The price of capacity is dropping, but uncertainty is fueling new interest in hedging the risk of price fluctuations.

By Nina Mehta

It’s beginning to look like there may be a hot new derivatives market in telecommunications capacity this side of the horizon. Then again, maybe not.

The rush is now on to develop forward trading in telecom capacity, or bandwidth. Bandwidth refers to the number of bits transmitted through a pipe per unit of time, and more bandwidth essentially equals more speed and the ability to run more complex Internet-based applications. As video conferencing and real-time data feeds become cheaper and more efficient, for instance, the demand for bandwidth increases. “When a Spanish schoolgirl comes home and sends the Encyclopedia Britannica around the world twice by mistake, that requires a lot of bandwidth,” says Richard Elliott, founder and director of Band-X, a London-based firm that pioneered Internet trading of telecom capacity two years ago. As demand increases, advances in IT and communications have also made bandwidth more plentiful. The problem that now exists for bandwidth buyers and sellers, however, is that no one has a good handle on how to price telecom capacity in the future.

A liquid derivatives market would allow network providers to hedge against unexpected shifts in bandwidth price.

A transparent, liquid derivatives market would give network providers and bandwidth users greater peace of mind. It would allow them to hedge against unexpected shifts in bandwidth price—and, according to some industry players, is likely to lead eventually to financial contracts and the introduction of speculators in the market.

But the challenges facing forward bandwidth trading are manifold. One basic problem is the lack of a liquid spot market. There are currently about half a dozen over-the-counter Internet services and clearinghouses that allow carriers and other customers to post bids and offers on their web sites for bandwidth transactions across various routes. The problem, says Ross Mayfield, vice president of marketing at RateXchange, a San Francisco-based Internet “exchange” for OTC telecom capacity, is that “when you agree on a route and rate, the time to close that transaction is usually 60–90 days.” Negotiating the contract and payment terms, physically testing the quality of a route by plugging into a circuit, and then executing the physical interconnection take time. Consequently, he says, only one in 10 transactions succeed in closing. Moreover, if the spot rate changes in the interim, one of the carriers has an incentive to back out of the deal or force a rate renegotiation at the very end.

The answer, of course, is to bring some standardization to the table. But one of the basic hurdles to trading bandwidth is commoditizing telecom capacity in the first place. Bandwidth is more complicated than other commodities because contracts are often written for six months or a year at a time, and because, notes Band-X’s Elliott, it’s a service that has no single moment of transfer of ownership. Although bandwidth has been compared to the power markets, telecom capacity is even more difficult to commoditize than power, says Tom Gros, vice president of global bandwidth trading at Enron Communications, a subsidiary of Enron Corp., the energy giant. “Like power, it cannot be stored,” he says, “but unlike power, bandwidth standards are likely to change over short periods of time—that is, two years from now a lot of what we will be trading this year will start to look obsolete.”

An additional physical layer of complexity is that international data and transmission standards are still evolving. Right now, network providers such as Enron and Williams Communications, Internet service providers such as America Online, bandwidth resellers, and other industry players often have different, specific requirements for bandwidth transactions. Carriers with similar switching equipment, for example, can transact with one another, but technical incompatibilities often prevent dynamic switching between carriers, or between carriers and end-users.

Telephone voice minutes, which represent the low end of bandwidth, have an extremely liquid spot market. OTC exchanges and clearinghouses that have ramped up the wholesale international minutes market over the last few years have lately been moving into bandwidth. In addition to Band-X and RateXchange, the companies facilitating wholesale bandwidth trading include Arbinet Communications in New York, Amsterdam-based InterXion, Hong Kong-based ACE and a few others. These Internet-based services facilitate transactions, often anonymously. If terms and conditions are met, the exchange—if it owns a switch—physically delivers the trade. Alex Mashinsky, chairman of Arbinet, which has a large and liquid minutes market and was the first to transact a forward contract and take the step of physically clearing trades, notes that having this physical layer is becoming increasingly important for active trading. Anything listed on his exchange, he points out, is already connected to Arbinet’s switches, which increases the speed of delivery.

Earlier this year, Enron generated a flurry of industry attention when it announced plans to trade forward bandwidth contracts for physical delivery. In May it unveiled two products based on discussions with 20 large industry players. One is based on a T1 line from New York to Los Angeles that transmits 1.5 million bits per second, and the other is based on a DS3 line between Washington, D.C., and San Francisco that transmits 45 million bits per second. Enron plans to begin trading these products toward the end of this year, once industry terms and standards are settled and the hardware to create the physical pooling points—real-time provisioned switches that enable telecom traffic to be switched between interconnected wires—is built.

Slouching toward consensus

Although the telecommunications industry is competitive and volatile, consensus seems to have emerged on two points. The first is that Enron deserves a round of applause for announcing that it believes telecom bandwidth can be commoditized. The second item of consensus is that Enron is not a neutral player—and that what it proposes will be good for Enron but not necessarily for the rest of the industry.

Since Enron is a large capacity provider, so the argument goes, it will sell its own capacity through the pooling points first. “The company is looking to trade and that’s how it’s going to make all its money—from trading, not facilitating the market,” says one market participant. “Enron has designed the contracts it will trade to favor the design of its networks,” says another person. “The majority of networks in bandwidth today are not on an Internet Protocol infrastructure. So what it’s doing [with its DS3 IP contract] is giving itself an advantage and making other carriers bear large costs...It’s also designating who the pooling point operator is going to be—that is, who’s going to be the NASD of Nasdaq. Who knows how neutral the pooling point operator will be.”

Enron’s Gros categorically rejects these criticisms. Enron, he says, took pains to create an industry-accepted, neutral, level playing field—and is helping set up the market but will not run the market. “We are handing the pooling points over to a neutral third party such as PricewaterhouseCoopers,” he says. “If AT&T and Sprint want to do a deal, we agree that they shouldn’t have to call Enron.”

Enron’s contracts will be for well-trafficked telecom routes in the United States, but, says Jahangir Raina, a director at Cape Saffron, a telecom clearinghouse consultancy in London, a carrier that wants to buy capacity from Enron would typically need end-to-end capacity, rather than capacity only from hub A to hub B. Raina expects there to be a “niche market” for bandwidth forwards in general, but doesn’t think the market will take off as easily as commodity markets for paper or copper, for instance.

Carl Carrie, president of CastleNet, a software firm that’s looking into bandwidth forward trading as a capacity end user and as a potential provider of data and transactional support, says that the main issues for trading telecom capacity are the need for clear standards and documentation, and the availability of historical and real-time market data. Without this, producing a forward curve for pricing will be difficult and transparency nearly impossible. In addition, he says, the telecom industry needs more transparent market segmentation since bandwidth is not a homogeneous commodity. “For example,” he notes, “if you’re delivering real-time market data, IP packet latency is a huge factor, since you can’t afford [to lose] more than a couple hundred milliseconds of response time—but you don’t need the latency characteristics of true voice-over-IP quality.”

“Like power, bandwidth cannot be stored. But unlike power, bandwidth standards are likely to change over short periods of time.”

New products will inevitably be launched, but for now most web-based bulletin board exchanges are developing the market and trying to attract liquidity. Band-X’s Elliot notes that there is a liquid market on bandwidth routes with competitive offerings, and that international standards are emerging, especially in deregulated countries. Nonetheless, he has reservations about the development of a financial market in bandwidth derivatives. “A benchmark has to reflect the pricing of the asset that a company is trying to hedge,” he observes. “So it is no good trying to protect yourself from a movement in T1 between Marseilles and Cyprus by hedging it with a contract in the coast-to-coast T1 price in the United States [one of the contracts Enron has floated]. Finding a single—or even a couple—high-volume contracts against which people would be prepared to enter a financial derivatives contract is, in my view, a tall order.”

Only time will tell just how tall.

Two new risk indices help risk managers see the world a little more clearly.

Everybody likes to talk about global markets getting more and less volatile, but nobody has ever bothered to quantify global volatility and correlation numbers in a systematic way.

Now it’s possible to get those macro statistics with RiskMetrics Group’s Global Volatility Index and Global Correlation Index. The two indices, updated daily on the RMG web site (www.riskmetrics.com), show the aggregate global volatility and correlation among 28 countries in the equity, fixed-income, foreign exchange and commodity markets. The indices use July 1997 as the par level of 100, since that month represented the average volatility over the three-year period 1995–97.

As Figures 1 and 2 indicate, in October 1998 volatility spiked to breathtaking index heights of 235—roughly 2.3 times the average—while correlation dropped sharply, from more than 300 on June 17, 1998, to 102 by September 11, 1998. The volatility spike, we know now, was precipitated by the Russian government de facto default, while the correlation decrease marked the massive flight to quality that temporarily inverted the U.S. Treasury yield curve.

How can the RMVI and RMCI help risk managers in such situations? By presenting global risk and correlation figures in a simple visual fashion, the indices can alert risk managers quickly to big changes in global volatility and correlation, allowing them to shock their risk numbers accordingly. “We’re trying to get the whole marketplace to view things more from a risk perspective,” says Pradeep Menon, product manager for DataMetrics at RMG. “The whole concept of risk is nonvisual, and takes a great deal of conceptual understanding. We’re making things a bit more visual.”

The problem with rigid, static indices of such broad market developments is the lack of applicability to risk managers with more narrow portfolios. Not everyone, for instance, has big rupee exposures or massive gold positions. RMG has addressed this by making the RMVI and RMCI customizable, allowing users to build the indices to reflect their own specific portfolios, even when the products or countries are not included in the base RMVI and RMCI calculations.

Aftershock

What sorts of market reverberations has August 1998 wrought? Not many. “One thing that’s apparent is the volatility of global markets drastically dropped after the crisis, and so did the correlations,” says Menon. “You notice the U.S. market is going in a different direction from some of the other markets. The correlation index is at 60 now, which should mean that you would have an excellent diversification effect in your portfolio. Last August, correlations between the markets really broke down, and they’ve been getting lower and lower ever since.”

In addition to the risk visualization benefits, the RMVI and RMCI could serve as the underlying indices for derivative contracts, allowing risk managers to make relatively pure plays on volatility and correlation tailored to their specific portfolios. No deals have been reported thus far, but the next major yield curve inversion or currency collapse may spark a cottage industry in volatility and correlation products.

When the Financial Accounting Standards Board decided in May to delay the effective date of Financial Accounting Standard 133 for one year, from July 1, 1999, to June 15, 2000, the financial world breathed a collective sigh of relief. Many companies had been focusing most of their IT efforts on Y2K for the past year, and were thus ill prepared for the additional systems strain of FAS 133. Moreover, few—including some people at FASB—had mastered the intricacies and nuances of the new standard. It was clear to all that more time was necessary.

Now, corporate treasurers and other interested parties can monitor the FAS 133 situation in nearly real time. A new web site, www.fas133.com, has been created by the publisher of International Treasurer, a fortnightly newsletter, to keep people up-to-date on the weekly—if not daily—developments in the FAS 133 implementation process. In addition to news alerts and blow-by-blow reports on Derivatives Implementation Group meetings, the site allows corporate treasurers to ask “experts” questions relating to the standard, and offers other expert advice as well.

A six-month individual subscription to the site is $425, with a discount for International Treasurer subscribers.

Last year’s Russian default, and the frantic flight to quality that followed, changed the way risk managers view not only market risk but counterparty credit risk as well. Firms that held big exposures to failing counterparties across a variety of instruments under different master agreements found themselves more than a little uncertain as to their overall risk exposure.

The Bond Market Association hopes to change that in time for the next global crisis. The group announced in July a comprehensive cross-product master netting agreement covering a variety of securities, developed with the input of the British Bankers Association, the Emerging Markets Traders Association, the Financial Markets Lawyers Group and the International Swaps and Derivatives Association. The exposure draft is being circulated to regulators, central banks, legislators and legal types for comment before the new master agreement is finalized in September.

The BMA notes that the process of evaluating exposure across a variety of different products—such as when a firm has repurchase agreements, interest rate and currency swaps, and forward contracts, each documented by a different standard contract—is more complicated than necessary nowadays, because there are no standard industry cross-product netting agreements with uniform provisions.

The new document, by contrast, is a “credit-friendly” agreement that provides for cross-netting and also allows for cross-default, by stipulating that a default by one party under one transaction or agreement can constitute a default under any other transaction or agreement with the non-defaulting party. Moreover, the agreement allows for the netting of amounts due and owed between counterparties in connection with different products, whether or not the transactions are under separate master agreements. Rather than overriding underlying agreements such as ISDA’s master swap or the BMA’s master repurchase agreement documentation, the cross-product agreement allows for the netting of the amounts through the closeout, terminating and netting process under each respective master agreement to determine a single net amount due between two counterparties.

The agreement can be found at www.bondmarkets.com.

In the two-plus decades since Bankers Trust first introduced the idea of risk-adjusted return on capital (RAROC), financial institutions have gradually come to view the calculation as an essential component of sound risk management practice. But surprisingly, precious few institutions have figured out a way to arrive at accurate, firm-wide RAROC figures, says a recent report called “Risk-Adjusted Return on Capital” by Meridien Research, a Boston-based consultancy.

While RAROC is a simple, straightforward calculation, pulling together the underlying exposure and revenue figures from across the enterprise is a different story.

The problem isn’t one of methodology but of execution, says Deborah Williams, a director at Meridien. While RAROC is a simple, straightforward calculation, pulling together the underlying exposure and revenue figures from across the enterprise is a different story. “Risk managers who focus on small pieces of the bank such as market or credit risk are constantly working on refining their models to the nth degree so that everything is exactly right,” says Williams. “But RAROC calculations involve market, credit, operational and business risk. The RAROC group at the central level must come up with estimates for these exposures for capital-allocation purposes, even when no proven estimation techniques are available in order to start the process.”

Williams is not surprised that while all of the more than 30 firms contacted for the study—which included banks, insurance companies and asset management firms—are working on RAROC in some way, none have fully completed implementations of RAROC methodology. Even major banks with “strong risk management practices” are still getting a handle on how to translate what they know about their exposures into a full estimate of capital usage. To do RAROC, a firm has to create a hierarchy of all its exposures, and then match it exactly with a hierarchy of all its revenues, so that apples are matched with apples—a process that has proved to be easier said than done. “A lot of people said they can estimate capital usage on the risk side,” says Williams. “But revenue numbers are more difficult to come by, and while you should be able to get real revenue numbers from the systems, it’s surprisingly difficult to do at any level of detail or in comparable organizational or product hierarchies.”

While the industry’s history in implementing enterprise-wide RAROC systems has been slow, however, Williams notes that it’s important for firms to put a stake in the sand now. “RAROC is the way you manage any financial institution that makes money by taking risk,” she says. “So the successful institutions in the future will be the ones able to tackle this thing. The perfect solution is not just going to plunk itself down on your desk someday.”

Her strategy: get an infrastructure in place now. Since RAROC is built on information from each of a firm’s underlying business units, the more pieces the RAROC group can get from those units, the less they’ll have to wing it at the central level—and the more accurate the calculation will be.

From a technological perspective, financial institutions shouldn’t wait for an off-the-shelf RAROC solution to be developed. “It’s not rocket science to calculate RAROC once you have the exposure and revenue information figured out,” she says. “So my gut feeling is that there will never be a huge technological investment in systems specifically designed to perform the RAROC calculation. The investments should focus on getting better and more uniform exposure and revenue numbers across the enterprise. This investment can then be further leveraged by the RAROC group, which will probably continue to use spreadsheets and database-driven reporting for the foreseeable future.”

For a copy of the report, call Amy Habeshian at 607-796-2800.

More than 30 catastrophe bond securitizations have taken place since 1994, and that may only be the tip of the iceberg. According to a recent Standard & Poor’s report analyzing the 30 most costly insured losses from 1970–1995, there has been an increase in the frequency of large claims since 1989, represented in 1992 dollars.

The report, called “Modeling Catastrophe Reinsurance Risk: Implications for the Cat Bond Market” and found at www.standardandpoors.com/ratings, notes that “insured property losses of $75 billion or more could result from Atlantic basin hurricanes,” while a magnitude 8.5 earthquake in the New Madrid seismic zone (Arkansas, Illinois, Indiana, Kentucky, Mississippi, Missouri and Tennessee) could cause insured losses of more than $115 billion. “Aside from government support,” says the report, “the only other source of capital to finance these risks may be the capital markets.”

As the table below indicates, a single insured loss of $1 billion or more can be expected about once a year on average, while single loss events of $3 billion or more occur less than every three years. The return period is the average time until an event exceeding a certain threshold occurs; the non-encounter probability is the probability that no such event occurs in a given period. But since the loss estimates below are based on 1992 dollars, billion-dollar events are even more likely than these figures indicate. It may not be long before the long-predicted convergence of the insurance industry and the capital markets comes to fruition.

Estimated Return Periods and Non-Encounter Probabilities for Various Catastrophic Losses (Single Events)
Loss (in billions of 1992 dollars)	Return period (years)	Non-encounter probability
1.0	0.88	0.3174
2.0	1.10	0.4000
3.0	2.68	0.6881
5.0	6.05	0.8466
10.0	15.42	0.9382
15.0	25.15	0.9611
20.0	35.46	0.9718
Source: Standard & Poor’s

Was this information valuable? Subscribe to Derivatives Strategy by clicking here!