ISDA PRESS REPORT - NOVEMBER 6, 2001 EURO * Italy rebuts claims over swap contract - Financial Times (North American Edition) * Rome 'did not cheat over deficit' - Financial Times (European Edition) EMERGING MARKETS * Cavallo defends Argentina's plan for debt swap - Financial Times OPERATIONS * After Liffe - The Economist TRADING PRACTICE * Cut Short - The Economist Italy rebuts claims over swap contract Financial Times (North American Edition) - November 5, 2001 By James Blitz The Italian Treasury firmly rebutted allegations on Monday that it had structured a complicated swaps contract with the aim of deflating its 1997 budget deficit figure and qualifying for the single European currency. In a formal statement, the Treasury said that swap contracts - in which a bond issuer can trade his obligation to make payments in one currency rather than another - were a regular method of "improving management of public debt". Privately, meanwhile, Treasury officials sought to explain why Italy had undertaken a swap contract highlighted over the weekend by a report for the International Securities Market Association. On May 15 1995 the Italian government issued a bond for Y200bn. At the time, after the dramatic 1992 devaluation of the lira, the Italian Treasury was gradually seeking to regain credibility in international markets, and did so by issuing bonds in a range of currencies. When the Y200bn bond was issued, the yen-lira exchange rate was at L19.3. By December 1996, however, the yen had depreciated by 30 per cent to a level of L13.4 to the yen. The Treasury then sought to lock in its currency gains over this period. Treasury officials say they could have undertaken to start buying back the Y200bn bond issue, but given its sheer size, this was unrealistic. They therefore decided to undertake a cross-currency swap in which the Treasury could convert its yen liabilities into lira. The Treasury faced a serious technical problem, however. Under European Union statistical rules pertaining at the time, the debt of all EU countries could only be reported in the original currency in which the bonds had been issued, in this case yen. Any swap contract agreed by the Treasury in order to close its foreign exchange risk would thus be irrelevant when it came to calculating the overall debt figure. This was highly pertinent to how the swap agreement had to be structured. The Italian Treasury could have simply closed the swap transaction when the Y200bn bond matured in September 1998, realising all its exchange rate gains at that date. But a strong appreciation of the yen during the course of 1997 might have left Italy's official debt looking higher at the end of that year than it did at the end of 1996. This could have seriously undermined the country's bid to enter the eurozone. The Treasury therefore needed to keep the formal calculation of its debt consistent by realising their exchange rate gain during the lifetime of the bond. Both the exchange rate and the interest rate of the swap contract were structured to allow this. Treasury officials say the 30 per cent foreign exchange gain from the Y200bn bond was highly unusual. They dismissed any notion that this could be a regular phenomenon in debt management as absurd. Nor, say officials, could the swap be judged as a way of "window dressing" the deficit figure. If window dressing had taken place, Italy would have seen its deficit and debt shoot up after it had successfully entered the single currency. The fact remains that Italy's deficit and debt have both been on a steadily downward path since 1996. Rome 'did not cheat over deficit' Financial Times - November 6, 2001 (European Edition) By Peter Norman The European Commission and Eurostat, the European Union's statistical agency, yesterday rejected suggestions that Italy had used the over-the-counter derivatives market to camouflage the true size of its budget deficit and so help its admission to the European single currency. Gerassimos Thomas, spokesman for Pedro Solbes, the economic and monetary affairs commissioner, said the Commission's preliminary evaluation was that the use of interest rate swap transactions by one member state in 1997, as highlighted in an International Securities Market Association (ISMA) report, did not amount to cheating on the budget deficit figures. Mr. Thomas said the purpose of such swap transactions was to save money for governments and they were therefore not discouraged by regulators. Although the ISMA report referred only to an unnamed member state, it was understood to be Italy. Yves Franchet, the director-general of Eurostat, said his agency knew in 1997 about the Y200bn Italian bond issue and swap transaction mentioned anonymously in the report. The effect of that deal was to reduce Italy's deficit of around 2.7 per cent of gross domestic product in 1997 by a marginal 0.02 percentage points. The swap deal was therefore not of a size to influence significantly Italy's ability to produce a deficit well below the 3 per cent ceiling set in the Maastricht Treaty. Mr. Franchet said Eurostat consulted widely on how to treat swaps before defining the deficit of Italy and other member states. The agency had to work out the public deficits of member states for economic and monetary union at a time of statistical transition between national accounts based on a standard known as ESA79, which took no account of swaps, and before formal adoption of the ESA95 system, which recognised swaps. After consulting with expert committees, Eurostat decided to apply the ESA95 standard in calculating member states' suitability for Emu. Aware that swaps could have a positive or negative effect on deficits, Eurostat also conducted a survey of swap use by member states. According to Mr. Franchet, the practice was not widespread. Cavallo defends Argentina's plan for debt swap Financial Times - November 6, 2001 By Thomas Catan Domingo Cavallo, Argentina's economy minister, yesterday mounted a defence of his country's controversial debt swap plan, saying investors must accept lower interest payments if his country was to avoid an outright default on its Dollars 132bn debt. "Any reasonable person knows that Argentina cannot grow if it has to pay interest on its debt that ranges between 11 per cent to 25 per cent - and in the case of some provinces, up to 30 per cent a year," he told an audience of businessmen. "We . . . seek to ensure payment on the basis that Argentina is viable and to stop trying to pay (interest rates) that only reflect the march of Argentina towards default. It's a question of telling the truth." Starting today, Argentina will offer private creditors new bonds backed by future tax revenues that will pay a maximum of 7 per cent. Repayment on bonds coming due in the next 10 years will also be pushed forward by three years, Mr. Cavallo said. This leg of the debt restructuring appears to be aimed mainly at domestic investors - local pension funds, insurance companies and banks - that hold at least a third of Argentina's Dollars 95bn in bonds. These local institutions, often units of international banks, are heavily exposed to Argentine debt and are seen as more susceptible to government pressure. A second "global exchange" for all of Argentina's bonds should be ready within 2-4 months, Mr. Cavallo said. By then, Argentine officials hope to have additional guarantees from multilateral lending agencies to offer foreign investors in return for accepting lower-interest bonds. Argentina hopes this will enable it to avoid an outright default on its debt. Investors entering the first, mainly local, exchange will be entitled to enter any subsequent deal, Mr. Cavallo said. Pension fund managers had feared being taken to court by future retirees for having acted against their interests. "Those who have confidence in Argentina are going to have two opportunities because no one knows if the global exchange will have better or worse terms," Mr. Cavallo said. Argentina is attempting to cut its annual interest bill by at least Dollars 4bn to free up resources to restart its ailing economy, now in its fourth year of recession. To do so, the government is implementing a range of tax cuts and other measures to spark spending, such as cutting employees' private pension contributions. Investors remain concerned that Argentina's debt proposal effectively constitutes a default. However, Mr. Cavallo is now putting them on notice that they must accept lower interest payments if the country is to continue to service its debt. The government is also pressing the 23 provinces to accept a cut in their guaranteed monthly tax transfers. After Liffe The Economist - November 1, 2001 JEAN-FRANCOIS THEODORE, the head of Euronext, is a surprise winner. The London Stock Exchange (LSE) was widely expected to triumph in the bidding for Liffe, London's derivatives exchange. Yet on October 29th the board of Liffe recommended that its shareholders accept a ?555m ($806m) offer from Euronext, the three-way merger between the Paris, Amsterdam and Brussels stock exchanges. Although Euronext's offer was less than the LSE's, it was all in cash (not in combination with shares). It also promised to retain Liffe's management, and to shift all of Euronext's derivatives business to London to trade on Connect, Liffe's trading system. That combination made it unbeatable. Euronext's coup is a blow for the LSE, which had hoped that buying Liffe would strengthen its position in the forthcoming consolidation of European stock exchanges. But the LSE misplayed its hand, advertising its interest for too long in advance and then quibbling over too many details with Liffe's management. It will now have to find some other strategic option if it is not to become prey to one of its rivals. Setting up its own derivatives business will be hard: it might instead seek to buy one of the American exchanges, perhaps the Chicago Mercantile. The third big European stock exchange, Deutsche B?rse, which had also bid for Liffe, will also have to find an alternative. Yet one obvious idea, to resurrect last year's abortive marriage between it and the LSE, will be hard to do under the two exchanges' present management, because the bust-up was so acrimonious. That may put Euronext in the best position to become the dominant European exchange. Europe's investors may not care so long as trading becomes cheaper and easier. Anyway, most of them fret more about improving clearing and settlement in Europe, which is much more expensive than in America and so offers greater scope for savings. The Liffe/Euronext deal immediately triggered speculation about which European clearing houses might now merge. The London Clearing House (LCH), which clears trades on Liffe, had inconclusive talks last year with Clearnet, which clears Euronext trades. A merger would now be logical. Less obvious is which way the Luxembourg-based Clearstream will jump. On October 31st it received offers from Deutsche B?rse (which already owns 50%) and Brussels-based Euroclear, the biggest clearer of international bonds. Deutsche B?rse is keen to own all of Clearstream. This would create the first big European "silo", in which trading, clearing and settlement have a single owner. Werner Seifert, chairman of Deutsche B?rse, has long championed silos, which he thinks provide the reliability required by the market. Critics reckon vertical silos distort competition. Benn Steil at the Council on Foreign Relations in New York says that Deutsche B?rse might impose discriminatory tariffs on non-German-based traders in German shares if it were to own all of Clearstream. Others point to possible cross-subsidy from the monopolised settlement arm to the trading platform. One alternative is the horizontal integration of settlement agencies and clearing-houses, to create large central counterparties-maybe two or three for the whole of Europe. Traders would then be able to net their cash and derivatives positions on several exchanges with a single clearing house, saving capital. Don Cruickshank, chairman of the LSE, thinks the European Commission in Brussels should go further and impose a single European clearing and settlement system like America's. That is a very long shot. It took the intervention of Congress and the Securities and Exchange Commission to set up the Depository Trust and Clearing Corporation-which moved American non-government securities markets from seven settlement agencies to one settlement organisation and one central counterparty. Besides the defenders of silos, the European Commission would have to contend with a different regulatory and legal system in each member country. More realistically, market forces will drive clearing and settlement houses to join forces, because it is more cost-efficient when buyer, seller and security are linked. Cut short The Economist - November 1, 2001 The American Treasury's announcement that it will issue no more 30-year bonds should delight corporate treasurers and depress fund managers. Cynics also suggest that Peter Fisher, under-secretary at the Treasury, made this move to help Alan Greenspan, chairman of the Federal Reserve Board, bring down long-term interest rates, in a fair imitation of a bull market. The 30-year Treasury bond has been illiquid for some time because until recently America had been retiring debt. Now that the country is a net borrower again, it is the wrong time to take long-term debt off the menu, say Mr. Fisher's critics. Many have a vested interest, however. The Chicago Board of Trade, which usually carries great clout in Washington, immediately protested that economic uncertainty since September 11th obliges the Treasury to keep all its funding options open, including at the long end. It is worried about losing its flagship 30-year-bond futures market. Bond traders, as well as inter-dealer brokers, such as Cantor Fitzgerald, will now have to satisfy themselves with shorter maturities-these are more liquid, but with less of the volatility that dealers love. Those traders and investment banks that cover their 30-year trading positions with repos (bond sales and repurchases) will find life more expensive-they will ultimately have to buy and sell corporate bonds, which carry credit risk, rather than supposedly risk-free government bonds. Perhaps they will use British 30-year gilts instead. There are winners. Swap dealers and long-term bond issuers, notably two government agencies, Fannie Mae and Freddie Mac, should find more demand for their 30-year bonds. It will please, too, those who think interest-rate swap rates a better benchmark than Treasuries for pricing fixed-income securities. The biggest gripe will come from insurance companies and pension funds with long-term liabilities-especially defined-benefit pension plans. Long-term rates may be lower but will now come with credit risk attached. Surely Mr. Fisher read a paper published in July by the American Academy of Actuaries entitled "The Impact of Inordinately Low 30-year Treasury Rates on Defined Benefit Plans"? If he did, this plea to spare the life of 30-year Treasuries failed to move the man of steel. **End of ISDA Press Report for November 6, 2001** THE ISDA PRESS REPORT IS PREPARED FOR THE LIMITED USE OF ISDA STAFF, ISDA'S BOARD OF DIRECTORS AND SPECIFIED CONSULTANTS TO ISDA ONLY. THIS PRESS REPORT IS NOT FOR DISTRIBUTION (EITHER WITHIN OR WITHOUT AN ORGANIZATION), AND ISDA IS NOT RESPONSIBLE FOR ANY USE TO WHICH THESE MATERIALS MAY BE PUT.

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ISDA PRESS REPORT - NOVEMBER 6, 2001