DERIVATN'ES

Danger-kids atplaye $r bittion loss by Baring Brothers, a $175 millionadjustment by Salomon Brothers for derivatives losses it didn'tknow 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 brokeelementary rules oFcontrol. That rvas the rootofits 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 theirpositions to market risk.

Bur, after Barings' $r billion debacle' are

rhese other sophisticated 6rms as sure ofthemselves 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, butit turned into a bit of a horror story. A handfulof swap-dealing bank in various countrieswere asked by the Basle Committee on Bank-ing Supervision last September to run thesame sample derivatives portfolio throughtheir internal risk management models andcome up with a number for value at risk.

Value at risk (van) is a prediction of theamounr a portfolio might lose in value rvithina finite period - one day, ro days, or more - ina variecy o[ trading conditions. The vennumber is based on assumptions about histor-ical or implied volatiliry and a level ofconfidence, say 95o/o or 990/0, that the numberwon't be exceeded.

van is an excellent risk management tool. Itgives a dealer or risk manager a snapshot ofthefuture and a feel for how sensitive his positionsare to likely shifts in prices, interest rates andexchange rates. But ven has its limitations.

Banks and central banks were remindedhow severe those limitations are when the firstresulrs 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. Someparameters lvere set, such as a ro-day holdingperiod and a 99o/o confrdence level, to encout-age uniformiry. There were Four variations ofthe portfolio. Two were balanced (that is, withno directional view on interest rates) - onewith options positions, the other without.Two were unbalanced (with a directionalview) and one of those also included optionspositions. The unbalanced portfolio withoptions was understandably the most rislryand the mosr difficult to predict. Even so itr.vas a shock to learn that, according to onebank supervisor, the banks' van numbers forthis portfolio varied at the extreme ends by a

factor of eight. Exact numbers aren't availablebut iC for example, the bank at one extremehad calculated a maximum loss in ro days of$3o million, the bank at the other extreme was

predicting $z4o rnillion! This was not veryencouraging if supervisors and banks were

hoping that the van numbers would at least be

in the same ball-park.

Learning processNaturally rhere were urgenr meetings todiscuss the discrepancies. Some bankers andrisk advisers had already murmured that theparameters given by the supervisors -left toomany assumptions open. Historical data canbe viewed, sampled, weighted in many differ-ent ways. Confidence levels can be calculateddifferently; high correlation can be judgedgood or bad for a portfolio. There are manyviews on the valuation of bond options. IFtheBasle Commitree had preset all these assump-

tions then, barring mathematical error, thebanks should have arrived at the samenumber.

C

Euromoney I March ry95 43

Certainly, after consultation, the numberswere much closer together, but not close

enough for the Basle Committee to be surethey're on the right track. Supervisors see theexercise 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 notenough. It is a useful trading and risk manage-

ment tool. It shows potential losses in reason-

ably normal trading conditions, but it doesntcapture the extremes, which are what banksupervisors 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. TheBasle Commitree is about to release a new set

of draft proposals on capital charges For

market risk. These are expected to includesome use o[ internal van models. But even atthis late stage the supervisors are uncomfort-able about the discrepancies they saw Ifvan is

used, then rhere will be multipliers or add-onsthat dwarf the van number. Some supervisorswonder 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 investedtens of millions of dollars on risk managementsystems. Those systems have greatly refinedthe identification, unbundling and pricing ofrisk.

Since rhe Group of Thirry (c;o) report onderivatives in 1993, senior management of6rms have made great progress in assimilatingthe derivatives area into their view of opera-tions. But the cao reporr was a little weak inthe area of reconciliation, that is, marrying uprhe activiqy of rhe front office, dealing andorigination, with what finally comes out of theback office. "Many trades have been forcedinto systems that can't cope," says DavidCannon, a partner at Ernst & Young inLondon. "Sometimes deals have to be inputtwice to capture different components. Youcan get huge differences berween the profitand loss account, the balance sheet and actualrecords. This is a very grubby area of banking.Someone has to make sure that expectedcashflows turn into actual cashfows."

JoeJett syndromeA glaring example of this was provided bySalomon Brothers, which on February z

announced it was making good a $r4o millionhole in its accounts, accumulated since 1988,which it had discovered after reconciling thepredicted cashfows on swaps that had beenwritten with the actual cashfows. Then itannounced another $3i million adjustment onFebruary 27 rc the cashflows of a yen swapwritten in 1988.

One veteran market participant relers tothis as "Joe Jett syndrome" - the back officeand internal audit not questioning rigorouslyenough the value that front office dealers puton the business they write. Some dealers are

44 Euromoney I March 1995

highly conservative about the value of theirpositions; others might overvalue them, notleast because the value affects their bonuses.

Joe Jett quit Kidder Peabody last year aftergovernmenl bond positions he had writtenturned out to have been overvalued by around$35o million. "You need to be very sure ofyourself to cross-question what the arrogantfront-office guys are telling you," the veteransays.

!7ith blind-spots like these revealed in deal-ers' risk management controls, why should rve

be surprised when end-users' controls also failto identifr a ballooning risk? The corporatederivatives disasters seen in the last ry monthsmake dealing firms look bad whichever waythey are studied. Either the dealer didntunderstand the sheer scale of the downsiderisk it was selling irs client, because it wasn'twarned by its own risk systems; or it didunderstand but failed to pass that wisdom onto the clienr.

In a field rvhere quantifring risks is so hard,swap dealers are beginning to recognize thatthey have some responsibiliry to pass a little oftheir hard-won knowledge on to the client.'Whether that is a legal obligation or simply a

good marketing strategy is a matter of fiercedebate.

Richard Breeden, former src chairman,now chairman of international financialservices at Coopers & Lybrand, recentlysuggested that, had Gibson Greetings been inthe habit of marking its positions to market, ic

would have spotted and arrested much earlierthe deterioration of its swap deals withBankers Tiust. Should Bankers Tiust have

done that for them? Even if it had no legaiobligation it would probably volunteer to doso today, rather than, as it apparently did, Iieabout the graviry ofits position and then getfound out.

One side-effect of the BankersTiust/Gibson Greetings case has been a greaterwillingness by dealers to share their riskmanagement expertise with customers. "fuskmanagement is what the market craves, andsharing 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 helpingthem correlate and anallue their risks, for a

fee. More recently, responding to clientrequests, and recognizing that fees alone won'tpay for the service, Bankers Tiust has beenmore actively seeking risk managementcontracts with clients which include dealingon rheir beha.lf, or acting as preferred deaierwith reduced and visible margins.

Cynics might see this as a rather obviousattempt to put sheep's clothing on the wolfthat last year was caught apparently preyingon unwary corporate treasurers.

But even Bankers tustt sternest criticswould 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 offeraspects of r.isk management expertise, Bankersalso provides a "real live market knowledgeand culture", he says.

No other major dealer has followed Bankerstust into the separate marketing of riskmanagement advisory services.

"1We do it anpvay, as part of our clientservice," says Fred Chapey, head of globalderivatives at Chase Manhattan Bank in NewYork. "'We offer the full array for analyzingtheir risk, but generally not for a fee."

Customer detenteSumitomo Bank Capital Markets (sncrrr) inNerv York traded the sr'vap porrfolio ofConfederation teasury Services as an adviser,but for a limited time, because of Confedera-tion's bankruptcy. That made rhe .laboriousexercise oIrransferring all the rransactions intoits system hardly worthwhile. John Copen-haver, presidenr of sscila, agrees thar "seniormanagemenr in banks like rhe idea of fee-based stable cash-fows. But theret a limit tohow much money you can make. It pays theIight 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 obviousopenings on the transaction side." Recently,Bankers rvas awarded a big risk managementassignment with a utiliry company, rvhereby itwould place a dozen of its stafffull-rime to setup a risk management system, and jointlymanage its hedging operations, before hand-lng rt ovef.

In the spirit of detente berween dealer andcustomer Jp Morgan launched its RiskMetricsdatabase in October. This is not a riskmanagemenr service, it is a too.l, the productof a huge data-collection and analysis exercisewhich Morgan has made available to themarketplace. To be useful, the database, whichincludes interest rate, currency, equiry indexand government bond volatilities, must be

plugged into an existing risk managementsystem - Morgan has a list o[soffware vendorswhose product can take fuskMetrics. ForMorgan it has been an image-building andmarketing tool, and it gets them closer to theirclients. "lrt a relarionship-building producr,"says Jacques Longerstaey, worldwide RiskMet-rics coordinator at Jp Morgan in New York.Almost more useful than the database itselfisay rivals, is the roo-page technicai documentthat accompanies it, explaining the subtleriesof volatiliry and correlation analysis. But fusk-Metrics is not a panacea for customers withderivatives positions, nor was it meant to be. Itdoesn't include option volatility - the volatil-iry of volatiliry - which is the key to thesemarkets, say dealers. "It's wrong to say fusk-Metrics doesn't handle derivatives," counrersLongerstaey. "But clearly it handles somebetter than others. For options, we measure

the delta equivalents. There is a way rhatwould avoid that simplification, and we'reworking on it."

The real contribution of fuskMetrics is thedemonstration of something approachingaltruism. Gathering the information, affirm-ing its integriry providing the calculations,would be a hrrge i-ount of work for a firmstarting 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 ourshare- of it," says Peter Hancock, managingdirector 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 becomean indusiry standard simply by default. "Thevolatiliry is time-weighted," says a Morgansource. "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 adviceservice to its product. "If somebody lostmoney on that kind of system, maybe theycould sue Morgan," muses one. DeurscheBank has no such qualms about its db-Analyst2.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 Germanclients, it gives them a Vindows-basedprogram which will assimilate their portfolioof bond, swap and derivative positions and

give them a "money at risk" measurement. "lt'snot a trading tool. It hasn't got the last compli-cated option valuation model but it gives youa 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, forexample, "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 bidand offer. But a rival at another German banksays Deutsche may be heaping up trouble foritself. "Considering how badly we treat oursofrware 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 lostmoney."

Used car dealersThe client/dealer relationship has come underclose scrutiny since the Bankers Tiust cases oflast summer. Late last month the InternationalSwaps & Derivatives Association Gsoa) held a

r.-irra. in \Tashington to discuss the legaland ethical aspects ofthis relationship. Is it orto lie to your client? No. But should youvolunteer information if your client doesn'task the right question? Brandon Becker, capi-tal markets division director at the us Securi-ties & Exchange Commission (snc) comparesthe situation io that of the used-car dealer.Legally the dealer is not allowed to lie bytampering with the cart odometer. But if the

46 Euromoney I March 1995

car has been in a crash he might only admit itif 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 understandthat, 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 stupiddecisions - it's important that rhey do, andthat the government doesn't intervene".

But because derivatives are so complex, savs

Andrea Corcoran, a division director at theCommodiw Futures Trading Commission(crrc), "there may be a special dury of care inmarketing 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 fiduciaryor arms-length? If it is Educiary the dealer isalso adviser. As an adviser his recommenda-tions, if they're misleading or negligent, couldrebound 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, treatingthe customer as a "consenting adult" - Isoe is

developing a "code of conduct for wholesaletransactions". The scope is not just derivatives.After a beaury-contest of existing codes, suchas the London code of conduct for wholesalemarkets, 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 tomake your client a better price to get him outof a particular trade, which perhaps youtailored for him? The bid from the streetmight be much lower. Does thar me:tn youcarinot make a more favourable otf-marketprice?

As if this uncertainry were not enough,swaps in the us exist in limbo under constantrhreat 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 thembut, as Corcoran reminded her \Tashingtonaudience, "the cFTC has nerer explicitly saidswaps are lutures or rhat they're not futures".Some srvaps or derivatives embedded in tradedinstruments might be regarded as securities. Ifrhey were ever defined as such, a rn'hole new set

ofobligations to protect retail clients would

"We might benefit from passing Iegislationdefining orc [over-the-counter] derivatives as

not futures or securities," says Jack Fields,

chairman of the House of Representatives

subcommittee on telecommunications andfinance. But he warns, "product regulationfails almost all hurdles, because it's static".

Derivatives dealers rnight like more legalcertainrv on enforceabiliry of contracts andthe deaier/client relationship. They are partic-ularly concerned that last yeart controversial

losses may tempt other firms experiencinglosses to reach for their lawyers rather thanpay. "The new rule of law," warns ErniePatrikis, general counsel at the Federal Reserve

Bank of New York, "is 'heads I win, tails youlose' - that concerns me. Commercial lawshould be clear."

But derivative dealers don't want new legis-lation. Nor do they seem to mind thar orcderivatives defr definition and regulation byone or other us authoriry. The swap markethas thrived in this grey zone berween the moreclassical financial instruments. Its practition-ers have done a remarkable job of discipliningthemselves and anticipating problems - with a

few notable exceptions. One explanation is

that the entry costs are high. The globalforeign 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 forexmarket is not perfect," says Patrikis, "but ittpretry high."

Reputation roller-coasterBut there is a general perception that deriva-tives reached a watershed last year. Some of thepersuasive sales-talk behind the morecomplex, leveraged insrruments has beenshamed into silence. Exotic derivatives are stillthere 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 complexhedge for the seller. Leveraged productssurvive, but mostly as toxic waste in theprocess oI immunization and burial.

According to tsoet latest figures, orc deriv-arives outstandings grew to $4.2r trillion ofnorional principal by June 1994. There are

indications that much of this volume was

extremely short-term: $3.r8 trillion of newbusiness 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 ofswap exposures became accepted in severaljurisdictions. The bread-and-butter businesswill not go away. But for dealers which need towin 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. Nosanction or 6ne can compare with the loss ofreputation. You only have to look at the resultsof certain firms in rg94 to see what I mean".One got the impression he didn't just meanBankers Tiust.

After the demise of Barings, the entireuniverse of derivatives players comes undercloser scrutiny. There was no obviousourward sign that some vital control mecha-nism was missing at Barings. If that was thecase there, why shouldnt it be true of someother prestigious house. Just when rheythought they had cleared last year's nastyhurdles, derivatives dealers find themselvesunder further inquisition.