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Who's on First? Credit Derivatives & Counterparty Risk; Basel II: Is the EU Really Leading the Way?
September 21, 2005

In the wake of the meeting sponsored by the Federal Reserve Bank of New York regarding the mounting backlog of unconfirmed trades in the credit derivatives ("CD") market, the dealer community has been tasked with finding a solution. Unfortunately, the very nature of this unregulated and non-homogenous market, and the behavior of the hedge funds which make up the majority of non-dealer participants, may render attempts to improve settlement efficiency problematic.

The issue of unconfirmed CD trades began to fester earlier this year when Ford (NYSE:F), GM (NYSE:GM) and their key parts suppliers, Visteon (NYSE:VC) and Delphi Corp (NYSE:DPH), were subjected to multiple credit downgrades by the major rating agencies. At the time, we predicted that Detroit's slow-motion progression towards default would eventually destabilize the US financial markets (GM, Ford and Health Care: Was Hillary Right?)

The bankruptcy of a number of smaller suppliers of the Big Two has already started a cascade of events that may eventually (and unfortunately) make our prediction come true. As our friends at Daily Bankruptcy News reported last week: "Saying it cannot turn a profit at prices under existing contracts, Collins & Aikman Corp., the auto trim and instrument panel component manufacturer that filed chapter 11 in May, has given its principal customers one week to agree on raising prices, else the company will begin filing motions to reject 3000 existing contracts. The customers are Ford, GM, and DaimlerChrysler."

The next shock to the system came with the bankruptcy filings of Delta and Northwest airlines last week, two events where disputes regarding CD contracts may actually test the legal standing of derivatives generally. So far, the securities industry has managed to conceal the true scale of the legal problems involved with the CD market under the hideous veil of mandatory arbitration, but the growing number of large corporate bankruptcies may eventually force a federal judge to rule on some basic issues, such as when the assignment of a derivatives contract is "final" - even when the trade is in dispute or has not been confirmed or properly documented.

Former NY Federal Reserve President E. Gerald Corrigan and other regulators deserve kudos for asking increasingly tough questions about the trading practices and related back office problems facing the CD market, but their expressed concerns may be too little too late. News reports that CD market participants will agree to provide additional data to enable regulators to track the fast-growing CD market may comfort some observers, but we have doubts that such expedients will prove effective. The proverbial horse left the barn long ago and global regulators are now playing catch-up ball, especially agencies like the Fed which have always backed the expansion of OTC derivatives dealing by the larger banks.

The basic problem with CDs specifically and the entire market in OTC derivatives is that the growing tendency by hedge funds to assign CD contracts, sometimes without informing the original counterparty, has created huge operational and credit risk issues for the dealer banks. As one senior banker told The IRA this week, the issue is not that a dealer bank won't continue to accept the economics of a given CD contract, but "we may require additional collateral and/or different terms if the new counterparty is not of the same credit standing as the original obligor."

It is no small irony that settlement and credit issues, and not the strategy behind speculative trading in these ersatz financial contracts, is the point of vulnerability for the entire global financial system. For decades, proponents of derivatives have argued that these instruments should not be subject to regulation or traded on exchanges because the size of the market and the number of participants is small and, in any event, only rich individuals and institutions play with such gaming contracts.

But now that CDs have become the largest single market for many corporate issuers, acting as a de facto, highly leveraged proxy for the cash markets, the lack of practical limitations on assignments and the dysfunction of the CD clearing process now threatens the stability of the entire marketplace. Whereas exchange traded products eliminate settlement risk by requiring clearing members to cross guarantee all trades, no such counterparty credit risk mitigation mechanism exists in the OTC derivatives market. Instead the stability of the multi-trillion dollar derivative market depends on bilateral credit relationships between dealers and their clients, relationships that the serial assignment of these same contracts undermines.

The fact that much of the derivatives exposure which so worries regulators lies between commercial banks and unregulated hedge funds only adds to the opacity of the systemic risk facing the entire market. Regulators have rightly begun to ask questions about the institutional and systemic exposure of banks to derivatives, but simply asking the hedge fund community and their dealer banks to suggest a fix may not be a reasonable approach. Sympathy for hedge funds among market participants has reached a new low, but imposing a way out of this mess may require more than just voluntary agreements to provide data by the obvious suspects.

Unfortunately, the "solution" to the festering problems in the CD market may require wholesale regulation of the hedge funds which comprise the bulk of non-bank CD counterparties. Placing hard restrictions on contract assignment seems inevitable, but such a palliative only hastens the day when the entire CD market will be forced into an exchange structure with minimum capital requirements for counterparties and tiered pricing for the widely varied credit risk profiles of the participants.

Basel II: Is the EU Really Leading the Way?

We are�growing weary�of reading reports�in the financial press to the effect that�Europe is�leading the way�in terms of �implementation of Basel II.� In our first contribution to Global Risk Regulator, we argue that, in fact,�the EU is years behind the US in terms of creating the basic regulatory infrastructure necessary to actually implement the New Basel Capital Accord.� Here is an excerpt:

"While EU banks may indeed believe that they are exemplars in the world of risk management and banking supervision, objective observers may debate the findings of the Accenture survey. In particular, if you take a close look at the lack of transparency and public disclosure in the European supervisory process, the assertion of EU leadership starts to unravel... There is no reporting regime in existence or in prospect in Europe which even begins to approach the level of regulatory disclosure and transparency already adopted by US banks."

Click here to read our comment in the September issue of Global Risk Regulator regarding Basel II.

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