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December 3, 1992

Challenges Posed by OTC Derivatives

Remarks of

Susan M. Phillips
Member, Board of Governors of the Federal Reserve System

at the

Tenth Annual Meeting of the
National Futures and Options Society

December 3, 1992
New York, New York

I am very pleased to have an opportunity to participate in
this timely program developed by the National Futures and Options
Society for its annual meeting.

Since joining the Federal Reserve

Board a year ago, I have been keenly interested in the emerging debate
over appropriate public policy responses to the rapid growth of the
over-the-counter (OTC) derivatives markets.

As a former regulator of

the futures markets and a current member of one of the banking
regulatory agencies, my perspective on these issues is perhaps a bit

What I see emerging as banking organizations expand their

activities in the OTC derivatives markets is a clash of cultures, both
within banking organizations themselves and within the regulatory

Today, I would like to share with you my views on how

public policy could help resolve these cultural clashes in a way that
best serves the public interest.
A Clash of Cultures
The rapidly expanding activities of banking organizations in
the derivatives markets clearly has been a source of interest and even
concern to some banking regulators.

Regulators are understandably

concerned that rapid growth may be a sign of trouble ahead.

At the

level of individual institutions, rapid asset growth in the 1980s very
often was followed by credit quality problems that burdened not only
shareholders but also taxpayers.

Too often, rapid growth at an

individual institution has been a sign that internal risk controls
were inadequate or that intermediation services were being provided at
unprofitable margins.

At the industry level, every banking regulator

is aware of how industry-wide deterioration of credit standards
produced huge losses in the LDC, HLT, and commercial real estate

- 2 -

But, in m y view,

c u l t u r a l d i f f e r e n c e s a p p e a r to h a v e

c o n c e r n s about b a n k s ' p a r t i c i p a t i o n in OTC d e r i v a t i v e s

and t h r e a t e n e d to p r o d u c e an o v e r r e a c t i o n to t h e

derivatives participation actually entails.
m a r k e t s too r e a d i l y can be c h a r a c t e r i z e d
the e c o n o m i c v a l u e of s p e c u l a t i o n too
the c o m m o d i t i e s i n d u s t r y and

risks that

A c t i v i t i e s in t h e s e

as s p e c u l a t i v e a c t i v i t y and

r e a d i l y can b e o v e r l o o k e d .


among c o m m o d i t i e s r e g u l a t o r s , the

role played by s p e c u l a t o r s in f a c i l i t a t i n g the t r a n s f e r of

p r i c e risk by p r o v i d i n g l i q u i d i t y to f u t u r e s ,
d e r i v a t i v e s m a r k e t s is c l e a r l y a p p r e c i a t e d .



By c o n t r a s t ,

I see signs

t h a t , in some s e g m e n t s of the b a n k i n g i n d u s t r y and the b a n k i n g

community, activities

speculative activities.

in d e r i v a t i v e s are seen s o l e l y as

Speculation, then,

in t u r n ,

is seen as

g a m b l i n g or the c r e a t i o n of risk rather t h a n the a s s u m p t i o n of risk
from entities less c a p a b l e or less d e s i r o u s of m a n a g i n g
d i f f e r e n c e s in p e r c e p t i o n



reflect the fact that the b a n k i n g i n d u s t r y

historically has played a relatively


role in i n t e r m e d i a t i n g

p r i c e risks, the m a j o r e x c e p t i o n s b e i n g t h o s e b a n k s a c t i n g as d e a l e r s
in f o r e i g n e x c h a n g e , in U . S .
securities markets


or m u n i c i p a l s e c u r i t i e s ,


In s h a p i n g a s u p e r v i s o r y p r o g r a m for b a n k s ' a c t i v i t i e s
OTC d e r i v a t i v e s m a r k e t s ,

I b e l i e v e it is c r i t i c a l that we not

sight of the i m p o r t a n t public b e n e f i t s that

or in

or of t h e i m p o r t a n t

l i q u i d i t y to t h e s e m a r k e t s .

in the


are p r o d u c e d by t h e s e

role that b a n k s are p l a y i n g in p r o v i d i n g
We should not

seek to d i s c o u r a g e b a n k s

from a s s u m i n g risks in the O T C d e r i v a t i v e s m a r k e t s .

Rather, we


seek to e n s u r e that t h e risks t h e y a s s u m e are p r u d e n t l y m a n a g e d
t h r o u g h the i m p l e m e n t a t i o n of a p p r o p r i a t e c a p i t a l
e x a m i n a t i o n p r o c e d u r e s , and a c c o u n t i n g and


reporting standards.


- 3 -

addition, as the central bank, the Federal Reserve has a role to play
in encouraging and supporting initiatives by market participants, both
banks and nonbanks, designed to reduce the potential systemic risks
that could emerge should a major participant in the OTC derivatives
markets encounter financial difficulty.
In the remainder of my remarks I would like to describe the
various efforts underway at the Federal Reserve to achieve these

I will then conclude with some observations on regulatory

issues which might receive further attention by the Congress in the
next several years.
Initiatives to Enhance Supervision and Regulation of Banks'
Derivatives Activities
Perhaps I should begin by noting that the Federal Reserve has
supervisory responsibility for many of the largest participants in the
OTC derivatives markets.

We are the primary federal regulator of

state-chartered banks that are members of the Federal Reserve System,
including several derivatives "giants."

While the Comptroller of the

Currency has primary responsibility for national banks, some of these
banks have nonbank subsidiaries active in the derivatives markets for
which the Federal Reserve has supervisory responsibility under the
Bank Holding Company Act.

Finally, we have regulatory responsibility

for U.S. operations of foreign banks, many of which conduct a
substantial share of their global derivatives activities from their
U.S. offices.
I suspect that the most visible element of the Federal
Reserve's supervisory program related to OTC derivative products is
the treatment of credit risks associated with derivatives that is
contained in the Basle Capital Accord.

These capital requirements

were developed by the Basle Supervisors Committee and included as part

of the original Accord that was announced in 1988.

They apply to all

internationally active banks that are chartered in the group of major
industrialized countries known as the Group of Ten.

The Basle

Supervisors currently are considering various refinements to the
treatment of OTC derivatives.

In particular, the current capital

requirements give only very limited recognition to the risk-reducing
effects of netting contracts, which are now widely utilized by
participants in the OTC derivatives markets, largely as the result of
the efforts of the International Swap Dealers Association (ISDA).
At the time of the initial accord, I understand a cautious
approach to the recognition of netting seemed appropriate because of
substantial uncertainty about the legal enforceability of such

Although in some jurisdictions considerable uncertainty

remains, in the United States legal certainty has been achieved for a
wide range of contracts and counterparties through legislation,
including amendments to the bankruptcy code and provisions of FIRREA
and last year's FDIC Improvement Act.

Capital requirements for OTC

derivatives need to take account of these developments and I hope that
the Basle Supervisors will act soon to recognize netting in cases
where a high degree of legal certainty has been achieved.
A broader review of the capital requirements for credit risk
also is under consideration by the Basle Supervisors.

Such a review

appears warranted in light of the appearance in recent years of new
classes of OTC derivatives, notably commodity and equity derivatives.
In addition, more sophisticated techniques have been developed for
measuring potential credit exposures on derivatives, and use of those
new techniques may point to refinements of the existing approach.
Finally, the Basle Supervisors have been working for some
time to develop capital requirements for market risk.


derivatives play an important role in the management of market risk,
those proposals will, of course, address the measurement of market
risks associated with derivatives.
Although capital requirements are an essential element of our
supervisory approach to OTC derivatives, in my view a far more
important, though less visible, element is our program of on-site
examination of banking organizations.

As a general matter, the

Federal Reserve recognizes that regulation cannot substitute for
effective management of bank activities by senior bank management.
This should be especially evident in the case of derivatives, where
the very simple .types of rules used in regulatory capital standards
cannot be expected to measure accurately the risks entailed.


a bank prudently manages the risks associated with its derivatives
activities depends critically on the policies, procedures, and
information systems established by senior management and the board of

Consequently, the most critical element of our supervisory

program is the on-site examination and assessment of the adequacy of
internal controls.
Both the enhancement of internal controls by senior
management and the enhancement of examination procedures by regulators
pose difficult challenges, in part because of the cultural differences
to which I alluded earlier.

Some senior bank executives, who attained

their current positions through credit experience rather than trading
experience, have indicated unease about the risks posed by OTC
derivatives activities, even though to date those activities generally
have been highly profitable.

A challenge for market participants is

how to create information systems that provide senior management with
a more accurate and comprehensible picture of the risks and returns
that derivatives activities create.

The Group of Thirty has recently

- 6 -

l a u n c h e d a study of the d e r i v a t i v e s m a r k e t s ,

one o b j e c t i v e of w h i c h is

to d e m y s t i f y t h e d e r i v a t i v e s b u s i n e s s for senior m a n a g e m e n t


d e s c r i b i n g c l e a r l y the



risks involved


s e t t i n g out



L i k e w i s e , the e n h a n c e m e n t
to OTC d e r i v a t i v e s m u s t



i n c l u d e n e w t r a i n i n g for e x a m i n e r s and

o f f i c i a l s who,

e x p e r t i s e but

of e x a m i n a t i o n p r o c e d u r e s

in m a n y c a s e s , h a v e c o n s i d e r a b l e



r e l a t i v e l y l i t t l e e x p o s u r e to t r a d i n g a c t i v i t i e s .

of n e w t r a i n i n g p r o g r a m s is one element


of a t h o r o u g h

review of s u p e r v i s o r y a p p r o a c h e s to d e r i v a t i v e s that

is c u r r e n t l y

u n d e r w a y in the F e d e r a l R e s e r v e S y s t e m .
In a d d i t i o n to the


r e f i n e m e n t s to c a p i t a l

another important

r e c o n s i d e r a t i o n of a c c o u n t i n g and
generally accepted
address interest


accounting principles

of this


r e v i e w is a


The fact that

(GAAP) do not d i r e c t l y

rate swaps or m a n y other t y p e s of OTC d e r i v a t i v e s

a cause for c o n c e r n .

pace w i t h m a r k e t


s t a n d a r d s that

Nor h a v e r e p o r t i n g


r e q u i r e m e n t s kept

d e v e l o p m e n t s , a l t h o u g h the d i s c l o s u r e s m a d e by

banking organizations

g e n e r a l l y are m o r e t h o r o u g h t h a n t h o s e m a d e by

other O T C d e r i v a t i v e s m a r k e t


Indeed, the a b s e n c e of

generally accepted

accounting standards

m e to be i m p o r t a n t

factors in p e r p e t u a t i n g c u l t u r a l b i a s e s against

derivatives trading.

and o p a q u e

Both r e g u l a t o r s and m a r k e t

r e p o r t i n g a p p e a r to

p a r t i c i p a n t s must


m o r e to address c o n c e r n s in t h e s e areas.
I n i t i a t i v e s to L i m i t

Systemic Risk

Regulators have expressed




from the f a i l u r e of a m a j o r d e a l e r in the OTC

derivatives markets.
losses that

c o n c e r n s about the s y s t e m i c

In p a r t , t h e y are c o n c e r n e d

a f a i l u r e could

i m p o s e on the d e a l e r ' s

about the p o t e n t i a l

- 7 -

But concerns about systemic risk are not limited to these direct
effects on counterparties of a failed participant.

Rather, they

extend to the potential impacts on the liquidity of markets, not only
the OTC derivatives markets but also the cash markets and the exchange
markets to which the OTC derivatives markets are closely linked
through the complex arbitrage strategies employed by major dealers.


loss of market liquidity would heighten both credit and market risks
for all participants in the derivatives markets.

Furthermore, the

expansion of market linkages, which cut across national boundaries and
embrace a wide range of financial and nonfinancial firms, raises
concerns about the ability of central banks to contain systemic
difficulties should they emerge.
The Federal Reserve has attempted to limit systemic risk in
the OTC derivatives markets in two different ways.

First, as I have

already discussed, we have exercised our authority as a banking
regulator to attempt to ensure that entities subject to our
supervision are not a source of systemic disturbances.

Second, we

have encouraged a variety of market developments that would tend to
contain systemic pressures should a major intermediary encounter
Most recently, the G-10 central banks prepared a report on
Recent Developments in International Interbank Relations (the Promisel
Report), which was published by the BIS in October.

This report

focused on the growth and implications of derivative markets,
stressing the linkages to other markets.

It urged market participants

to enhance their own risk management procedures and continue efforts
to improve the institutional infrastructure that would enable markets
to reduce risks.

- 8 -

Another important effort by the Federal Reserve and other
central banks has been the encouragement of sound arrangements for
netting OTC derivative contracts.

In November 1990, the BIS published

the Report of the Committee on Interbank Netting Schemes of the
Central Banks of the Group of Ten Countries (the Lamfalussy Report).
The central conclusion of that report was that netting schemes have
the potential to reduce systemic risk, provided that certain
conditions are met.

With respect to those conditions, the report set

out minimum standards for the design and operation of cross-border and
multicurrency netting and settlement schemes.
In the case of bilateral netting arrangements, such as the
ISDA master agreement, the condition that is perhaps most relevant and
certainly the most challenging is that a netting scheme should have a
well-founded legal basis under all relevant jurisdictions.

As I noted

earlier, a series of legislative changes that have been supported by
the Federal Reserve have created legal certainty with respect to the
netting of most derivative contracts by most participants in the
United States.

In other jurisdictions, the legal effectiveness of

netting is often less certain, although ISDA has obtained favorable
legal opinions with respect to each of the G-10 countries.
The Federal Reserve also has supported efforts to reduce
legal uncertainty by clarifying the Commodity Futures Trading
Commission's authority to exempt classes of OTC derivative instruments
from regulation under the Commodity Exchange Act, including the Act's
prohibition on off-exchange trading of futures.

The Futures Trading

Practices Act of 1992 indicated explicitly that the Commission has
this authority, and the Commission has acted promptly to exercise it,
issuing for public comment in early November a broad exemption for
interest rate swaps (and other OTC derivatives) .

I was pleiased to see


that the p r o p o s e d

exemption would

remove all

r e s t r i c t i o n s on the use

of b i l a t e r a l c o l l a t e r a l and m a r g i n i n g p r o c e d u r e s to
on d e r i v a t i v e s t r a d e s .
multilateral netting
the p r o p o s a l

In a d d i t i o n , w h i l e t r a n s a c t i o n s

seemed to leave the door open to


subject to

(clearing h o u s e a r r a n g e m e n t s ) w e r e not


such p r o p o s a l s in t h e

I b e l i e v e that the a p p l i c a t i o n of c l e a r i n g h o u s e m e t h o d s to

OTC d e r i v a t i v e s has c o n s i d e r a b l e p o t e n t i a l , but
such a r r a n g e m e n t s

should not

of the G - 1 0 c e n t r a l b a n k s

limit c r e d i t

a principle


go u n s u p e r v i s e d .

or has

Indeed, the G o v e r n o r s

(including the F e d e r a l R e s e r v e ) h a v e

in the L a m f a l u s s y R e p o r t that

d e r i v a t i v e s c l e a r i n g h o u s e that

I share the v i e w that

an OTC

c o n d u c t s s e t t l e m e n t s in f o r e i g n

foreign bank participants


be subject


official oversight.
P r o s p e c t s for A d d i t i o n a l R e g u l a t i o n of the D e r i v a t i v e s M a r k e t s
The C o n g r e s s does not

a p p e a r to

T r a d i n g P r a c t i c e s Act

of 1992 as the


it has




s t u d y of the need


studies w h e n t h e y

are c o m p l e t e d .


At t i m e s

last w o r d

p a s s a g e of the Futures
on r e g u l a t i o n of OTC


for a d d i t i o n a l

an i n t e n t i o n to act

p r o p o s a l s for a d d i t i o n a l





on the i s s u e s

I h o p e that

of t h e s e

raised by the



r e g u l a t i o n of the d e r i v a t i v e s m a r k e t


I h a v e heard e x p r e s s i o n s of c o n c e r n a b o u t

in the OTC d e r i v a t i v e s m a r k e t s , w i t h the u n d e r l y i n g

p r e s u m p t i o n that every f i n a n c i a l m a r k e t

is in need

of r e g u l a t i o n .

B e f o r e i n t r o d u c i n g any a d d i t i o n a l r e g u l a t i o n s , we need to
i d e n t i f y c l e a r l y the public p o l i c y o b j e c t i v e s that the
i n t e n d e d to a c h i e v e .

We should

also c o n s i d e r w h e t h e r o f f i c i a l

of p r i v a t e s e c t o r i n i t i a t i v e s

of m e e t i n g t h o s e o b j e c t i v e s .

r e g u l a t i o n s are

And w e

is a m o r e e f f e c t i v e m e a n s

should be m i n d f u l

of t h e


potential adverse effects of regulation on competition, efficiency,
and innovation in the OTC derivative markets.
I believe that further efforts by private industry could do
much to allay the concerns that have been expressed by regulators and
to ensure a favorable outcome to legislative deliberations regarding
the OTC derivatives markets.

The Group of Thirty study is a promising

initiative that, at a minimum, should promote understanding of markets
that are viewed with suspicion in part because of their complexity and
lack of transparency.

As I suggested earlier, further study needs to

be followed by concrete action to improve accounting and reporting
In addition, because I am a former futures regulator, you
should not be surprised to hear that I believe some further elements
of self-regulation might be both prudent and appropriate.


example, industry agreement on a "code of conduct" for dealings with
commercial and other "end users" of derivatives would lessen the
likelihood that isolated abuses could lead to excessive regulation.
also think the industry should give further consideration to the
potential problems that might be encountered in assigning or
terminating a complex derivatives book in the event of the failure of
a major dealer.

I am aware that to date the liquidation of failed

intermediaries has been accomplished relatively smoothly, but I can
assure you that it remains a concern to many regulators and central

Either the Group of Thirty or the ISDA crisis management

committee could make an important contribution by identifying
potential problems and ways to avert their realization.
To use an old expression, in all of the areas I have just
cited, "an ounce of prevention may be worth a pound of cure."




b e c a u s e d e r i v a t i v e s m a r k e t s don't

l o o k " b r o k e n " doesn't m e a n t h e y

can't b e m a d e to w o r k b e t t e r or b e used m o r e b r o a d l y .