SUNS  4305 Tuesday 20 October 1998


FINANCE: OTC TRADING AMONG BANKS REACH DAILY $1360 BILLION

Geneva, 18 Oct (Chakravarthi Raghavan) -- The average daily turnover in the over-the-counter (OTC) derivatives instruments (currency swaps and options) increased by about 85% between 1995
and 1998, but remained a small fraction of the overall trading, the Basle-based Bank of International Settlements reported Sunday in its preliminary global turnover data.

The BIS preliminary data is from the Triennial Central Bank Survey of Foreign Exchange Derivatives Market Activity in April 1998. This brings out that, after making allowances for double-counting (from local and cross-border inter-dealer transactions), the average daily turnover in the "traditional" global foreign exchange instruments (spot transactions, outright forwards and foreign
exchange swaps) are estimated at $1490 billion compared with $1190 billion in April 1995.

The data also shows that the "trading" of the various OTCs, among banks themselves, rather than through the "exchange" and "clearing house" markets, is a whopping $1360 billion - and this daily
turnover is not subject to the general oversight and rules of exchange markets (and their boards) and built-in circuit-breakers (to halt trade), but only subject to general bank oversights - like capital adequacy ratios and reserves against value-at-risk of the trading.

In the wake of the current financial crisis, a number of financial experts have been calling for better monitoring and regulation of inter-bank lending, and for central bankers and banking regulators
getting a handle on the generation of the OTC derivatives.

Martin Meyer, who had published extensively on banking and financial matters, in a Brookings Institution briefing paper, has underlined that avoiding or mitigating of the crisis as now, that
originated in Asia but has spread to all regions, is not possible unless central banks monitor and regulate better inter-bank lending, and necessarily for this to deal with the banks "generating" and trading in OTC derivatives.

The term derivatives cover a wide range and include both plain "vanilla" instruments -- defined by the BIS as instruments traded in generally liquid markets according to more or less standardised
contracts and market conventions -- and custom-tailored derivatives.

The BIS data shows that apart from the "traditional" foreign exchange instruments, the notional value of transactions in interest rate derivatives (forward rate agreements or FRAs, swaps
and options) amounted to $265 billion, compared with $151 billion in 1995.

The survey shows that the deutsche mark (DM) has overtaken the dollar as the most important currency of denomination in OTC interest-rate swaps, rising seven-fold over the 1995-1998 period to occupy 30% share of the market. DM swaps, the BIS says, has been increasingly popular in single-currency swaps, since such DM-denominated swaps often acted as counterparts to cash and
derivatives transactions involving other currencies as a proxy for the euro.

The share of the UK in the OTC derivatives business rose from 27% in 1995 to 36% in 1998 - with the growing buoyancy of European currency transactions more than compensating for a subdued pace of activity in the yen. The US, with 19% share, takes second place as the most important location of such activity, while France has overtaken Japan as number three, and Germany replacing Singapore in the fifth position.

The fall in market share of Singapore from 7% to 2% is probably related to the drying up of liquidity in instruments based on yen and a number of other Asian currencies, the BIS says.

The common argument of authorities of major industrial countries against regulation of such trading is that if they do so, the trades may shift to off-shore centres, with little or no oversight.

However, while true to some extent, this argument overlooks the fact that all these operations in such "off-shore" centres and financial and banking secrecy and tax-havens, are in fact subsidiaries of their own major banks and financial institutions, and the "offices" at such places may at best have a computer, a modem and fax machine and one or two persons. All the transactions and decisions are taken at the offices of the main institutions in the major industrial nations, and none of "wizards" engaged in such trade would actually go and live in these off-shore centres or tax havens.
The Brookings institution briefing paper by Meyer argues that the solution to the derivatives dilemma can be easily found and administered. The risk-reduction purpose of derivatives can be
achieved by use of exchange-traded and publicly priced future and options contracts, and cites a paper published in 1994 (by David Folkerts-Landau, Director of IMF Capital market research and Alfred Steinherr of the European Investment Bank) which received an AX Bank Review brilliancy prize.

In the paper the two authors argue that by increasing the capital requirements for OTC derivative positions, and thus making them more costly relative to exchange/clearing house positions, it is
possible to induce a shift towards exchange/clearing house market structure. In terms of the various risks generated by OTC derivative activity, credit risk would be reduced by marking to market with margining, transparency of price discovery would increase, liquidity risk would be reduced by the fungibility of contracts, legal risks would be eliminated under existing laws, and operational risk would be reduced.

Why don't central banks, and the central bank of the central banks and Basle-based bank regulators use this to reduce the dangers of the OTC derivatives? Says Meyer:

"What is actually happening is that the central banks, the BIS, and the private sector Group of 30 are all looking for ways to reduce the capital that banks must allocate against their derivatives
positions. Chairman Greenspan has said that 'stress tests, which address the implications of extreme scenarios', will take care of the garbage in problems the mathematical models now cannot solve. 'As credit risk analysis and risk management processes in general become more sophisticated, he added, 'the framework for regulation and supervision, including the framework for capital charges, will need to adapt to, and take advantage of, evolving risk management practices.'

"Central banks are the source of moral hazard in cross-border banking. Concerned by the diminishing franchise value of a banking charter, they are virtually without exception eager to help banks try new things that promise higher rewards. To the extent that these rewards are bought by greater risk, they are not real. As Schumpeter wrote in 1911, 'The compensation for greater risk is
only apparently a greater return; it has to be multiplied by a probability coefficient whereby its real value is again reduced - and indeed by exactly the amount of the surplus. Anyone who simply
consumes this surplus will atone for it in the course of events.' But like the money illusion at the beginning of inflation, profits from taking positions in derivatives look good early on.

"It is because the large banks know that the central banks will take care of their liabilities, especially in an international context, that they engage in risky behaviour. The violence of the break when trouble occurs is because the market loses faith in the central banks. The recommended remedy on all sides is better accounting practice for all, more transparency and market discipline. But central banks want to maintain their discretion to use charitable (emphasis added) accounting procedures that will give their banks a bella figura, they believe in bank secrecy, and their view of market discipline is that of Mckinney & Co.'s Lowell Bryan, "socalled market discipline is simply another name for bank panic."

Meyer in effect argues that since banks are no longer needed for the payments system, and deposits are no longer a major part of the funding of a large bank -- two activities that require them to be protected against a systemic risk -- and banks themselves wish to be brokers rather than holders of assets, the dangers of a run on banks is greatly diminished. And as seen from the experience of the failure of Drexel, very large securities firms, very significant participants in international clearing operations, can be allowed to fail without systemic consequences. Depository institutions and payments providers should be separated from the wholesale financial institutions that would be authorized to (engage) in all versions of pending US banking legislation. Financial intermediaries, reporting their assets at market prices, financed by the market and relying on their own rather than government's safety net, will be better partners for the developing world.