End-Users Speak Out

''Principles and Practices for Wholesale Financial Market Transactions," a code of conduct for all financial markets participants including dealers and end-users, was released by the Federal Reserve Bank of New York in August 1995. It represented the culmination of 13 months of effort by representatives of six trade associations, including the International Swaps and Derivatives Association (ISDA), the Securities Industry Association (SIA), the Public Securities Association (PSA), the Emerging Markets Traders Association (EMTA), the Foreign Exchange Committee of the New York Federal Reserve Bank and the New York Clearing House. Negotiations were coordinated by the New York Fed.

Although the document was designed to cover all financial transactions, it was perceived as having particular relevance for dealers and end-users of derivatives. The code is not legally binding, but its treatment of the dealer/end-user relationship quickly aroused great dismay and resentment among end-users that has not gone away. What was and is particularly worrying to U.S. end-users are the assumptions that there exists a level playing field between counterparties, and that all transactions between them are conducted completely on an arm's length basis unless otherwise stated in a written agreement.

The document placed the responsibility for any transaction on the shoulders of the end-user. It stated that dealers need not evaluate the suitability of a transaction for any of their clients. Whether or not to go ahead with a transaction was the responsibility of the end-user. Although it said the dealer should answer all questions honestly and comprehensively, the so-called "unasked question" was also the end-user's responsibility. The code also made explicit that dealers do not have a fiduciary responsibility to the their clients. As lawyers said at the time, the code would make it more difficult for the end-user to claim that it had made a loss through a dealer's bad advice.

Soon after the document was released, the End-Users of Derivatives Association (EUDA) vociferously opposed the document. Their dislike of it and its implications has not slackened in the intervening seven months-as the following discussion with four EUDA board members indicates.

Participants: Bill Miller, director of General Motors Investment Management Corporation; Sue Becht, treasurer of Duke Power; Kevin MacKenzie, associate general counsel of Freddie Mac; Kathleen Mullarkey, general counsel for the Federal Farm Credit Bank. The interview was conducted by Derivatives Strategy managing editor Simon Boughey.

Derivatives Strategy: EUDA has been around for about two years now. Looking ahead, what are your main purposes and what are your objectives going forward?

Miller: We now have a little over 65 members, more than twice as many as last year. EUDA provides a forum for end-users to discuss common issues and common concerns and to provide help and assistance to each other.

Becht: I come from an industry that hasn't traditionally used derivatives, so my industry peer group was not a resource for me. EUDA is the kind of group that can be a resource for those of us who need that direction.

Miller: We have a common interest as end-users of derivatives. Derivatives are not our main line of business, but they are useful products in managing the overall risks and certain costs of our business. Within that context we are very interested in a very healthy, safe and sound derivatives market that is going to grow and be liquid to meet our future needs as we grow as well.

DS: How have you tackled your response to Principles and Practices (P&P) over the past year?

Miller: When P&P came out early last year, we attempted to work with the Federal Reserve Bank of New York and the Principles Drafting Committee to get our views across. We were troubled by a number of the provisions, but primarily we saw our relationships with the dealers as much different from those described in the P&P. In addition, we wanted to be an equal partner in the development of those principles and practices since we are the other side of the dealer's transaction. Our request for such participation was denied. That was a significant effort for us, and in the future we do wish to work with the drafting committee as they modify their Practices and Principles. As an outgrowth of those P&P, there was the ISDA non-reliance language which we did comment on. We took the view that "one size does not fit all." It is the same view we took regarding P&P; hopefully we can work with ISDA to modify their positions further.

DS: What other issues will you be tackling over the coming year?

Miller: We want to take a look at such things as accounting issues, the SEC's stance on disclosure, tax issues, legal issues. We also want to take a look at the work the FIA did in response to the Barings collapse.

EUDA and ISDA

DS: ISDA has called for more end-users to be members. Why did you think it necessary to form your own organization?

Becht: This is probably the only area in the finance world where a group of dealers have shaped both the products and all of the surrounding rules and regulations, with no input from those who are not dealers. For those of us that use derivatives simply as a supplement to our main line of business, there really has not been a forum to discuss the development of the products or the regulation that surrounds them.

Miller: I think ISDA has been primarily seen as a dealer organization. Its previous name was the International Swap Dealers' Association. The name has changed, but I'm not sure anything else has. End users do not have a policy making role in ISDA. If you look at the dealer side, you've got a sixty something trillion dollar market and a couple of dozen brokers that make up that portion of the dealer market. On the end-user side, there are thousands of end-users, none of which come up to the size of even one of those dealers in terms of total outstandings or daily transactions. And that means we are not always going to see eye to eye.

DS: How are relations with ISDA?

Miller: From our perspective, we hope they're friendly. I'm on good terms with all of the people I talk to at ISDA. But that raises a concern: if I'm on good terms with all of them and they can see my point of view, then why do we have some of the output we do from them as a group?

Mullarkey: There's a natural tension when there are two parties to any transaction. I think ISDA focuses on different issues. One side of the derivatives transaction is represented in certain circumstances by ISDA, and EUDA represents the other side of the transaction.

MacKenzie: Freddie Mac is an subscriber member of ISDA as well as a member of EUDA and I think we look to our membership in each organization for somewhat different things. We are a subscriber member of ISDA because we learn about certain developments through that membership, and we learn about other sorts of developments that are of particular interest to end-users through the EUDA membership. I think that some of the hedge accounting issues that come up may ultimately be of more concern to end-users than dealers, although ISDA has also been active in trying to address these issues.

EUDA and the Dealer

DS: We hear a lot about the rebirth of relationship banking these days. Is P&P compatible with relationship banking?

Miller: P&P is at odds with the whole idea of relationship banking. When dealers come in they typically say, "We've been your banker for a long time, we've got a lot of expertise, and you can trust us." That's the kind of relationship I and many of our members are accustomed to and that's why we like it. But now they've come up with P&P and say it's all arm's length. What you used to assume can't be relied on any more.

Becht: The implication is that relationship banking went away for a while. While you did hear certain institutions say, "we want the income" or "we won't support you with credit or maintain the relationship," there were many who didn't take that approach and who continued relationship banking throughout that period. When a banker stays involved with transactions with all areas of an institution it implies a relationship.

Miller: I think the banks take relationship building very seriously, but you have very different segments within the broker-dealer community. I'm not sure those responsible for P&P envisioned the impact it would have on relationship building and the strategic alliances senior managements in many, many brokerages are looking to build.

Some bankers say they need to protect the income flow after they've done a deal, so P&P is needed, and yet you need relationships to bring in clients in the first place. So its like the two are at odds. You get in, you can't get out anymore, and the rules have changed once you've crossed the line.

After P&P was released, we opposed it strongly in the press. In our view it held no validity; it was not an industry standard, and there was no economic justification for it. Some investment bankers did not go along with P&P, and we were hoping it would just die a peaceful death, but I think it's starting to come back again. My theory is that the marketing people are very different from those who drafted P&P.

MacKenzie: We're in the process of trying to work out mutually with dealers what rules ought to apply to this market. It's not a securities market, it's not a commodities market, it straddles these different regulatory areas. The whole debate between between end-users and dealers is trying to determine the best general regime that ought to apply to this market. Recognizing that there is no one regulator that will come in and impose that regime, we have to agree among ourselves. EUDA has stressed in its various comments that it is incumbent on both sides to come to the table and negotiate just what relationship we are going to have. Don't presume that the relationship is one way or another.

Miller: What is disturbing is that dealers are being somewhat presumptuous in claiming what the industry standard is by modifying documents to reflect P&P or similar type things. We are cautioning our members to be watchful of those things. The non-reliance provision, for example, is being put into documents by the dealers on the basis that this is the industry standard, but we're saying, "No, its not," and many of our members have removed it. It's disturbing that the dealers aren't doing this in a very forthright manner.

EUDA and Legislation

DS: Are you reassured that there is now no threat of government action on derivatives?

Miller: I think our current regulatory structure works pretty well in terms of bringing all the participants together to air their views. With that said, regulators and legislators have a role here, and I wouldn't want to say they are not part of the picture anymore. There are very intelligent and responsible congressmen and regulators who are very concerned about the safety and soundness of the markets. And it is comforting to me that they have constant vigilance in areas where there might be potential problems. They have provided a useful service, one they don't often get credit for.

Becht: I don't know that we would necessarily view legislation as a threat, but it is unfortunate if you can't work out your relations with the dealers without having to have legislation imposed. We wouldn't necessarily consider this a threat but it is something we would rather see happen only if it is really necessary.

Mullarkey: Perhaps we're not seeing government action because when these issues came to the floor, legislators looked into it, held hearings, examined the issues, and discovered that safety and soundness regulations were already in place. And there was no need for further action.

Miller: We were happy to hear that the suitability provision was dropped from the legislation proposed by Rep. Fields, and if it had gone further we were prepared to take further action to modify that.

Defending Principals & Practices

Ernest Patrikis, first vice president at the Federal Reserve Bank of New York, was the midwife to Principles and Practices and is well aware of the feelings of end-users towards it. However, in both a speech at the EUDA Conference at Washington in April and in an interview last month with Derivatives Strategy, he strenuously rebuffed the criticisms that have been made.

In the speech he acknowledged that the idea to frame a set of best-practice guidelines was "clearly mine" and addressed the issue of why EUDA was not invited to participate: "P&P arose when I asked a number of trade associations in New York City with which I was familiar whether there was a need for a broad overarching code of conduct for the wholesale financial market....When we started down the path there was no EUDA. That is why EUDA was not invited to join as a sponsoring trade organization. In addition, we did not know whether it would be possible for the six trade associations to agree on a code."

In a recent interview with Derivatives Strategy, he argued that the critics of P&P should not confuse the concept of a responsible relationship between bank and client with that of a fiduciary relationship. Patrikis believes the idea of an arm's length relationship, which P&P presumes to exist between bank and client, should not in any way undermine trusting relationships between banks. "If I'm a dealer, the key question is 'Am I a fiduciary?' If two parties are involved in a fiduciary relationship, there is a special standard. That has nothing to do with whether they have any other kind of relationship with each other in the course of dealing. P&P deals with a separate issue: If I'm a dealer and you want to rely on my recommendations or suggestions and you want me to act as a fiduciary, let's agree to that in writing."

He also argued that end-users shouldn't confuse investment recommendations with statements of fact. Although Principles and Practices states that a non-fiduciary relationship should be presumed to exist unless explicitly stated, it doesn't mean a counterparty can't rely on a dealer for factual details. "If I sit down and tell you that this product will work this way, then the product ought to work this way," he said. "[Some end-users] think the document doesn't say this. If Principles and Practices is regarded as ambiguous on this point, that ambiguity should be removed in any future revision. I have talked to Bill Miller and tried to correct some misimpressions he had."

Patrikis added that the document was not the work simply of dealers, and that trade associations like the Securities Industry Association who helped draft the P&P include many end-users in their membership; it was the the product of the six trade associations and not the Fed. He also noted that EUDA and others commented on the draft and participated in meetings on Principles and Practices. The document, moreover, does not relate only to derivatives, but covers securities, FX instruments, other OTC instruments and, in Patrikis' words, "transactions we don't know how to define yet."

In his speech to the EUDA membership, Partikis said that end-users must not be afraid of telling dealers that they don't understand something. He said that a participant should act honestly and that caveat emptor is not the general rule. "Some would say that an end-user stands no chance against a dealer," he said. "What I think this boils down to is a tendency to be unable to acknowledge that they do not comprehend the transaction being pitched to them by a marketing staff. My initial response to that is that the employer of that firm has some responsibility. Why would a firm allow that sort of individual to have the authorized responsibility to bind the firm?"

In his interview with Derivatives Strategy, Patrikis elaborated on this point: "Putting on my supervisory hat, we should be quite upset with a bank that is an end-user allowing a individual who doesn't understand a product to deal in that product without obtaining advice under a formal advisory relationship on a product from its proposed counterparty or an independent third party. If the cost of obtaining that advice is too high, perhaps the end-user should not be doing the deal at all."

If an end-user does wish to rely on communications as investment advice, added Patrikis, before it enters into the transaction involving that reliance it should 1) put its counterparty on notice in writing that it is relying on the counterparty; 2) obtain the counterparty's agreement in writing to do business on that basis; and 3) provide the counterparty with accurate information regarding its financial objectives and the size, nature and condition of its business.

In fact, according to Patrikis, the recently formulated London Code of Conduct takes a very similar line to that adopted by P&P. It states: "As a general rule core principals [dealers] will assume that their counterparties have the capability to make independent decisions and to act accordingly; it is for each counterparty to decide if it needs to seek independent advice. If a non-core principal (end-user) wishes to retain a core principal as its financial adviser it is strongly encouraged to do so in writing, setting forth the exact nature and extent of the reliance it will place on the core principal...." It would be a good thing, Patrikis believes, if the two leading financial centers followed the same approach.

The Drafting Committee Responds

Derivatives Strategy spoke recently with Gay Evans and Louis "Woody" Teel, the two co-chairs of the Principles and Practices Drafting Comittee to get their response to EUDA's charges. Evans is a managing director at Bankers Trust International and chairman of the International Swaps and Derivatives Association. Teel is executive vice president at Bank of America, and chairman of the New York Fed's Foreign Exchange Committee.

1. Derivatives is the only area of finance in which all the products and rules have been shaped by dealers alone.

Evans: "If the rules had been shaped solely by the dealer community, then we wouldn't have witnessed the continued growth in privately negotiated derivatives transactions. You don't just trade with a screen, you have to sit down with someone else."

2. ISDA is a clubby dealers' organization.

Evans: "We have three aspects to our ISDA membership-dealers, subscribers and associate members-and all three have grown substantially in recent years."

3. The document "Principles and Practices" is in contradiction with relationship banking.

Teel: "Banks take their relationships with clients very seriously, and P&P is in no way at odds with the idea of relationship banking."

4. EUDA was locked out of a role in the framing of P&P.

Teel: "As soon as the six trade bodies responsible for P&P had something worth talking about, we opened the process up for discussion in the spring of 1995 and took those comments into account."

5. P&P has no economic justification and no validity.

Evans: "P&P is simply the best practice guidelines for those that are regular users. They are not rules."