Some 60 derivatives end-users have sent comment letters to the SEC on its latest disclosure concepts, first unveiled last winter. (See Derivatives Strategy, February 1996.) The proposals called for quantitative disclosure of market risk information, disclosure of leveraged derivatives positions, a complete breakdown of traded and non-traded derivatives, and the inclusion in disclosures of commodity derivatives and all market-risk-sensitive instruments.

To all of which most end-users have expressed extreme displeasure, finding the SEC's plans excessive, costly and unnecessary. That is the nut of a 10-page study released last month by Donald L. Horwitz, editor of Futures & Derivatives Law Report, and Robert J. Mackay, a professor at Virginia Tech University. At the time of its trial balloon on derivatives disclosure, the writers say, the SEC "went out of its way to compliment itself on how much they'd learned about derivatives in the preceding 18 months" and framed their presumed knowledge into a number of guiding principles.

The authors combed through the SEC's collection of comment letters to see how users had reacted to these disclosure principles. They found that many users "could not make a bright line distinction between each principle." One reason, they surmised, is that the SEC had not adhered to those principles in framing the proposed regulations. Result: a mismatch between intent and execution.

1. Investors should have a better understanding of how derivatives affect a statement of financial position and cash flow and result of operations. [The SEC gave registrants three disclosure options-net asset, VAR and tabular stress testing-in an effort to make financial statements more meaningful. Many end-users, however, found the requirements burdensome.]

"We feel that the proposals would not achieve this result [of better understanding] and, in fact, may actually tend to mislead investors." Deere & Co.

"The level of detail required under the proposal will only serve to further confound a true understanding of how an issuer uses the derivative instruments to assist in the management of its assets and businesses. Also, ...the proposal seems directly contrary to the spirit of the recommendations of the SEC Task Force on Disclosure Simplification." General Mills

"The proposed regulations represent disclosure overload to the investing public with, at best, incremental value and, at worst, misleading or confusing information to the average investor." Eli Lilly

"To add the disclosure of quantitative information would not aid investors in evaluating the derivatives activities of registrants and would result in incomplete, confusing and potentially misleading disclosures." Intel

2. Companies should provide additional information about market risk. [Some non-financial companies objected to the SEC's market risk proposals, arguing that they do not materially affect their companies' operations.]

"Non-financial institutions primarily derive their income from products or services that are not sensitive to changes in the market rates of financial instruments. Therefore, market risk is not typically a primary business risk for non-financial institutions unless they enter into derivative transactions for trading purposes." Xerox

"For companies which use derivatives solely for risk management purposes, we believe that the proposed quantitative disclosure requirements are excessive and could result in the disclosure of information that is either misleading or competitively damaging." Caterpillar

"For an integrated petroleum and chemical company, the proposed quantitative disclosure requirements are not appropriate. Risks related to derivative instruments are only a small portion of the company's market risk exposure. It would be misleading to quantify Amoco's market risk associated with the derivative instruments, such as in a value-at-risk model, without quantifying the related and generally offsetting physical positions." Amoco

3. Investors should understand how market-risk-sensitive instruments are used. [Although most end-users felt this was a good idea in principle, many believed it went too far and could force a company to disclose proprietary information.]

"We are concerned that the voluminous disclosure currently required by FAS 119 and suggested in the Release put far too much emphasis on what is only one of many risks involved in operating a business. This problem is amplified when derivatives are used in limited circumstances and have an innocuous effect on the business enterprise as a whole." Union Pacific

"Let me discuss a hypothetical example involving two companies operating in the textile industry. One company rarely, if ever, uses derivative cotton instruments to control price risk. A second company uses derivative cotton instruments in the traditional business role to guarantee delivery of its cotton and to establish a maximum cost. In the first example this company would make no disclosures even though a rising price of cotton could cause significant business risk to this entity. However, ...the second company would be required to make significant disclosures, some of which would lead to a competitive disadvantage, since they would be required to disclose data about volume, average price, extent of coverage, etc." Westpoint Stevens

"Many non-financial companies do not currently use VAR or sensitivity models to evaluate their financial instruments due to the limited nature of the use of derivatives. Therefore using the value-at-risk or sensitivity approaches would add significant cost to those companies." Chrysler Corp.

"Application of this proposal could give rise to a page or more of disclosure related solely to derivatives, thereby dwarfing most of the disclosures. Financial statement users may draw improper conclusions about the relative importance of derivatives based upon the relatively large volume of derivative disclosures." Financial Executives Institute

4. Disclosures about market risk should not focus on derivatives in isolation, but rather should reflect the risk of (the) loss inherent in all market sensitive instruments. [End-users felt that while this was true in principle, the SEC's regulations violated the principle because they require disclosure of derivatives in isolation.]

"Disclosure of quantitative market risk measurements should not be required of non-trading entities because such market risk measurements are generally not used to manage their business." Cigna

"Adding too much additional information may only confuse investors and give them a distorted view of the impact of derivatives based on the amount of information devoted to this area." McDonald's

"The Commission should permit registrants to use different alternatives to report the different categories of market risk exposure for non-trading activities." First Chicago

5. Market risk disclosures should be flexible enough to accommodate different types of registrants, degrees of market risk exposure, and alternative ways of measuring market risk. [Some end-users felt flexibility was conspicuously lacking in the proposed regulations because once a method of disclosure is chosen a company has to stay with it.]

"The proposed amendments should be applicable to financial institutions and not to non-financial institutions. Trading in derivatives is generally a significant part of financial institutions' business and deserves more disclosure." Reynolds Metals

"The disclosure requirements in the proposal should relate to those organizations that use derivatives for trading purposes." Motorola

"While the proposed rule is probably appropriate for registrants who engage in extensive trading and/or hedging activity, it does not appropriately address the concerns of registrants who have limited hedging activity." Unocal

"We believe that investors will obtain the greatest benefit from this disclosure if the registrant is able to present an analysis that is consistent with the way it practices risk management and quantifies its exposure to market risk. Accordingly we suggest that the commission allow registrants the flexibility to provide quantitative disclosures that are consistent with the registrant's risk management practices." Allstate Insurance

"We believe the disclosure framework for market risk should allow registrants the flexibility to present information based on the methodologies they use for internal management purposes. The impact of the proposal on organizations that are not financial institutions illustrates the importance of allowing registrants maximum flexibility in providing market risk disclosures." JP Morgan

6. New disclosure requirements should build on existing disclosure requirements, where possible, to minimize compliance cost of registrants. [End-users argued that the SEC failed to reflect their own principle in their proposals as many companies will have to overhaul current reporting practices to comply.]

"The cost of complying with the Commission's proposed rules for registrants that limit their use of derivative financial and commodity instruments to hedging activity could exceed the value the added disclosures provide to financial statement users." Unocal

"Our major concerns relate to costs of compliance, relevance of disclosures produced solely for reporting and not used by management, disparity of disclosures as compared to other business risks, and potential standards overload. Investors have had only one year to review and react to annual filings which contain the new financial instrument, derivative and market risk disclosures mandated by FASB." Enron Corp.

"The quantitative proposal raises issues about increasing information overload and burdens on public companies with respect to collecting information, preparing additional disclosures, and increasing the cost and time to prepare and distribute registration statements and reports." Lucent Technologies

The SEC invited users to comment on whether their proposal might force companies to disclose proprietary information. This what it got:

"[Northeast Utilities is] generally concerned that disclosure of certain quantitative methods...may expose company confidential or proprietary information..." Northeast Utilities

"We are concerned that the amendments would require disclosure of highly proprietary information and put the company at a competitive disadvantage. Since we are a huge purchaser of cocoa in the United States, if we were required to make disclosures anticipated by the amendments, our primary competition may be able to determine a major portion of the cost structure of the corporation's business, thereby achieving a significant advantage." Hershey Foods

"In addition, the proposed requirements would impose extraordinary cost and time burdens on issuers, and would force issuers to disclose sensitive, proprietary information and circumstances in which the mandated disclosures would be of questionable value to investors." Intel

"The proposed amendments... would require disclosure of information considered proprietary by registrants. Proprietary information for many registrants is considered a competitive advantage." Chrysler

"Disclosures about the extent of hedging activities could harm our competitive position because of the proprietary nature of the information. Providing details of transactions could disclose information that would make Ford vulnerable to competitors operating in the marketplace." Ford Motor Co.

"We are concerned that unduly rigid quantitative disclosure requirements could force disclosure of highly proprietary information relating to risk management strategies and positions in some situations." Amoco

"Since many registrants are currently making voluntary disclosures in this area, there should be few proprietary concerns. However, the more detail provided, the greater the concern about disclosing proprietary information." First Chicago

"Both of these methodologies would require dealers to produce and incorporate into annual and quarterly reports voluminous amounts of data; much of it proprietary in nature. This is particularly true of sensitivity analysis, which, if disclosed in annual and quarterly reports, would provide readers with confidential information about the dealer's positions." Merrill Lynch

World Bank debtors can now not only borrow in any currency of their choice, from September 1 they can begin to convert the terms of their existing loans to a new currency. Fixed or floating rate terms are both available according to preference. Flexible borrowing alternatives were introduced by the World Bank on a pilot basis in 1993, but the wholesale introduction of these terms without restriction and the opportunity to convert old debt to new terms is a fresh departure.

The World Bank announced the initiatives on June 25, and new Treasurer Gary Perlin, who took over from Jessica Einhorn in March, calls them "sweeping changes in the range of loan options." The World Bank has always been a very extensive user and advocate of derivative instruments-and was counterparty to the world's first currency swap in 1981-but the increased range of loan options it is now offering means an even more pronounced role for it in these markets. "This development spells much greater use of swaps by the World Bank, there's no doubt about that," says a market expert who follows the World Bank closely. Perlin agrees: "We will most definitely be using the swap market more, both to handle the additional demands at the margin and also to facilitate the conversion of old debt."

Debt hungry

It remains to be seen whether increased currency swap activity, including the swapping of dollar-denominated global bonds, will lower the World Bank's aggregate funding cost. It has always prided itself on its ability to achieve a very low after-swap cost of funds, and though Perlin declines to discuss these issues in detail, market sources say that its aggregate cost of funds is considerably in excess of Libor less 40 basis points. However, this cost is subsidized by very low cost borrowings in second-tier bond markets, like lire and Australian dollars. For example, its last global issue was priced to yield 7 basis points over the five-year U.S. Treasury note, indicating an after-swap cost of only around Libor less 15­20 basis points.

If the World Bank is forced to make more borrowings of this kind, and make more frequent and less opportunistic trips to the second-tier markets, its aggregate cost of borrowing may increase. Perlin dismissed the danger. "Our experiences in the swap markets recently, for example in collateralized swaps, means we have access to a wide variety of counterparties. We will remain as opportunistic as ever, and if we need say 80 percent floating dollars, we will use many different currencies and markets to achieve this. The aggregate cost of funds should not go up," he says.

In the past, the World Bank has offered what it calls currency pool loans, which were multi-currency obligations in three main currency blocs. These were U.S. dollars, yen and the so-called deutsche mark group, comprising deutsche marks, Swiss francs and Dutch guilders. Borrowers were obliged to take a mix at the conversion rate of $1:125 yen:DM2 was established, so for every one dollar borrowed, an equivalent amount of yen and deutsche marks was also borrowed. These were essentially pass-through loans, whereby the World Bank's debt would be passed through as loans at a spread over the same denominations and on the same terms as the outstanding debt.

From June 25, it has been offering single currency loans in U.S. dollars, deutsche marks, yen, Swiss francs, Dutch guilders and also French francs and sterling. Currency pool loans are still available for those that want them. Borrowers may also choose whether the loans are to be pegged in fixed or floating rate without any restriction on volume.

In with the new

The most novel feature of the development is the opportunity given to clients to convert old loans to new terms. Any undisbursed balances, that is to say loans which have not yet been paid out against fresh borrowings, may be converted to single currency loans without limit. Disbursed balances may be converted to one of four new currency pools, which will be comprised of U.S. dollars, yen, deutsche marks and Swiss francs. The difference between the old pools and the new is that the latter will be dominated by the borrower's currency of choice at a set rate. Finally, entire loans, comprising both disbursed and undisbursed balances, may be converted to single currency pool terms. Perlin says that around $50 billion equivalent of all outstanding loan commitments is undisbursed and $100 billion is disbursed.

The offer runs until July 1, 1998, and conversion to single currency loans can take place at any time during this period. Conversion to currency pools is to take place on three dates: July 1, 1997, January 1, 1998 and July 1, 1998.

In years gone by the World Bank was not only able to predict the volume of its borrowing with some degree of accuracy, it could specify the amount of borrowing to be conducted within each of the three designated currency pools. From now on, the currency composition of its borrowing will perforce fluctuate, according to demand. Over the fiscal year which began on June 30, the Bank expects to raise around $13­14 billion, a little more than in recent years.

The pressure to mark all derivatives to market gained ground on July 18, when Britain's Accounting Standards Board unveiled its first-ever disclosure rules for derivatives. "Derivatives can speedily transform the position, performance and risk profile of a company in a way that is not readily apparent within the present accounting framework," said the board. Its solution? Bam! All financial instruments, derivatives and fixed income borrowings should be marked to market. The board took an equivocal position on the merits of hedge accounting, noting that it could be used to postpone the reporting of derivatives losses. As to the chances that this radical plan will be adopted in full, the Financial Times said maybe in the next century.

Japan is also preparing tougher derivatives enforcement. Effective March of next year, Japanese firms will be required for the first time to disclose their swap and forward delivery positions and mark them to market. Previously disclosure was limited to futures, options and FX derivatives. All will be included in the auditor's certificate, and corporations will have to declare whether the holdings are for trading or for long-term investment. The rules apply to both listed and OTC products. What's more, there are severe penalties to companies that don't toe the line. "Failure to comply with the rules will carry a penalty of ¥500,000," warned a Finance Ministry official.

Listed derivatives exchanges are alive and well in Europe, judging from the flurry of activity in recent weeks. In June Portugal's Bolsa de Derivados do Porto opened for business with a futures contract on ten-year Treasury bonds and the Portuguese Stock Index of 20 leading local companies. Electronic trading, a variant of that in use by MEFF Rantal Fija in Spain, was briefly suspended on two subsequent days: one halt was due to technical problems, the other to a power failure in the main building. In the same week the MEFF launched a new yield spread contract between Spanish debt and the debt of Germany and Italy.

Brussels' Belfox exchange announced in early July plans to launch new derivatives based on European share sector indices. The move was defensive according to Belfox director Jos Schmitt, as the exchange anticipates that the advent of the EMU (European Monetary Union) will wipe out its fixed income related business, which is half of current volume. Paris's MATIF also announced that it is blueprinting some new derivatives to make up for the impending decline in interest rate products.

The Austrian Futures and Options Exchange (OTOB) last month also cobbled together new index-based products derived from four Eastern European markets: Hungary, Poland, the Czech Republic and Slovakia. Hungarian officials expressed surprise and were irked that the new products would compete with options and derivatives under development at the Budapest Stock Exchange.

Meanwhile in Greece plans for an equities derivatives market inched forward. A draft bill on derivatives was cleared by the exchange and the country's capital markets regulators and could come before the legislature by the end of the year. And in Warsaw the Polish cabinet in mid-July approved a new securities law that permits short selling and trading in options and futures contracts.

Complying with the rules governing risk-based capital requirements in collateralized transactions is guaranteed to give any derivatives user a headache. The Federal Reserve Bank, the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC) and the Office of Thrift Supervision (OTS) have each constructed different sets of rules governing the transactions.

But relief is on its way. A draft agreement that promises to harmonize rules among the four regulatory groups was agreed to in May, and is likely to be published for comment soon in the Federal Register.

As the draft makes clear, the current rules for the risk-based capital treatment of collateralized deals constitute "the most substantive difference among the Agencies' capital standards." Since December 1994 there have been three different procedures. The FDIC and OTS say that the portion of a transaction collateralized by cash on deposit in the lending bank or by the market value of central government securities in countries belonging to the OECD are assigned a 20 percent risk weighting. The Fed's rules are similar, with one major difference: Fed rules state that for transactions fully collateralized by cash or OECD government securities a zero percent risk weighting may apply. The OCC's rules are different still: the portion of a transaction that is collateralized may receive a zero percent weighting.

The proposed changes would introduce uniformity to this patchwork quilt. They would permit portions of claims collateralized by cash on deposit with the financial institution or by OECD securities to be eligible for a zero percent risk weighting. To qualify, the arrangement would need to specify the portion of the claim which would be continuously collateralized, either in dollar terms or as a proportion of the overall transaction. The position would need to be marked to market on a daily basis, making suitable changes to the collateral, and also taking into account daily changes in credit exposure and the market value of the collateral. In the cases where only a portion of the claim qualifies for this treatment, the remaining slice of the transaction would receive a 20 percent weighting.

Officials at the Fed says they believe that the proposed treatment would allow a zero percent risk weight for partially collateralized transactions "in a manner that is consistent with safety and soundness." They add that it is important to eliminate inconsistencies in the four Agencies' capital standards.

As the document has not yet been published in the Federal Register, trade bodies most affected, like ISDA, have not yet offered any official comment. But any proposal that both reduces current confusion and decreases the risk weighting given to collateralized transactions is bound to succeed.

Some weeks ago The Clifton Group launched a tongue-in-cheek contest to find a substitute for the much-maligned "d" word. The prize was awarded last month to Vishant R. Shah, an analyst with Jeffrey Slocum & Associates. His winning coinage: "Cantilevered Gearings." Why? Cantilevered because derivatives are an efficient extension of traditional portfolios. Gearings because they can be geared up (leveraged) or down (hedged). The second-place ribbon in the hard-fought contest went to the inventor of PICKLES, a Protected Investment Carefully Krafted to Limit Exposures. Also-rans: ORANGES (for Original Ridiculous Adventure by a Naïve Government Executive) and BOMBS (for Bloody Outrageous Maliciously Ballistic Securities).