ISDA PRESS REPORT - MAY 30, 2001


Credit Derivatives
* ISDA tackles default swap successor definition - IFR

Risk Management
* Basel 2 comment period ends, work for banks begins -
Reuters
* Hedge funds drive risk tool boom - IFR

Regulatory
* New U.K. Financial Regulator Draws Fire From
Institutions - The Wall Street Journal

Other
* US Equity Derivatives - FOW


ISDA tackles default swap successor definition
IFR - May 26, 2001

The International Swaps and Derivatives Association's credit derivatives
market practice committee last week moved to tackle the question of
reference entity for credit default swaps in the event of a de-merger.

With the dismantling of AT&T looming, the need to resolve the "successor"
issue is heightened, say industry officials, who note that resolution would
enhance legal certainty for the product. AT&T's restructuring plan calls for
splitting the company into four different units and assigning the bulk of
the firm's massive debt burden to two of the entities.

Under the ISDA 1999 credit derivatives definitions, the entity that assumes
"all or substantially all" of a firm's debt responsibility after a break-up
should be used as the reference entity for outstanding credit default swap
contracts. The AT&T example highlights the need for clarification because no
one entity stands to assume the majority of the company's debt obligations.
Also, AT&T is one of the most heavily traded names in the credit default
swap market.

One potential answer may be to allocate a de-merging company's default
protection among the newly formed companies according to the percentage of
debt that each entity is allocated, said credit derivatives officials in New
York. No historical guidance exists currently.

The issue first rose to prominence last year with the question of the
reference entity for credit default swaps on the UK's National Power
following the company's de-merger.

International Power was eventually agreed to be the reference entity because
it had to take on new debt at the time of the de-merger.

Many end users of default swaps were unhappy with the way major dealers spun
out the debate over this case, however.

Firms representing the key participants in the credit derivatives market on
June 5 will report back to the credit derivatives market practice committee.
The firms consulting the marketplace include a credit derivatives dealing
firm, a bank portfolio manager and an end user of credit derivatives. Each
group has European and US representation.

It is unclear whether the clarification on the successor issue, which will
probably be released, as a supplement later this summer, will apply
retroactively, one market official said.


Basel 2 comment period ends, work for banks begins
Reuters - May 30, 2001
By Alice Ratcliffe

ZURICH, May 30 (Reuters) - An industry comment period on new global capital
rules dubbed " Basel 2" ends on Thursday, but the work will just be starting
for banks calculating how the sweeping changes will affect their businesses.

The new rules are due to be enforced in various legal jurisdictions starting
in 2004. They will apply to most of the world's banks now subject to the
outmoded Basel Accord dating from 1988. Basel 2, once adopted, will also set
standards for securities and brokerage firms in the European Union.

Despite outcry from some industry participants that the new rules were
formulated too quickly, supervisors appear set to complete Basel 2 by
year-end, in time to implement it by 2004, according to industry sources.

One reason for the haste is that the Basel Committee on Banking Supervision
drafting the new rules worries an industry stalemate could delay adoption of
the badly-needed new rules in some key jurisdictions. The 2004
implementation date is already seen as a sop to the lengthy EU legislative
process.

"Time (Basel 2) uses up eats into time for the EU directive," said a source
familiar with the issues, adding the Basel Committee is "between the devil
and the deep blue sea".

SWEATING OVER CALIBRATION

Of course, that doesn't make the process any smoother.

Officially, banks are to have all comments submitted by May 31. Unofficial
dialogues will likely continue for a long while.

One area of concern is Basel 2's approach to capital needed to cover lending
exposure. It allows for banks, which meet certain qualifications, to measure
the risk of a borrower defaulting using an internal system, in a way similar
to an earlier advance adopted in the 1990s is used to measure market risk.

In the approach to market risk, banks deemed eligible by supervisors can use
their own internal "Value-at-Risk" (VAR) models to assess market risk to
assess capital requirements.

Basel 2 foresees letting eligible banks use an "internal ratings based"
(IRB) approach to measure credit risk. But unlike market risk, banks are not
allowed to use their own models to calculate the capital needed to cover
credit risk, at least not yet, as such models are not deemed advanced enough
for this.

Instead, banks will compute their regulatory capital using their own
internal ratings. But they must then plug internal numbers into formulae
spelled out by Basel 2, computed on an indexed or "calibrated" basis. This
is where problems arise.

"The first thing we said was that the calibration of the whole proposal has
to be re-worked," said one banker.

Banks complain Basel 2's calibration formulae, as spelled out in a draft
published in January, penalise the IRB approach, saying set-asides for risky
corporates, for example, could be higher than what is called for by a
standardised approach applied for less sophisticated banks.

One fear is that this could lead small and mid-sized banks using the
standardised approach to wind up with a disproportionately larger exposure
to riskier borrowers.

Supervisors are expected to work out the kinks, however, and are expected to
take into account data collected by the Basel Committee under a Quantitative
Impact Study (www.bis.org).

"I have the strong impression there are going to be substantial changes to
the document...," said one banker whose own institution had run simulations
which took into account its profile including a large amount of emerging
market loans.

He said the simulations showed his bank "would have been seriously
penalised" by the earlier proposal. "But now it looks as though it will be
changed. The Basel Committee seems to be open to our point of view," he
said.

Banks are to submit findings on such technical issues to country regulators
by June 1. The Basel Committee could finish analysing these by October, and
is likely to incorporate them into the finished version of Basel 2.

OPERATIONAL RISK PALPITATIONS

Operational risk is a new category foreseen by Basel 2 alongside credit and
market risk. No one doubts that such risk exists. But requiring banks to
quantify it and set aside enough capital to satisfy regulators is proving
another headache.

Some private bankers worry that asking banks to set aside capital for such
risk could adversely affect the burgeoning business of wealth management
which in theory requires a low capital base compared to lending or trading
activities.

"A lot of banks have gone into private banking and asset management and have
paid a fortune to do so. The message is they want these glamorous purchases
because they need low capital and offer good returns," said one European
banker, adding the original proposed changes "move the goalposts".

The Basel Committee raised a storm when it suggested a capital set aside of
20 percent - a provisional figure - for operational risk. The final figure
has not yet been set.

Basel 2 defines operational risk as "the risk of direct or indirect loss
resulting from inadequate or failed internal processes, people and systems
or from external events" and refers to "an average of 20 percent of economic
capital".

Alongside smaller banks, big ones are irked that the calculation ignores
what one banker said was big banks' more diversified income, and hence
reduced risk of failure.

Some banks would also like included in the calculation the "hit absorption"
of a bank, meaning that a bank making losses would first use income, not
capital, as a cushion.


Hedge funds drive risk tool boom
IFR - May 26, 2001
By Kathleen Fitzpatrick

Dubbed virtual portfolios, risk measurement services that include a
'what-if' scenario along with the more traditional kind of risk analysis are
gaining in importance. The hypothetical feature allows for a more customised
and flexible approach to the management of risk and answers situational
hedging questions about a portfolio.

"What would happen if I added a hedge into the portfolio? What if I buy or
sell futures?" are questions that Deutsche Bank's dbRiskOffice scenario
analysis can now address, said Michelle McCarthy, managing director, risk
analytics at Deutsche Bank. Deutsche's 'What-if Positions Change'
enhancement, released to clients in mid-May, includes features to determine
changes in value at risk (VAR), tracking error and surplus-at-risk resulting
from a variety of hypothetical situations.

Deutsche's client risk reporting system, available via an internet browser,
specifically targets risk managers who outsource their risk measurement,
instead of building up an entire department to monitor their VAR. Deutsche's
customers are keen on obtaining cross-asset class VAR coverage, according to
McCarthy. Managers who incorporate the use of the client risk reporting
enhancement would have a better handle on whether a particular position will
better correlate a fund to an index, for example.

The current VAR analysis tools have already been mastered by the fund
community, which is now looking for better predictors of risk. VAR is tied
to a particular probability at present and fails to capture an exceptional
move in an index, for example, said Guillaume Blacher, senior managing
director, pricing advisory and risk management. at Reech Capital in London.

"Risk managers have been consistently going for greater flexibility.' added
Deutsche's McCarthy. "More managers want to work with the numbers, rather
than have a single number that comes out once a day," she said, referring to
the benefits of scenario analysis over traditional risk measurement
practices.

The hypothetical scenario tools, along with the traditional VAR risk
measurement systems, are needed by fund managers in a complementary way,
stated Reech Capital's Blacher. However, the hypothetical tools give more
flexibility to analyse potentially substantial losses. "VAR has shown its
limitations . . . it tends to capture bad days, not the extremes," according
to Blacher.

Hypothetical analysis tools will assist the risk manager in deciphering what
positions are needed to get back within a fund manager's limit, he added.

Option competition
The need for faster and more reliable scenario hedging for managers
investing in equity options has been a key driver of demand for 'what-if'
scenario analysis lately. "The stock option market has become tighter, more
competitive," noted Ravi lain, chief executive officer of Egar Technology, a
New York and Moscow-based firm that launched its own real-time equity
options trading and risk management platform (Equity Trading System) last
week.

"We have already seen an incredible amount of interest from market-makers
moving upstairs and the hedge fund community," lain said.

He also credits the more educated investor who may be prompting the fund
manager to install better risk management and reporting systems,
particularly for option based funds, as fuelling the current demand for
hypothetical risk analysis. "Aside from the trading and risk management
systems, there is a lot of need for decision support tools," he added.

Michael Gannon, sales and marketing associate at Imagine Software, the
software maker that powers the Derivatives.com trading site, agreed that
more sophisticated investors are a force behind fund manager demand for this
kind of system.

Banks such as Deutsche Bank and Citigroup use Derivatives.com risk
measurement tools in their sell-side operations, according to Gannon. And it
is precisely the use by these banks that smaller Imagine Software clients
like.

However, the current risk measurement systems can be expensive for all but
the largest trading organisations, and especially for start-up funds. "Hedge
funds are not going to spend US$1m on buying a big system," said Egar's
lain. Instead, he said, they will investigate the more customisable decision
analysis tools.

Imagine Software implemented its hypothetical 'what-if' position analysis
last year. Its Derivatives.com website features a 'hedge as you re-hedge'
component that allows funds to rehedge during the simulation to give the
portfolio a two-dimensional real-time projection of a trade.

MicroHedge, a web-based platform that caters to option traders, also offers
'what-if' scenario analysis in its Micro-Hedge Portfolio Risk product. That
platform, however, targets the needs of active market-makers, rather than
hedge fund derivatives users.
The fact that these virtual portfolio hypothetical analysis tools are now
available is beginning to make it easier for hedge funds to start up,
according to Imagine's Cannon. With the right risk analysis tools, a hedge
fund could be up and running in a week, instead of hiring an entire IT
staff, he said.

Certainly, the growth of hedge fund start-ups continues at rapid pace. Hedge
funds are expected to expand with a compound annual growth of 27%, according
to a study by Freeman & Co.


New U.K. Financial Regulator Draws Fire From Institutions
The Wall Street Journal - May 30, 2001
By Silvia Ascarelli

LONDON -- Will too much bureaucracy cause a logjam in the City?  A think
tank warned of growing discontent among major financial institutions with
the Financial Services Authority, which this year will take over the duties
of all of the financial regulatory agencies in the United Kingdom, and said
the FSA's style eventually could undermine the international competitiveness
of the City, as London's financial district is known.

The FSA is seen as "bureaucratic, intrusive and insensitive," and its
regulatory style risks becoming a rules-based system for the benefit of
lawyers and compliance officials, according to the Centre for the Study of
Financial Innovation, in London.

The conclusions, which are based on interviews with officials at about 70
financial institutions, including foreign banks with large operations in the
U.K., come as the FSA nears a still-unnamed date when it will officially
replace 10 regulators and 14 different rule books. During the past four
years, the FSA has been a virtual regulator that contracted some of its
duties to the agencies that it will replace.

The FSA said the think tank -- which admits it began with negative
preconceptions -- ended up with some positive conclusions. For instance, the
study found little evidence, despite many complaints, that the FSA's
approach has cost the London's financial center any business. Rather, it
found that the FSA is seen as more sophisticated than other European
regulators and that new banks and companies are setting up shop in the U.K.
at an unprecedented pace.

The think tank itself acknowledged that some of the institutions may be
grumbling because they prefer the old regime and because the FSA isn't
completely formed. The think tank also warned of "inexorable forces" driving
the City toward rule-bound regulation, rather than a more flexible,
individual approach. Some respondents said they feared that the FSA may be
less hospitable to innovation and start-up companies.

The CSFI also claimed that regulatory costs are rising in most parts of the
City because of higher compliance costs. An FSA spokesman said the report
didn't back that claim up with hard analysis and that indirect costs are
included in the cost-benefit analysis that the agency performs on policy
proposals.


US Equity Derivatives
FOW - May 2001
By Anuszka Ranslev

The economic slowdown of global markets has had a dramatic effect on the US
equity derivatives market. Although the underlying market is proving to be
quite uncertain, traders report a remarkable time for equity derivatives.
One trader describes this as "probably the single best I environment for
equity derivatives that we've seen in the last decade". Compressed levels of
volatility at the beginning of the year, combined with uncertainty in the
market, has lead to an increased usage of equity y derivatives. While
volatility levels dropped in the first few months of the year due to supply
and demand factors, the past month has seen volatilities begin to move up
again.

However, one US-based broker warns that volatilities have not moved up as
much as the market would expect. "We would predict, with the current supply
and demand imbalance, that vols would rise more significantly than they
have," he says. "The fact that vols have not risen in this way creates good
value for those looking to use equity derivatives."

Meanwhile, there are reports of a diversity of business being traded across
the board, with no significant markets being favoured. While February saw no
signs -of a herd mentality since March there has been much copycat trading
going on. This has lead to reports of the US leading the market with Europe
and Asia following. However, at the beginning of April, traders report some
diversions from this copycat trading, particularly with the Nikkei rising by
several per cent.

Convertibles remain the core of activity in the market.  A dealer comments:
"If you can get the premium high enough, although people aren't crazy about
selling their stock at this level, convertible financing is pretty viable."
The demand in the convertible market has lead to a significant growth of
convertible arbitrage. This sector has become the best performing
alternative investment hedge fund strategy, rising from last year, with a
total return of approximately 350/0. The dealer warns: "There is a lot of
new money that has moved into this arena, but there are just not that many
new funds, and now, as funds come on, there aren't that many convertibles
available."

The convertible market continues to offer zeros with many large over night
deals being witnessed. One trader comments that: "The big buyers of
convertibles believe that the arbitrage funds are very material to the
market, although they would prefer them on a hedge basis with more
attractive volatility." However, he warns: "In this market of convertibles
you need to be aware of where you can get stock off, where the credit should
be trading and where you can distribute that credit."

Traders report a record year, so far, in equity derivatives and speculate
that the market is the one area in investment banking, other than fixed
income, that is really having a good year. A head of desk concludes:  "This
is a period of divergence where there is so much uncertainty in the market
that it is hard to trade and hard to take direction. Yet, this is often when
derivatives have the best opportunities and can provide the best solution."


**End of ISDA Press Report for May 30, 2001**

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Scott Marra
Administrator for Policy & Media Relations
ISDA
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Phone: (212) 332-2578
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Email: smarra@isda.org