player in one part of the market will spread to other markets. How is this risk to be dealt with? Necessarily, other elements of systemic risk include credit risk and legal risk, which have already been addressed. The hope is that progress will be made in getting a handle on each of these incremental elements. In any event, the appropriate response to systemic risk should be one of concern but not overreaction.
Legislative and Regulatory Risk
Legislative and regulatory risk (a risk not formally on the list presented at the beginning of the chapter) is the potential for overreacting to the risks of derivatives. Derivatives lawyers have expressed concern over the legality of certain transactions because of the difficulty of determining how they fit in a legislative or regulatory scheme.14 Here, the concern is—and the General Accounting Office’s report recognizes this—that, if any one country imposes rigorous new regulatory or legislative requirements without proper international coordination, the market can successfully move to another jurisdiction, with destabilizing effects.
There is also the concern that, without international coordination, new regulatory or legislative requirements will accomplish nothing other than to dampen the utility of products that provide very important benefits, not just to end users who can manage their portfolios, but also to the dealers, for whom derivatives represent a strong source of profitability. It is possible that new requirements would hamper certain players’ use of derivatives. Regulators or legislators might impose suitability, disclosure, and capital requirements, all of which potentially have an impact on the ability of participants to use the market. Lack of adequate disclosure, certainly, is something that the marketplace is attempting to correct; the hope, however, is that legislators or regulators will not overreact in a way that will destabilize the business.
COMMENT
DAVID FOLKERTS-LANDAU
The absence of legally binding netting arrangements is a pernicious factor that could aggravate a distress situation or a default in the derivatives market. In a typical situation, the counterparty of the dealer has a number of claims against the dealer implicit in the over-the-counter (OTC) contracts held by the counterparty, who will at the same time owe a number of payments or claims to the dealer. Any doubt about the dealer will immediately translate into tardiness on the part of this counterparty in paying the obligations to the dealer. The immediate result would be a liquidity crisis, as the counterparty would simply postpone the payments until a more propitious time. Sorting out legal enforceability would occur much farther down the road. That is the nature of the problem: without netting arrangements, a counterparty can selectively hold back payments that are legally due to the dealer or to another institution on the other side of the transaction. Netting helps to eliminate that possibility and thereby reduces the possibility of systemic risk through a seizing up of payments.
Legality of Netting
A key question is whether it is possible to construct legally binding netting schemes. One should bear in mind in this respect that netting schemes, if there is doubt about their legal enforceability, may be worse than no netting schemes at all. When there is no netting scheme, one can assess the situation accurately and take steps accordingly. However, when one has a netting scheme but does not quite trust it, one cannot make an accurate assessment of risk or deal with it with certainty.
A legislative solution is the only satisfactory way to achieve the necessary level of certainty. Such a solution should optimally be encouraged at the international level. It can be achieved through extensive bilateral efforts or perhaps a multilateral effort spearheaded by the Bank for International Settlements. Absent specific legislation in the relevant countries, however, one cannot be certain that netting is legally binding in the OTC markets. In this regard, the U.S. experience probably provides a good precedent.
In the United States, pre-emptive federal legislation contained in the Financial Institutions Reform, Recovery, and Enforcement Act of 1989,1 the amendments to the Bankruptcy Code,2 and Subtitle A of Title IV of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA)3 have gone a long way toward legalizing netting. Interestingly, Title IV of FDICIA covers multilateral as well as bilateral situations. The impetus for this legislation was the Herstatt Bank case and what it did to the foreign exchange transactions of the Clearing House Interbank Payments System (CHIPS). There was no netting in place at the time. Herstatt closed when the American markets were still open, and it had not yet made its payments even though counterparties overseas had made payments. This incident caused a major problem for CHIPS and raised the concern of the U.S. central bank.
When considering situations such as the Herstatt case, the following question should be raised: If a foreign bank fails, will a receiver in that country honor CHIPS’s contractual arrangements? Some may, but some may not. Because OTC and foreign exchange markets are international markets (they are not exclusively U.S. or U.K. markets), the international dimension looms large. The fact that market participants and regulators should be concerned about the actions of receivers on the other side of the border shows how fundamental bilateral netting efforts are.
Advantages of Multilateral Clearinghouses
A basic question about the architecture of the derivatives market is why roughly half of all derivatives activities are carried on in the OTC market and half on the futures exchanges. The usual answer given is the need to customize derivatives transactions. However, this answer is wrong; an examination of the swap book—and swaps account for close to 60 percent of all transactions—reveals that in excess of 75 percent of all swap deals are standard deals with maturities of 1, 2, 5, 10, and 15 years. Also, despite the large volumes, there are only about a dozen dealers. Their staffs cannot possibly customize the $1.5 trillion in documents underlying the swaps. Therefore, even without looking at the books, one knows that a tremendous amount of standardization must be taking place.
Why is a particular contract not traded on the exchange as a swap contract? What are the advantages offered by a multilateral clearinghouse structure? Two advantages are (i) liquidity and (ii) the lack of credit risk. With respect to the first advantage, the exchange can become, in effect, the counterparty to contract trades on the exchange if the primary party fails to perform. The contract is thus fully fungible; it is no longer merely an unsupported bilateral contract between the dealer and its counterparty. The contract becomes liquid, like a futures contract. Second, with respect to credit risk, an exchange requires a mark to market on a periodic basis, traditionally at the end of the day, through its automatic and explicit margining requirements.
The current market structure has functioned well through times of tremendous stress, growth, and diversity. Why is there so much activity in a market that has significant faults and is subject to significant risks? Part of the answer is resistance from the industry, particularly those dealers that have an AAA rating. If they participate in a clearinghouse, they will lose the comparative advantage derived from their rating. The clearinghouse itself would, in effect, be rated; presumably, because of its risk-management features, it would receive an AAA rating. One reason why, despite the objections of the dealers, the OTC market or a large portion of it continues to exist can be found in the current structure of capital requirements for banking institutions. The associated costs of replacing a defaulted transaction may approximate the amount of margin money that would have to be paid if these contracts were traded on an exchange. Those costs, which would be funded by banks and would show up on their balance sheets, must reflect an 8 percent capital requirement. Effectively, then, participants avoid a capital charge by using an OTC market.
Pressure is now building from several sources to move toward a clearinghouse approach. First, pressure comes from the industry itself, because several large players have found that their exposure to the dealers is full. Essentially, they are running out of counterparties with the dealers and, therefore, pushing for multilateral clearing arrangements with or without counterparty features. Second, pressure is coming from the exchanges themselves, which are introducing products to allow flex options and other features that resemble those in the OTC market. Some of the liquidity element may be lost as flexible features are introduced, because the product will be more fungible; this problem will have to be addressed. Third, in the foreign exchange market, very serious efforts are under way to create multilateral clearinghouses—the European Clearing House Organization’s Exchange Clearing House Limited and the North American Clearing House Organization. Such efforts are growing, and a structure is emerging.
The derivatives industry has been immensely beneficial to the world at large. The efficiency gains, the pricing gains, and the liquidity gains have been incomparable. The importance of derivatives in this century is equivalent to the establishment of limited liability in the nineteenth century. That is why trying to make changes at the margin to deal with risks is probably not very satisfactory. That is why the multilateral clearinghouse approach should be encouraged. The efforts that must be made for this approach to work are enormous. By way of example, the legal aspects of multilateral clearing and the status of clearinghouses are several times more complex than those involved in bilateral netting.
In thinking about the supervisory and regulatory aspects of derivatives markets and their architectural design, one should take a close look at the advantages offered by a multilateral clearinghouse structure. Such a structure would take the activity that can be standardized out of the banking system and relieve banking supervisors of the burden of having to watch over it.
