01 Jun 2005, Risk magazine, Risk magazine
BoE deputy governor warns about risk of instability
Bank of England deputy governor Sir Andrew Large has warned about the potential adverse impact of derivatives transactions. In an address to an Istanbul conference on financial stability in May, Large said the rapid growth of derivatives instruments and complex structured products has "added to the risk of instability arising through leverage, volatility and opacity".
The challenge for central bankers and regulatory authorities is to achieve the optimal level of financial stability without curtailing the efficient functioning of the markets, he said. "The task is made harder because we are dealing with tail events – low probability scenarios – rather than central projections. [It is] less predictable and harder to model."
Credit, market and liquidity risk, infrastructure (including payment systems) and emerging market exposures were potential sources of threat, he said. "What resources would it have taken to foresee that default of the Russian government on its debt in 1998 would, through a complex chain of events, eventually result in the failure of the hedge fund Long-Term Capital Management in New York? Equally, what resources would it be wise to devote to assess what implications, if any, the downgrades of General Motors' and Ford's debt this month might mean for the financial sector and ultimately for financial stability?"
He stopped short of proposing specific solutions, but acknowledged that as the complexity of the financial markets grows, so would the sophistication of regulatory oversight.
Valuation of illiquid assets a key concern
A survey of hedge fund managers, investors and hedge fund service providers has highlighted the valuation of illiquid assets as the most significant challenge with regard to hedge fund portfolio valuation.
The survey, conducted by the Alternative Investment Management Association (AIMA), found that 32% of respondents identified illiquid assets as a key concern. However, hard-to-value assets – consisting of strategies in long-dated convertible arbitrage, distressed securities, emerging markets and mortgage-backed securities – represent just 14% of the aggregate value of the funds.
The report recommends that the industry should encourage a more consistent approach for pricing and valuation, and that these processes should be documented and approved by the board of directors, trustees or general partner of the fund. The AIMA also recommends that any decision to use a pricing model rather than a market price in determining asset value should be justified, while net asset value calculations should be produced by parties not involved in the investment process.
"We believe the results of this research will be a useful resource for hedge fund managers and investors," says Segun Aganga, chairman of the AIMA research committee, pointing out that the survey was an ongoing exercise and represented a first important step to establishing a dialogue on best practice in the industry.
AIMA's global survey was answered by 76 institutional investors, managers and service providers such as prime brokers and administrators, combined with an extra 16 qualitative interviews.
JP Morgan and SunGard team up
JP Morgan and SunGard have teamed up to create a collateral management system based on SunGard's Adaptiv product for over-the-counter derivatives. Aimed at smaller end-users, it will allow existing JP Morgan clients, such as corporate treasurers, insurance companies and hedge funds, to outsource their collateral risk management, clearing and settlement systems.
"Our new OTC derivatives collateral management service will help provide increased efficiencies for our clients," says Murray Brown, JP Morgan's head of derivatives collateral management. "We expect particular interest from the buy side of the OTC derivatives market, where participants seek to outsource the non-core parts of their trading and hedging activities."
SunGard claims its technology will result in cost savings in systems administration, personnel and IT equipment, while maximising trading opportunities through efficient updating of limits. "This arrangement helps JP Morgan concentrate on providing a world-class derivatives service to its institutional clients," says Juerg Hunziker, president of SunGard's Adaptiv unit.
Effective collateral management systems have become increasingly important as the posting of collateral becomes increasingly popular for OTC derivatives transactions. Collateral volumes leapt 18.4% to $1.2 trillion, according to the International Swaps and Derivatives Association's 2005 survey, published in March. The survey also found that 55% of all derivatives transactions were now underpinned by collateral, measured by volume or exposure.
Asset manager wages rise
Total compensation for risk professionals in the asset management industry has jumped by 15% compared with one year ago, according to a remuneration survey by Risk Talent Associates, a New York-based risk management executive search firm.
Hedge funds and funds of funds have driven much of this growth, with compensation in senior positions often exceeding $1 million backed by substantial bonuses.
"The entry point for a seasoned, but hands-on risk manager at an [alternative] asset manager often hits $500,000 or more, which is markedly up from a few years ago," says Michael Woodrow, president of Risk Talent Associates. "We have seen particularly heavy activity in the first quarter of 2005 with our hedge fund and fund-of-funds clients."
Market Axess and DTCC team up
Electronic bond trading platform company MarketAxess has teamed up with the Depository Trust & Clearing Corporation (DTCC) and 11 global dealers to create an electronic client-to-dealer trading platform for credit default swap (CDS) indexes. The CDS index trading system is scheduled for launch in the second half of this year.
The development comes after the UK's Financial Services Authority warned banks this year about the level of unsigned confirmations in the credit derivatives market.
MarketAxess is working closely with DTCC subsidiary Deriv/Serv, a full-service provider of automated trade-processing solutions. The company is planning to integrate its front-end trading system with Deriv/Serv to offer an end-to-end electronic trading solution to eliminate trade discrepancies and expedite the confirmation process.
The 11 global dealers involved in this initiative are: ABN Amro, Banc of America Securities, Bear Stearns, BNP Paribas, Credit Suisse First Boston, Dresdner Kleinwort Wasserstein, Goldman Sachs, JP Morgan, Merrill Lynch, Royal Bank of Scotland and UBS.
TradeWeb to launch US rate swaps platform
Thomson TradeWeb, a US-based fixed-income electronic market specialist, is planning to launch a multi-dealer dollar interest rate swaps trading platform in the third quarter of 2005.
The firm named JP Morgan, Merrill Lynch, Barclays Capital, ABN Amro, Dresdner Kleinwort Wasserstein, HSBC and Wachovia as the founding members of the new platform.
TradeWeb IRS, as the new market will be known, will allow institutional investors to request quotes from multiple dealers and execute trades.
In early May, TradeWeb said it was working with JP Morgan, Goldman Sachs and Morgan Stanley to create a credit default swap index trading platform. It is expected to go live in the second half of 2005.
TradeWeb already runs an electronic trading service for euro-denominated swaps, which it launched in February.
CAO improves debt restructuring
Singapore-listed China Aviation Oil (CAO) has improved the terms of its debt restructuring scheme, offering creditors $275 million, up from the initial $220 million.
China Aviation, which revealed that it had notched up $550 million in oil derivatives losses at the end of last year, will now pay creditors an initial cash amount of $130 million, comprising of a $100 million cash injection from CAO's parent company, China government-owned China Aviation Oil Holding Company, and a new investor (likely to be Singapore government-owned Temasek Holdings), plus $30 million from existing assets of the company. The company had originally said it would pay creditors $100 million up front.
In addition, the firm will pay an additional $275 million over five years, comprising cashflows from the company's operations, dividends and the proceeds from its sale of a 5% stake in Spanish petroleum transportation and storage company Compania Logistica De Hidrocarburos. The company had previously offered creditors $220 million over five years. Under the new deal, investors will be able to recover 54% of their cash, up from 41% under the initial scheme.
The improvement in the terms of the restructuring follows threats by some creditors to put the company under new, independent management. In March, South Korea's SK Energy Asia filed a judicial management petition with Singapore's High Court, which was adjourned until after May 20 after CAO said it was working to improve the terms of the offer.
China Aviation Oil Holding Company has previously said it will only proceed with the cash injection if creditors agree to the restructuring. CAO needs to win the support of a majority of creditors, representing 75% of the total debt, for the scheme of arrangement to be approved.
"CAO intends to call for a meeting of creditors shortly to meet with its obligation under the order of court dated December 10, 2004, to call a meeting of the creditors on or before June 10, 2005 for the purpose of voting on the final scheme of arrangement to preserve the company as a viable going concern," says Gu Yanfei, head of the special task force appointed by the board of directors of CAO.
Size matters, finds Greenwich survey
The ability to execute large currency trades is one of the key components in winning new forex business from corporates and institutional clients, according to the latest research from Greenwich Associates. "If you want the biggest bang for the buck in the forex markets, commit the capital needed to efficiently and competitively execute large trades – provided, of course, that the bank knows its accounts well enough to understand their direction and not get hammered on the trades," says Woody Canaday, a consultant at Greenwich.
The 1,435 top-tier forex professionals interviewed by the research firm also rank provision of competitive quotes on forwards and spot in major currencies, while active day-to-day coverage – including phone calls, emails and faxes – hits the top of clients' wish lists.
When drilling down to various client segments, the research found success factors to emphasise differing aspects of service quality.
For example, lending carries much more importance with corporates than among any other type of account. "They are not professional traders; instead, they view forex as part of their day-to-day business, and often they link forex business to the overall lending relationship they have with their banks," explains consultant Peter D'Amario.
Banks, on the other hand, rank competitive spot quoting on majors and consistent quoting in volatile markets as more important. "Many of these customer banks are professional traders themselves, so these 'convenience factors' carry more weight relative to 'value-added' measures," says Tim Sangston, a consultant at the firm.
Indeed, the results showed e-trading capabilities – both single-bank systems and multi-bank portals – carried more weight with banks than other customer types. "Most banks are looking for fast and competitive execution, not for ideas or advice," he adds.
Hedge funds want global co-ordination of coverage, competitive spot quoting on major currencies, making good use of time and currency options capabilities. The research also found that back-office processing is more important to hedge funds than to other customer segments. "For hedge funds, it's about execution and contact, as opposed to the other value-added services," adds Canaday.
Meanwhile, fund managers value custody relationship and back-up coverage more than other clients. "The importance of custody is obvious – many fund managers use forex trading as a 'reward' for their custodians," says consultant Frank Feenstra. "The importance of back-up coverage is more subtle, but probably has to do with convenience – busy fund managers want seamless coverage."
Overall e-trading capabilities surfaced in the lower half of the table. Sangston explains that, globally, less than half the accounts the firm talks to trade online and "for half the market it's not even a factor". "It's only a factor at all for half the market, now for that half of the market it may be important, but there's roughly 50% of the market or more that don't even trade online at all," he says.
He adds that the results may have been tainted by the fact that much of the e-trading volumes go through third-party systems such as FXall, while the regression model used in the research asked for key drivers to making a bank a top-three dealer for forex.
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