By Robert Hunter

When a group of seven major banks announced they were developing an Internet-based bond-trading system called BrokerTec to shrink the interdealer broker piece of the fixed-income pie, the world’s major derivatives exchanges barely batted an eye. They were preoccupied with their own problems—mainly, how to divide up the listed derivatives markets among themselves to keep upstart electronic and, eventually, Internet exchanges from stealing their business.

BrokerTec’s goal: to create a global derivatives trading system that links together the underlying cash products in order to reduce margin, clearing and settlement costs for its stakeholders.

But shortly after BrokerTec put forth its raison d’être—to provide Internet-based order-matching for Treasuries and euro-denominated debt —the new trading entity made a stunning announcement: It was venturing into the world of listed derivatives, and was accepting proposals from parties interested in jumping onboard. The exchanges took note. Unlike the other Internet-based derivatives changes ready to hit cyberspace, BrokerTec has a direct link to major money-center banks—a sobering thought to exchanges already faced with more competitive pressure than they can bear.

BrokerTec, which is the progeny of seven of the world’s eight biggest fixed-income dealers—Citigroup, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley—has one overarching goal: to help its stakeholders save money. By linking huge fixed-income houses together via a common trading interface, BrokerTec hopes to squeeze voice brokers—and their spreads—out of this corner of the market. It’s motto: if it’s brokered, fix it.

Now, BrokerTec hopes it can achieve similar cost savings in the listed derivatives markets. In July, the entity sent letters to major futures exchanges, clearinghouses and even some software firms, inviting all of them to join forces to create an electronic platform for futures and options trading, with a submission deadline of August 16. BrokerTec’s goal: to create a global derivatives trading system that links together the underlying cash products in order to reduce margin, clearing and settlement costs for its shareholders. After waiting for years for major derivatives exchanges to reach similar cross-margining and common-clearing agreements, it seems BrokerTec’s stakeholders could wait no longer.

At press time, no major accords had been announced, but it appears that it’s only a matter of time before some prominent exchanges join forces with the fledgling trading system. Liffe, desperate for market share and fresh on the heels of developing Liffe Connect, is considered a likely candidate. Liffe’s relationship with the London Clearing House, which will soon start clearing over-the-counter interest rate swaps and repurchase agreements, makes it all the more attractive to BrokerTec.

Perhaps more to the point, Liffe struck an agreement with the Chicago Mercantile Exchange on August 5 to allow for cross-exchange electronic access and cross-margining of short-term interest rate futures via the LCH, and to create a separate, for-profit company to “develop new products and services to meet the needs of the market.” The synergetic possibilities with BrokerTec are clear. The Liffe-Merc agreement came at a time when both the Merc and the Chicago Board of Trade had been considering demutualization and even initial public offerings to compete with more streamlined competitors. Linking up with BrokerTec could provide them a quick salve to soothe competitive burns.

Not everyone, however, is convinced that BrokerTec is marching inexorably toward world domination. Big European banks are keen to defend their euro-denominated bond business, and are reportedly put off by BrokerTec’s decidedly American flavor. They will likely make it difficult for any other European derivatives exchange to join the BrokerTec initiative. Meanwhile, JP Morgan is reportedly developing an electronic trading system for euro-denominated government bonds called Euro MTS.

Voice brokers, moreover, are predictably skeptical of any disintermediated electronic approach. In times of market stress, they point out, a system such as BrokerTec is unproven, and will not be able to provide the market transparency and service offered by voice brokers—a complaint that open-outcry proponents have been making for years with less and less credibility as electronic trading gains market share.

The BrokerTec consortium certainly isn’t letting such complaints stand in its way. BrokerTec believes in itself so much, in fact, that it has said it will move forward with or without strategic partners.

The Russian and Asian crises that plagued the financial markets over the last two years made things difficult for the credit default swaps business.

When the markets tanked and defaults started piling up, buyers of credit default swaps—those who had shed the risk of a loan or bond by transferring it to a counterparty willing to accept that risk—believed they were entitled to payment, since they were being affected by forces that constituted clear credit events as they understood them. The sellers of these instruments, however, often had a different view of things, and, after quibbling over the precise definition of a credit event, took their problems to the legal system for answers. Settling the contracts often became more than a little thorny—as Daiwa Europe and Deutsche Bank, counterparties in a famous credit default swap imbroglio, can attest.

Such uncertainty, particularly during periods of high volatility when liquidity is so essential, has scared away many players who otherwise would consider using credit default swaps.

But now, the International Swaps and Derivatives Association has taken important steps to calm those fears. In July it published an expanded set of credit derivatives definitions to provide a common set of terms for counterparties to use in preparing confirmations. The new definitions amend the definitions ISDA released in 1997, and make some of the murkier areas of credit derivatives far more transparent. And to make things less cumbersome for everyone, ISDA has created a dramatically shorter confirmation sheet—10 pages, a drastic improvement over the 19-page tomes that used to clog up dealer fax machines.

The new definitions are a major improvement over the existing literature. They include choices for what constitutes a credit event, what classes of debt it would apply to, and what types of debt can be delivered to the seller of the default swap. The biggest innovation of the definitions, says Robert Pickel, general counsel at ISDA, is the treatment of debt restructuring. “Renegotiating the terms of indebtedness happens all the time,” he says. “Restructuring, as defined in the new definitions, covers the situations when those restructurings occur as a result of the deterioration in credit quality of a party, and not the more ordinary type of renegotiations that occur when a corporate entity’s credit improves and it goes back to its banks to renegotiate a new interest rate. We want to make sure that those types of situations don’t trigger the restructuring definition, and we’ve made some changes to the definition to address that.”

ISDA’s new, expanded set of credit derivatives definitions provides a common set of terms for counterparties to use in preparing credit-default swap confirmations.

The new agreement provides greater flexibility to parties in structuring their transactions to cover different types of obligations with a variety of characteristics, and is far more explicit about the length of time a borrower has before triggering a default. It also pins down some of the prickly physical settlement issues that have plagued credit deals in the past.

In addition, says Pickel, ISDA has provided greater coverage for loans and other types of payment obligations. “That’s particularly important,” he says, “because the key to wider acceptance of these types of transactions is being able to use loans and other types of payment obligations as the triggering obligation. A greater number of banks are going to use credit derivatives to hedge their loan portfolios, and corporations are going to use them more to hedge exposures they may have in their day-to-day trade business to suppliers or to other creditors of the corporation. We’ve tried to provide greater coverage to facilitate the growth in the market in these ways.”

The results of the new definitions, many believe, will be greater certainty and market transparency—and therefore greater liquidity. Pickel hopes the new definitions will also encourage people who have been afraid of credit derivatives in the past to take a closer look at the products. The new definitions are expected to result in cost savings, both in legal fees and in manpower, since contracts can be finalized more quickly with less documentation.

All this is expected to add up to a boom in credit default products. The British Bankers Association has forecasted the market to grow to $740 billion by 2000, up from only $350 billion in 1998. Indeed, it appears the new definitions are already making a difference. JP Morgan and Paribas have reportedly begun using the new rules in earnest, and other banks are expected to start shortly.

Financial institutions are continuing to make major investments in risk management systems, despite the billions they’re spending on Y2K-related initiatives. That’s the conclusion of a recently released report by Newton, Mass.-based Meridien Research, which estimated annual spending plans for risk management technology.

The financial institutions surveyed include 300 banks, 100 insurance and asset management firms, and 100 securities firms. Meridien estimated spending in six areas: enterprise risk management systems, credit risk management systems, market risk management systems, global limits systems, asset and liability management systems, and front- and middle-office trading-room systems.

1999 Spending Estimates for Risk IT
	Enterprise-Level Risk Systems	Front- and Middle-Office Systems
Banks	$1.3 billion	$3.2 billion
Insurance and Asset Management Firms	$525 million	$411 million
Securities Firms	$775 million	$4.6 billion
Total	$2.6 billion	$8.3 billion
Projected Expenditures, 2004	$5.4 billion	$12 billion

Global spending estimates on enterprise-level risk systems, for instance, increased to $2.6 billion for 1999, up from $890 million for 1998. By 2004, enterprise risk IT expenditures are projected to more than double to $5.4 billion. For front- and middle-office systems, global spending estimates are expected to rise from $8.3 billion for 1999 to approximately $12 billion five years from now.

Meridien increased the number of financial institutions surveyed from 400 to 500, in part because the population of financial institutions investing in risk technology has increased. It is that increase—rather than a sudden jump in spending by the largest 400 institutions—that accounts for much of the rise in estimated expenditures, says Deborah Williams, a director at Meridien.

Spending estimates in all categories increased more or less proportionally across geographic regions over the last year, with a “bit of a shift in spending from Asia Pacific and Europe to North America,” notes Williams. Over the next five years, Meridien predicts, global risk IT expenditures are likely to grow at a rapid pace. Credit expenditures are expected to be the fastest-growing category, with an estimated annual growth rate of 21 percent. Spending on asset and liability management systems is projected to grow at an annual rate of about 12 percent; spending on enterprise risk management systems at 16 percent; spending on enterprise market risk at 14 percent; and spending on front- and middle-office systems at 8 percent.

Some areas of risk IT spending, however, will “decelerate” over this period, says Williams. Market risk is expected to be the first area where this will occur, while credit risk will continue to see new expenditures through 2004 and beyond. Credit risk expenditures will increase at a faster pace because credit risk is a “much bigger problem [than market risk] and far more complex,” says Williams. “With credit portfolios, an institution often has hundreds or thousands of counterparties, whereas with foreign exchange markets, for instance, there are dollars, Deutsche marks, sterling, euros and a handful of others. What drives market risk is much more straightforward, but we don’t know what drives credit risk yet—there could be macroeconomic variables, fundamentals of the business cycle, the impact of currency devaluations and other factors.”

Operational risk and legal risk IT expenditures, which currently are not large, are likely to become much more signficant over the next five years. Nonetheless, the Meridien report notes, “the biggest influence over the total levels of spending...will be the number of institutions that are investing in this type of technology.” Smaller banks and securities firms are beginning to look more closely at risk IT systems, and, over time, notes the report, “this deepening of the market will have a much greater impact on both the spending levels and the shape of risk solutions, than will the moderate increases in spending by individual institutions.”

By Robert Hunter

When the International Securities Exchange, an all-electronic upstart, filed a request with the Securities and Exchange Commission last November to become the first new U.S. options exchange in more than 20 years, seeking to trade 600 of the country’s most active options contracts, the U.S. options establishment got busy preparing for the new electronic threat. Mergers were announced and then abandoned—most notably, between the American Stock Exchange and the Philadelphia Stock Exchange—and everyone started beefing up their electronic capabilities.

But some were more successful than others, and now the slowest of the slow-pokes is paying for its tardiness.

On August 18, the CBOE made an earth-shattering announcement: that it was to begin listing options on Dell Computer Corp., the PHLX’s flagship product and the most-traded option contract in the United States, the following Monday. The announcement effectively obliterated a long-honored gentlemen’s agreement between exchanges not to cross-list competitors’ products. Within hours, the PHLX retaliated by announcing that it would begin listing options on IBM, Coca-Cola and Johnson & Johnson the following Monday as well. That same day, the Amex got into the game, announcing that it would also begin trading Dell options the following week, so PHLX responded by announcing that it would trade Apple Computer options, which had been listed exclusively at Amex.

Why did the CBOE fire the opening salvo in what could become an all-out listings war? “Firms had come to us and said they wanted an alternative place to trade Dell options,” says William Brodsky, chairman of the CBOE. “It’s as simple as that.”

The announcement obliterated a long-honored gentlemen’s agreement between exchanges not to cross-list competitors’ products.

The roots of the war go back to the proposed Amex-PHLX merger. When the Amex agreed to the deal, it realized that it was linking up with a partner that was technologically bereft. Traders had long complained about cramped quarters and outmoded, paper-based execution systems, and the exchange was still a long way away from carrying off any major technological upgrades. The Amex, peering into the future and the ISE threat (see box), decided to try to prop up the PHLX’s Dell options, by far its most successful product, with its own technology. So while the PHLX’s old systems continued to cover the exchange’s other products, the Amex execution system was patched in to handle Dell options.

But this summer, the merger fell apart, and the Amex decided to tear off its Dell band-aid by September 1. The prospect of returning to the PHLX’s system, which in the past had sometimes taken more than an hour simply to open trading, sent firms running to the arms of the CBOE for help.

The ISE Threat

The listings battle may prove to be only a prelude to a much bigger war, pitting the International Securities Exchange against the rest of the exchange world. The populist startup believes that the investing public should be given top priority, and says its trading system has three core principles: Customer orders will always be executed before professional orders. The price at which a customer order is filled will be the best price available from all options markets; The ISE will be the only fully electronic market in the world that incorporates quotes from other exchanges so that customers trade at the best price. A complete, detailed electronic record (audit trail) of all transactions, time stamped to the nearest 1/100 of a second, will be immediately available for surveillance purposes. It’s easy to see why the options community is preparing for war. If the SEC approves the ISE proposal, options trading as it’s known today could be changed forever.

“We’ve taken lots of steps over the last six to nine months to get prepared for a more competitive environment,” says Brodsky. The exchange has retooled its trade engine, giving it more trading capacity, and has recently voted to put a designated primary market-maker in every pit to help keep things running smoothly. The CBOE also plans to roll out an electronic trading system for its smaller contracts next summer, and has created a rapid-opening system to perform the opening rotation in a matter of seconds rather than the 15 or 20 minutes it used to take. All these things, says Brodsky, compelled Dell traders to seek shelter at the CBOE. “We have the best facility, the best systems and the largest group of market-makers in the world,” says Brodsky. “We’re in great shape.”

On the first day of trading, however, it wasn’t clear which exchange had the advantage. The PHLX, jarred by the Amex’s announcement on August 18 that it was taking back its Dell trading technology on August 23 rather than September 1, had worked furiously to improve its opening system. On August 23, the exchange claimed that it made its opening in eight seconds, beating the CBOE. The CBOE, meanwhile, maintained that it opened in four seconds. At the end of the trading session, according to the Wall Street Journal, PHLX traded a total of 68,118 Dell options, compared with 59,584 contracts at the CBOE and 31,616 contracts at the Amex. But as Eurex has shown the exchange world, liquidity can be stolen quickly.

It had to happen. The financial world’s obsession with hedge funds has finally led to the latest new gizmo: investable hedge fund index products. Credit Suisse First Boston and Tremont Advisers last month formed a joint venture company, Credit Suisse First Boston Tremont Index LLC, to construct a series of industry benchmarks and a “line of investable index products” tied to the new indices.

The company will launch a capitalization-weighted master index next month, followed by a series of cap-weighted sub-indices based on hedge fund investment strategies and styles. The indices, updated monthly, will be based on the TASS+ database of 2,600 hedge funds, created in March by the merger of Tremont and TASS Investment Research Ltd.

The CSFB Tremont Index will differ from existing hedge fund indices by being cap-weighted. This provides a “more accurate reflection of an investor’s dollar when invested within the hedge fund asset class,” says Roland Lorenzo, a director and president of CSFB Index Co. “If you don’t asset-weight an index,” adds Hunt Taylor, senior vice president at Tremont, “you get an extremely skewed impression of what the bulk of [investors’] money is experiencing.”

The indices will be geared toward institutional investors—mainly hedge fund investors and fund managers seeking to benchmark fund performance. “We’re trying to offer our customers a way to benchmark their investment dollars vs. other categories of investments, such as mutual funds,” says Lorenzo. “Our customers have been asking for these types of benchmarks. They want to know how their investments in the Standard & Poor’s 500 or other categories of investments compare with hedge fund returns.” In addition, the indices will enable individuals to evaluate managers relative to how their peers have performed, says Taylor.

Another audience for the indices, Taylor points out, is the media. Hedge funds can’t advertise or market themselves. At the same time, “you’re not going to see the media writing stories headlined ‘Convert Arb Fund Knocks Out 12% Again,’” he says. “It’s just not newsworthy. So the only thing that makes it into the public consciousness is the poor hedge fund that had a problem. It’s a negative selection process.” He notes that a hedge fund with problems often becomes a proxy for the whole industry. “People assume that because Long-Term Capital Management had a problem, all hedge funds were having problems,” he says. “Or they assume that because LTCM had a high-risk profile, all hedge funds did, when that wasn’t true at all. So we think the industry needs a frame of reference—so that when stories percolate up...the media will be able to contrast that [particular] hedge fund’s performance with the overall performance of the industry.”

For the time being, CSFB and Tremont Advisers are tight-lipped about the investable index products they plan to launch. However, “anyone who is an asset allocator and is looking to allocate a portion of an investment into the hedge fund asset class might utilize the products as a means of achieving that,” says Lorenzo. “The products are geared toward more qualified institutional investors, as is the hedge fund business as a whole.” The firm will release information about the index products next month and expects to launch the products in 2000.

By Nina Mehta

PricewaterhouseCoopers’ recently completed six-month study of operational risk management in seven leading banks found that operational risk management initiatives are increasingly beneficial to organizations when they are incorporated into daily risk management processes. The difficulty for senior management, according to the report, “lies in quantifying this increasing value.”

“Some had strong assessment processes. Others had advanced organizational models but were weak in some other area.”

The purpose of the private study, says Michael Haubenstock, a partner at PwC, was to “identify leading practices among large financial institutions and to give them a sense of how they stood against the industry.” The study addressed corporate-wide operational risk management initiatives and organization, focusing on the “existence of operational risk definition, objectives and policy,” says Haubenstock. “In individual organizations, we looked at how evaluation and self-assessment risk processes worked, and the presence of culture and motivation.” No single bank was found to have stellar operational risk management processes across the board; instead, good practices were found in different areas across the institutional base. The banks that participated in the study were ABN Amro, Barclays, Chase Manhattan, Deutsche Bank, ING Group, JP Morgan and UBS.

In the brief time that operational risk has begun to make a name for itself as a discrete risk discipline, various definitions have emerged, ranging from everything that isn’t market risk or credit risk, to losses resulting from fraud, lapses in internal control and transaction-processing errors. Although none of the banks surveyed defined operational risk the same way, the definitions generally covered “internal issues around people, processes and technology, and exposures to external issues beyond the organization’s control, other than market and credit risk,” says Haubenstock. There was consensus among the banks about the importance of articulating a clear and “actionable” definition of operational risk, about the value in having an operational risk manager, and about the benefits of integrating operational risk management into the institutional risk management structure.

One surprise the PwC study highlighted was the variety of ways institutions have begun to address operational risk. “Some people started on definitions,” says Haubenstock. “Some people had an extremely quantitative approach. Some had strong assessment processes. Others had advanced organizational models but were weak in some other area.” For all these differences, however, the study found that “cultural processes”—that is, an institutional emphasis on sound risk policies and the way people act on a day-to-day basis—are critical to successful operational risk management. At the same time, the study found that the banks have so far not established training programs or devised ways to link compensation to success in operational risk management in order to help reinforce beneficial risk management procedures.

The banks in the study have not been shy about spending money to get a handle on operational risk. They have spent up to $16 million in the last year on dedicated resources for operational risk management—from people and staff to related IT systems. The banks are also starting to collect databases of operational risk loss events to quantify what operational risk failures are costing their organization and to determine where to put their resources. This information is fragmentary and banks have been reluctant to turn to outside databases of loss information, but so far, says Haubenstock, “the potential exposures that banks are most worried about are fraud and operational failures—in other words, things that happen in the back office.”

So how can banks get a grip on operational risk? “It’s not just internal controls, it’s not just systems, and it’s not just reporting,” notes Haubenstock. “You have to create an awareness that this is an issue that could cost the bank real dollars, and develop a coordinated approach toward that end. That means working on internal controls but also having proactive thinking about what’s happening in the business, where potential exposures are, what is being done about it, and where those efforts can be improved.” In addition, it also involves collecting information to help focus management’s attention; doing empirical analysis about what happened, what could happen and what happened to others; and management reporting about the issues, exposures, incidents and how risk indicators are moving. Operational risk management also involves the “establishment of committees at the business line or corporate level to receive that information and to get the decision-making established in order to react quickly,” he adds.

The main hurdles for banks in the future: getting a range of individuals in the institution in the right mindset to focus on what can be done to prevent operational risk losses and protect shareholder value; getting management to recognize each individual’s role; and strengthening the metrics that provide a clear link between good operational risk practices and executive performance measurement. All the banks surveyed recognize the need to develop quantitative assessment processes and specific operational risk indicators that will enable the banks to view operational risk “as a business issue rather than an informal management practice,” according to the study.

The PwC study was commissioned by the seven banks involved. A broader industry survey being conducted by the International Swaps and Derivatives Association, the British Bankers Association and Robert Morris Associates, with the help of PricewaterhouseCoopers, is expected to be completed later this year and will be made available to the public.

When the weather derivatives market began to develop two years ago, dealers’ main task was getting the word out and explaining the new products to the corporate world. A busy conference circuit and a deluge of articles in the financial press indicated that people were listening, and a booming over-the-counter market in weather derivatives quickly developed.

Now, the Chicago Mercantile Exchange hopes to cash in on weather mania. The Merc begins listing on September 22 four futures contracts based on a heating degree-day index in four U.S. cities: Atlanta, Chicago, Cincinnati and New York. A degree day is the deviation of a day’s average temperature from 65 degrees Fahrenheit. A heating degree day is the wintertime measure of degree days below 65 degrees, used to figure out how much energy is needed to heat homes and businesses; a cooling degree day, conversely, is the summertime measure of degree days above 65.

The first wave of Merc contracts is geared primarily toward energy producers. “The rationale behind these products,” says Pete Barker, director of interest rate product marketing at the Merc, “is that power companies can use temperature to manage volumetric risk. In the Midwest, for example, everybody heats their houses with natural gas and cools them with electricity. Gas companies know that in a winter when temperatures are warmer than expected, they won’t sell as much gas. They can hedge the price risk in natural gas all they want with Nymex futures contracts, but those contracts don’t provide a way to hedge the revenue risk. Weather futures allow them to hedge the demand side.”

The contracts are based on the average daily temperature in the city in question, as measured by the National Weather Service. Earth Satellite Corp. reports the figures to the Merc, and the Merc posts the figures daily on its web site to help end-users.

The exchange doesn’t expect the contracts to break volume records anytime soon. Companies located in the four cities in question can use the products reliably, but companies outside those cities inevitably inject basis risk into the equation whenever using the products. An energy producer in Western Pennsylvania, for instance, would have weather exposures vastly different from both New York and Cincinnati, the two closest cities served by the Merc contracts.

The basis risk will keep such players in the over-the-counter market for a while, but that’s all right with the Merc. “We’re hoping these things will work like eurodollar futures work in the interest rate business,” says Barker. “If you want to do a transaction with an OTC dealer for a city that’s closer to where you are located, go ahead. The hope is that the dealer will turn around and try to dump off some of that risk in the listed market.”

The Merc is sanguine enough about the new products to start thinking about a second wave. Next year, it plans to expand its coverage to include Dallas, Philadelphia, Portland, Ore., and Tucson, Ariz., and plans to list additional cooling degree day contracts on all eight cities. The exchange has received approval from the Commodity Futures Trading Commission to list products on Las Vegas and Des Moines, Iowa, temperatures as well.

All the Merc’s weather contracts will trade exclusively on Globex2, sized at $100 times the CME HDD index (or CDD index) for the city in question.

“We know the volumes for these products will never equal eurodollar futures,” says Barker. “But if they trade along the lines of some of our agricultural products, we’ll be happy.”

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