14 September 2003 12:07
Derivatives remain contentious
The legendary investor Warren Buffet’s outspoken comments against the derivatives industry generated endless
headlines earlier this year. However, while several like-minded columnists and investors echoed his views, there was a
noticeable lack of comment from regulators.Indeed, many regulators – and most notably Alan Greenspan, chairman
of the US’s Federal Reserve – appear to be firm supporters of the industry. Even while the derivatives
industry develops apace in the more established markets, regulators in other countries have made active moves this year
to see their own markets develop.
Korea has the fastest growing derivatives market in the world; in India whole new families of derivatives instruments
have been introduced, and in Russia and China regulators and law-makers are introducing legislation that will propel the
market’s growth still further.
Not long after Buffet’s views were aired in March, Greenspan was speaking at a conference in Chicago, where
he reiterated his belief in derivatives as sound risk management tools. He said: "The use of a growing array of
derivatives and the related application of more sophisticated methods for measuring and managing risk are key factors
underpinning the enhanced resilience of our largest financial intermediaries. The benefits of derivatives, in my
judgment, have far exceeded their costs.'
Bob Pickel, chief executive of the International Swaps and Derivatives Association (Isda), who spends much of his
time dealing with regulatory authorities across the world, says Greenspan’s comments were a "positive
response' to Buffet, and observes that most other regulators are also more than supportive of the instruments.
Pickel says: "Many of the bank regulators, particularly those that are actively involved in the Basel process,
have acknowledged the benefits of these instruments, and have made it known they would like to see banks use them to
offload credit risk.'
Such is Buffet’s sway, however, that the discussion continues. His comments were the subject of a discussion
at the annual exchange-traded derivatives industry conference held in Bürgenstock earlier this month.
Unable to secure Buffet or an alternative spokesperson to defend his tenets before so many staunch derivatives
supporters, John Langton, chief executive and secretary general of the International Securities Markets Association
(Isma) was forced to read out Buffet’s comments. Unsurprisingly, they found little sympathy.
One of those speaking on the panel was Roy Leighton, chairman of the European advisory board at Crédit
Lyonnais, and the European Futures and Options Association (FOA). Although Leighton acknowledged that derivatives indeed
have the potential to do serious damage, he was swift to add that this was only the case in the wrong hands or control
environment.
He said: "In today’s environment that it is a remote possibility. The standards that go into vetting
and hiring and educating those operating in these markets is very high. A modern trader is subject to as much
post-qualifying education as any other professional. Similarly, the control environment today is well developed;
exchanges, regulators and clearers form a formidable array of defences.'
The only area of potential danger that Leighton pointed to was in the over-the-counter (OTC) area of the derivatives
business – a market that the Bank for International Settlements (BIS) estimates to have been worth in excess of
$140 trillion (€126 trillion) at the end of last year. The OTC business has recently outpaced growth of the
exchange-traded business. During the second half of last year the market grew 11% from the $127.5 trillion recorded at
the end of June, while in the same period open positions in exchange-traded contracts fell by 1%.
Because the OTC market is more complex, opaque and thus less strictly monitored than the exchange-traded side of the
business, there is more potential for – if not abuse – at least misuse, misunderstanding or
mis-application of the instruments.
To eradicate this potential hazard, Lyonnais’ Leighton advocates that each country should introduce a single
regulatory regime overseeing all areas of the market – a trend that is already developing.
Meanwhile Isda, which represents the OTC market, is working on the operational and legal issues which underpin the
business.
Earlier this year, it developed a new Master Confirmation Agreement, which is a single document for the inter-dealer
community, as well as new credit derivative definitions, which should ensure greater legal certainty for the
instruments.
Other industry initiatives, which have been encouraged by Isda and regulators will see new codes of conduct
developed, a move towards more automation of confirmations and processing and the wider introduction of centralised
clearing.
Efforts are also being made from outside the industry, which will also tighten up the application of these
instruments. The big losses suffered by Barings, Long-Term Capital Management and others, have led to calls for more
stringent regulation of derivatives activity.
One of the areas where such calls have been most evident is in respect to the need for greater transparency in the
disclosure of derivatives positions.
The US has seen the introduction of new accounting standards that demand a far higher level of transparency in
company accounts when dealing with derivatives, while the International Accounting Standards Board is working towards
its own standards, which are to be widely deployed from early 2005. Although these are yet to be finalised, and have
caused much debate, they will in all likelihood introduce some clarity.
However, the regulators and accounting standard setters can only do so much – it is up to investors to
ensure that companies disclose this information properly. Alarmingly, a recent survey by the universities of Birmingham
and Dundee, and funded by the Institute of Chartered Accountants in England and Wales, found that institutional
investors have not even fully investigated the present disclosures.
The survey examined the UK’s Financial Reporting Standard 13, which requires narrative and numerical
disclosures about companies’ use of derivatives. While the research showed that the UK’s powerful and
influential body of institutional investors are aware of an increase in their investee companies’ use of
derivatives, fund managers still place a greater emphasis on companies’ strategic and operational activities,
rather than on their risk management practices.
Professor Chris Mallin, director of the Centre for Corporate Governance Research at Birmingham Business School, says:
"Our analysis of the interviews undertaken for this study shows that institutional investors tend not to discuss
the use of derivatives with directors, which is interesting, given the potential risk exposure consequences of
inappropriate derivatives usage.
"Following the recommendations of the Turnbull Report (1999) on the management of internal controls and risk, it
may have been assumed that items of this nature would have been included on the agenda of meetings between institutional
investors and directors. However, on the whole, this does not seem to be the case.'
[UKIR [UK & Ireland Intelligence Wire]] |
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