Ms. Phillips reviews major milestones, key factors and future directions of the OTC derivatives market  (Central Bank Articles and Speeches, 26 Mar 98)
Central bank: fed | Type: speech | Date: 1998-03-26

## Ms. Phillips reviews major milestones, key factors and future directionsthe OTC derivatives market Remarks by Ms. Susan M.

Phillips, a member of the Board o Governors of the US Federal Reserve System, before the International Swaps and DerivAssociation, 13th Annual General Meeting in Rome on 26/3/98.

## Lessons and PerspectivesThank you for inviting me to speak at this annual meeting of ISDA.

When vis Rome, we are all conscious of the rich history and grandeur of the Roman Empire.

This puts into perspective the short history of the swaps and derivatives market -- desp come a long way, the market for over-the-counter derivatives is still relativel Nonetheless, it is not so young that it cannot benefit from a reassessment of its past with an eye toward using those lessons to inform and guide the future.

## Major MilestonesAt meetings such as this one, it often is the practice to review major eve development of the over-the-counter (OTC) derivatives market and to chronicle its grow milestones of the market are often recorded as the introduction of new products, be the swaps, interest rate swaps, caps, collars, floors, or credit derivatives.

While this products in their historical context, it does not provide a framework against which t subsequent evolution of products and the market.

An alternative approach that may b informative is to focus on OTC derivative dealers and how their role in the market has that is, to chronicle changes in the ways dealers conduct their business and manage From this latter perspective, the first stage in the evolution of OTC derivatives was c by matched transactions.

Intermediaries arranged deals directly between counterparties as brokers rather than dealers.

This activity evolved to a second stage in which the i began dealing rather than brokering.

Intermediaries took the opposite sides of contract counterparties and in effect became OTC derivatives dealers.

Positions were warehoused dealers until their risk could be offset by a mirroring transaction with another c Dealers incurred exposures, but these exposures arose because of the asynchronous natur business.

Over the long haul, their books remained basically matched.The need to find a pairwise offsetting transaction obviously limited the potential of the market.

The most critical stage in the evolution of OTC derivatives d that vastly expanded the potential growth of the market, was dealers' adoption of a approach to their business.

Instead of offsetting individual deals, dealers came t business as a portfolio of cash flows whose risk could be managed.

This approach management was a necessary condition for the subsequent expansion in both the volume an range of products that has been a characteristic of the industry.

Dealers could never hope to match or to pairwise offset individual structured products.

They could, however the exposures to the basic risk factors that were embodied in the cash flows of these risk management processes of dealers now involve highly sophisticated systems and model portfolios.

In essence, the emphasis had changed from individual product design to design and portfolio risk management.

The development of this systems portfolio approa set the stage for the phenomenal growth the market has experienced.

## Key Factors Supporting the Growth in the IndustryIn order for dealers to implement this portfolio management approach and th support the growth in the industry, certain essential elements also needed to be in pla methods for determining market values of individual instruments and portfolios were ne The

value-at-risk approach of mapping instruments into common risk factors needed broadly accepted.

Data on common risk factors such as zero coupon yields, exchange rat volatilities had to be readily available and in some cases, had to be developed.

F availability of liquid hedging vehicles, such as Eurodollar futures and Treasury rep that allow dealers to adjust their exposures to the common risk factors was key.A focus on these supporting factors -- valuation and risk management meth data and hedging vehicles -- is useful as an analytical device because it helps identif may either foster or inhibit the growth of new or future products.

Take credit deriva example.

Credit derivatives are one of the most interesting products developed in derivative market in quite some time.

They offer a means for counterparties to direc credit exposures to specific firms or to diversify industry or geographic concentrat potential is enormous because credit risk is the major risk faced by financial service derivatives' growth to date, however, has been fairly limited, and this limited grow traced to deficiencies in some of these supporting factors.

Data to price the ins relatively poor.

Analysts typically look to corporate bonds, but historical data on bon limited.

Information on loan values is even more difficult to obtain.

The growth derivatives also has been constrained by the lack of hedging instruments.

There real exchange-traded instruments that can be used to effectively hedge credit risk.

Given association with exchange-traded markets, I am surprised that this profit opportunity been exploited.

It illustrates, no doubt, the difficulty of overcoming the impedime availability and of pricing credit risk.A discussion of factors that have supported the growth of OTC derivative ma would not be complete without also noting the importance of infrastrucuture developmen ISDA's contributions in that area.

Master agreements have played a critical role, counterparties to manage the credit risk of their positions more effectively.

ISD members perceived the value of uniform documentation and supported development of standard master agreement that allows for acceleration and close-out netting in the default.

Work didn't end with the creation of the master agreement, however, and IS played a continuing role educating counterparties about the importance of utilizin agreements.As time passes, I have come to appreciate more and more the role t infrastructure elements play in fostering the growth of markets.

ISDA has developed documentation for some credit derivatives, for example, which should aid in the develop that product.

Collateral agreements are another development that shows great promi helping market participants manage their credit risk and for facilitating growth of Here also, ISDA has made useful contributions.

Standard collateral agreements, eit transfer or pledge, have been developed for several jurisdictions.

Collateral agreemen master agreement, must be based upon sound legal foundations, and ISDA has suppor analysis in this area, too.

These efforts give market participants additional tools manage the risks in their OTC business and ensure that any perceived reductions in risk sound legal foundation.Viewed broadly, the Group of Thirty study of derivatives ranks as anothe supporting factor in the development of the market.

As I noted earlier, the broad acc the value-at-risk approach for managing portfolios of derivative instruments fostered of the market and the diversity of products that could be offered.

Discussions in the G also formed the basis of the internal-models approach that supervisors ultimately adopt capitalization of market risk in trading accounts.

The Report defined a set of s management practices for dealers and end-users as well as describing VaR techniques.

R both the qualitative and quantitative standards in the internal-models approach can b the Report's discussions.

## Derivatives No Longer the ScapegoatIt is, no doubt, a reflection of the overall quality of risk management in derivatives

business, and the widespread acceptance of the principles articulated in Report, that derivatives are no longer the scapegoat for all episodes of market volatil that derivatives can play in allowing counterparties to manage risks is now widely Previously, counterparties might simply have borne these risks or elected not to unde business that entailed the risks.

Derivatives are now seen as an essential tool t participants have for managing risk.

The rhetoric even from banking supervisors and banks has become more muted of late as they also acknowledge derivatives' role and market developments and models in new supervisory standards.This change in the attitude toward derivatives has occurred in no smal because more and more observers of the market are learning to distinguish betwee instrument itself and the way in which that instrument is used by market participants. are a means of shifting risk.

Problems do not arise simply because a party that is be bear risk agrees, for a fee, to assume that risk from a party that is less able to b problems arise if the parties to the agreement do not understand the risks that they a or have inadequate controls for managing that risk.

Much of the shift in attitud derivatives has occurred because 'problems' with derivatives are correctly seen as aris behavior of the parties entering into the contracts rather than in the contracts themse

## Perspectives on AsiaEvents in Asia are providing a test of more than just attitudes toward der Turmoil in these markets also has provided an important test of the risk management p that OTC derivatives dealers have put in place and the infrastructure supporting thos The jury is still out in some respects, but preliminary reports of how U.S. banks provides valuable insights and lessons.

Perhaps most importantly, evidence indicates t risk management processes and the tools of risk management such as value-at-risk s worked as expected.

Most banks had identified Asia as an area of potential risk during going.

Robust internal communication channels along with the timely identification enabled banks to take steps to mitigate some of that risk.

Positions were reduced instances, and hedges were put in place in others.In reviews of events, the basic elements of portfolio management also were under a bright light.

Banks reported that their ability to revalue positions genera Furthermore, the discipline of identifying and reporting sources of profits and lossestheir trading businesses on a daily basis was very valuable.

Banks also reported that systems worked as expected.

Of course, VaR is only designed to cover 95 or 99 percent moves, and many of the price changes observed were certainly draws from the tai distributions.

The occurrence of these large price moves strongly reinforces the need techniques to be supplemented by a program of stress testing.

Stress tests, after encompass precisely the type of events that have been occurring.

When done rigorously, reported that stress tests were accurate and led in some instances to reductions in pos the market turmoil was fully blown.

Stress tests that had been done by a central management function also provided an additional check on the exposures of business lin that inevitably have a narrower perspective on risk.

The results of these stress tests sources of discussion for centralized decision-making by senior management.This record, while reassuring, should not imply that areas in need of impro were not also exposed.

Some of these areas were unexpected and are of the nature of lessons that one discovers as one lives through a crisis.

Other areas for improvement basic, however, and indicate practices that should become a standard part of ban management tool kits.

If we go back to the basic factors that were essential for a management approach to the OTC derivatives business -- valuation techniques, risk manag methods, data, and hedging vehicles -- the events in Asia exposed areas for improvementWhile banks reported that their ability to value positions held up, they a that they had difficulties revaluing the less liquid positions.

This observation probab about the ability to evaluate the liquidity risk in positions than valuation techni Nonetheless, an analysis of lessons to be drawn from these events probably should inclu systematic approaches to incorporating liquidity risk in valuation techniques and methodologies.Events also point to areas in which risk management methods could and shoul strengthened.

As banks trade new and innovative products or employ new and sophisti trading strategies, it is important that risk management methodologies continue to i well.

Where simplistic risk modeling techniques are employed, they often do not management to have a complete understanding of the risks being borne.

Similarly, bank noted the importance of stress tests in identifying significant concentrations of ris have noted, however, that events unfolded over much longer periods of time than the typ day horizon of a stress test and that contagion across markets was faster than antici argues for assumptions of multi-day events in some stress scenarios, particularly whe with less liquid instruments.

Making appropriate judgements about the liquidity of ins or lack thereof, in determining the size of acceptable exposures is a theme that em variety of contexts when assessing market movements of the fourth quarter.Another area in which valuable lessons were learned is the importance of h hedging instruments available for the full range of risks that are being assumed throu offerings.

Banks have reported that liquidity dried up in some instruments they were d upon for hedging.

This forced them into proxy hedging strategies using instrumen inevitably exposed them to basis risk.

As I noted earlier, the availability of hedging has been key to the growth and the broad product line that is found in OTC markets.

E the last year may, however, have highlighted the fact that some dealers are not thinkin and critically enough about the ways they are going to hedge the risks assumed in vari of business.

In this area also, the theme of the availability of liquidity emerges.The final area related to the lessons of Asia that I would like to touch old-fashioned topic of concentrations of credit risk.

The turmoil in Asian markets h provided a test of the risk management processes associated with derivatives dealing. end of the day, the lessons to be learned may be related less to derivatives themsel why dealers analyze credit risk and view diversification.

Prices moved dramatically an risk became credit exposures.

These events raised the sensitivity of bank management potentially high correlation between credit exposures and the probability of counterpa during stressful times.

At a minimum, they illustrate the importance of diversification of business and the need to view diversification in the broadest context.Despite the fact that I think there are numerous improvements dealers could to their risk management systems, I do not want to end with the impression that de dealers and their systems somehow failed this test of market volatility.

Systems performed well.

The very conduct of a post mortem, after all, demonstrates the basic existing procedures and systems.

That said, however, we should not forego the opport learn from the events and possibly strengthen systems even further.

## Future DirectionsLooking to the future, the lessons of Asia provide sign posts for the area management

in which work by both market participants and supervisors is likely concentrated.

Volatility, after all, usually leads to innovations to help deal with management emerged as one theme in assessments of the Asian volatility.

A reassessme liquidity risk was another.

An emphasis on the infrastructure of the market no do continue as well.Firms already were working upon ways to apply techniques developed for t management of market risk in the context of credit risk.

Supervisors also were evalu potential for applying such an internal models approach to the determination of regulat requirements for credit risk.

Events in Asia highlight not only the promise of such a but also the hurdles that must be overcome if their potential is to be realized. recognizes the correlation between market risk and credit risk, the next step is a cons a global approach to risk management and the possibility of extending an internal approach beyond market risk.

The application of that approach implies, however, that pr be obtained from thin markets and used effectively in risk measurement.

As we conti pursue new approaches to credit risk management, the basic questions arise again and ag data and techniques for revaluing positions available?

Can acceptable risk measurement be developed?

Are hedging vehicles available?

These questions represent hurdles that jumped.

They will not necessarily be easy, but neither were other hurdles that this i overcome.Another theme that emerges is liquidity risk.

A fundamental assumption of risk management procedures is the ability to get out of a position or to hedge it.

Ev demonstrated once again that assumptions about liquidity in normal markets rarely hold volatile ones.

This argues both for a reassessment of the assumptions themselves and careful and fundamental thinking about liquidity risk in risk management procedures.At the outset of my remarks, I noted my appreciation for infrastru developments as a foundation for the growth of the market.

Certainly, their imporunlikely to diminish in the near term.

Market participants generally have an apprec potential legal risk but continuing reassessment is valuable.

Episodes of volatility counterparties strong incentives to try to walk away from losing contracts.

Such event areas where further legal work may be necessary to ensure that the market's infra remains sound.The industry has had a phenomenal record of growth and innovation over the few years, but plenty of work remains to be done over the next few years.

Many of the be faced are not easy.

However, I have no doubt that the energy, creativity, and compet of the industry will ensure that these issues are dealt with and that the future of OT is a bright one.

The leadership role that ISDA has played in the past will undoubtedly upon in the future.