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For release on delivery
8 40 a m EST
February 23, 1996
Remarks by
Alan Greenspan
Chairman, Board of Governors of the Federal Reserve System
at the
Financial Markets Conference
of the
Federal Reserve Bank of Atlanta
Coral Gables, Florida
February 23, 1996
I am pleased to participate once again in the Federal Reserve
Bank of Atlanta's annual Financial Markets Conference
Now in its
fifth year, this conference has earned a reputation for bringing
together groups of distinguished academics, practitioners, and
policymakers to discuss important policy issues
promises to enhance that reputation
This year's program
The principal topic of the
program is the transparency and liquidity of derivatives
More
precisely, it is the implications of the relative opaqueness and
illiquidity of many customized, over-the counter (OTC) derivatives for
risk management, public disclosure, and relationships between
counterparties
By choosing this topic, this conference distinguishes
itself from the many others on derivatives and risk management
In
effect, the conference focuses our attention on the challenges that
lie ahead rather than on the very impressive advances that have been
made in recent years
In my remarks today I shall attempt to set the stage for the
sessions that follow
I shall begin by clarifying the characteristics
of OTC derivatives that determine their transparency and liquidity and
that tend to make a significant portion of these instruments opaque
and illiquid
Then I shall identify some of the challenges that are
created by the use of opaque and illiquid financial instruments
I
shall conclude by offering some suggestions on how to meet them
Before beginning I want to emphasize that by discussing these
difficulties and challenges I do not mean to call into question the
benefits of OTC derivatives or the utility of the risk management
techniques that derivatives dealers have developed
bank loans pose essentially the same difficulties
I would note that
Like OTC
derivatives, bank loans are customized, privately negotiated
agreements that, despite increases in availability of price
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information and in trading activity, still quite often lack
transparency and liquidity
This unquestionably makes the risks of
many bank loans rather difficult to quantify and to manage
Yet no
one seriously questions the public benefits of bank loans, and most
would agree that efforts to apply modern risk management techniques to
bank loans should be supported and encouraged
Indeed, it is my hope
and expectation that by addressing the challenges posed by the lack of
transparency and liquidity of the more customized OTC derivatives, the
way will be paved for significant and parallel advances in the
management of the risks of bank loans and the many other relatively
opaque and illiquid instruments
The intermediation and unbundling of credit risks and market
risks are critical functions of a financial system
These functions
can be achieved only partially through standardized instruments and
organized exchanges
Hence, more opaque and illiquid financial
instruments serve an invaluable function in our economy
The use of
such instruments entails higher risks which, of necessity, are
reflected in higher intermediation costs
As advances in risk
management are achieved, however, these risks and related costs can be
expected to decline
Transparency and Liquidity of OTC Derivatives and Other Financial
Instruments
At the outset I should clarify what I mean by transparency
and liquidity
By the transparency of a financial instrument I mean
the degree of certainty with which one can determine its "fair value,"
which the Financial Accounting Standards Board (FASB) defines as "the
amount at which the instrument could be exchanged in a current
transaction between willing parties, other than in a forced or
liquidation sale "
Thus, fair values are a matter of conjecture
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rather than fact, they cannot be known, but must be estimated
FASB
has noted that quoted market prices, when available, are the best
indicators of fair values
As I shall note later, however, even
quoted market prices are not always reliable indicators of the values
at which transactions could be executed
Moreover, quoted market
prices simply are not available for many financial instruments,
despite a rapid expansion of sources of price information, such as
broker screens
When quoted market prices are unavailable, fair
values typically are estimated on the basis of quoted market prices
for related instruments
Such estimates require assumptions about
relationships between fair values of different instruments
Inaccurate or outdated assumptions inevitably heighten uncertainty
about potential transactions prices
By the liquidity of a financial instrument, I mean the
percentage of its fair value that could be realized in a forced or
liquidation sale
A perfectly liquid financial instrument is one
whose fair value could
if necessary, be realized instantaneously
Few financial instruments, however, are perfectly liquid
For most
instruments, time is required to search out a counterparty who is
willing to transact at the fair value of the instrument
In general,
the less time that is available to complete the transaction, the
smaller is the percentage of fair value that can be realized
Also,
the percentage of fair value that can be realized tends to decrease
with the size of the transaction
By these definitions, many OTC derivatives are neither highly
transparent nor highly liquid
The defining characteristic of OTC
derivatives is the customization of terms through private negotiations
between counterparties
To be sure, broker screens provide market
quotations for the more standardized or "plain vanilla" OTC
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derivatives, and these account for a large portion of outstanding
contracts
Even for plain vanilla derivatives, however, the
estimation of fair values generally involves adjustments to market
quotations to reflect operating, hedging, and other potential costs
For more customized OTC derivatives, the estimation of fair values
often involves use of a mathematical model that relates fair values of
the customized instruments to available market quotations for more
standardized products
For example, the fair values of OTC options
often are estimated using pricing models that utilize market
quotations for the underlying asset and implied price volatilities
from exchange-traded or plain-vanilla OTC options as inputs
Especially for more complex options, the choice of a pricing
model and of certain inputs to the model includes important elements
of art as well as science
Assumptions must be made, for example,
about the shape of the sampling distributions of prices and price
volatilities of the underlying assets
The growing availability of
independent valuation services allows users of complex instruments to
assess whether or not their price estimates are consistent with other
estimates
But for many instruments the range of estimates can be
quite wide
Moreover, estimates are estimates
Without timely
transactions prices for very similar instruments, the accuracy of the
estimates remains questionable
In principle, the value of an OTC derivative can be promptly
realized either by terminating the contract or by transferring it to
another counterparty
In practice, however, either procedure is
likely to be time-consuming and may require the counterparty seeking
to liquidate the contract to accept something less than the fair
value
In either case, the prior consent of the original counterparty
usually must be obtained
Counterparties typically require prior
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consent for termination because termination would require them to bear
the costs of replacing the terminated contract with a new contract
In general, the more customized the contract, the greater will be the
cost of replacement, for which the counterparty
compensation
will expect
Prior consent typically is also required for a
transfer, so as to protect the other counterparty against the
possibility of a transfer to a less creditworthy counterparty
Although accommodating a transfer request generally would be less
costly than the cost of accommodating a termination request, the
counterparty may nonetheless seek compensation
This discussion suggests that the opaqueness and illiquidity
of many OTC derivatives stems from both the customization of contract
terms and differences in creditworthiness across counterparties
Users of the more customized OTC derivatives, in particular, are
forced to accept a trade-off between the benefits of individually
tailored contract terms and credit relationships and the costs of
opaqueness and llliquidity
This trade-off can perhaps be seen more
clearly by comparing the benefits and costs of exchange-traded
derivatives and OTC derivatives
Exchange-traded derivatives are highly transparent and
liquid, but these advantages are not achieved costlessly
of contracts traded on exchanges are very standardized
The terms
In addition,
credit risk is standardized by substitution of the exchange's clearing
house as the central counterparty to every trade
The standardization
of contract terms limits the precision with which users can manage
their risk exposures
The standardization of credit risk requires the
clearing house to impose costly margin requirements that are not yet
routinely imposed in OTC transactions
Users of highly customized OTC
derivatives evidently perceive the benefits of tailoring contract
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terms and counterparty credit relationships as exceeding the costs
associated with less transparency and liquidity
Otherwise they would
choose more standardized contracts, either of the plain vanilla OTC or
exchange-traded variety
Over time, the terms of this trade-off between the benefits
of customization of contract terms and credit relationships and the
costs of opaqueness and illiquidity are likely to improve
In recent
years, futures and options exchanges have successfully introduced socalled "flex" products that allow for greater tailoring of terms than
traditional exchange offerings
At the same time, the use of
bilateral margining agreements for OTC derivatives has been spreading
Existing proposals to create facilities for the centralized
administration of such bilateral margining agreements may prove to be
the first step toward the creation of clearing houses for OTC
derivatives
In general, I expect that we shall see further
convergence between the characteristics of OTC and exchange-traded
derivatives
But I believe that it would be a mistake for
policymakers to attempt to force this process
Economic forces will
ensure that market participants will seek to implement exchange or
clearing house arrangements if they can enhance liquidity and
transparency while maintaining most of the benefits of customized
contracts
Implications for Risk Management
The development of OTC derivatives unquestionably has
stimulated very significant improvements in financial risk management
practices
In particular, concerns about the risks associated with
use of OTC derivatives prompted the Group of Thirty to sponsor
development and publication in July 1993 of a set of recommended risk
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management practices that have been extremely effective in fostering
improvements
Critical elements of the G-30 risk management framework
are accurate assessments of the fair values of financial instruments
and portfolios and the use of risk measures that presume significant
portfolio liquidity
The authors of the G-30 study recognized that a
series of difficulties arise in applying this framework to financial
instruments that are relatively opaque and illiquid, including the
more customized OTC derivatives
But the study's discussion of
practices and procedures necessary to address these difficulties was
rather vague
Our banking supervisors report that at the most
sophisticated U S
banks the relevant practices have been rapidly
evolving but remain diverse
In part, the diversity reflects
differences in risk profiles and business strategies, but varying
levels of refinement also are apparent
Opaqueness and illiquidity affect each of the critical
elements of risk management--valuation, risk measurement, and risk
control
The critical first step in risk management is determining
the current market value of the portfolio
Earlier I noted that
market quotations simply are not available for many financial
instruments
I should emphasize that these include not only the more
customized OTC derivatives but also thinly traded securities, as many
investors in mortgage-backed securities discovered in early 1994
Values of these instruments must be estimated on the basis of market
quotations for other, more standardized instruments
This requires
use of mathematical or economic models that relate the values of the
customized instrument to the values of more standardized instruments
Sophisticated risk managers recognize the uncertainty and the
potential for error in valuation methods for opaque instruments and
seek to compensate for various sources of error by creating reserves
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Among the reserves that institutions often create are reserves for
additional hedging costs, for uncertainty about the accuracy of
models, especially in valuing new or especially complex products, and,
quite explicitly, for illiquidity
The values of these reserves can
be quite significant, especially in the aggregate
In addition, some
institutions establish a credit risk reserve that is intended to
incorporate credit quality into fair values
While these reserving
practices can be described within a broad common framework, there
appears to be no common understanding within the industry of the
circumstances in which many of these reserves should be created or on
their appropriate size
Risk measurement is the assessment of potential future
changes in portfolio values
Opaqueness affects the measurement of
both market risk and credit risk
Consistent with the recommendations
of the G-30, sophisticated managers typically measure market risk by
value-at-risk ("VaR"), often defined as the amount of losses over one
day that would be expected to occur only one day out of a hundred
In
practice, VaR measures typically assume that the values of all
instruments in a portfolio are determined by a common set of
underlying risk factors --interest rates, exchange rates, commodity
prices, and stock indexes --most of which are readily hedgeable
But
the sensitivity of customized instruments to these factors sometimes
is difficult to assess
Furthermore, the values of such instruments
may be influenced importantly by risk factors other than common
hedgeable factors recognized in VaR measures
One can hope that these
residual risks are well diversified, but, absent a means of measuring
them, this may be nothing more than wishful thinking
Unfortunately,
the measurement of these risks requires accurate measures of fair
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values which, by definition, are problematic in the case of opaque
instruments
The difficulties in valuing some financial instruments also
make accurate measurement of credit risk quite difficult
In the case
of OTC derivatives, much progress has been made in modeling potential
future claims on counterparties, which often are termed potential
future credit exposures
However, as is the case for any financial
instrument, the credit risk of an OTC derivative depends on the
creditworthiness of the counterparty
If the holder seeks to transfer
an OTC derivative, the amount that a transferee will be willing to pay
for the contract will depend on market discount rates then applying to
claims on the counterparty
Likewise, the amount that the counterparty
will be willing to pay in a negotiated termination will depend on the
cost at which the counterparty could replace the terminated contract,
which will depend on these same future discount rates
The
development of techniques for estimating potential future discount
rates remains at the frontier of risk measurement
Even in the best
of circumstances--in which the counterparty has issued actively traded
corporate bonds --techniques extracting estimates of the relevant
discount factors remain at an early stage of development
Assessments of the liquidity of financial instruments are
critical to efforts to control risks
VaR measurements often are
translated into position limits for traders, which are a critical
element of internal risk controls
When VaR is measured using a one-
day horizon, it is implicitly assumed that risk exposures in the
portfolio can, if necessary, be offset within a day
This assumption
does not require that all of the financial instruments in the
portfolio can be liquidated within a day
Rather, it merely assumes
that the hedgeable risk exposures that are the focus of VaR measures
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can be offset that quickly, presumably through use of highly liquid
instruments such as exchange-traded derivatives
liquid markets may experience periods of
Still, even the most
illiquidity
As noted in the
title of today's first session, one needs to consider the consequences
if everyone can't get into the lifeboat at the same time
Furthermore, as I have suggested, the unhedgeable instrument-speciflc
risks of illiquid instruments cannot be ignored
Losses stemming from
an inability to offset or close out portfolios promptly are among the
risks that sophisticated risk managers seek to assess through socalled "stress tests "
However, stress testing is another area in
which our bank supervisors observe considerable diversity of practice
Consensus has not yet emerged on how to identify scenarios that pose
the greatest risk of loss or, as important, on appropriate responses
to test results
As I have noted, some banks establish reserves to
cover the potential costs of llliquidity
Others supplement VaR-based
risk limits with instrument-specific position limits
In principle,
stress tests could be used to evaluate the size of such reserves and
limits
Implications for Public Disclosure
The opaqueness and llliquidity of customized OTC derivatives
and other financial instruments create uncertainty about the financial
position and performance--the net worth, earnings, and risk profile-of users of such instruments
Concerns about such uncertainty often
are termed concerns about the transparency of financial statements, a
concept that is broader than the concept of transparency I have been
using thus far
These concerns have prompted issuance in recent years
of a series of new accounting standards and proposals by the FASB and
the Securities and Exchange Commission
The most recent changes have
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required disclosure of accounting policies for derivatives, of the
purposes (trading or hedging) for which derivatives are used, and of
fair values of derivatives, either carried on the balance sheet or in
supplemental schedules
FASB has encouraged disclosures of
quantitative information on market risk, and the SEC recently has
proposed to require such disclosures
I have discussed the difficulties involved in determining
fair values for the more customized OTC derivatives and the diversity
of valuation practices actually employed
An implication of this
discussion is that market participants could better assess the
financial position of users if more information were disclosed on
valuation policies, including the size of the various reserves, if
material, and how those reserves are determined
Fuller disclosure
would reduce not only uncertainty but also the danger that reserves
could be manipulated to reduce the volatility of reported earnings
My discussion of risk measurement issues suggests that
disclosure of quantitative measures of market risk, such as value-atrisk
is enlightening only when accompanied by a thorough discussion
of how the risk measures were calculated and how they related to
actual performance
Moreover, no single quantitative measure can
summarize all aspects of such a complex concept as market risk
These
conclusions are fully consistent with an analysis of appropriate
public disclosures of market and credit risks (the Fisher Report) that
was released in September 1994 by the Euro-currency Standing Committee
of the Group of Ten central banks
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Implications for Counterparty Relationships
The opaqueness and illiquidity of some OTC derivatives also
have contributed to tensions between counterparties, tensions that in
some instances have produced litigation or threats of litigation
As
I noted earlier, even when a market quotation is available, there may
be uncertainty and confusion about what the quotation is intended to
convey and how it should be interpreted
In particular, there may be
confusion about whether a quotation represents an estimate of the fair
market value of an instrument or a firm offer to transact in the
instrument at the quoted price
By definition, transaction prices of illiquid instruments can
be different, possibly significantly different from fair market
values
A fair market value is an estimate of the price at which a
transaction might be executed with a willing counterparty
As I have
emphasized, estimation errors are to be expected, especially for more
customized, illiquid contracts
Moreover, a price concession may be
necessary to produce a willing counterparty
Consequently, the price
at which a transaction can be executed cannot be inferred from
estimates of fair market value
Transactions prices can be determined only by contacting
potential counterparties and soliciting offers to transact
Moreover
when soliciting quotations it is essential that it be made clear to
potential counterparties that a transactions price, rather than a fair
market value estimate or a nonbinding "indicative" price quotation is
desired
Likewise, counterparties that receive requests for
quotations should determine clearly what type of quotation is desired
before responding
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Addressing the Challenges Posed by Opaqueness and Illiquidity
Before concluding, I would like to offer a few brief
suggestions for addressing the challenges I have identified
On the
risk management front, there should be more public discussion of
valuation difficulties and best practices for addressing those
difficulties
This would appear to be an area in which an industry
initiative by derivatives dealers or by accounting or consulting firms
would be quite useful
Regarding public disclosure, I remain
convinced of the usefulness of the central recommendation of the
aforementioned Fisher Report, which called for financial
intermediaries to move in the direction of disclosing to the public
the quantitative measures of market risk and credit risk that the
firm's management relies upon
A November 1995 review by the Basle
Supervisors Committee and the Technical Committee of IOSCO found that
internationally active banks and securities firms had made progress in
implementing the Fisher Report's recommendations, but the Report also
concluded that further efforts were needed by intermediaries in many
G-10 countries
Finally, I believe the problems that opaqueness can
create for counterparty relationships can best be addressed by
heightening awareness of potential ambiguities associated with market
quotations and encouraging clarity in communications between
counterparties
The initiative on valuation that I have suggested
would clearly contribute to an understanding of the differences
between fair value estimates and transactions prices
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Conclusion
In my remarks today I have tried to identify the challenges
posed by the opaqueness and illiquidity of some OTC derivatives and of
many other financial instruments as well
I have done so on the
assumption that the long debate on derivatives has reached a stage of
maturity at which we can openly discuss difficulties and challenges
without running the risk of a legislative or regulatory overreaction
In any event, I am confident that, in the long run, frank discussions
like those that I expect to take place at this conference offer the
most effective hedge against that risk
@FedFRASER