DERIVATN'ES

Danger-
kids atplay
e
$r
bittion loss by Baring Brothers, a
$175
million
adjustment by Salomon Brothers for derivatives losses it didn't
know about. These are only the latest in a chain of instances
that show how far away apparently well-controlled firms can be
from calculating the true value of their risks. How many more
miscalculations are lurking out there? By David Shirreff
Merchant banking grouP Barings broke
elementary rules oFcontrol. That rvas the root
ofits fatal trading loss in Singapore. Such care-
lessness mav have been unique to Barings.
Most other firms operating in the derivatives
markets fancy thev have a better grasp of the
daily risla they are running. The most sophis-
ticared firms frequently stress-test their portfo-
lios and provide their management with a
daily number shorving rhe sensitiviry of their
positions to market risk.
Bur, after Barings' $r billion debacle' are
rhese other sophisticated 6rms as sure of
themselves as they used to be? Recent investi-
gations of the top dea.ling banks'risk manage-
ment porvers arenr that comforting.
It was supposed to be a simple exercise, but
it turned into a bit of a horror story. A handful
of swap-dealing bank in various countries
were asked by the Basle Committee on Bank-
ing Supervision last September to run the
same sample derivatives portfolio through
their internal risk management models and
come up with a number for value at risk.
Value at risk (van) is a prediction of the
amounr a portfolio might lose in value rvithin
a finite period
-
one day, ro days, or more
-
in
a variecy o[ trading conditions. The ven
number is based on assumptions about histor-
ical or implied volatiliry and a level of
confidence, say
95o/o
or
990/0,
that the number
won't be exceeded.
van is an excellent risk management tool. It
gives a dealer or risk manager a snapshot ofthe
future and a feel for how sensitive his positions
are to likely shifts in prices, interest rates and
exchange rates. But ven has its limitations.
Banks and central banks were reminded
how severe those limitations are when the first
resulrs of the Iirrlc rest came in.
The portfolio consisted of a hundred or so
swaps, swaptions, caps and floors, bonds and
bond options, in various currencies. Some
parameters lvere set, such as a ro-day holding
period and a
99o/o
confrdence level, to encout-
age uniformiry. There were Four variations of
the portfolio. Two were balanced
(that is, with
no directional view on interest rates)
-
one
with options positions, the other without.
Two were unbalanced
(with a directional
view) and one of those also included options
positions. The unbalanced portfolio with
options was understandably the most rislry
and the mosr difficult to predict. Even so it
r.vas a shock to learn that, according to one
bank supervisor, the banks' van numbers for
this portfolio varied at the extreme ends by a
factor of eight. Exact numbers aren't available
but iC for example, the bank at one extreme
had calculated a maximum loss in ro days of
$3o million, the bank at the other extreme was
predicting $z4o rnillion! This was not very
encouraging if supervisors and banks were
hoping that the van numbers would at least be
in the same ball-park.
Learning process
Naturally rhere were urgenr meetings to
discuss the discrepancies. Some bankers and
risk advisers had already murmured that the
parameters given by the supervisors -left too
many assumptions open. Historical data can
be viewed, sampled, weighted in many differ-
ent ways. Confidence levels can be calculated
differently; high correlation can be judged
good or bad for a portfolio. There are many
views on the valuation of bond options. IFthe
Basle Commitree had preset all these assump-
tions then, barring mathematical error, the
banks should have arrived at the same
number.
C
Euromoney
I
March
ry95
43
Certainly, after consultation, the numbers
were much closer together, but not close
enough for the Basle Committee to be sure
they're on the right track. Supervisors see the
exercise as "a learning process" rather than a
demonstration thar bantr<s' internal vAR
models should set the standards for supervi-
sory and capital adequacy purposes. The exer-
cise strongly suggests that vAR alone is not
enough. It is a useful trading and risk manage-
ment tool. It shows potential losses in reason-
ably normal trading conditions, but it doesnt
capture the extremes, which are what bank
supervisors worry about most. It is not a stress
test.
So if van is to become a component of
supervision and capital adequary calculatons,
there have to be other components too. The
Basle Commitree is about to release a new set
of draft proposals on capital charges For
market risk. These are expected to include
some use o[ internal van models. But even at
this late stage the supervisors are uncomfort-
able about the discrepancies they saw Ifvan is
used, then rhere will be multipliers or add-ons
that dwarf the van number. Some supervisors
wonder whether van should be used at all as a
supervisory and capital adequacy tool.
The swap communiry is interested in
dispelling these doubts. Dealers have invested
tens of millions of dollars on risk management
systems. Those systems have greatly refined
the identification, unbundling and pricing of
risk.
Since rhe Group of Thirry (c;o) report on
derivatives in 1993, senior management of
6rms have made great progress in assimilating
the derivatives area into their view of opera-
tions. But the cao reporr was a little weak in
the area of reconciliation, that is, marrying up
rhe activiqy of rhe front office, dealing and
origination, with what finally comes out of the
back office. "Many trades have been forced
into systems that can't cope," says David
Cannon, a partner at Ernst & Young in
London. "Sometimes deals have to be input
twice to capture different components. You
can get huge differences berween the profit
and loss account, the balance sheet and actual
records. This is a very grubby area of banking.
Someone has to make sure that expected
cashflows turn into actual cashfows."
JoeJett
syndrome
A glaring example of this was provided by
Salomon Brothers, which on February z
announced it was making good a $r4o million
hole in its accounts, accumulated since 1988,
which it had discovered after reconciling the
predicted cashfows on swaps that had been
written with the actual cashfows. Then it
announced another $3i million adjustment on
February 27 rc the cashflows of a yen swap
written in 1988.
One veteran market participant relers to
this as
"Joe
Jett
syndrome"
-
the back office
and internal audit not questioning rigorously
enough the value that front office dealers put
on the business they write. Some dealers are
44 Euromoney
I
March 1995
highly conservative about the value of their
positions; others might overvalue them, not
least because the value affects their bonuses.
Joe Jett
quit Kidder Peabody last year after
governmenl bond positions he had written
turned out to have been overvalued by around
$35o million.
"You need to be very sure of
yourself to cross-question what the arrogant
front-office guys are telling you," the veteran
says.
!7ith blind-spots like these revealed in deal-
ers' risk management controls, why should rve
be surprised when end-users' controls also fail
to identifr a ballooning risk? The corporate
derivatives disasters seen in the last ry months
make dealing firms look bad whichever way
they are studied. Either the dealer didnt
understand the sheer scale of the downside
risk it was selling irs client, because it wasn't
warned by its own risk systems; or it did
understand but failed to pass that wisdom on
to the clienr.
In a field rvhere quantifring risks is so hard,
swap dealers are beginning to recognize that
they have some responsibiliry to pass a little of
their hard-won knowledge on to the client.
'Whether
that is a legal obligation or simply a
good marketing strategy is a matter of fierce
debate.
Richard Breeden, former src chairman,
now chairman of international financial
services at Coopers & Lybrand, recently
suggested that, had Gibson Greetings been in
the habit of marking its positions to market, ic
would have spotted and arrested much earlier
the deterioration of its swap deals with
Bankers Tiust. Should Bankers Tiust have
done that for them? Even if it had no legai
obligation it would probably volunteer to do
so today, rather than, as it apparently did, Iie
about the graviry ofits position and then get
found out.
One side-effect of the Bankers
Tiust/Gibson Greetings case has been a greater
willingness by dealers to share their risk
management expertise with customers.
"fusk
management is what the market craves, and
sharing our [risk
management] skills has
become an important business for us," says
Lee Barba, head of the risk management advi-
sory group at Bankers Tiust. Since r99r,
Bankers Trust has offered to do risk manage-
ment studies for customers, including helping
them correlate and anallue their risks, for a
fee. More recently, responding to client
requests, and recognizing that fees alone won't
pay for the service, Bankers Tiust has been
more actively seeking risk management
contracts with clients which include dealing
on rheir beha.lf, or acting as preferred deaier
with reduced and visible margins.
Cynics might see this as a rather obvious
attempt to put sheep's clothing on the wolf
that last year was caught apparently preying
on unwary corporate treasurers.
But even Bankers tustt sternest critics
would concede that itt still one of the best
addresses for risk management experrise.
Barba maintains: "Where risks need to be
managed, we're the best in the rvorld."
Although consultants and accountants offer
aspects of r.isk management expertise, Bankers
also provides a
"real
live market knowledge
and culture", he says.
No other major dealer has followed Bankers
tust into the separate marketing of risk
management advisory services.
"1We
do it anpvay, as part of our client
service," says Fred Chapey, head of global
derivatives at Chase Manhattan Bank in New
York.
"'We
offer the full array for analyzing
their risk, but generally not for a fee."
Customer detente
Sumitomo Bank Capital Markets (sncrrr) in
Nerv York traded the sr'vap porrfolio of
Confederation teasury Services as an adviser,
but for a limited time, because of Confedera-
tion's bankruptcy. That made rhe .laborious
exercise oIrransferring all the rransactions into
its system hardly worthwhile.
John
Copen-
haver, presidenr of sscila, agrees thar "senior
managemenr in banks like rhe idea of fee-
based stable cash-fows. But theret a limit to
how much money you can make. It pays the
Iight bills but nor the bonuses".
Barba admirs:
"Fees
don't generate a signifi-
cant
pE{L.
But what's important is the develop-
ment of the relationship and the obvious
openings on the transaction side." Recently,
Bankers rvas awarded a big risk management
assignment with a utiliry company, rvhereby it
would place a dozen of its stafffull-rime to set
up a risk management system, and jointly
manage its hedging operations, before hand-
lng rt ovef.
In the spirit of detente berween dealer and
customer
Jp
Morgan launched its RiskMetrics
database in October. This is not a risk
managemenr service, it is a too.l, the product
of a huge data-collection and analysis exercise
which Morgan has made available to the
marketplace. To be useful, the database, which
includes interest rate, currency, equiry index
and government bond volatilities, must be
plugged into an existing risk management
system
-
Morgan has a list o[soffware vendors
whose product can take fuskMetrics. For
Morgan it has been an image-building and
marketing tool, and it gets them closer to their
clients.
"lrt
a relarionship-building producr,"
says
Jacques
Longerstaey, worldwide RiskMet-
rics coordinator at
Jp
Morgan in New York.
Almost more useful than the database itselfi
say rivals, is the roo-page technicai document
that accompanies it, explaining the subtleries
of volatiliry and correlation analysis. But fusk-
Metrics is not a panacea for customers with
derivatives positions, nor was it meant to be. It
doesn't include option volatility
-
the volatil-
iry of volatiliry
-
which is the key to these
markets, say dealers. "It's wrong to say fusk-
Metrics doesn't handle derivatives," counrers
Longerstaey. "But clearly it handles some
better than others. For options, we measure
the delta equivalents. There is a way rhat
would avoid that simplification, and we're
working on it."
The real contribution of fuskMetrics is the
demonstration of something approaching
altruism. Gathering the information, affirm-
ing its integriry providing the calculations,
would be a hrrge i-ount of work for a firm
starting from scratch. Morgan developed the
databaie for its own purposes but now has six
sraff minding and marketing fusk.iVletrics'
"\(/e're as ioncerned that rhe market should
be big and healthy as we are about keeping our
share- of it," says Peter Hancock, managing
director in charge of global derivatives at
Morgan.
There is some concern, howevet even
within Morgan, that the assumptions on data-
weighting built into fuskMetrics will become
an indusiry standard simply by default.
"The
volatiliry is time-weighted," says a Morgan
source.
"Is
Morgan's weighting the best
weighting? \7e think it is. But there's a.judge-
ment in there."
fuvais note that Morgan has been careful
not to append a risk management advice
service to its product.
"If somebody lost
money on that kind of system, maybe they
could sue Morgan," muses one. Deursche
Bank has no such qualms about its db-Analyst
2.o system which it released at the end of last
year
-
an updated version of a service it has
offered since 1989. Aimed mainly at German
clients, it gives them a Vindows-based
program which will assimilate their portfolio
of bond, swap and derivative positions and
give them a "money at risk" measurement.
"lt's
not a trading tool. It hasn't got the last compli-
cated option valuation model but it gives you
a very good idea of where you stand," says
Hans-Peter Preyer, in charge of German inter-
est derivative sales at Deutsche Bank in Frank-
furt. Deutsche is not exactly showing the
customer how it does its own pricing but, for
example, "if a client has a structured note, he
can see the market price for the product," says
Preyer. In theory banks will have to give a
client, armed with db-Analyst, a narrower bid
and offer. But a rival at another German bank
says Deutsche may be heaping up trouble for
itself.
"Considering how badly we treat our
sofrware vendors, I foresee they'll be in perma-
nent discussion with their clients on develop-
ing this thing. Then maybe one day they'll get
suid by ro-.or,. who took a position and lost
money."
Used car dealers
The client/dealer relationship has come under
close scrutiny since the Bankers Tiust cases of
last summer. Late last month the International
Swaps & Derivatives Association Gsoa)
held a
r.-irra. in \Tashington to discuss the legal
and ethical aspects ofthis relationship. Is it or
to lie to your client? No. But should you
volunteer information if your client doesn't
ask the right question? Brandon Becker, capi-
tal markets division director at the us Securi-
ties & Exchange Commission
(snc) compares
the situation io that of the used-car dealer.
Legally the dealer is not allowed to lie by
tampering with the cart odometer. But if the
46 Euromoney
I
March 1995
car has been in a crash he might only admit it
if het asked the right question.
"If asked a
question
-
you're not supposed to lie," says
Becker. The customer has the freedom to seek
independenr advice, and we a.ll understand
that, in this relationship, unless there's a six-
monrh guarantee, itt a case of caueat emPtor
-
let the buyer beware. Henry Hu, law professor
at the Universiry of Texas, insists that comPa-
nies
"have an inherent right to make stupid
decisions
-
it's important that rhey do, and
that the government doesn't intervene".
But because derivatives are so complex, savs
Andrea Corcoran, a division director at the
Commodiw Futures Trading Commission
(crrc), "there may be a special dury of care in
marketing them". Nevertheless, there is a
general reluctance among us regulators to seek
additional legislation on this point.
Dealers could avoid ambiguiry by esrablish-
ins uo-front what kind oF contractual rela-
ti&ship they have wirh a clienr. Is it fiduciary
or arms-length? If it is Educiary the dealer is
also adviser. As an adviser his recommenda-
tions, if they're misleading or negligent, could
rebound on him. The dealer should also estab-
lish whether it's an adviser just on that trans-
action or on the client's entire portfolio.
For arms-length dealing
-
that is, treating
the customer as a "consenting adult"
-
Isoe is
developing a
"code of conduct for wholesale
transactions". The scope is not just derivatives.
After a beaury-contest of existing codes, such
as the London code of conduct for wholesale
markets, rhe discussions have run into some
snags. One sticking-point is a proposed
commitment to deal at market rates.
'What
happens, asks one practitioner, ifyou want to
make your client a better price to get him out
of a particular trade, which perhaps you
tailored for him? The bid from the street
might be much lower. Does thar me:tn you
carinot make a more favourable otf-market
price?
As if this uncertainry were not enough,
swaps in the us exist in limbo under constant
rhreat o[ regulation by rhe crrc and possibly
the ssc. In r99z the act that reauthorized the
cp'rc allorved it to exempt swaps lrom regula-
tion as futures. So far, it has exempted them
but, as Corcoran reminded her \Tashington
audience,
"the cFTC has nerer explicitly said
swaps are lutures or rhat they're not futures".
Some srvaps or derivatives embedded in traded
instruments might be regarded as securities. If
rhey were ever defined as such, a rn'hole new set
ofobligations to protect retail clients would
"We
might benefit from passing Iegislation
defining orc
[over-the-counter]
derivatives as
not futures or securities," says
Jack
Fields,
chairman of the House of Representatives
subcommittee on telecommunications and
finance. But he warns, "product regulation
fails almost all hurdles, because it's static".
Derivatives dealers rnight like more legal
certainrv on enforceabiliry of contracts and
the deaier/client relationship. They are partic-
ularly concerned that last yeart controversial
losses may tempt other firms experiencing
losses to reach for their lawyers rather than
pay.
"The new rule of law," warns Ernie
Patrikis, general counsel at the Federal Reserve
Bank of New York, "is 'heads
I win, tails you
lose'
-
that concerns me. Commercial law
should be clear."
But derivative dealers don't want new legis-
lation. Nor do they seem to mind thar orc
derivatives defr definition and regulation by
one or other us authoriry. The swap market
has thrived in this grey zone berween the more
classical financial instruments. Its practition-
ers have done a remarkable job of disciplining
themselves and anticipating problems
-
with a
few notable exceptions. One explanation is
that the entry costs are high. The global
foreign exchange markets are an example of a
huge, largely unregulated forum that has
seldom broken down or been rocked by scan-
dal. "The moraliry and integriry of the forex
market is not perfect," says Patrikis, "but itt
pretry high."
Reputation roller-coaster
But there is a general perception that deriva-
tives reached a watershed last year. Some of the
persuasive sales-talk behind the more
complex, leveraged insrruments has been
shamed into silence. Exotic derivatives are still
there and, some dealers argue, still useful,
provided rhe side thar the customer sees is
simple and risk-mitigating. Range forwards,
lor example, are much in demand, simple flor
the buyer, despite being a reasonably complex
hedge for the seller. Leveraged products
survive, but mostly as toxic waste in the
process oI immunization and burial.
According to tsoet latest figures, orc deriv-
arives outstandings grew to $4.2r trillion of
norional principal by
June
1994. There are
indications that much of this volume was
extremely short-term: $3.r8 trillion of new
business was written berween
January
and
June ry94.
The bulk of derivatives activiry is
low-cost and high-volume, and that character-
istic has increased since the bilateral netting of
swap exposures became accepted in several
jurisdictions. The bread-and-butter business
will not go away. But for dealers which need to
win higher-margin, higher-va1ue business,
some image-building is needed. Reputation,
as Hancock told his Vashington audience, is
"hard to establish and easy to destroy. No
sanction or 6ne can compare with the loss of
reputation. You only have to look at the results
of certain firms in rg94 to see what I mean".
One got the impression he didn't just mean
Bankers Tiust.
After the demise of Barings, the entire
universe of derivatives players comes under
closer scrutiny. There was no obvious
ourward sign that some vital control mecha-
nism was missing at Barings. If that was the
case there, why shouldnt it be true of some
other prestigious house.
Just
when rhey
thought they had cleared last year's nasty
hurdles, derivatives dealers find themselves
under further inquisition.