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McDonough: Celebrating the 30th Anniversary of the International Monetary Market
May 14, 2002
William J. McDonough, President and Chief Executive Officer
Remarks by President William J. McDonough before the Chicago Mercantile Exchange I am delighted to be back in Chicago this afternoon. I want to thank my old friend Leo Melamed for inviting me to speak at the Chicago Mercantile Exchange luncheon celebrating the 30th anniversary of the International Monetary Market or IMM. The IMM, which began operations on May 16, 1972, was the first futures exchange created explicitly for trading in financial instruments. As such, with the subsequent development of computer technology, it played a large role in the emergence of financial derivatives, which today trade on markets throughout the world and are a daily fact of financial life.
In my remarks this afternoon, I would like to focus on a few aspects of derivatives markets that are of particular interest to me. More specifically, I want to argue in favor of better disclosure of derivatives transactions and more transparency in the use of derivatives and the risks against which they hedge. With improvements in disclosure and increased transparency, we may do a great deal to dispel some public misperceptions about how derivatives function and their usefulness in today's financial markets.
It's sometimes easy to forget the important role derivatives play in the financial markets when they usually appear in news stories about major financial failures, whether Barings, Metallgesellschaft, Orange County, LTCM, or more recently, Enron. The sources of these financial failures, however, are not derivatives per se, but rather weak risk management and corporate governance practices. Nonetheless, a gap in understanding seems to persist between public perceptions of derivatives and practitioners' actual use of them.
I believe that this basic misunderstanding has the potential to produce bad public policy when, in the heat of the next financial crisis, suspicions lead to cries that go well beyond reason or prudence to do something once and for all about derivatives. In my view, it is incumbent on the financial industry and market participants who are active in derivatives to make the effort to advance the public's understanding of these instruments, and to do it now.
The success of such an initiative, however, depends crucially on achieving greater transparency of derivatives markets and better disclosure of how individual firms use derivatives instruments in their businesses. Without question, the failure of accounting and disclosure practices to keep pace with financial innovation has contributed to the problems we face with respect to the publics understanding of derivatives activities.
The potential for reputational damage from misunderstandings about derivatives is particularly acute. The inherent leverage of a derivatives contract, its flexibility, and the failure of traditional accounting and disclosure practices to incorporate derivatives meaningfully into a firm's overall risk profile make these instruments susceptible to misuse. In my view, the best way to safeguard the prudent use of financial derivatives is to improve not only risk management procedures but also accounting and disclosure practices. In the absence of such improvements, derivatives markets will be vulnerable to mistaken finger pointing whenever a new financial crisis erupts.
Derivatives, a basic financial tool
The use of financial derivatives has grown tremendously over the past two decades as advances in computing and data processing technology have made possible ever more sophisticated quantitative risk management and pricing systems. At the same time, the intermediation of funds between savers and investors has increasingly been done with capital market securities instead of banking products.
This capital-market-based system of intermediation relies heavily on prices. In such an environment, changes in benchmark interest rates are felt quickly by all participants in the financial system, from those in the wholesale markets to homeowners in the residential mortgage market. These developments have created a need for financial instruments that can help manage market and price risks for investors as well as for issuers of securities. Derivatives meet this need. To date, they have proven to be an effective tool for the transfer of financial risk from those wishing to shed such risk to those more willing to accept it.
Todays residential mortgage market, or how risk is moved from Main Street to the financial markets
It is clear that derivatives should not be thought of as high-performance financial tools that only have the potential to cause trouble. On the contrary, the use of derivatives in reallocating risk provides real benefits. A case in point is the use of derivatives to manage interest rate risk.
Almost all residential mortgages in the United States, for example, contain a prepayment option that is an important benefit to homeowners. This embedded option allows homeowners to refinance a mortgage if and when they find it to be financially advantageous, while at the same time allowing them to cap their costs by borrowing at a fixed rate of interest. But allowing homeowners to undertake such a transaction exposes mortgage lenders to potentially severe interest rate risk.
In fact, before the interest rate derivatives markets were developed, the volatility of interest rates during the late 1960s and 1970s in the United States critically weakened the country's savings and loan institutions and set the stage for what became a major crisis by the early 1980s. These savings and loan institutions had failed to hedge their exposure to interest rate risk, in part because of the absence of efficient hedging instruments at that time.
Today, mortgage lenders can offer borrowers fixed-rate mortgages with prepayment options at relatively low spreads because of risk management tools that are now widely used in the mortgage market. These innovations, among which interest rate derivatives are prominent, have enabled interest rate risk in mortgage lending to be reallocated and dispersed, moving it from the lenders to those investors more willing to bear a portion of those risks. In the absence of these financial innovations, todays mortgage market would not have the flexibility and liquidity that are such a benefit to borrowers.
I want to be clear here. The reason why derivatives are so important is they allow interest rate risk to be unbundled and traded separately from the issuance of, or investments in, fixed-income securities. With derivatives, a lender can transfer interest rate exposure to an investor or speculator more willing to bear that risk.
The Federal Reserves Y2K options on repurchase agreements
The Federal Reserves use of options on repurchase contracts to stabilize the financing markets in the months leading up to the Y2K century-date change is another example of the positive use of derivatives. Signs of an aversion to funding risk surrounding Y2K were apparent throughout the spring and summer of 1999. To help ensure that market liquidity in the fixed-income markets remained at reasonable levels, the Federal Reserve held auctions of options on repurchase agreements that could be exercised in the period around year-end.
These options enabled market participants to establish predictable funding arrangements for their year-end positions. In so doing, the options encouraged marketmaking and the maintenance of liquid financing markets in the period surrounding the century-date change. A sign of the effectiveness of these repo options was the behavior of year-end funding premiums. These premiums declined substantially at key times during the options program, such as when the options were first announced, after the early auction results were reported, and later on when the number of auctions was extended.
Risk and derivatives
Based on our experience, it seems clear that the intrinsic leverage of a derivatives contract improves the efficiency with which capital is used in trading activity, thereby increasing turnover volume and market liquidity. This liquidity makes it easier for market participants to reallocate risks. I thus share Chairman Greenspans view that derivatives help to disperse financial risks, reduce risk concentrations, and generally make the economy more resilient and better able to withstand financial shocks.
Because derivatives play a prominent role in trading activity and the reallocation of risk in the economy, by their very nature they are likely to be on the premises when financial crises strike. Their mere presence, however, does not make them an inherent source of risk. This is why I believe that it is the critical task of those responsible for risk management, accounting, disclosure, and corporate governance to ensure that the financial tools they draw on-- of which a derivatives contract is only one--are properly used and explained.
The need for participants active in derivatives markets to continue to improve their risk management and control capabilities is especially important in the face of ongoing growth and innovation in the financial markets. All aspects of risk management are important, including senior management oversight, new product approval processes, due diligence for appropriateness, and effective risk measurement and aggregation in both market risk and credit risk.
In addition, the financial industry needs to continue to sustain the progress it has already made in understanding the market, credit, and liquidity risks arising from its trading and derivatives activities. More specifically, financial institutions must be capable of aggregating their exposures to counterparty credit risk across traditional lending and derivatives activities at the level of both their business lines and the overall firm. The flexibility of a derivatives contract makes it especially important for senior management to understand the ultimate purpose for which derivatives are used so that the risks involved can be managed properly.
The financial industry and the public
Although Im reasonably certain that most market participants understand and probably agree on the appropriate use of derivatives, I believe that the public should be equally well informed. The public needs to know generally about the role that derivatives play in todays economy and specifically about how derivatives affect the financial condition of the firms in whose securities they invest.
The financial industry must make an effort to improve transparency in both these general and specific respects. The cost of not doing so is to leave the financial system susceptible to repeated and often ill-considered demands to fix a derivatives problem that might not exist. Only with better information and greater transparency regarding how financial innovations are used will the public be able to understand and assess the true causes of the financial problems that will inevitably occur from time to time.
The need for a better public understanding of derivatives transcends the issue of regulated versus unregulated markets. As any risk manager will tell you, a trader can run up large losses with either an exchange-traded futures contract in a regulated market or an over-the-counter forward contract in an unregulated market.
In fact, the financial problems cited earlier involved both exchange-traded and over-the-counter derivatives. In the Barings and Metallgesellschaft cases, exchange-traded futures contracts were the tool with which traders got themselves into trouble. In the LTCM case, a forced unwinding of the firms positions in the event of a default would have wreaked havoc in both the exchange-traded and over-the-counter markets. Thus, all participants in derivatives activities have a shared interest in providing the public with a better understanding of these instruments, regardless of the specific markets in which the instruments trade.
What might the financial industry do?
In short, the financial industry needs to make a greater effort than it has to date to educate the public about derivatives and their use. A well-informed public is the best foundation for good policy relating to financial markets.
At the same time, the financial industry must recognize that an educational effort will lack credibility if the use of derivatives remains opaque. To be successful in improving the public's understanding of derivatives, the initiative requires improved transparency in derivatives markets and in the ways individual firms use these products. So whats to be done?
Accounting and disclosure
One of the most important efforts that the financial industry should undertake is to improve accounting and disclosure practices. Many officials have for some time recognized that accounting and disclosure practices have lagged behind the growing use of financial derivatives. In a 1994 BIS report titled "Public Disclosure of Market and Credit Risks by Financial Intermediaries," the central banks of the G-10 countries described how financial firms internal risk management and risk assessment practices had moved far ahead of the information available to shareholders and bondholders. The report urged that meaningful information about financial risks be included in firms public disclosures. Although leading financial institutions have made significant improvements in their disclosure practices since 1994, recent events have reminded us how important the integrity of accounting and disclosure is for all firms, both financial and nonfinancial.
If market discipline is to be strengthened, a renewed commitment to improving disclosure practices is necessary because the transparency of risk and outcomes to outsiders provides a strong incentive for firms to conduct their risk management properly. Market discipline is a fundamental part of financial stability. Indeed, the proposed new Basel Capital Accord assigns a key role to transparency and market discipline along with risk-based capital requirements and the supervisory process.
Accounting and disclosure practices should ensure that an institutions derivatives positions are meaningfully integrated into an overall view of the firms financial condition and exposure to financial risks. A firms derivatives positions can so fundamentally modify its exposure to financial risks that it is no longer acceptable to ignore their potential effects in the firms statements of its financial condition. Although banks and securities firms certainly have made important advances in the ways they include derivatives positions in their financial statements, I am convinced that they--as well as other types of institutions--can provide still more meaningful and informative disclosure.
Events in the past several months have clearly shown that the accounting improvements that need to be made go beyond the issue of derivatives per se. A common feature of recent financial crises, including those involving derivatives, is how financial innovation has made traditional accounting measures of leverage almost meaningless. Financial derivatives by their very nature can make a firms true leverage be far higher than it appears in traditional accounting statements or management reports. Other financial innovations, such as off-balance-sheet funding vehicles with contingent liabilities to the issuer, can also make a firms leverage far higher than what is disclosed in a traditional financial statement.
For risk managers, leverage is viewed as an institutions exposure to risk relative to its capacity to bear that risk. This understanding of leverage, however, appears to be difficult to capture in traditional accounting practices. The contrast between the way in which risk is assessed and understood by the best practitioners of risk management and the ways in which it is rendered opaque in traditional accounting and disclosure statements is growing ever more stark.
A critical challenge facing the financial industry today is how to describe leverage in meaningful ways in accounting and disclosure statements. Leading institutions in the financial industry have recognized and begun to address this problem, as demonstrated by the 1999 report by the Counterparty Risk Management Policy Group on "Improving Counterparty Risk Management Practices."
Although some improvements in disclosure practices could be achieved if institutions were willing to disclose information they already capture and track internally, other improvements require the development of better tools for characterizing risks. Risk assessments by their very nature can be a challenge to undertake and describe, especially with regard to liquidity risk and the effects of leverage. In these areas, improvements in disclosure practices might best be realized through initiatives in which the financial industry takes a leading role. Indeed, the need for cooperative efforts between the financial industry and their supervisory authorities was a conclusion of a 2001 BIS-published report, "Multidisciplinary Working Group on Enhanced Disclosure," on how to improve public disclosure.
Transparency of markets
There is no doubt that the derivatives markets, like
any market, are better understood when data are available describing how derivatives are used and by what types of market participants. I recognize that such information is available for many derivatives products and has served to allay concerns. Nevertheless, it is also clear that the availability of market data all too frequently lags behind financial innovation. Technological innovation, however, has made information much less expensive to produce, and we should be seeing steady progress in closing the gap.
A factor working against increased transparency is that dealers in derivatives markets often do not wish to reveal much about their customers or business because these revelations might compromise proprietary commercial objectives. I think these concerns are exaggerated. There is a broad middle ground between where we are today and a level of detail that starts to reveal proprietary information. Market participants might be well advised to consider the longer view and acknowledge that opaqueness can lend itself to a hunt for the usual suspects in a crisis and raise the risk of derivatives being falsely accused of having contributed to the crisis.
To conclude, I want to reiterate that I view financial derivatives as effective tools that enable practitioners in the capital markets to trade and manage risks. Without these instruments, the financial system would be far less efficient and far less able to fulfill its promise of being a stable and low-cost provider of funds to the real sectors of the economy. In order to preserve widespread public acceptance of derivatives and financial innovation, however, the users of financial derivatives must do a much better job of making these instruments more transparent to the public. The need for this transparency is critical because the inherent leverage in derivatives and the failure of traditional accounting and disclosure practices to include the effects of derivatives activities in a firms risk profile make them susceptible to misuse and misunderstanding.
Improvements in accounting and disclosure practices will help safeguard the proper use of financial derivatives. Transparency not only will provide a healthy incentive for firms to manage their risks prudently but also will contribute to a better public understanding of derivatives instruments. In the absence of these needed improvements, the derivatives markets will remain vulnerable to mistaken responses by the public to financial crises. Preemptive efforts by financial industry participants and end-users to foster greater transparency of derivatives markets and individual firms use of derivatives will go a long way toward sustaining the efficiency and robustness of the financial system in this country.