Ted Butler: Silver traders report shockingly bullish

Section:

Fed Eyes Risk in Backed-up Derivatives Back Offices

By Dan Wilchins
Reuters
Tuesday, September 6, 2005

NEW YORK -- The Federal Reserve Bank of New York is looking into the
credit derivatives market, but traders and regulators disagree about
whether the market is a risk to the broader financial system or just
encountering normal growing pains.

At issue is the processing of trades, an unglamorous area that is
widely acknowledged to have become a problem as paperwork backlogs
mount at dealers and hedge funds.

Credit derivatives, which investors can use to insure a company's or
country's debt against default, have surged in popularity in recent
years.

But the market has grown so fast that players' trade processing
systems have been unable to keep up, which has spurred the Fed and
other regulators to meet with 14 banks and brokers on Sept. 15.

Regulators and industry groups are clearly interested in fixing the
back office for credit derivatives.

In a speech in early May, Federal Reserve Chairman Alan Greenspan
called back-office issues in credit derivatives a "significant
problem," while the United Kingdom's financial regulator, the
Financial Services Authority, began looking into back office problems
in February.

The Counterparty Risk Management Group II, a group headed by Goldman
Sachs Chairman and former New York Fed president Gerald Corrigan,
said in a report in July that trade processing problems
demand "urgent industry-wide efforts."

The amount of outstanding credit protection has grown more than eight-
fold over the last three years, to $8.42 trillion at the end of 2004.

When any market grows quickly, unexpected problems in trade
processing result. The stock market and interest-rate derivatives
market have experienced processing problems in previous decades.

Traders identified two problem areas in back-office operations for
credit derivatives. The first is a lack of signed paperwork for
trades. Two traders may agree on a deal verbally, and then leave the
details to their back offices.

The final trade contract -- known as a confirmation -- can remain
unsigned for weeks or months, buried under a mountain of other
contracts still waiting to be signed, traders said.

If a company defaults, and an investor wants to collect on a credit
default contract, some parties may use the unsigned confirmation as a
way to renege on the contract.

"With unsigned contracts, it's not always clear what laws apply,"
said Conrad Bahlke, a partner at the law firm of Weil, Gotshal &
Manges LLP in New York.

Bahlke and traders did not see this problem as necessarily
catastrophic. Large investors and dealers that intend to stay in the
market long term have a real incentive to fulfill their obligations.

But smaller players would have less bargaining power with regard to
unsigned confirmations than larger players, David Mordecai, president
of financial engineering advisory firm Risk Economics, said.

The second problem area involves knowing who one's trading
counterparties are. A hedge fund, for example, that has sold credit
protection to a bank may later trade out of its position by assigning
its obligations to a different bank.

But back-office backlogs may result in the hedge fund failing to
notify in a timely fashion the bank to which it sold protection that
it had assigned the position to a new bank. Or the bank may be
notified but may not process the information in time.

In the worst-case scenario, if the market came under stress, parties
could be unsure to whom they had exposure and trading could be
interrupted, Risk Economics' Mordecai said.

More broadly, the stability of financial markets as a whole could be
called into question, said Doug Harris, a risk management consultant
and former senior deputy comptroller for capital markets at the
Office of the Comptroller of the Currency.

The solutions are fairly clear, said credit derivatives professionals
and regulators.

The New York Fed next month is likely to urge that dealers abandon
manual processing of trade details and invest in systems to improve
the process of confirming a trade, said Brad Hintz, adding that
predicting regulators' actions is not an exact science.

The Fed is also likely to recommend that every credit derivative
trade receive a unique serial number to identify it, similar to CUSIP
numbers for bonds.

The 14 banks invited to speak with the Fed include Bank of America
Corp., Barclays Group's Barclays Capital, Bear Stearns, Citigroup,
Credit Suisse's Credit Suisse First Boston, Deutsche Bank, Goldman
Sachs, HSBC, JPMorgan Chase & Co., Lehman Brothers, Merrill Lynch,
Morgan Stanley, UBS, and Wachovia Corp.

The Fed is likely to work cooperatively rather than ordering the
dealers to do anything, said Greg Zerzan, a former assistant
secretary at the U.S. Treasury.

"There's an implied stick, but banking supervisors don't like to show
it," Zerzan said.

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