International Treasury Trends

Conference bri efing

ISDA Manages
Its Risk
By joseph Neu
The derivatives dealers association
puts independent risk oversight in the
spotlight of its New York conference.
Risk management is something it can
teach regulators and corporate trea-
surers something about.
Best practi ces in the management of
derivatives r i sk are l argel y be in g
est ab li shed by members of th e
Internat ional Swaps and Derivat ives
Association (ISDA). Corporate treasur-
ers, whil e facing some different issues,
have much to learn from ISDA mem-
bers in this regard. The best lesson is
that nothing beats good internal risk
measurement and management- cer-
ta inl y not regulation or legislation.
The big picture agenda
Th e recent ISDA Conference:
Indepe ndent Risk Oversight: Ri sk
Measurement & Management held
jul y 26-28 at the Plaza Hotel showed
a cl ear agenda. ISDA is doing all it
can to keep regul ators and legislators
from interveni ng i n derivatives mar-
kets. Among other things, it hopes to
convince t hem that the superior risk
measurement and management tech-
niques being employed by its mem-
bers bode well for self-regu lation.
Indeed, most regul ators agree that in
terms of establishing best practices for
identifying, quantifying, and managing
the risks of derivatives, ISDA members
should be left to their own super ior
devices. Under the desired ISDA sce-
nario, regul ators would merely see to
it that these risk management prac-
tices are bei ng implemented-i. e.,
provide independent risk oversight-
wh ich is ultimately in the interest of its
own members.
This agenda was promoted heavily
over the course of the conferen ce.
4
Al so promoted was th e v i ew t hat
innovat ion should not suffer as a result
of ri sk oversight. Presentati ons wi th
tit les l ike "The Development of Ri sk
Management Control Without Stifling
Innovation" underscore ISDA' s point
most visibl y.
Despite the st ring of recent losses
resulting from some more innovative
derivatives transactions, corporates
should stop to think about ISDA's
point: financial innovation is good- it
is poor risk measurement and manage-
ment that causes problems.
To reenforce th is, presentat ions on
the risk of innovation all uded to the
fact that innovation, managed careful -
ly, actuall y can be made to enhance
control processes. Two points apply:
Use extra care with innovative
products. Compl ex products often
capture market arbitrages that can di s-
appear befOI'e the end-user and even
the dealer fu ll y understand all the risk.
Dealers become active in new prod-
ucts w ith guard ed grad uali sm and
learn more about the risks as they pro-
ceed . Known ri sks are monitored
meticulously and policies and proce-
dures are created that are specific to
first-use instruments and appli cations.
Systems capabiliti es are key, and
must be qu i ck l y adaptab l e to th e
newly identified risks of new products.
Analysis of new risks enhances
understanding of old ones. Attempts
to reverse engineer innovative prod-
ucts often help dealers to learn more
about the range of risks presented by
their use of other derivatives. Sticking
with pl ain-vanill a instruments to avoid
risk l imits a dealer's or an end-user's
underst anding of derivatives
markets- both the opportunities and
the risks.
Corporates on board
Whil e a majority of corporates a1e
stepping back from, or keeping quiet
about their derivat ives act iviti es for
th e moment, a sma ll number are
choosing to side, visibly, with ISDA. A
sprinklin g of " industri al " corporates
are I is ted among its subscriber mem-
bers. These include, Dow Chemical,
McDonald' s, and Mobil , as well as the
finance arms of GE, Ford Motor, and
Westinghouse. Presumably, they have
j oined in part to keep regul ation/ legis-
l at ion f rom be ing estab li shed that
wou ld curb innovation in derivatives
markets that they clearl y benefit from.
"Corporates with the expertise and
controls to safely use derivatives need
to speak out, " says Eli zabeth Glaeser,
manager of capital markets and invest-
ment banking at Mobil , in her presen-
tat ion on Mobil 's process for manag-
in g debt and deriv ati ves. Other
responsible users, meanwhile, li e low,
whi l e the press overdr amat izes the
impact of derivatives losses.
Mobi l ' s position is that derivatives
should be viewed in the context of
how they are used in conjunction with
cash instruments. Focusing on mark-
to-market losses on derivatives can be
mi sleading if they are not viewed in
conjuncti on with changes in the value
of the underl ying debt portfol io.
In theory, a loss of P&G's magnitude,
for instance, could be more than off-
set by gai ns made on the balance
sheet. Rarely does the press analyze
the business positions being hedged
with derivati ves.
Banks care
Banks are clearly becoming interested
in learning more about the derivatives
sop hi sti ca ti on of corporates (Ms .
Gl aeser' s prese nta tion was well
attended). Their interest is not merely
sales-driven.
One reason for their interest is the
potent ial costs of selling products to
customers that don't understand them.
Thi s is a cost that ISDA-members are
cl early facing up to. Mass unwinds of
interest- rate pos iti ons after the first
quarter of this year and the need to
field inquiri es from non-finance seniOI'
managers have taken time away from
more profitable activiti es. In addition,
Internati onal Treasurer/ August 8, 1994
attention must be shifted to manage
the legal and reputation risks associat-
ed with disgruntled customers.
Other Issues
In addition to spotli ghting 1isk manage-
ment expertise, ISDA took some time
to update members on progress made
on the documentation side. Perhaps
the most significant issue featured was
progress with the 1992 ISDA Master
Agreements (for mul t i-currency and
cross-border transactions).
Enforceability of ISDA Master
Agreements. Th e i ss ue of co ntract
enforceabi li ty in foreign jurisdictions
has been rai sed by the G-30 study and
elsewhere. Since the finalization of
the 1992 Master Agreement s, ISDA
has been invol ved in pursuing l ega l
opinions with regard to the enforce-
abi lity of nett ing. Favorabl e opinions
from leading legal counsel have been
given in the eleven "G-1 0" countries:
Bel gium, Ital y, Canada, j apa n,
En gland , Sweden , Fran ce, The
Netherlands, Germany, the US, and
Switzerland.
ISDA is current ly seeking cross-prod-
uct netting opinions from counsel in
Austra li a, Hong Kong, Singapore,
Spain, Portugal , Indonesia, Malaysia,
Denmark, and luxembourg. Th ese
opinions, according to an ISDA
Memorandum, are due later thi s year.
G-30 Recommendation 13. ISDA
al so shows its Agreements to all ow
compliance to the G-30 recommenda-
tion that one master agreement be
used as widely as possible.
Under the 1992 Master Agreement,
cross-product netting can be done
with a wide ran ge of products,
including interest rate swaps, bas is
swaps, forward rate transactions, com-
modity swaps and options, equity
/equity-index swaps and opt ion s,
bond options, interest rate options,
forei gn exchange transactions, cap
transactions, floor transactions, coll ar
transactions, currency swaps and
A modular approach to documen-
tation. In the spirit of a single Master
Agreement w ith eac h counterparty,
ISDA continues to encourage a modu-
lar approach to documentation. Under
this approach, annex agreements for
subsequent products, coll ateral, and
other documentation needs can be
added without completely redoing the
Master Agreement in pl ace.
Lessons from litigation. Al so,
worth noting is the fact that documen-
tation, including marketing and dis-
c l osure it ems, w ill increas ingl y be
refl ecting the l essons being l earned
from liti gation- fi led or contempl ated
- in the wake of recent losses.
Accordingly, document at i on w ill
inc reas ingly outl ine th e duties and
responsibiliti es of eac h counterparty
to assess and communicate the poten-
tial risks of derivat ives transactions.
Extreme care will likely be taken to
exclude from documentation any
statements that might later be con-
strued to have misrepresented these
risks. The same can be said of public
disclosures by end-users regarding
their derivatives use.
Ratings issues
Finall y, for treasurers pondering new
der ivat ives ratings and the impact of
deri vat i ves on credit r at in gs, two
points from S&P exec uti ve director
Cli fford Griep' s presentat ion:
Reputation risk, li qu idity, and sys-
tems for control and risk measurement
shou ld be as much a part of counter-
party assess ments as the ratin g on
their debt.
A demonstration of a lack of con-
trol or obvious spec ul ative use of
derivatives could lead to a credit rat-
ing downgrade.
Generall y speaking, S&P sees access
to derivat ives as a positi ve for all
industry sectors. Companies should
note that the use of derivatives- on
options, cross currency rate swaps, its own- will not be a factor in low-
and swaptions. Expanded produ ct er ing credit ratings.
coverage is on the agenda.
International Treasury Trends
The Post-Conference Questions
One obj ecti ve with any professional con-
ference is to all ow attendees to come
away with a few ideas to consider when
they return to thei1 jobs.The foll owing
quest ions are worth considering by cor-
porate treasurers.
(1) Do we know what "best practices"
are for risk measurement and manage-
ment and where we stand in relation?
More advanced corporate de1ivative users
are starting to benchmark systems and
methodologies against primary dealer
banks. Less sophisti cated corporate users
should at least be aware of what capabili-
ties are possible i n assessi ng the suitabili-
ty of their existing ones.
(2) Do we understand the documenta-
tion for our transactions and are there
any modifications we should make?
Modifications can and often should be
made to documents to reflect treasury' s
duties and responsibiliti es to sharehold-
ers. Corporate end-user concerns should
be a part of the on-going process to
enhance Master Agreements, for example.
(3) Are we prepared to use (or ignore)
the advantages of financial innovation?
Corporates shying from derivatives risk
mi ght wish to reassess the ways they can
benefit from them. In other words, don't
look solely or as quickly at the downside.
The opportunities for deri vati ves use are
infinite, so corporates best begin a
process to access whi ch opportunities are
valuable and how the ri sk/reward ratio
can be managed.
(4) Where do we stand in regards to
derivatives regulation and legislation?
Corporates that already benefit from
derivat ives shou ld consider becoming
more active in lobbying against regu la-
tions or legislation that mi ght make deri v-
ative markets less beneficial. Non-using
corporates might want to consider how it
mi ght I imit their access to derivatives in
the f uture.
International Treasurer/ August 8, 1994 5