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ISDA PRESS REPORT - SEPTEMBER 20, 2001 ACCOUNTING ? FASB to Issue for Comment Securitizations Guidance on Derivatives - BNA REGULATORY ? CFTC Offers Temporary Regulatory Reprieve in Wake of Terrorist Attacks - BNA TRADING PRACTICE ? ISDA moves to stabilise derivatives markets - Risk Magazine OTHER ISSUES ? Clearinghouses Diversify or Die - Appliederivatives.com FASB to Issue for Comment Securitizations Guidance on Derivatives BNA - September 20, 2001 NORWALK, Conn.--The Financial Accounting Standards Board Sept. 19 approved plans to publish guidance on an issue in which rules on derivatives accounting meet those for securitizations. However, the accounting pronouncement is effectively held in abeyance so that the public can make comments on it as part of FASB's due process. The guidance pertains to beneficial interests that arise in securitization transactions subject to FASB Statement No. 140, rules on transfers of financial assets that superseded FASB Statement No. 125. More specifically, the key provisions at issue would more clearly state which beneficial interests meet the definition of a derivative under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, and its amended version, FASB Statement No. 138. That guidance, which FASB tentatively decided to propose as part of a forthcoming "technical corrections" project on derivatives issues, would replace Derivatives Implementation Issue No. D1, on the application of Statement 133 to beneficial interests in securitized financial assets. Neel Foster and others on FASB spoke of the planned guidance as an improvement over Issue No. D1, which was devised with the assistance of FASB's Derivatives Implementation Group. FASB's staff proposed the reading of derivatives accounting rules as they pertain to beneficial interests as staff guidance. Although he supported the substance of the guidance, Foster said, "It clearly is an amendment of 133 and 138" that warrants FASB's full due process. Others on the board, such as John Wulff and Katherine Schipper, agreed. FASB Chairman Edmund Jenkins spoke of the importance of issuing timely guidance, and therefore supported a compromise devised in exchanges with Foster to issue guidance on beneficial interests that meet the definition of a derivative in the technical corrections effort that would be limited to issues stemming from the use of FASB Statements No. 133 and 138. In that way, what Foster argued was a substantive change worthy of due process reserved for a proposed amendment to a standard would be floated for wide public comment. The timetable for technical corrections project is yet to be determined. In the meantime, the proposed accounting prescription is to be posted soon at FASB's site on the World Wide Web. Language on Beneficial Interests as Derivatives Under the proposed guidance that was less controversial, FASB's staff described which beneficial interests are eligible for the scope exception under paragraph 14 of Statement No. 133--in other words, which beneficial interests arising in securitizations would not be accounted for as derivatives. On which beneficial interests meet the definition of a derivatives under paragraph 6 of FASB No. 133, the staff proposed: ? "If there is any initial net investment in a forward-based contract, the contract would not meet the criterion in paragraph 6(b). However, if a forward based contract has a de minimis initial net investment that represents compensation for terms that are more or less favorable than market conditions, an entity may choose to account for such a contract as either (1) a hybrid instrument that must be bifurcated into a debt host and a derivatives whose initial fair value is zero or, (2) a derivative in its entirety. ? "An options-based contract that involves an initial net investment that is equal to the fair value of the option would meet the criterion in paragraph 6(b)." Victoria Lusniak, a FASB staff accountant, suggested that, if the guidance is finalized or the change otherwise is made, existing DIG guidance would be affected. Issue No. A9, on prepaid interest rate swaps, would be superseded; Issue No. E15, on the "shortcut method" after a purchase business combination, would be modified; and Issue No. B12, would have to undergo minor changes, Lusniak said. DIG Issues Cleared In other business at FASB's Sept. 19 meeting, the board did not object to seven DIG issues, or items of guidance developed with the help of the group, which is moribund. Those include issues on the definition of a derivative, scope exceptions, hedges of fair value, cash flow, and foreign currency. The items are to be posted on FASB's Web site as final, cleared guidance on Oct. 10, said Robert Wilkins, a FASB project manager heading up the derivatives accounting effort. A DIG-related topic that generated the most debate was a proposal by Wulff to reconsider Issue No. C10, the result of earlier rulemaking on options and forward contracts with optionality features, to weigh exempting those derivatives from FASB No. 133 because they are deemed part of normal purchases or normal sales. Such derivatives are used by energy companies. However, by a vote of 6 to 1, with Wulff dissenting, the board rejected that course. Separately at the Sept. 19 meeting, FASB extended the comment deadline to Oct. 5 for two pending items that have been floated before the board's constituents and other interested parties. One item is a tandem proposal to possibly add two topics--on performance reporting and disclosures about intangible assets--to its rulemaking agenda. The other is a survey of the Financial Accounting Standards Advisory Council on what standard-setting projects should be undertaken by FASB. The deadlines were extended because of the terrorist attacks of Sept. 11, which FASB, in its first meeting since the tragedy, marked with a moment of silence for the victims. CFTC Offers Temporary Regulatory Reprieve in Wake of Terrorist Attacks BNA - September 20, 2001 The Commodity Futures Trading Commission moved Sept. 19 to salve some of the functional sting from the Sept. 11 attacks on New York's financial district, by announcing a package of regulatory relief aimed at giving registrants extra time to meet normally mundane commission requirements. The CFTC said that for all registrants--including futures commission merchants, introducing brokers, commodity pool operators, and commodity trading advisors--it will not consider Sept. 11-Sept. 14 as "business days" for the purposes of calculating and meeting specific reporting and capital requirements, as well as bulk transfer obligations and records inspection requirements. The delay effectively extends those reporting deadlines. Furthermore, firms that were physically disrupted as a consequence of the attacks and thus unable to make certain calculations concerning segregated funds and secured amounts, have been excused from that obligation for those four days. Such damaged firms also will not have the four days counted against them, as either business or calendar days, for purposes of confirmation statements, transaction applications, and position closeout requirements, the CFTC said. Additionally, such firms will be excused for 31 days from requirements that their records be readily accessible. Collateral Consequences Though trading in most futures and options contracts resumed two days after the Sept. 11 attack, the CFTC said relief was necessary because of the collateral damage caused by the explosions and their aftermath. While most trading takes place in Chicago and electronically from all points, many registrants were located at ground zero in lower Manhattan. "This ... recognizes that firms may have had difficulty last week in moving funds, issuing notices, providing customers with access to records, or precisely measuring portfolio values," the CFTC said in a statement Sept. 19. The commission also extended relief to firms that have taken residence in temporary or incomplete facilities. Those operations will be allowed through Oct. 11 to extend deadlines for calculations on segregated funds that normally would be due at noon on a given day, to the close of the business day. Similarly, firms that are unable to access time-stamping equipment will be allowed to use "reasonable alternative methods" to document times through Sept. 21. The CFTC also is asking firms that normally would file papers with the commission's New York regional office--which had been located in the now leveled World Trade Center--to send the items to the Chicago regional office at 300 South Riverside Plaza, Suite 1600 North, Chicago, Ill., 60606. The National Futures Association, the leading organization representing the futures and options industry, said it worked with the commission to come up with the relief package. Larry Dyekman, a spokesman for NFA, said if the measures turn out not to be adequate, the group would consider pushing for more remedies. Acting CFTC Chairman James Newsome, in a Sept. 19 statement, praised the registrants' preparedness for the almost unthinkable. "The foresight of their contingency plans, the steady hand of their leadership, and, most of all, the courage and tenacity of all of their people should instill in each of us great confidence in our nation's financial system," he said. ISDA moves to stabilise derivatives markets Risk - September 18, 2001 By John Ferry The International Swaps and Derivatives Association has issued guidelines to help traders close outstanding equity derivatives positions following the major disruptions to financial markets caused by last week's terrorist attack on the World Trade Center. The trade body also said the posting of one-year dollar swaps rates has resumed. "ISDA believes it is important to continue supporting orderly markets," said Jonathan Moulds, chair of ISDA's trading practice committee and head of global rates at Bank of America. ISDA advised that "unless parties otherwise agree", Tuesday to Friday of last week should not be considered days on which valuation or expiry of equity options should have occurred. The statement is relevant only "where trading on a relevant exchange in the United States ceased or did not open as a result of the events occurring in New York City". The latest statements follow advice given on Friday for the closing of energy-based derivatives contracts. ISDA advised that closing prices for the first day of trading following the market disruption should be used. Clearinghouses Diversify or Die Appliederivatives.com - September 2001 Diversification. That's the name of the game in the futures clearing community today. Derivatives clearinghouses, sparked by the demutualization of the traditional exchanges they serve, are now under more pressure than ever to search for new sources of revenue. Moreover, to retain their existing clients, they are expected to continuously expand and improve their technology and services. Indeed, regardless of whether you are talking about the Board of Trade Clearing Corp. (Botcc), the London Clearing House (LCH) or the Chicago Mercantile Exchange's (CME's) Clearing House division, the ability to wear multiple hats while filling the specific needs of different types of customers is integral to success. "Just like the exchanges, clearing organizations are trying to reinvent themselves into traditional for-profit companies, almost as a way to try and ensure their survival," says a source close to the Botcc's board. Of course, there is no standard recipe for reinvention. All of the world's largest derivatives clearinghouses are leveraging their assets in the name of evolution, but their business models and strategies for growth vary significantly. For example, the CME and Stockholm, Sweden-based OM have attempted to separate their internal clearinghouses from the pack by licensing their in-house developed clearing systems to derivatives markets across the globe. In contrast, in lieu of licensing its software, the independently owned LCH has expanded its reach and power by providing central counter-party transaction processing services to many different markets in its home country. Meanwhile, the Botcc is attempting to secure its future by offering its technology and services to up-and-coming B2B derivatives markets. In fact, to that end, the Botcc recently developed Meta-Clear, a comprehensive, Internet-based suite of applications that covers everything from traditional clearing to transaction processing and payment for over-the-counter derivatives. Unlike its clearinghouse counterparts, however, the Botcc has one potentially large stumbling block in its path: the looming demutualization of its largest client, the Chicago Board of Trade (CBOT). Though the Botcc, like the LCH, is independently owned, it still receives most of its revenues from the CBOT, which clears all of its U.S. transactions through the 76-year-old clearing firm. But the CBOT, following in the footsteps of other large derivatives markets like the CME, will probably eventually go for-profit-morphing from a member-owned exchange into a shareholder-driven market. And when it does, the management of the CBOT, facing pressure to increase profit from shareholders, may be forced to re-evaluate the exchange's long-standing clearing relationship with the Botcc. "There is no doubt that demutualization at the CBOT could potentially lead to other views being taken of the services provided by the Botcc. So the Botcc needs to diversify ... (because) it is, at the moment, a very undiversified entity," says a LCH official. Noting that the LCH provides central counter-party clearing services for the London International Financial Futures and Options Exchange, the London Metal Exchange, the International Petroleum Exchange, the London Stock Exchange, eSpeed and EuroMTS-among other clients-the official says that the LCH has an edge because it is truly independent. What's more, he says that while other clearinghouses focus on licensing their derivatives-clearing software, the LCH differentiates itself by providing full-service clearing services for a variety of instruments. "Others lead the way by trailblazing new technology, we lead it by trailblazing new types of service," the official says. "There is no other clearinghouse in the world that does futures and options, cash equities, interest-rate swaps and fixed income-in the form of repo and cash bonds." That said, while expanding into new markets is part of the LCH's modus operandi, the firm currently has no aspirations to chase after B2B derivatives exchanges. The B2B marketplace today, says the LCH official, is too illiquid to derive any benefits from central counter-party clearing. "All that a central counter-party is doing, with so few buyers and sellers within that space, is simply adding cost. So we just do not see an upside there," he says. Betting on B2B While the LCH is skeptical about B2B, the Botcc believes that the marketplace is ripe with untapped clearing opportunities. Thus far, the firm, which began its earnest pursuit of B2B in early 2000, has snagged two new clients: Opt4-a Berkeley, Calif.-based B2B trading systems vendor which the original Meta-Clear application suite was designed for-and Traiana-a developer of front-end applications targeted at online, B2B derivatives markets. In the last couple of years, the Botcc has also signed agreements to provide U.S. transaction-processing services to BrokerTec-an all-electronic interdealer-broker of fixed-income securities-and the St. Louis Merchants Exchange-a start-up market that trades large freight futures contracts. What's more, says Botcc President and CEO Dennis Dutterer, the clearing corporation will likely ink deals with "two or three" more participants in the B2B space by year end. Keeping all this in mind, Dutterer says the Botcc is confident that it can use its B2B strategy to diversify, while simultaneously maintaining its deal with the CBOT. Sixty-five percent of the Botcc's revenues, he says, come directly from transactions funneled to the firm through the CBOT, and an additional 25 percent is derived through "capital" and shareholder fund management. The remaining 10 percent comes from other revenue sources, including B2B clients. Still, though it clearly thinks B2B is an important market segment, Dutterer refuses to make any predictions about what percentage of Botcc's revenues will stem from B2B clients in the future. "We have not targeted a year-end revenue change, because that type of thing does not occur overnight," he says. The source close to the Botcc's board of governors says that B2B truly presents a dilemma for the clearing corp. On the one hand, he says, the exchange-traded futures business is currently saturated-meaning very few clearing contracts remain up for grabs. However, though there may be as many as 50 new B2B markets, they have probably collectively traded only a few hundred contracts, the source says. "Their only chance to diversify in a big way is to score a home run with one of these B2B deals," he says. "But at the end of the day, how much transactional B2B business is out there? Virtually none." Integrated Approach OM, like the LCH, does not think today's B2B markets offer a lot of opportunities for clearing firms. Richard Dour, the sales and marketing head of the financial systems unit of OM's technology division, says that OM is not actively trying to license its standard clearing system-Secur-to B2B markets. Rather, OM has marketed Secur to traditional derivatives and energy exchanges, at times trying to take advantage of the breadth of technology platforms it offers. In addition to licensing its respective clearing systems on a standalone basis, OM and the CME can offer prospective clients something that the Botcc and LCH do not-an integrated trading engine/clearing system package. Together with its Clearing 21 platform, the CME offers exchange clients the ability to deploy Globex2-its trading engine-on an integrated basis. Similarly, OM can provide a combination of Secur and Click-its derivatives trading engine-for clients that desire an integrated solution. Citing the fact the CME has publicly declared its intent to investigate a potential IPO, Merc officials declined to be interviewed for this story. But Dour says OM's integrated Secur/Click offering has netted the company a few exchange clients. Indeed, he says that in addition to OM's own exchanges, the Korea Futures Exchange, the Hong Kong Exchanges and Clearing Ltd., the Vienna Stock Exchange, the Athens Stock Exchange and Nordpool have selected the integrated Click/Secur package. The source close to the Botcc's board says that the integrated offerings definitely provide the CME and OM with an edge in the battle for clearing contracts. "If you're a B2B or a new exchange, you need a trading vehicle and you need a clearing vehicle. They've got both of those systems, and the Botcc really only has one," says the source. However, citing the development of Meta-Clear and the clearing corp.'s new clients-as well as its 76 years of experience-the Botcc's Dutterer says his firm matches up well with every other clearinghouse. While conceding that the likes of the CME, OM and LCH may have a larger client base of exchange customers to refer potential clients to, Dutterer adds that customer references will not make or break any clearing deal. "Large sophisticated organizations won't look solely at existing clients. They won't buy a Chevrolet just because their brother bought a Chevrolet. Rather, they will sit down and (evaluate) what features are offered," he says. The source close to the Botcc agrees that exchanges are looking deeper than just client references when they search for clearing solutions. However, he says that in the U.S., at least, the public perception is that the CME Clearing House is better positioned than the Botcc. ""I think the Botcc product line may be better than the CME's clearing offerings, but the Merc does a better job with marketing," the source says. The CME Clearing House, he elaborates, also has an edge because it is owned by an exchange that has already gone for-profit-and is therefore "more aggressively" seeking new business opportunities. That said, regardless of which Chicago clearinghouse holds an advantage today, rampant speculation about consolidation continues to cloud the future of the Botcc and CME Clearing House. A couple of years back, of course, those organizations signed a letter of intent to merge-but never finalized the deal. However, pointing to merger talks that took place earlier this year between the Botcc and the Options Clearing Corp., the source close to the Botcc says that consolidation, in the name of survival, is inevitable. "I don't really see a lot of opportunities for growth in the U.S. clearing market. Instead, I see consolidation. All of these clearing organizations in the U.S. are not going to make it," the source prognosticates. **End of ISDA Press Report for September 20, 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. Scott Marra Administrator for Policy & Media Relations ISDA 600 Fifth Avenue Rockefeller Center - 27th floor New York, NY 10020 Phone: (212) 332-2578 Fax: (212) 332-1212 Email: smarra@isda.org
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