OTC Derivatives: Additional Oversight Could Reduce Costly Sales Practice
Disputes (Chapter Report, 10/02/97, GAO/GGD-98-5).
Pursuant to a congressional request, GAO reviewed the sales practices
for over-the-counter (OTC) derivatives, mortgage-backed securities
(MBS), and structured notes, focusing on the: (1) federal sales practice
requirements applicable to these products and the dealers marketing
them; (2) extent of end-user satisfaction with sales practice, product
use, and related disputes and the costs of these disputes; (3) views of
end-users and dealers on the nature of their relationship and
responsibilities; (4) actions dealers and end-users have taken to reduce
the potential for sales practice disputes; and (5) actions regulators
have taken to address sales practice issues.
GAO noted that: (1) the extent to which OTC derivatives are subject to
federal sales practice requirements intended to protect end-users
varies, depending, in part, on whether they are considered to be
securities, futures, or neither; (2) when they are considered to be
securities or futures, their sale is covered by the federal securities
or commodities laws, and they are regulated by the Securities Exchange
Commission (SEC) and the Commodity Futures Trading Commission (CFTC),
respectively; (3) to the extent that these products are not securities
or futures, end-users with sales practice disputes would need to seek
redress against a dealer by asserting primarily state statutory or
common law claims; (4) in contrast to most OTC derivatives, MBS and
structured notes are typically securities and, thereby, subject to the
federal securities laws, except when exempted from specific provisions;
(5) the extent to which sales practice requirements apply to the dealers
marketing OTC derivatives in the United States also varies, depending on
whether the dealer offering them is regulated; (6) when OTC derivatives
are marketed by banks, they are subject to supervisory guidance issued
by federal bank regulators; (7) securities, futures, and insurance
firms, unlike banks, typically market OTC derivatives that they consider
to be neither securities nor futures from affiliates that are not
subject to any direct federal financial regulatory oversight, although
some individual transactions may be subject to such oversight; (8)
although sales practice requirements vary by product and dealer,
according to GAO's survey, most end-users were generally satisfied with
the sales practices of the dealers with whom they entered transactions;
(9) GAO's survey also found that relatively few organizations reported
using OTC derivatives; (10) GAO's review of regulatory and public
records, covering 1993 through 1996, indicated that cases involving
actual or alleged deficiencies in dealer sales practices were limited in
number; (11) however, the dealers and end-users involved in these cases
often experienced significant costs; (12) although generally satisfied
with dealer sales practices, end-users' views on the nature of
counterparty relationships sometimes differed from those of dealers;
(13) in addition, bank regulators have taken certain actions to address
sales practice issues; and (14) although SEC and CFTC do not directly
regulate the affiliates that securities and futures firms use to conduct
their OTC derivatives activities, SEC and CFTC worked with the most
active of these firms to produce one of two sets of voluntary guidance.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: GGD-98-5
TITLE: OTC Derivatives: Additional Oversight Could Reduce Costly
Sales Practice Disputes
DATE: 10/02/97
SUBJECT: Derivative securities
Securities arbitration
Securities regulation
Mortgage-backed securities
Losses
Interagency relations
Banking regulation
Information disclosure
Futures
Securities fraud
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Cover
================================================================ COVER
Report to the Honorable
Edward J. Markey,
House of Representatives
October 1997
OTC DERIVATIVES - ADDITIONAL
OVERSIGHT COULD REDUCE COSTLY
SALES PRACTICE DISPUTES
GAO/GGD-98-5
OTC Derivatives Sales Practices
(233441)
Abbreviations
=============================================================== ABBREV
CEA - Commodity Exchange Act
CFTC - Commodity Futures Trading Commission
CMO - collateralized mortgage obligation
EUDA - End-Users of Derivatives Association
GFOA - Government Finance Officers Association
GSE - government-sponsored enterprise
ISDA - International Swaps and Derivatives Association
LDT - leveraged derivative transaction
MBS - mortgage-backed security
NASAA - North American Securities Administrators Association
NASACT - National Association of State Auditors, Controllers and
Treasurers
NASD - National Association of Securities Dealers
NAST - National Association of State Treasurers
NYSE - New York Stock Exchange
OCC - Office of the Comptroller of the Currency
OTC - over-the-counter
REMIC - real estate mortgage investment conduit
RSWG - Risk Standards Working Group
SEC - Securities and Exchange Commission
SRO - self-regulatory organization
TMA - Treasury Management Association
Letter
=============================================================== LETTER
B-259982
October 2, 1997
The Honorable Edward J. Markey
House of Representatives
Dear Mr. Markey:
This report presents the results of our review of sales practices for
over-the-counter (OTC) derivatives, mortgage-backed securities, and
structured notes. On the basis of your request that we review sales
practice issues related to OTC derivatives, we report on the
applicable federal requirements, extent of end-user satisfaction with
dealer sales practices, end-user and dealer views on the nature of
their relationship, and actions taken by market participants and
regulators to address sales practice issues. Because disputes and
concerns were also prevalent for transactions involving
mortgage-backed securities and structured notes, we included these
products in our review as well.
This report includes recommendations to the President's Working Group
on Financial Markets to (1) develop a formal mechanism for collecting
data on sales practice issues and (2) consider assisting dealers and
end-users in resolving their disagreements over the nature of their
relationship as a part of OTC derivatives transactions. Also
included are recommendations that the Federal Reserve update its
guidance to better address sales practice issues and that the
Securities and Exchange Commission (SEC) and the Commodity Futures
Trading Commission (CFTC) collect information on the extent to which
securities firms are following the sales practice provisions of
voluntary guidance related to OTC derivatives.
As agreed with you, unless you publicly release its contents earlier,
we plan no further distribution of this report until 7 days from its
issue date. At that time, we will provide copies to interested
members of Congress, appropriate congressional committees, CFTC, the
Department of the Treasury, the Federal Reserve Board, the Office of
the Comptroller of the Currency, SEC, the National Association of
Securities Dealers, and the New York Stock Exchange.
Major contributors to this report are listed in appendix X. If you
have any questions, please call me at (202) 512-8678.
Sincerely yours,
Thomas J. McCool
Director, Financial Institutions
and Markets Issues
EXECUTIVE SUMMARY
============================================================ Chapter 0
PURPOSE
---------------------------------------------------------- Chapter 0:1
In 1994, some users of over-the-counter (OTC) derivatives,\1
mortgage-backed securities (MBS),\2 and structured notes\3
experienced large and highly publicized losses. Allegations or
evidence of deficient dealer\4 sales practices were associated with
some of these losses, raising congressional concerns about whether
end-users\5 were adequately protected against such practices. In
response to these concerns, the former Chairman of the Subcommittee
on Telecommunications and Finance, House Committee Energy and
Commerce, requested that GAO determine the prevalence of disputes in
the sale of OTC derivatives. Because market participants and others
also expressed concerns about sales practices associated with MBS and
structured notes, GAO expanded its review to include these products.
To address concerns associated with sales practices for OTC
derivatives, MBS, and structured notes, GAO analyzed (1) the federal
sales practice requirements applicable to these products and the
dealers marketing them; (2) the extent of end-user satisfaction with
sales practices, product use, and related disputes and the costs of
these disputes; (3) the views of end-users and dealers on the nature
of their relationship and responsibilities; (4) the actions dealers
and end-users have taken to reduce the potential for sales practice
disputes; and (5) the actions regulators have taken to address sales
practice issues.
--------------------
\1 OTC derivatives are privately negotiated financial contracts whose
market value is determined by the value of an underlying asset,
reference rate, or index.
\2 MBS are debt securities that are created from pools of residential
mortgages. Investors in MBS receive the interest and principal
payments generated by the mortgage pools.
\3 Structured notes are debt securities whose principal and interest
payments vary according to specific formulas or as a result of
changes in exchange rates or equity and commodity prices; they may
also contain derivatives.
\4 Dealers stand ready to act as buyers, sellers, counterparties, or
intermediaries for end-users and other dealers.
\5 For simplicity, GAO uses the term end-user to refer to
counterparties or customers of dealers in transactions involving OTC
derivatives, MBS, and structured notes.
BACKGROUND
---------------------------------------------------------- Chapter 0:2
Innovative and often complex financial products known as OTC
derivatives can be used to manage financial risks associated with
volatility in interest rates, foreign exchange rates, and equity and
commodity prices. OTC derivatives can also allow end-users to
increase investment yields and reduce borrowing costs. These
benefits do not come without risk because using OTC derivatives,
similar to using other financial products, can result in losses from
adverse market movements, credit defaults, or operations errors.
The notional/contract amount\6 outstanding of OTC derivatives was
estimated at $47.5 trillion worldwide and $11 trillion in the United
States, as of March 1995.\7 The bulk of this volume was in "plain
vanilla," or relatively standardized and uncomplicated, OTC
derivatives contracts. However, more complex contracts whose values
can be based on more than one underlying asset, reference rate, or
index were also being used.
In addition to OTC derivatives, a wide variety of MBS and structured
notes have been issued by government-sponsored enterprises (GSE)\8
and private companies to finance their operations. In 1996,
issuances were $474 billion for MBS and $12 billion for GSE-issued
structured notes.
Dealers of OTC derivatives, MBS, and structured notes are primarily
U.S. and foreign banks, registered broker-dealers,\9 and affiliates
of securities firms and insurance companies. These dealers may
receive no federal oversight or be overseen by one or more federal
regulators, including the Federal Reserve System, the Office of the
Comptroller of the Currency (OCC), the Securities and Exchange
Commission (SEC), the Commodity Futures Trading Commission (CFTC),
and various industry self-regulatory organizations (SRO).\10 The
federal financial market regulators jointly address issues related to
OTC derivatives, MBS, and structured notes through the President's
Working Group on Financial Markets. This group, which is chaired by
the Secretary of the Treasury, considers issues concerning the
competitiveness, integrity, and efficiency of the financial markets.
To gather information about end-users of OTC derivatives, MBS, and
structured notes, GAO sent questionnaires to the financial officers
of nearly 2,400 randomly selected U.S. organizations in 1995.
Designed to be representative of U.S. public-sector and
private-sector entities, the sample was drawn from over 49,000 U.S.
organizations that GAO identified as potential end-users of one or
more of the products, and the sample was stratified by industry and
organization size.\11 GAO received about 1,800 responses to the
survey, allowing statistically valid estimates for the population of
(1) the level of satisfaction these organizations experienced with
dealers' sales practices and (2) the extent to which these products
were used across the organizations. In addition, GAO followed-up
with about 50 survey respondents to obtain more information about
their use of these products and satisfaction with dealer practices.
--------------------
\6 The notional amount is the amount upon which payments between
parties to certain types of derivatives contracts are based. When
this amount is not exchanged, it is not a measure of the amount at
risk in a transaction. According to the Federal Reserve, the amount
at risk, as measured by the gross market value of OTC derivatives
outstanding, was $328 billion for U.S. entities, as of March 1995,
or about 3 percent of the notional/contract amount. (The gross
market value is the cost that would be incurred if the outstanding
contracts were replaced at prevailing market prices.)
\7 These estimates were based on a comprehensive survey done by the
Bank for International Settlements and represent the most current
data available. The Bank for International Settlements, among other
functions, provides a forum for cooperative efforts by the central
banks of major industrial countries.
\8 GSEs are privately owned financial intermediaries established
pursuant to federal law to facilitate lending for purposes that the
federal government has deemed socially important, such as education,
agriculture, and housing.
\9 Broker-dealers are agents that handle public orders to buy and
sell securities. They also act as principals that buy and sell
securities for their own accounts.
\10 SROs play an extensive role in the regulation of the U.S.
securities and futures industries. SROs include all of the U.S.
securities and commodities exchanges, the National Association of
Securities Dealers, the National Futures Association, and the
Municipal Securities Rulemaking Board. In addition, state agencies
also oversee banking, securities, and insurance activities, although
this report does not address such oversight in detail.
\11 See appendix I for information on the survey sample design.
RESULTS IN BRIEF
---------------------------------------------------------- Chapter 0:3
The extent to which OTC derivatives are subject to federal sales
practice requirements intended to protect end-users varies,
depending, in part, on whether they are considered to be securities,
futures, or neither. When they are considered to be securities or
futures, their sale is covered by the federal securities or
commodities laws, and they are regulated by SEC and CFTC,
respectively. To the extent that these products are not securities
or futures, end-users with sales practice disputes would need to seek
redress against a dealer by asserting primarily state statutory or
common law claims.\12 In contrast to most OTC derivatives, MBS and
structured notes are typically securities and, thereby, subject to
the federal securities laws, except when exempted from specific
provisions.
The extent to which sales practice requirements apply to the dealers
marketing OTC derivatives in the United States also varies, depending
on whether the dealer offering them is regulated. When OTC
derivatives are marketed by banks, they are subject to supervisory
guidance issued by federal bank regulators. This guidance is
primarily intended to ensure that OTC derivatives activities do not
adversely affect the financial condition of banks. Securities,
futures, and insurance firms, unlike banks, typically market OTC
derivatives that they consider to be neither securities nor futures
from affiliates that are not subject to any direct federal financial
regulatory oversight, although some individual transactions may be
subject to such oversight.
Although sales practice requirements vary by product and dealer,
according to GAO's survey of a broad range of U.S. organizations,
most end-users were generally satisfied with the sales practices of
the dealers with whom they entered transactions. GAO's survey also
found that relatively few organizations reported using OTC
derivatives. About 10 percent reported using plain vanilla OTC
derivatives, and 2 percent reported using more complex OTC
derivatives. Within each type of industry, the larger organizations
were the predominant users of these products.
Furthermore, GAO's review of regulatory and public records, covering
1993 through 1996, indicated that cases involving actual or alleged
deficiencies in dealer sales practices were limited in number.
However, the dealers and end-users involved in these cases often
experienced significant costs. These were primarily sales
practice-related costs associated with compliance risk--such as
litigation costs and regulatory fines--and reputation risk--such as
reduced revenues and income due to a diminished business or
professional reputation.
Although generally satisfied with dealer sales practices, end-users'
views on the nature of counterparty relationships sometimes differed
from those of dealers. According to GAO's survey, about one-half of
all end-users of plain vanilla or more complex OTC derivatives
believed that a fiduciary relationship of some sort existed in some
or all transactions between them and their dealer. Some end-users
told GAO that this meant dealers had an obligation to provide
accurate product descriptions and disclose material risks. In
comparison, two dealer groups issued guidance asserting that such
transactions are conducted on a principal-to-principal, or an
"arm's-length," basis unless more specific responsibilities are
agreed to in writing or otherwise provided by law. According to this
guidance, end-users would be expected to make their own decisions
about a transaction without relying on statements made by dealers.
Representatives of end-users and dealers have called for both sides
to reach agreement on this issue, with some indicating that federal
financial market regulators could play a role in resolving
differences. Notwithstanding the disagreement over the nature of
their relationship, some dealers and end-users have taken
steps--individually and collectively--to reduce the potential for
sales practice-related disputes to arise.
In addition, bank regulators have taken certain actions to address
sales practice issues. In 1993 and 1994, OCC and the Federal Reserve
issued guidance for use by their examiners and the banks they
regulate covering the marketing of OTC derivatives, MBS, and
structured notes. GAO also found that these regulators had conducted
examinations that were generally thorough in addressing banks' sales
practices. However, in conducting these examinations, regulators
addressed areas that were not listed in their guidance, including
several key areas in which alleged deficiencies in dealer practices
have led to costly disputes with end-users. In 1997, OCC updated its
guidance to address these weaknesses. The Federal Reserve has not
yet issued updated guidance, but plans to do so by the end of 1997.
The revisions are to address the areas not specifically covered in
its current guidance.
Although SEC and CFTC do not directly regulate the affiliates that
securities and futures firms use to conduct their OTC derivatives
activities, SEC and CFTC worked with the most active of these firms
to produce one of two sets of voluntary guidance. This guidance
presents a framework of management systems and controls for the
participating firms to follow related to sales practices. However,
the guidance does not provide for SEC and CFTC to receive information
about the extent to which participating firms follow its sales
practice provisions. Adherence to these provisions is important to
promoting market fairness and integrity.
Although GAO found that the extent to which sales practice
requirements apply to OTC derivatives and their dealers vary,
end-users were generally satisfied with the sales practices of the
dealers they used and sales practice disputes were limited in number.
However, these findings must be viewed in the context of the
relatively small number of end-users and dealers active in these
markets as well as their relatively high level of financial
sophistication. If new dealers enter the markets, use of complex
products becomes more widespread, or marketing to or product use by
less sophisticated end-users increases, disputes over sales practices
might increase. This could cause the financial market regulators to
reconsider whether sales practice requirements for OTC derivatives
are sufficient to protect end-users from abusive practices.
--------------------
\12 Common law is derived from judicial decisions rather than from
statute.
PRINCIPAL FINDINGS
---------------------------------------------------------- Chapter 0:4
FEDERAL SALES PRACTICE
REQUIREMENTS VARY
-------------------------------------------------------- Chapter 0:4.1
The federal sales practice requirements intended to protect end-users
of OTC derivatives vary, depending on whether the product involved is
a security, futures contract, or neither and on whether the dealer is
regulated. OTC derivatives that fall within the definition of a
security or futures contract are generally subject to the antifraud
provisions of the federal securities or commodities laws,
respectively. Their sale is also subject to SEC and CFTC
oversight.\13 The antifraud provisions of the securities and
commodities laws place certain obligations on those marketing
securities or futures. For securities, these obligations include
disclosing material information about and assessing the suitability
of a product before recommending a transaction. For futures, these
obligations include disclosing product risks and obtaining
information on the financial condition of the end-user before
engaging in transactions. To the extent that a specific OTC
derivative product is not covered by federal securities and
commodities laws, end-users with sales practice disputes would need
to seek redress against a dealer by asserting primarily state
statutory or common law claims, such as fraud or breach of fiduciary
duty.\14
Although SEC and CFTC actions can indicate whether they consider
certain types of OTC derivatives to be securities or futures, such as
when the agencies respond to inquiries about specific proprietary
contracts a dealer is developing, these actions have not covered all
OTC derivatives. For example, CFTC has exempted certain swaps\15 and
other OTC derivatives from almost all provisions of the Commodity
Exchange Act (CEA); however, it did so without determining that such
products were futures.\16
Furthermore, CFTC did not exempt swaps from the act's antifraud
provisions, but such provisions only apply insofar as swaps are found
to be futures or commodity options.\17 In addition, SEC and CFTC have
taken a cooperative enforcement action against one dealer, Bankers
Trust,\18 for violating the antifraud provisions of the federal
securities and commodities laws in connection with OTC derivatives it
marketed. In contrast to most OTC derivatives, MBS and structured
notes are typically securities and subject to the federal securities
laws, except when exempted from specific provisions.\19
The sales practice requirements applicable to OTC derivatives in the
United States also vary, depending on whether the dealer offering
them is regulated. Banks marketing these products are overseen by
federal bank regulators who are responsible for ensuring the safety
and soundness of banks. To address this responsibility, bank
regulators issued guidance in 1993 and 1994 applicable to the
marketing of OTC derivatives that requires banks to take steps to
ensure that such transactions are understood and are appropriate for
the end-user. Banks marketing MBS and structured notes that are
securities are also subject to the antifraud provisions of federal
securities laws. As such, they are tasked with providing risk
disclosures and assessing the suitability of these products before
recommending them to an end-user.
Although SEC oversees securities firms and CFTC oversees futures
firms, these firms typically market OTC derivatives that are not
securities or futures\20 through affiliates that are not subject to
either regulator's direct oversight. Similar to securities and
futures firms, insurance firms typically market these products from
affiliates that are not subject to direct federal or state financial
regulatory oversight. Nonetheless, if SEC or CFTC determined that a
specific transaction was a security or a futures contract, it would
be subject to that agency's laws and jurisdiction, absent an agency
exemption\21 or a successful court challenge.
After considering the market's characteristics, the President's
Working Group on Financial Markets concluded that the existing
authority of these agencies as well as current sales practice
requirements for OTC derivatives are adequate to protect end-users
and the financial markets. Additionally, Working Group participants
told GAO that the agencies comprising the group do not routinely
collect information on sales practice-related market characteristics,
such as changes in the number of disputes or in the types of
end-users being offered certain products. Therefore, the Working
Group has no formal mechanism for identifying changes in market
characteristics that would cause it to reassess the adequacy of
existing sales practice requirements for OTC derivatives.
--------------------
\13 SROs assist SEC and CFTC in implementing the federal securities
and commodities laws.
\14 End-users could also seek redress under the federal Racketeer
Influenced and Corrupt Organizations Act. In addition, dealers may
be subject to federal criminal enforcement actions under applicable
mail fraud or wire fraud statutes.
\15 Swaps are OTC derivatives contracts that typically require
counterparties to make periodic payments to each other for a
specified period. The calculation of these payments is based on an
agreed-upon amount, called the notional amount, that is not typically
exchanged.
\16 CFTC was granted this exemptive authority by the Futures Trading
Practices Act of 1992 (P.L. 102-546). See The Commodity Exchange
Act: Legal and Regulatory Issues Remain (GAO/GGD-97-50, Apr. 7,
1997).
\17 Commodity options give the purchaser the right, but not the
obligation, to buy or sell a specified quantity of a commodity or
financial asset at a particular price on or before a certain date.
\18 Unless otherwise indicated, Bankers Trust refers to the parent
firm--Bankers Trust New York Corporation, which is a bank holding
company--and two of its wholly owned subsidiaries--Bankers Trust
Company, which is a bank, and BT Securities Corporation, which is a
securities broker-dealer.
\19 Structured notes that are hybrid financial instruments could be
futures or commodity option contracts if they do not meet the terms
and conditions of CFTC's hybrid instrument exemption (17 C.F.R. Part
34). A hybrid financial instrument possesses, in varying
combinations, characteristics of forwards, futures, options,
securities, and/or bank deposits. Unlike many other derivatives,
hybrid financial instruments generally serve a capital-raising
function. For the purposes of this report, GAO assumed that
structured notes meet the conditions of CFTC's hybrid exemption and,
therefore, are securities and not futures.
\20 Firms would also typically market OTC derivatives that CFTC has
exempted from the CEA from these unregulated affiliates.
\21 SEC has not exempted any products from the antifraud provisions
of the securities laws. Similarly, except for certain energy
products, CFTC has not exempted any products from the antifraud
provisions of the CEA.
SATISFACTION WITH SALES
PRACTICES WAS HIGH AND
DISPUTES WERE LIMITED, BUT
LOSSES WERE OFTEN LARGE
-------------------------------------------------------- Chapter 0:4.2
According to GAO's 1995 survey of a broad range of U.S.
organizations, most end-users were generally satisfied with the sales
practices of dealers marketing OTC derivatives, MBS, and structured
notes. For plain vanilla OTC derivatives, 2 percent of the
organizations that had used these products reported being somewhat or
very dissatisfied with the sales practices of the dealers they
used.\22 For MBS, 7 percent of the end-users reported being
dissatisfied with the dealers they used; for structured notes, 13
percent of the end-users reported being dissatisfied.
GAO's survey found that OTC derivatives were used less frequently
than either MBS or structured notes. It found that 10 percent of the
population reported using plain vanilla OTC derivatives, while 24
percent reported using MBS and 16 percent reported using structured
notes. Also, the reported use of these products was comparatively
greater for large organizations than for small organizations.\23
Nonetheless, in certain industries, small organizations reported
active use of these products. For example, smaller banks, credit
unions, and insurance companies, as a group, reported using MBS and
structured notes at about twice the rate as did all other
organizations combined.
GAO's review of complaints filed with regulators, regulatory
enforcement actions, and public records of litigation, from 1993
through 1996, also indicated that sales practice problems involving
OTC derivatives, MBS, and structured notes were not widespread.
Moreover, a majority of these instances of alleged sales practice
problems were attributable to a small number of dealers. The
specific concerns generally involved dealers misrepresenting
potential transaction risks or offering products that were unsuitable
for the end-user.
Using public information and regulatory data, GAO identified 360
end-users losses\24 that involved OTC derivatives, MBS, and
structured note transactions with U.S. dealers.\25 These losses
totaled over $11.4 billion, with the earliest loss occurring in April
1987 and the latest loss occurring in March 1997. Sales practice
concerns were raised by end-users or regulators in 209, or 58
percent,\26 of these losses and were associated with an estimated
$3.2 billion in losses. Although many of these losses were large,
they involved a relatively limited number of dealers. Of the
end-user losses with sales practice concerns, 18 involved OTC
derivatives, but one dealer--Bankers Trust--was involved in 9 of
these losses. MBS and structured notes were used more often than OTC
derivatives and were associated with more sales practice concerns.
For these products, GAO identified 190 losses with sales practice
concerns; however, 8 dealers were involved in 148 of these losses.
Similarly, GAO's review showed that regulators were investigating as
many as 44 dealers from 1993 to 1996, but only a small number of the
investigations involved multiple end-users. Given the many thousands
of transactions in OTC derivatives, MBS, and structured notes and the
hundreds of billions of dollars at risk in these transactions over
the period reviewed, GAO found that sales practice concerns were not
widespread.
Although the number of reported problems was limited during the
period GAO reviewed, many of the transactions in which concerns over
dealer sales practices arose entailed serious losses for the
end-users involved. For example, Procter & Gamble reported an after
tax loss of $102 million on its complex OTC derivatives transactions
with Bankers Trust. Various organizations reported losses involving
MBS that were as high as $660 million. Additionally, in 1994, Orange
County, CA, announced losses totaling $1.7 billion on its use of
various products, including structured notes.
The dealers and end-users in these cases also frequently incurred
significant compliance and reputation risk costs. For example,
Bankers Trust's compliance risk costs have totaled at least $400
million, including regulatory fines, legal fees, and other costs
associated with end-user litigation settlements. The impact on its
reputation was evidenced, at least in part, by the subsequent
declines in its revenues, profits, and stock price. In addition,
Orange County faces compliance losses from suits by its investment
pool participants, SEC actions against the county's staff, and a
countersuit by a dealer, Merrill Lynch. The county's credit rating
has also been lowered, causing it to pay higher rates of interest on
the debt used to finance its operations.
--------------------
\22 The number of survey respondents that used more complex OTC
derivatives was too small to reliably estimate dissatisfaction.
\23 Large organizations were usually those in the top 10 percent of
their respective industry/government grouping on the basis of their
assets, revenues, or other indicators of financial size. All other
organizations were considered small.
\24 The amount of reported losses includes not only realized losses
but also unrealized losses as well as losses for which the loss
amounts were not reported. In addition, some of the losses may
involve products not covered in this report.
\25 The information in this database was compiled from press accounts
and other public records as well as from nonpublic regulatory data.
Many of the losses are supported by multiple sources, but the
accuracy of the information generally was not confirmed.
\26 This percentage is not a statistically valid estimate of the
actual extent to which sales practice concerns have been raised in
connection with OTC derivatives, MBS, and structured note
transactions. It is based on a compilation of losses that is not
necessarily representative of the population of such transactions.
DISAGREEMENT OVER
COUNTERPARTY
RESPONSIBILITIES INCREASES
THE POTENTIAL FOR DISPUTES
-------------------------------------------------------- Chapter 0:4.3
According to GAO's survey, about 53 percent of end-users of plain
vanilla OTC derivatives believed that dealers had certain fiduciary
responsibilities to end-users in some or all cases. In follow-up
interviews, end-users told GAO that these responsibilities included
accurately describing a product's function and potential performance
as well as adequately disclosing relevant risks. Responses to GAO's
survey also indicated that an estimated 59 percent of plain vanilla
OTC derivatives end-users and a similar percentage of end-users of
more complex OTC derivatives relied on dealers to provide investment
advice from "some" to a "very great extent" as part of these
transactions.
Dealers viewed their responsibilities differently. Two sets of
voluntary guidance issued by dealer groups assert, unless altered by
agreement between the parties or otherwise provided for by law, that
OTC derivatives transactions are conducted at an arm's length,
meaning that each party to the transaction--the dealer and the
end-user--is responsible for ensuring that the transaction is
appropriate.\27 However, some end-users and legal scholars have
questioned the reasonableness of asserting that an arm's-length
relationship always exists between parties to these transactions,
particularly when the end-user is unsophisticated or inexperienced in
the use of a particular product. Others expressed concern that the
dealer-issued guidance does not obligate dealers to fully disclose
the risks of the transactions they propose. For their part, dealers
told GAO that presentations to end-users are designed to explain
potentially useful products and various investment and risk
management alternatives, but should not be construed as investment
advice that end-users should accept without performing their own
internal evaluations. Furthermore, dealers indicated that they would
assume more specific responsibilities, such as acting as an
investment advisor or fiduciary, if such relationships were agreed to
in writing.
Conferences and other forums have provided end-users and dealers
opportunities to hear each other's views. However, as of June 1997,
the parties had not reached agreement on the nature of their
relationship in OTC derivatives transactions, nor did such an
agreement appear imminent. Regulators and others have called for
more discussions between end-users and dealers on this issue. In
addition, some market participants have indicated that federal
financial regulators could assist end-users and dealers in reaching
agreement.
To reduce the likelihood of losses and related sales practice
disputes, some dealers and end-users have acted, individually or as
part of groups, to ensure that their internal controls and practices
are prudent. Various groups of market participants have also offered
guidance and recommended practices to dealers and end-users to
address the risks of financial products, including the risks related
to the sale of these products. The need for these efforts was
demonstrated by the weaknesses in controls and practices that
regulators and others found.
--------------------
\27 The two sets of guidance are the Framework for Voluntary
Oversight, issued in 1995 by the Derivatives Policy Group, which is
comprised of representatives from the six U.S. securities firms
whose affiliates are most active in the OTC derivatives markets, and
The Principles and Practices for Wholesale Financial Market
Transactions, issued in 1995 by various dealer associations under the
auspices of the New York Federal Reserve Bank.
SOME IMPROVEMENTS IN
OVERSIGHT OF REGULATED FIRMS
HAVE BEEN MADE
-------------------------------------------------------- Chapter 0:4.4
In late 1993 and early 1994, the Federal Reserve and OCC issued
guidance for use by their examiners and the banks they regulate
covering the marketing of financial products, including OTC
derivatives, MBS, and structured notes. In response to publicized
sales practice disputes, in 1994 and 1995, these regulators conducted
focused examinations of the largest bank dealers that addressed their
sales practices. The scope of these examinations was broader than
that required by the 1993 and 1994 Federal Reserve and OCC guidance.
Using information from regulators, private groups, and analyses of
losses in which sales practice issues were raised, GAO identified
various elements that a comprehensive examination could include.
Using these criteria, GAO found the bank examinations to be generally
thorough in addressing the key elements related to sales practices.
However, GAO found that the bank regulators' new guidance did not
address several key areas in which dealer practices led to costly
disputes with end-users in the past. For example, it did not direct
examiners to assess the adequacy of bank policies and controls
related to product risk disclosure, fiduciary or advisory
responsibilities, or supervising marketing personnel. In January
1997, OCC expanded its guidance and addressed all of these areas.
The Federal Reserve has not yet issued updated guidance. However,
Federal Reserve officials provided GAO with a draft of the updated
guidance, and the planned revisions would address the elements we
identified as missing in the existing guidance. Federal Reserve
officials said the agency expects to issue the updated guidance by
the end of 1997.
To address ongoing concerns about OTC derivatives use, in 1995, the
six securities firms whose affiliates are most active in the OTC
derivatives markets cooperated with SEC and CFTC in developing the
Framework for Voluntary Oversight.\28 The Framework has resulted in
SEC and CFTC receiving information to supplement the reports they
receive under prior legislation passed in response to the risks of
unregulated activities of registered securities and futures firms.
These supplements are to be voluntarily provided and include
additional reporting to the regulators, pledges by participating
firms to follow certain practices, and external auditor verification
of participating firms' adherence to certain provisions of the
Framework.\29
However, the additional reporting and the external auditor
verification do not extend to the sales practice provisions of the
Framework, which include suggestions for alternative ways of
disclosing transaction risks and providing accurate pricing
information. SEC officials told GAO that they expect participating
firms to follow these provisions because doing so is important for
ensuring market fairness and integrity.
--------------------
\28 The six firms are CS First Boston, Goldman Sachs, Lehman
Brothers, Merrill Lynch, Morgan Stanley, and Salomon Brothers.
\29 Because its OTC derivatives affiliate is subject to oversight in
the United Kingdom, CS First Boston is not subject to the additional
reporting requirements but has committed to adhering to the other
elements of the Framework. SEC officials told us that under SEC risk
assessment rules, the agency receives copies of quarterly financial
reports that the affiliate files with its U.K. regulator.
CHANGES IN MARKET
CHARACTERISTICS COULD AFFECT
THE CURRENT REGULATORY
APPROACH
-------------------------------------------------------- Chapter 0:4.5
Notwithstanding the variance in sales practice requirements that
apply to OTC derivatives and their dealers, end-users were generally
satisfied with the sales practices of the dealers used and sales
practice disputes were limited in number. The individual federal
financial market regulators currently monitor OTC derivatives issues
as part of their oversight of the firms they regulate, and they
discuss new developments in these markets as part of their
participation in the Working Group. Although the Working Group
concluded that, on the basis of existing market characteristics, no
additional sales practice requirements are currently needed for OTC
derivatives, the characteristics that contributed to the high level
of end-user satisfaction and the limited number of sales practice
disputes experienced to date could change as the markets evolve.
These changes could include increased market participation by new
dealers, more widespread use of complex products, or increased
marketing to or product use by less sophisticated end-users. Such
changes to market characteristics could cause the Working Group to
reconsider whether current requirements are adequate to protect OTC
derivatives end-users and the financial markets. However, the
Working Group's lack of a formal mechanism for periodically obtaining
the information on relevant market characteristics means that it
could fail to detect changes that would warrant reassessment of the
adequacy of the sales practice requirements for OTC derivatives.
The potential for additional end-user losses to spark costly sales
practice disputes could affect the soundness of the financial
condition of regulated institutions and perceptions of market
fairness and integrity. The potential for these additional disputes
is heightened because dealers and end-users have not reconciled their
differing views on the nature of counterparty responsibilities in OTC
derivatives transactions. So far, the financial regulators have not
acted to assist the parties in reaching agreement. However, such a
reconciliation of views could have several benefits, including
clarifying positions about transaction risks and uncertainty about
counterparty roles and responsibilities. The Working Group could
provide regulators a forum for assisting end-users. In addition,
unaddressed weaknesses in bank guidance correspond to areas where
sales practice disputes have arisen, and SEC and CFTC lack
information on compliance of unregulated dealer affiliates with the
sales practice provisions of the Framework.
RECOMMENDATIONS
---------------------------------------------------------- Chapter 0:5
GAO recommends that the Secretary of the Treasury, as Chairman of the
President's Working Group on Financial Markets, take the following
actions:
-- Ensure that the Working Group establishes a mechanism for
systematically monitoring developments in the OTC derivatives
markets to assess whether developments warrant introducing
specific federal sales practice requirements.
-- Lead the members of the Working Group in considering the extent
to which it should assist end-users and dealers in reaching
agreement on the nature of their relationship in transactions
involving OTC derivatives.
GAO also recommends that
-- the Federal Reserve Board Chairman implement planned revisions
to the Federal Reserve examination guidance, which are to more
specifically address the need to assess the adequacy of banks'
policies and controls related to disclosing risks, creating
advisory relationships, and supervising marketing personnel and
-- the SEC and CFTC Chairpersons establish a mechanism for
determining that participating firms are following the sales
practice provisions of the Framework for Voluntary Oversight.
AGENCY AND INDUSTRY COMMENTS
AND GAO'S EVALUATION
---------------------------------------------------------- Chapter 0:6
GAO obtained comments on a draft of this report from the heads, or
their designees, of CFTC, the Department of the Treasury, the Federal
Reserve Board, OCC, and SEC. Comments were also obtained from the
National Association of Securities Dealers, the New York Stock
Exchange, the End-Users of Derivatives Association (EUDA); the
Government Finance Officers Association (GFOA); the International
Swaps and Derivatives Association (ISDA); and the National
Association of State Auditors, Comptrollers and Treasurers (NASACT).
The comments are presented and evaluated in chapter 7.
Overall, no consensus emerged on the benefits of implementing GAO's
recommendations. The banking regulators and the associations that
represent primarily end-users generally concurred with GAO's findings
and/or recommendations. The Federal Reserve also stated that this
report makes a useful contribution to assessing the current state of
financial market sales practices. OCC commented that the report is
comprehensive in evaluating sales practices from the perspectives of
dealers, end-users, and regulators. GFOA said this report will be an
extremely helpful reference on derivatives, and NASACT stated that it
provides an excellent study of sales practice issues facing the OTC
derivatives market. In contrast, Treasury and ISDA generally
objected to GAO's recommendations, while SEC's views were mixed.
Regarding the recommendation that the Working Group establish a
mechanism for systematically monitoring developments in the OTC
derivatives markets, SEC and Treasury commented that the Working
Group's current efforts, which generally include the principals
meeting every 6 weeks and the staff meeting every 2 weeks, are
adequate to address market developments. Similarly, ISDA commented
that it is not readily apparent that a formal monitoring mechanism
would be any more effective than the existing structure. In
contrast, EUDA, GFOA, and NASACT supported GAO's recommendation.
EUDA indicated that taking the recommended steps--as they relate to
this and GAO's other recommendation to the Working Group--will lead
to greater market safety and soundness, particularly concerning new
dealers or end-users entering the markets.
GAO continues to believe that the Working Group needs a formal
mechanism for monitoring the OTC derivatives markets. This report
recognizes that the federal financial market regulators monitor the
OTC derivatives activities of the firms subject to their respective
oversight, and they discuss market developments of which they become
aware through their joint participation in the Working Group.
However, this report also observes that the agencies that participate
in the Working Group do not routinely collect the information
necessary to ensure that they are able to systematically detect
changes in market characteristics. Thus, the Working Group lacks a
formal mechanism for obtaining the necessary information for
monitoring market developments related to sales practices. Such a
mechanism is important because it could alert the Working Group to
the need for reassessing the adequacy of existing sales practice
requirements applicable to OTC derivatives. The information to be
assessed could include the number and types of new dealers and
end-users entering the markets, the types of complex new products
being introduced, and changes in the types or sophistication of
end-users to whom products are being marketed.
Treasury and ISDA also objected to GAO's recommendation that the
Working Group consider the extent to which it should assist end-users
and dealers in reaching agreement on the nature of their relationship
in transactions involving OTC derivatives. Treasury was concerned
that, because such relationships are contractual, no single model may
be appropriate. ISDA commented that no need exists for the Working
Group to involve itself in mediating between dealers and end-users,
that the involvement of market participants and regulators to date
has been sufficient, and that the issues involved are complex and
federal involvement may not result in an agreement that is widely
accepted. SEC commented that it believes the Working Group would be
willing to hold discussions with end-users and professional
counterparties (dealers); however, it is not necessary for the
government to intervene and define contractual obligations for
professional and sophisticated counterparties. The Federal Reserve
noted that it has recognized the importance of and encouraged
voluntary industry efforts in this area, and the three end-user
associations supported GAO's recommendation.
GAO continues to support its recommendation that the Working Group
consider assisting market participants in reaching agreement on the
nature of their relationship in OTC derivatives transactions. This
report acknowledges that the issues involved in reaching agreement
between dealers and end-users are complex and may not lend themselves
to a single, widely accepted solution. For this reason, GAO does not
intend that the Working Group impose a model that defines
counterparty relationships in OTC derivatives transactions. However,
GAO's survey indicated that end-users and dealers do not always agree
on the nature of their relationship, as indicated by the majority of
end-users reporting that dealers had fiduciary responsibilities in
some or all OTC derivatives transactions and that they relied on
dealers from some to a very great extent as part of these
transactions. To the extent that the differing views of end-users
and dealers increase the likelihood of sales practice disputes that
expose regulated institutions to material losses or that otherwise
effect the sound financial condition of regulated institutions and
the fairness and integrity of the markets, we concluded that the
federal financial market regulators have an interest in the
reconciliation of these differences.
Treasury officials commented that the draft report appeared to be
critical of establishing an arm's-length relationship as the default
model for OTC derivatives transactions. ISDA officials supported the
arm's-length relationship as the default model, noting that it is the
appropriate starting place for institutional market participants.
This report does not reach a conclusion on the appropriate default
model for counterparty relationships. It presents the views of both
those who support and oppose an arm's-length relationship as the
default model. GAO concludes that the type of relationship and
accompanying responsibilities that should prevail in OTC derivatives
transactions should be agreed-upon by market participants and
recommends that the Working Group consider assisting market
participants in reaching agreement on these issues.
The Federal Reserve commented that it has efforts under way that
would fully respond to GAO's recommendation that the agency revise
its examination guidance to more specifically address the need to
assess the adequacy of banks' policies and controls related to
disclosing risk, creating advisory relationships, and supervising
marketing personnel. In addressing GAO's recommendation that SEC and
CFTC establish a mechanism for determining that participating firms
are following the sales practice provisions of the Framework, SEC
indicated that it is willing to discuss with the affected parties the
feasibility of extending the external auditor's role to incorporate a
review of sales practice procedures. This appears to be an
appropriate first step toward implementing GAO's recommendation.
CFTC did not comment on this recommendation.
INTRODUCTION
============================================================ Chapter 1
In 1994, we reported on a number of risks associated with the use of
over-the-counter (OTC) derivatives,\1 but we did not specifically
address sales practice issues. However, since the beginning of 1994,
major legal and regulatory actions have been associated with sales
practices for OTC derivatives, mortgage-backed securities (MBS), and
structured notes, suggesting that the topic deserved closer scrutiny.
In addition, we found that an estimated $11.4 billion in reported
losses resulted from transactions in such products from April 1987
through March 1997--about $3.2 billion of which involved end-user\2
concerns about dealer\3 sales practices.\4
Federal financial market regulators have an interest in these markets
as a part of their responsibilities for ensuring the soundness of
regulated financial institutions and maintaining the efficiency and
stability of U.S. financial markets. In response to a request by
the former Chairman of the Subcommittee on Telecommunications and
Finance, House Committee on Energy and Commerce, we reviewed sales
practices for OTC derivatives. Because users of MBS and structured
notes had also experienced losses that sometimes involved sales
practice disputes, we expanded our review to include these products.
--------------------
\1 See Financial Derivatives: Actions Needed to Protect the
Financial System (GAO/GGD-94-133, May 18, 1994). We reported on the
status of our recommendations in Financial Derivatives: Actions
Taken or Proposed Since May 1994 (GAO/GGD/AIMD-97-8, Nov. 1, 1996).
\2 For simplicity, we use the term "end-user" to refer to
counterparties or customers of dealers in transactions involving OTC
derivatives, MBS, and structured notes.
\3 Dealers stand ready to act as buyers, sellers, counterparties, or
intermediaries for end-users and other dealers.
\4 See chapter 3 for a discussion of how we estimated the amount of
reported losses and the amount of such losses associated with
concerns about dealer sales practices.
OTC DERIVATIVES
---------------------------------------------------------- Chapter 1:1
OTC derivatives contracts are privately negotiated outside of an
organized exchange and have a market value determined by the value of
an underlying asset, reference rate, or index (called the
underlying). Underlyings include stocks, bonds, agricultural and
other physical commodities, interest rates, currency exchange rates,
and stock indexes. OTC derivatives are customized to satisfy
specific end-user requirements that cannot always be met by the
typically more standardized exchange-traded derivatives, which
include futures\5 and options\6 contracts. Although the economic
terms of OTC derivatives are privately negotiated, counterparties
commonly elect to use standardized contract language contained in
master agreements, such as those developed by the International Swaps
and Derivatives Association (ISDA).\7
Both OTC and exchange-traded derivatives are used by firms around the
world to manage market risk\8 by transferring it from entities less
willing or able to manage it to those more willing and able to do so.
In transferring this risk, OTC derivatives counterparties, unlike
their U.S. exchange-traded counterparts,\9 typically remain subject
to credit risk--the risk of counterparty default. Derivatives can be
more cost-effective for market participants than transactions in the
underlying cash markets because of the reduced transaction costs and
the leverage\10 that derivatives provide. These benefits do not come
without risk because using OTC derivatives, similar to using other
financial products, can result in losses from adverse market
movements, credit defaults, or operations errors.
As discussed in the following sections, the basic types of OTC
derivatives are forwards, options, and swaps. These basic products
can be combined with each other in a multitude of ways or with other
financial products to create more complex OTC derivatives.
--------------------
\5 Futures contracts obligate the holder to buy or sell a specific
amount or value of an underlying asset, reference rate, or index at a
specified price on a specified future date.
\6 Options (American-style) give the purchaser the right, but not the
obligation, to buy (call option) or sell (put option) a specified
quantity of a commodity or financial asset, or to settle for its cash
value, at a particular price (the exercise or strike price) on or
before a specified future date. For this right, the purchaser pays
the seller (writer) an amount called the option premium. A
European-style option can only be exercised on its expiration date.
Options may be traded on an exchange or OTC.
\7 ISDA is a trade association that represents 318 members worldwide.
Its primary membership includes 183 dealers.
\8 Market risk is the exposure to the possibility of financial loss
caused by adverse changes in the values of assets or liabilities.
\9 For exchange-traded derivatives, credit risk is borne by
clearinghouses that serve as intermediaries between the parties to
all transactions by becoming the buyer to every seller and the seller
to every buyer. Clearinghouses guarantee the performance of
exchange-traded contracts so that parties to these transactions do
not have to evaluate the creditworthiness of each other.
\10 Leverage is possible when the capital needed to own, control, or
receive financial gains from an investment is less than the
investment's full value. Derivatives provide leverage because they
require less capital than that needed to directly participate in the
underlying markets. Greater leverage results in the possibility of
greater gains or losses relative to capital.
FORWARDS
-------------------------------------------------------- Chapter 1:1.1
Forwards are OTC contracts that obligate the holder to buy or sell a
specific underlying at an agreed-upon price, quantity, and date in
the future. The price of each forward contract may be agreed upon in
advance or determined at the time of delivery. Forward contracts
exist for many underlyings, including traditional agricultural or
physical commodities, as well as for currencies (referred to as
foreign exchange forwards) and interest rates (referred to as forward
rate agreements). Market participants can use forwards to protect
their assets and liabilities against the risks associated with rate
and price movements, called hedging, or to profit from correctly
anticipating rate and price movements. Generally, counterparties to
forwards intend either to make or take delivery of the underlying.
OTC OPTIONS
-------------------------------------------------------- Chapter 1:1.2
OTC options are privately negotiated contracts that can be used for
hedging or to profit from correctly anticipating rate and price
movements. OTC option contracts also exist for many underlyings,
including commodities, currencies, interest rates, and equities.
Like other OTC derivatives, OTC options are designed to satisfy
specific end-user requirements because specific terms, such as the
exercise price, maturity date, and type of underlying, are
negotiated.
SWAPS
-------------------------------------------------------- Chapter 1:1.3
Swaps are OTC agreements that typically require counterparties to
make periodic payments to each other for a specified period. The
calculation of these payments is based on an agreed-upon amount,
called the notional amount, that generally is exchanged only in
currency swaps.\11 The periodic payments may be a fixed or floating
(variable) amount. Floating payments may change with fluctuations in
interest or currency rates or equity or commodity prices, depending
on the contract terms. Swaps are used to hedge a risk or obtain more
desirable financing terms, and they can be used to profit from
correctly anticipating rate and price movements.
--------------------
\11 When the notional amount is not exchanged, it is not a measure of
the amount at risk in a transaction.
PLAIN VANILLA OTC
DERIVATIVES
-------------------------------------------------------- Chapter 1:1.4
The simplest derivatives, such as the basic forwards, options, and
swaps previously described, are generally called plain vanilla.
These OTC derivatives are typically offered by many dealers due to
their relative simplicity. As a result, dealer price quotes tend to
be very competitive--falling within a narrow range. Also, the price
at which dealers are willing to enter into plain vanilla
derivatives--the bid-ask spread\12 --tends to be narrow.
Furthermore, large transactions can be executed through one dealer at
a single price. Therefore, through the availability of dealers,
liquidity is provided for plain vanilla OTC derivatives. Although no
official data are available, according to some dealers, plain vanilla
OTC derivatives account for 80 to 90 percent of all OTC derivatives
activity.
--------------------
\12 The bid-ask spread is the difference between the highest price a
buyer will pay and the lowest price a seller will accept for a
particular product.
MORE COMPLEX OTC DERIVATIVES
-------------------------------------------------------- Chapter 1:1.5
In contrast to plain vanilla OTC derivatives, the more complex OTC
derivatives have features that may make them more difficult to value.
Their values may be based on, or derived from, more than one
underlying asset, reference rate, or index. An example of a more
complex OTC derivative is a "rainbow call option," whose value is
based on the highest 1-year yield available from among four
underlyings--cash, the 10-year U.S. Treasury note, the 30-year U.S.
Treasury bond, and the Standard & Poor's 500 Index.\13 Unlike plain
vanilla interest rate swaps in which the notional amount remains
constant to maturity, this amount may change during the life of more
complex swaps. Some OTC derivatives may be complex because they
contain, or have embedded in them, other derivatives--for example, a
swap with an embedded option that grants the holder the right, but
not the obligation, to terminate the swap contract at some future
time. Complex OTC derivatives may have other features, such as a
multiplier that magnifies the effect of a price movement in the
underlying.
In contrast to plain vanilla OTC derivatives, more complex OTC
derivatives are offered by fewer dealers, or they may even be the
creation, or proprietary product, of one dealer. Fewer dealers means
less liquidity and wider bid-ask spreads, making it more difficult to
offset\14 or unwind\15 an earlier transaction at a favorable price.
Also, an end-user may find it difficult to independently determine
the price or value of a complex OTC derivative that has very
complicated terms or that is the proprietary product of one dealer.
End-users may attempt to determine the market price of OTC
derivatives on the basis of a model. However, the resulting price
may not correspond closely to what would actually occur in the
marketplace, assuming a buyer or seller could be found. The large
fees that some more complex OTC derivatives transactions generate are
an economic incentive for dealers to develop new products and refine
existing products developed by other dealers.
--------------------
\13 The Standard & Poor's 500 Index measures the performance of 500
common stocks.
\14 Offset of an OTC derivatives contract occurs when a market
participant enters into an equal but opposite contract. Entering
into an equal but opposite contract with the same counterparty
eliminates the market and credit risks associated with the original
contract. Doing so with a different counterparty eliminates the
market risk but not the credit and other risks associated with
carrying two contracts.
\15 Unwind of an OTC derivatives contract occurs when the
counterparties agree to settle or terminate the original contract or
assign one party's contractual obligations to a new party.
MORTGAGE-BACKED SECURITIES
---------------------------------------------------------- Chapter 1:2
MBS are debt securities that are created from residential mortgages.
They are backed (collateralized) by pools (groups) of mortgages, most
of which are 30-year obligations.\16 The process of pooling mortgages
and using them to back a new issue of securities is called
securitization.\17 Investors in MBS are entitled to receive a portion
of the interest and principal payments generated by the mortgage
pool. MBS provide funds to the mortgage market by enabling mortgage
lenders to sell the mortgages that they originate, thereby
replenishing their funds for additional mortgage lending. MBS
effectively expand funds available for housing by attracting
investors in mortgage loans.
MBS consist of mortgage pass-through securities (also called
mortgage-backed certificates) and collateralized mortgage obligations
(CMO).\18 Mortgage pass-through securities entitle investors to share
on a pro rata basis in all principal and interest payments received
from the mortgage pool. CMOs, which are a form of multiple-class
securities, entitle investors to share in principal and interest
payments in accordance with a payment schedule. The payment schedule
may divide the mortgage pool into classes, called tranches, and
specify the order in which the tranches are to receive principal and
interest payments. CMO tranches receiving the earliest payments, by
design, contain less risk than is found in simple mortgage
pass-through securities. However, the creation of these relatively
safe and stable tranches requires the creation of more risky tranches
that can be highly volatile in price.
--------------------
\16 Mortgages may be pooled according to a common characteristic such
as their maturity date, as in a pool of 30-year mortgages.
\17 Technically, MBS are a subset of asset-backed securities, which
is a term that is used to describe securities created from
securitized assets. In addition to mortgages, other types of assets
that are securitized in creating asset-backed securities include auto
loans, credit card receivables, equipment leases, and corporate
bonds. Because market participants distinguish MBS from all other
asset-backed products, this report follows that convention.
\18 The term "CMO" is commonly used to refer to both CMOs and real
estate mortgage investment conduits (REMIC). Unlike other CMOs,
REMICs allow investors to select securities containing the desired
levels of risk. This greater selection is possible because REMIC
mortgage pools are separated by maturity and credit risk classes,
while other CMO mortgage pools are separated only by maturity class.
REMIC mortgage pools may contain mortgages of lesser credit quality,
while other CMO mortgage pools generally consist of top quality
mortgages. As a result, REMICs receive a range of credit ratings,
whereas other CMOs normally receive the highest ratings. The
overwhelming majority of multiple-class MBS are REMICs.
STRUCTURED NOTES
---------------------------------------------------------- Chapter 1:3
Structured notes are debt securities\19 that combine elements of
traditional debt instruments and OTC derivatives.\20 Interest
payments for traditional debt instruments are generally either a
stated fixed amount or a variable amount that is based on
fluctuations in a specified interest rate. In contrast, the interest
and/or principal payments for structured notes may be linked to two
or more specified interest or currency rates, or to equity or
commodity prices. Structured notes may contain precise formulas
describing how these payments are tied to such rates and prices and
how they are to be computed. For example, a more complex type of
structured note, the inverse floater (also called an inverse floating
rate note) pays investors a rate of interest that moves in the
opposite direction of a specific market interest rate. Because its
value tends to move in the opposite direction of other debt
instruments, the inverse floating rate is often used for hedging.
Inverse floating rate notes typically contain options that
effectively set maximum and minimum rates that will be paid to
holders.
Structured notes may also have OTC derivatives embedded in them, such
as forwards, options, and swaps. By combining debt and OTC
derivatives into a single product, structured notes can provide a
more efficient and economic means of managing certain risks than debt
and OTC derivatives as separate products. For example, a company
can, by purchasing a structured note, limit its credit risk to one
party (the issuer) and limit its risk management costs to one
product.
Structured notes can be attractive both to investors and issuers.
They can be customized to meet investors' preferences for risk and
return. Such customization, which is hard to replicate with
traditional debt securities, can be attractive to investors seeking
to hedge their unique risks or possibly earn greater returns than
those offered by traditional debt securities.\21 The customization is
not needed by issuers but is offered to attract investors.
Structured notes can be attractive to issuers seeking to lower their
cost of capital through access to cheaper financing sources.
However, the customized features, though attractive to investors, can
contain rate and price risks that are unwanted by the issuer. To
offset such unwanted risks, issuers can enter into swaps or options
with dealers at the time of issuance. Structured notes are generally
of high credit quality because most are issued by highly rated
(AAA/Aaa or AA/Aa)\22 corporations or government-sponsored
enterprises (GSE)\23 and, therefore, are considered by market
participants to have minimal credit risk.
--------------------
\19 To the extent that structured notes are hybrid financial
instruments, they can be futures or commodity option contracts if
they do not meet the terms and conditions of the Commodity Futures
Trading Commission's hybrid instrument exemption (17 C.F.R. Part
34). A hybrid financial instrument possesses, in varying
combinations, characteristics of forwards, futures, options,
securities, and/or bank deposits. Unlike many other derivatives,
hybrid financial instruments generally serve a capital-raising
function. For the purpose of this report, we assume that structured
notes meet the conditions of the Commodity Futures Trading
Commission's hybrid instrument exemption and, therefore, are
securities and not futures.
\20 A universally accepted definition of structured notes does not
exist. For example, the Federal National Mortgage Association and
the Federal Home Loan Bank (the central credit system for savings and
loan institutions) differ on the types of callable debt they consider
to be structured notes. Also, certain other market participants
consider all callable debt to be structured notes because the
callable feature is an embedded call option.
\21 Structured notes also may be preferred by some market
participants over traditional debt and derivatives because of certain
accounting, regulatory, or tax considerations that are beyond the
scope of this report.
\22 According to major credit rating agencies--Standard & Poor's and
Moody's--AAA/Aaa are the highest credit ratings, indicating that the
capacity to repay debt is extremely strong. AA/Aa indicate a very
strong capacity to repay, differing from AAA/Aaa by only a small
degree.
\23 GSEs are privately owned financial intermediaries established
pursuant to federal law to facilitate lending for purposes that the
federal government has deemed socially important, such as education,
agriculture, and housing.
OTC DERIVATIVES, MBS, AND
STRUCTURED NOTE MARKETS' GROWTH
AND PARTICIPANTS' ACTIVITIES
---------------------------------------------------------- Chapter 1:4
Growth in the OTC derivatives market has continued since 1993 because
of the popularity of plain vanilla products, which continue to
dominate the market relative to more complex products. In contrast,
the MBS market and the largest segment of the structured note market
experienced significant declines between 1993 and 1995, but they are
now showing signs of recovery. OTC derivatives market participants
include dealers and end-users. In addition to these participants,
the MBS and structured note markets include issuers and underwriters.
Various types of financial institutions market OTC derivatives, MBS,
and structured notes.
MARKET GROWTH
-------------------------------------------------------- Chapter 1:4.1
According to the most recent global survey by the Bank for
International Settlements,\24 the notional/contract amount
outstanding of OTC derivatives was estimated at $47.5 trillion
worldwide and $11 trillion in the United States, as of March 31,
1995.\25 MBS issuances\26 grew from $371 billion in 1990 to a peak of
$991 billion in 1993. MBS issuances then declined 45 percent between
1993 and 1994 to $541 billion and declined another 40 percent between
1994 and 1995 to $326 billion. However, total issuances for 1996
grew to $474 billion.
Structured note issuances grew each year between 1990 and 1994, which
is the last year for which we were able to obtain estimates for
corporations.\27 Structured note issuances for both GSEs and
corporations were estimated to be $18 billion in 1990 and $92 billion
in 1994. Structured note issuances by GSEs alone were estimated to
be $44 billion in 1993. In 1994, they were estimated to be $40
billion and accounted for 43 percent of the estimated structured note
issuances for that year. However, in 1995, GSE-issued structured
notes declined by 75 percent to $10 billion. This decline was
consistent with the significant drop in overall structured note
activity that market participants told us they experienced or
witnessed that year. In 1996, GSE-issued structured notes, though
still below the peak reached in 1993, increased to $12 billion.
--------------------
\24 The Bank for International Settlements, among other functions,
provides a forum for cooperative efforts by the central banks of
major industrial countries.
\25 Central Bank Survey of Foreign Exchange and Derivatives Market
Activity 1995, Monetary and Economic Department, Bank for
International Settlements (Basle, Switzerland: May 1996). The Bank
for International Settlements conducts this comprehensive survey
every 3 years and these amounts represent the most current data
available. As previously discussed, the notional amount does not
measure the amount at risk in derivatives transactions. According to
the Federal Reserve, the amount at risk, as measured by the gross
market value of OTC derivatives outstanding, was $328 billion for
U.S. entities, as of March 1995, or about 3 percent of the
notional/contract amount. (The gross market value is the cost that
would be incurred if the outstanding contracts were replaced at
prevailing market prices.)
\26 Issuances are not the same as trading volume. Issued securities
are counted only once in issuance statistics, but may be counted more
than once in trading volume to reflect each change in ownership.
\27 The data do not include structured notes issued by foreign
corporations and foreign banks, structured certificates of deposit,
structured commercial paper, or structured notes issued in the
European medium-term note market. Our data sources were Bloomberg
Financial Markets and the Journal of Applied Corporate Finance.
THE NATURE AND EXTENT OF
ISSUER, UNDERWRITER, AND
DEALER ACTIVITIES
-------------------------------------------------------- Chapter 1:4.2
MBS and structured notes are similar to other securities, such as
stocks and bonds, in that they are issued--created and sold to
investors--to raise capital. Securities underwriting is a
capital-raising activity that involves distributing newly issued
stocks and bonds as well as MBS and structured notes, and it is a
major function of securities firms and some banks. Often, individual
underwriters join with other underwriters and form underwriting
groups, or syndicates, to handle a new issue. As underwriters, these
firms agree to offer the securities of the issuer to other investors
in two different ways. One way that underwriters agree to issue
securities is on a "firm commitment" basis, whereby the underwriting
firm agrees to accept all of the issued securities from the issuing
entity. If all of the securities are not sold to other dealers or
investors, the firms underwriting the issue will own the unsold
portion of the issuance. Underwriters can also agree to offer
securities on a "best efforts" basis, whereby any portion of the
issuance that is not purchased by other dealers or investors is
returned to the issuing entity.
VARIOUS TYPES OF
INSTITUTIONS ACTIVELY MARKET
OTC DERIVATIVES, MBS, AND
STRUCTURED NOTES
-------------------------------------------------------- Chapter 1:4.3
Dealers from various industries market OTC derivatives, MBS, and
structured notes. Data on the total number of banks, securities
firms, and other dealers of OTC derivative products were not
available. In the United States, banks account for the majority of
OTC derivatives volume. In 1996, the top 10 bank holding
companies\28 in terms of assets, all of which market these products,
accounted for about 94 percent of the total volume of OTC derivatives
held by all banks. Regulated broker-dealers market OTC
derivatives.\29 In addition, the affiliates of some securities firms
actively market nonsecurities OTC derivatives, with the affiliates of
six of the largest firms being the most active. Insurance company
affiliates are also somewhat active, with three affiliates actively
marketing nonsecurities OTC derivatives in volumes comparable to that
of some of the securities firm affiliates. Together, these dealers
conduct thousands of OTC derivatives transactions annually. Complete
statistics are not available on the total number of dealers marketing
MBS and structured notes, but regulators estimated that hundreds of
financial institutions market these products. Securities firms
account for the largest volumes, but banks and bank affiliates also
market MBS and structured notes.
--------------------
\28 Bank holding companies are corporations that own one or more
banks.
\29 Broker-dealers are agents that handle public orders to buy and
sell securities. They act as principals that buy and sell securities
for their own accounts.
SALES PRACTICES FOR OTC
DERIVATIVES, MBS, AND
STRUCTURED NOTES
---------------------------------------------------------- Chapter 1:5
The sales practices that dealers use to market OTC derivatives, MBS,
and structured notes can involve various activities. For example, in
discussing potential transactions, dealers may attempt to determine
whether a particular product is appropriate or suitable for the
end-user by considering several factors, such as the product's
complexity relative to the end-user's sophistication as well as the
end-user's risk management needs or investment objectives. Dealers
may also make disclosures about the product's benefits and risks,
such as how the product's value may be favorably or adversely
affected by changes in interest rates or foreign exchange rates.
This information is sometimes provided to an end-user as part of a
"term sheet" that outlines the relevant terms of the transaction,
including price, quantity, and maturity dates, and that may also be
included as a part of the confirmation materials that document the
transaction.
Another aspect of marketing these products is the establishment of
the transaction price. The transaction price is usually negotiated
between the dealer and the end-user and can be influenced by market
conditions and other factors, including whether the end-user has
other business transactions with the dealer, such as loans or
securities underwriting. After a transaction is entered into, the
dealer may be asked to periodically assist the end-user in
determining the current value of the product. End-users are less
likely to need such assistance for plain vanilla OTC derivatives that
have readily available dealer price quotes or for certain MBS
products that have an active secondary market. Dealers may also be
asked to unwind an OTC derivatives contract, and this may require one
party to pay the other an amount representing any change in the
contract's market value.
The nature of the relationship and expectations between dealers and
end-users can vary, depending on the product involved. OTC
derivatives transactions create obligations between counterparties
that continue over the life of the contracts, and thus involve
counterparty credit risk. Because of counterparty credit risk,
dealers and end-users of OTC derivatives usually seek to enter into
transactions with credit-worthy counterparties. Such
creditworthiness concerns are important because the counterparties to
a swap, for example, are obligated to exchange periodic payments over
the life of the contract. Therefore, until the contract matures,
each party is at risk that the other may not fully meet its
obligations. In contrast, some securities transactions, including
those in MBS and structured notes, involve a change in ownership, and
thus no additional obligations would exist between the dealer and
end-user.
VARIOUS REGULATORS OVERSEE THE
DEALERS MARKETING OTC
DERIVATIVES, MBS, AND
STRUCTURED NOTES
---------------------------------------------------------- Chapter 1:6
The dealers of OTC derivatives, MBS, and structured notes may be
subject to oversight by various federal or other regulatory
bodies.\30 Bank dealers are generally overseen by either the Federal
Reserve System, which oversees the bank holding companies and
state-chartered banks that are its members, or the Office of the
Comptroller of the Currency (OCC), which oversees nationally
chartered banks. Of the 10 largest bank OTC derivatives dealers as
of 1996, 3 are overseen by the Federal Reserve and 7 are overseen by
OCC. In addition, many banks have established separate legal
entities to conduct securities activities, including marketing MBS
and structured notes, and these entities are also subject to
oversight by the Securities and Exchange Commission (SEC). Banks can
also conduct limited securities activities--primarily in securities
issued by the U.S. government, GSEs, or certain state or local
governments--from the banking entity itself.
As previously noted, the activities of dealers marketing OTC
derivatives that are securities as well as those marketing MBS and
structured notes are overseen by SEC. The activities of dealers
marketing OTC derivatives that are determined to be futures are
subject to the Commodity Futures Trading Commission's (CFTC)
oversight. Firms that market securities must do so from an entity
registered with SEC and subject to various regulations, such as
regulations requiring minimum levels of capital. In addition, firms
offering futures and commodity options to the public must register
with CFTC and comply with the Commodity Exchange Act (CEA) and
regulations promulgated under the act, unless otherwise exempted.
Registered securities and futures firms are also required to join and
subject themselves to the rules and requirements of a self-regulatory
organization (SRO).\31 Such SROs also impose sales practice-related
requirements on their members. Most OTC derivatives are not
considered to be securities or futures by the dealers offering them.
Nonsecurities and nonfutures activities may be conducted in a
subsidiary separate from the regulated entity. Consequently,
securities and futures firms typically conduct their nonsecurities
and nonfutures OTC derivatives activities outside of their registered
entities in affiliates that are not subject to SEC or CFTC
regulation. CFTC has also exempted swaps and certain other OTC
derivatives from the requirement that such activities be conducted in
an affiliate subject to its regulation, but CFTC has retained the
authority to take action against fraudulent conduct involving
exempted products that are futures. (Ch. 2 discusses the regulatory
framework for OTC derivatives, MBS, and structured notes in greater
detail.)
In addition to working individually, the federal financial market
regulators also work collectively to address issues relating to the
financial markets. The heads of the Department of the Treasury,
CFTC, the Federal Reserve, and SEC comprise the President's Working
Group on Financial Markets. Staffs from OCC and other regulatory
agencies also participate in this group's activities. The Working
Group was established after the 1987 market crash to address issues
concerning the competitiveness, integrity, and efficiency of the
financial markets, and it is chaired by the Secretary of the
Treasury. The Working Group meets periodically to share information
and to coordinate regulatory policies and activities, and it also
meets on those matters relating to OTC derivatives.
--------------------
\30 State agencies also oversee banking, securities, and insurance
activities, although this report does not address such oversight in
detail.
\31 SROs play an extensive role in the regulation of the U.S.
securities and futures industries. SROs include all of the U.S.
securities and commodities exchanges, the National Association of
Securities Dealers, the National Futures Association, and the
Municipal Securities Rulemaking Board.
OBJECTIVES, SCOPE, AND
METHODOLOGY
---------------------------------------------------------- Chapter 1:7
To address congressional concerns associated with sales practices for
OTC derivatives, MBS, and structured notes, our objectives were to
analyze (1) the federal sales practice requirements applicable to
these products and the dealers marketing them; (2) the extent of
end-user satisfaction with sales practices, product use, and related
disputes and the costs of these disputes; (3) the views of end-users
and dealers on the nature of their relationship and responsibilities;
(4) the actions dealers and end-users have taken to reduce the
potential for sales practice disputes; and (5) the actions regulators
have taken to address sales practice issues.
To analyze federal sales practice requirements applicable to these
products and the dealers marketing them, we reviewed federal laws and
regulations related to sales practices and discussed them with
federal financial market regulators. We also reviewed the proposed
and final rule issued jointly by the three federal bank regulators\32
regarding bank sales of government securities, which include MBS and
structured notes issued by GSEs. In addition, we reviewed the sales
practice guidance provided by federal bank regulators for their
examiners and the dealers they oversee.
To analyze the extent of end-user satisfaction with sales practices
involving OTC derivatives, MBS, and structured notes, we sent
questionnaires to the financial officers of nearly 2,400 randomly
selected U.S. organizations in 1995.\33 Using the best information
we could identify, we constructed a universe of over 49,000
public-sector and private-sector U.S. organizations that might be
using these products,\34 including not only the largest
organizations, which were determined on the basis of financial or
other measures of size, but also the smaller organizations in each
industry. Our sample was drawn from 19 populations of such
organizations. Some of these 19 populations were divided into 2 or
more strata on the basis of an appropriate measure of organization
size--such as assets, revenues, student enrollment, or census counts.
Our questionnaire requested data on the use of these products within
the 12 months preceding the survey.
Our questionnaire asked organizations to rate the sales practices of
dealers with whom they entered into contracts across the following
six dimensions: (1) disclosure of downside risks, (2) quality of
transaction documentation provided, (3) suitability of products
proposed, (4) competitiveness of pricing and fees, (5) provision of
accurate mark-to-market\35 pricing information, and (6) assistance in
unwinding transactions. Our questionnaire also asked the
organizations to separately rate the sales practices of dealers that
proposed contracts but who they did not use for the three applicable
dimensions listed above--(1), (3), and (4). We developed these sales
practice dimensions on the basis of reviews of regulatory and dealer
documents and discussions with regulators, dealers, and end-users.
We also asked the organizations to provide overall ratings of sales
practices both for dealers with whom the organizations entered into
contracts as well as dealers that proposed contracts but who they did
not use.
To analyze the extent of product use, we evaluated the approximately
1,800 responses received to our questionnaire. We developed
statistically valid estimates of the extent of each product's use
across all 19 populations, subject to a 95-percent confidence level,
unless otherwise indicated. We compared our results to regulatory
data and 27 other recent studies that reported rates of OTC
derivatives usage. We also compared our survey results regarding the
reasons derivatives were used to studies by other organizations.
To analyze the extent of sales practice disputes between end-users
and dealers and the costs of these disputes, we collected data on
investigations by securities regulators and on complaints these
organizations received in the 4-year period from January 1993 through
December 1996. We also reviewed reports and findings of federal
regulators and state audit departments for cases where an end-user
incurred a loss and subsequently alleged deficient dealer sales
practices. Additionally, we used public and nonpublic information to
compile a list of entities that were known to have incurred losses on
OTC derivatives, MBS, or structured notes, and we attempted to
identify those cases where sales practice allegations had been
raised.
To analyze the views of end-users and dealers on the nature of their
relationship and responsibilities, we evaluated the responses of
survey respondents who reported being satisfied as well as those who
expressed being dissatisfied with dealer sales practices. We also
interviewed by telephone 50 survey respondents, including about
one-half of whom expressed satisfaction and about one-half of whom
expressed general dissatisfaction with dealer sales practices. The
respondents were judgmentally selected from the industries we
surveyed to include large and small organizations and users of OTC
derivatives, MBS, and structured notes as well as nonusers that had
heard sales presentations. The interviews were performed, among
other reasons, to learn more about (1) why end-users were satisfied
or dissatisfied with dealer sales practices and (2) what opinions
end-users had on fiduciary relationships.
In addition, we analyzed two sets of voluntary guidance prepared by
two dealer groups that address sales practice issues. We also
reviewed comments on this voluntary guidance made by end-user
associations, legal experts, the U.S. Department of Labor, and
others. Finally, we attended industry conferences; reviewed
conference documents, court cases, and congressional testimony; and
interviewed dealer, end-user, and federal and state regulatory
officials regarding the relationship and responsibilities of dealers
and end-users in OTC derivatives transactions.
To analyze the actions that dealers and end-users have taken to
reduce the potential for sales practice disputes, we interviewed 14
dealers active in marketing OTC derivatives, MBS, and structured
notes, including securities firms, banks, and insurance companies; 15
small, medium, and large end-users; 11 dealer and end-user
associations; and 5 U.S. federal regulators. We interviewed the
end-users and dealers regarding their internal controls and the
practices they used to reduce the likelihood of sales practice
disputes. In addition, we reviewed studies by other organizations
that surveyed end-user management practices and internal controls for
OTC derivatives, MBS, and structured notes. We also interviewed
regulators and reviewed regulatory examination results regarding
weaknesses they identified in policies, procedures, and practices
that could lead to sales practice disputes. Furthermore, we reviewed
end-user association guidance to members regarding the policies and
practices that should be in place before using these products.
Finally, we reviewed state legislation whose goal was to minimize the
risks that OTC derivatives, MBS, and structured notes pose to
governments at the state level or lower and that was enacted by 14
states between January 1994 and September 1996.
To analyze the actions that regulators have taken to address sales
practice issues, we interviewed federal financial market regulators.
We also reviewed the examination reports and supporting workpapers
for the special examinations of the seven largest banks marketing OTC
derivatives, MBS, and structured notes. These special examinations
were conducted by OCC and the Federal Reserve from mid-1994 through
mid-1995. We reviewed the guidance provided by federal bank
regulators for their examiners and the dealers they oversee that
addresses sales practices and overall risk management
responsibilities. We also reviewed congressional testimony,
examination policies, guidance, procedures, workpapers, and reports
pertaining to the marketing of these products.
We did our work in Chicago, Cincinnati, Dallas, Los Angeles,
Minneapolis, and Washington, D.C., between June 1994 and August 1997
in accordance with generally accepted government auditing standards.
We requested comments on a draft of this report from the heads, or
their designees, of CFTC, the Department of the Treasury, the Federal
Reserve Board, OCC, SEC, the National Association of Securities
Dealers (NASD), and the New York Stock Exchange (NYSE). We also
requested comments from the End-Users of Derivatives Association
(EUDA),\36 the Government Finance Officers Association (GFOA),\37
ISDA, and the National Association of State Auditors, Controllers and
Treasurers (NASACT).\38 The nontechnical comments from these
organizations are presented and evaluated at the end of chapter 7 and
are reprinted along with additional responses in appendixes III
through IX.
--------------------
\32 The three federal commercial bank regulators are the Federal
Deposit Insurance Corporation (which oversees state-chartered banks
that are not members of the Federal Reserve System), the Federal
Reserve System, and OCC.
\33 Our survey also included a request for data on asset-backed
securities, but because of the relative absence of reported sales
practice problems associated with these products, we do not report
our survey results for these products, except when they cannot be
separated from those for MBS. See appendix I for more details on the
survey design, methodology, and results, and see appendix II for a
reprint of the survey questionnaire.
\34 See appendix I for a discussion of how we determined which
organizations might be using OTC derivatives, MBS, and structured
notes.
\35 Marking to market is the practice of periodically adjusting the
valuation of an asset or liability to reflect current market values.
\36 EUDA monitors and provides educational material to members on
legal, tax, regulatory, and accounting issues affecting OTC
derivatives, GSEs, and financial institutions.
\37 GFOA represents approximately 13,000 finance officers from
federal, state, provincial, and local governmental entities in the
United States and Canada.
\38 The National Association of State Auditors, Comptrollers and
Treasurers represents the fiscal and auditing professionsals of state
governments and provides for information sharing, training, and
policy formulation.
FEDERAL SALES PRACTICE
REQUIREMENTS VARY BY PRODUCT AND
DEALER
============================================================ Chapter 2
The federal sales practice requirements designed to protect end-users
of OTC derivatives vary, depending, in part, on whether the specific
product in question is a security, a futures contract, or neither
product. If an OTC derivative falls within the definition of a
security or futures contract, the transaction is subject to the
applicable sections of the federal laws governing the sale of those
products. Although it is not always clear which OTC derivatives fall
within these definitions, SEC and CFTC agreed that one dealer's sales
practices related to certain OTC derivatives warranted action, and
they cooperated in taking enforcement action against the dealer. If
an OTC derivative is not covered by the federal securities or
commodities laws, an end-user with a sales practice complaint would
need to seek redress against a dealer by asserting primarily state
statutory or common law claims.\1 In contrast to OTC derivatives, MBS
and structured notes are typically securities; therefore, their sale
is subject to the federal securities laws, except when exempted from
specific provisions.
The sales practice requirements that a dealer must follow when
marketing OTC derivatives in the United States also vary, depending
on which regulator, if any, oversees its activities. If the dealer
is a bank, all of its activities are subject to oversight by one of
the federal regulatory agencies responsible for ensuring that banks
are appropriately managing their risks. Unlike the requirements
applicable to securities, which are intended to protect investors,
the requirements placed on banks marketing OTC derivatives are
intended primarily to limit the risk that such activities pose to a
bank. Securities and futures firms, as well as insurance companies,
that offer nonsecurities and nonfutures OTC derivatives typically do
so from affiliates that are not subject to direct regulatory
oversight.\2 However, should SEC or CFTC determine that a specific
OTC derivatives transaction is a security or a futures contract, the
transaction would be subject to the respective regulator's
jurisdiction, absent an agency exemption or a successful court
challenge. Members of the President's Working Group on Financial
Markets have stated that the scope of SEC and CFTC authority and
existing sales practice requirements are adequate to protect the
markets and OTC derivatives end-users.
--------------------
\1 Common law is derived from judicial decisions, rather than from
statute.
\2 Firms would also typically market OTC derivatives that CFTC has
exempted from most provisions of the CEA from these unregulated
affiliates.
SALES PRACTICE REQUIREMENTS
VARY, DEPENDING ON THE PRODUCT
---------------------------------------------------------- Chapter 2:1
The sales practice requirements designed to protect end-users of OTC
derivatives vary. Some OTC derivatives are subject to the
requirements found in the securities laws, including their antifraud
provisions and SRO rules. Some OTC derivatives may be subject to
similar requirements found in the laws applicable to futures trading
in the United States. When federal laws do not apply, disputes
involving OTC derivatives would need to be addressed by asserting
primarily state statutory or common law claims, such as fraud or
breach of fiduciary duty. In comparison, dealers marketing MBS and
structured notes that are securities must comply with the federal
securities laws.
SOME OTC DERIVATIVES ARE
SUBJECT TO THE FEDERAL
SECURITIES LAWS
-------------------------------------------------------- Chapter 2:1.1
OTC derivatives that are securities are subject to the sales practice
requirements in the federal securities laws that SEC administers.
OTC derivatives that are considered to be securities include OTC
options on securities, including options on stock indexes. However,
such OTC derivatives represent a small portion of the overall volume
of these products. According to the most recent global survey by the
Bank for International Settlements, the notional amount of equity OTC
derivatives--which would include products either previously
determined or likely considered to be securities--was $579 billion,
or 1.4 percent of the total OTC derivatives contracts outstanding
(net of local and cross-border double-counting), at the end of March
1995. The gross market value for equity derivatives was $50 billion,
or 2.8 percent of the total OTC derivatives contracts outstanding, at
the end of March 1995. Although SEC could not provide comparable
data on the extent to which U.S. broker-dealers market OTC
derivatives that are securities, an SEC official confirmed that the
percentage of such U.S. firms' activities were likely to be similar
to those identified in the Bank for International Settlements survey.
The sale of any OTC derivative contract that is considered to be a
security is subject to the antifraud provisions of the securities
laws that are intended to protect customers and to foster market
integrity by prohibiting fraudulent conduct in securities
transactions.\3 A dealer can violate these antifraud provisions by
making material misstatements about the security being recommended or
misleading a customer by omitting information material to the
transaction. Under the authority granted by these laws, SEC can act
against dealers or their personnel for violating these provisions,
including imposing fines on them, restricting their activities, or
revoking their registration. An end-user may also bring a civil
action for a violation of these laws and seek rescission (or undoing
of the transaction) or damages.
In addition to complying with the securities laws, dealers marketing
OTC derivative securities must comply with the requirements of the
securities industry SROs of which they are members.\4 For example,
NASD's members offering securities to the public must comply with its
Conduct Rules.\5 These rules, among other things, require that a
dealer, before recommending a product to an end-user, obtain and
evaluate information about the end-user's financial condition and
investment objectives to ensure that the product is suitable. (A
recently issued NASD rule interpretation that discusses dealers'
responsibilities relating to institutional end-users is discussed
below.)
The extent to which some OTC derivatives are securities and,
therefore, subject to the securities laws is not always clear. SEC
officials told us that, as a matter of policy, the agency does not
limit its authority by delineating categories of OTC derivatives that
are not securities. Relative certainty exists for options on
securities, which are considered to be securities under the
securities laws. For other OTC derivative products, case-by-case
determinations are made. SEC officials said that the agency
responds, when requested, to dealer inquiries about whether SEC would
consider a specific proprietary OTC derivative contract to be a
security. In other cases, dealers independently evaluate the
characteristics of individual OTC derivative products to determine
whether the products meet the definition of a security as defined in
the securities laws. However, when dealers conduct activities in
products on the basis of their own determination that the product
involved is not a security, SEC or a court may later disagree with
their determination. Even if a product meets the definition of a
security, SEC officials told us that they can exempt products from
various provisions of the securities laws, although, according to
agency officials, the agency has never exempted any product from the
antifraud provisions of these laws.\6
In cooperation with CFTC, SEC took action under the securities laws
against Bankers Trust,\7 in 1994, for its conduct in transactions
with Gibson Greetings, Inc., involving two OTC derivatives contracts.
In acting against Bankers Trust, SEC found that the two transactions
involved were securities because they were options on U.S. Treasury
securities.\8 Accordingly, SEC found that Bankers Trust violated
various sections of the securities laws, including making false
statements or omissions in the sale of securities, supplying
materially inaccurate valuations of derivatives transactions, and
failing to supervise marketing personnel.\9
--------------------
\3 As indicated in chapter 1, all of a firm's activities in
securities must be conducted in an affiliate registered with SEC as a
broker-dealer and subject to that agency's oversight as well as to
the rules and oversight of one or more securities industry SROs.
\4 These suitability requirements and SRO activities to enforce them
are discussed in chapter 6.
\5 Until July 1996, these Conduct Rules were known as Rules of Fair
Practice.
\6 Similarly, except for certain energy products, CFTC officials
indicated that their agency has not exempted any products from the
antifraud provisions of the CEA.
\7 SEC's action was taken against Bankers Trust's securities
affiliate--BT Securities--as summarized in Securities and Exchange
Act Release No. 35136, dated December 22, 1994. Unless otherwise
indicated, in this report "Bankers Trust" refers to the parent
firm--Bankers Trust New York Corporation, which is a bank holding
company--and two of its wholly owned subsidiaries--Bankers Trust
Company, which is a bank, and BT Securities Corporation, which is a
securities broker-dealer.
\8 The basis for CFTC's action against Bankers Trust is discussed on
pages 71 and 72.
\9 Although SEC acted against Bankers Trust's registered
broker-dealer affiliate, it could not have taken these sales practice
actions unless the transactions in question were securities.
SOME OTC DERIVATIVES ARE
SUBJECT TO THE FEDERAL
COMMODITIES LAWS
-------------------------------------------------------- Chapter 2:1.2
Some OTC derivatives are subject to the CEA, which governs futures
trading in the United States and which is administered by CFTC. U.S.
firms offering futures and certain options\10 contracts to the public
must register with CFTC and comply with the CEA and regulations
promulgated under the act as well as with applicable SRO rules. The
CEA provides various sales practice-related requirements that must be
adhered to by these and other firms offering such products, unless
otherwise exempted from such requirements. When establishing
accounts, firms are required by SRO rules to obtain certain
information pertaining to their customers' financial condition and
trading experience. CFTC generally requires that firms make certain
disclosures about the risks of products and provide customers with a
standardized risk disclosure document before engaging in
transactions. The CEA also prohibits fraudulent conduct, including
material misstatements and omissions. CFTC can bring actions against
firms for violating the CEA. In addition, the CEA allows futures and
options customers to pursue private claims against a firm for fraud,
but questions have been raised about the application of the CEA's
fraud provisions to OTC derivatives transactions.\11
The extent to which some OTC derivatives are subject to the CEA is
uncertain.\12 CFTC's regulatory framework is focused primarily on the
oversight of exchange-traded futures and certain options and of
intermediaries engaging in such transactions on behalf of customers.
CFTC has issued regulations that allow trade options\13
on commodities, except on certain enumerated domestic agricultural
commodities,\14 to be traded off-exchange. Forwards and certain OTC
foreign-currency transactions are excluded from regulation under the
CEA,\15 including its antifraud provisions. In 1992, Congress
granted CFTC the authority to exempt certain OTC derivatives,
including swaps, from almost all of the CEA's provisions.\16 Without
determining that swaps were futures, CFTC issued a rule that exempted
eligible swaps from all but the CEA's antifraud and antimanipulation
provisions.\17 Although CFTC's swaps exemption preserves the CEA's
antifraud provisions, the provisions only apply to the extent that
swaps are found to be subject to the act.
As previously discussed, CFTC took a sales practice-related action,
in cooperation with SEC, against Bankers Trust for activities
involving swaps and other products that are subject to the CEA
exemption. In taking this action, CFTC enumerated the transactions
that were involved in the violations but did not indicate whether it
considered the transactions to be futures or options contracts
subject to the CEA. Instead, it asserted that Bankers Trust, by its
conduct, had assumed the role of a commodity trading advisor\18
and had violated the antifraud provisions of the CEA governing such
parties' activities.
--------------------
\10 Such options include options on commodities, futures, and stock
index futures traded on a board of trade but do not include options
on securities, securities indexes, or foreign currencies traded on a
national securities exchange. CEA section 2(a)(1)(B), which codified
the Shad-Johnson Jurisdictional Accord, excludes options on one or
more securities from CFTC's jurisdiction but provides CFTC with
jurisdiction over futures (and options thereon) on broadly based
stock indexes. Options on securities are regulated by SEC under
federal securities laws. In addition, U.S. firms offering trade
options are not required to register with CFTC. Trade options are
options that are offered to commercial counterparties who enter into
these transactions solely for purposes related to their business.
\11 For example, the judge in Procter & Gamble Co. v. Bankers Trust
Co. and BT Sec. Corp., 925 F. Supp. 1270 (S.D. Ohio, May 9,
1996), concluded that Procter & Gamble could not bring a claim under
section 4b of the CEA, the general antifraud provision. Section 4b
prohibits fraud in connection with a futures contract made "for or on
behalf of any other person." The judge concluded that Bankers Trust
could not act "for or on behalf of" the company because both were
principals; therefore, the typical customer-broker relationship did
not exist.
\12 See The Commodity Exchange Act: Legal and Regulatory Issues
Remain (GAO/GGD-97-50, Apr. 7, 1997).
\13 See 17 C.F.R. � 32.4 (1996).
\14 On June 9, 1997, CFTC issued an advanced notice of proposed
rulemaking in the Federal Register seeking comment on whether it
should lift its ban on trade options on domestic agricultural
commodities.
\15 The forward exclusion is set forth in CEA section 1(a)(11). The
Treasury Amendment excludes certain OTC foreign-currency transactions
from the CEA; this exclusion is set forth in CEA section
2(a)(1)(A)(ii). As discussed in our April 1997 report on the CEA,
the scope of the Treasury Amendment has been unclear.
\16 CFTC was granted the authority to exempt swaps meeting certain
criteria and other OTC derivatives traded among appropriate persons
from the CEA by the Futures Trading Practices Act of 1992. See our
April 1997 report for a more detailed discussion of CFTC's use of its
exemptive authority and related issues.
\17 These provisions do not cover the standardized risk disclosures
that would otherwise be required when marketing futures and options
contracts subject to the CEA. See C.F.R. Part 35 (1996). In a
similar action, CFTC exempted certain energy contracts from the CEA's
antifraud provisions but not from its antimanipulation provisions.
\18 A commodity trading advisor is an individual or firm that, for
pay, issues analyses or reports concerning commodities, including the
advisability of trading in futures or commodity options.
STATE STATUTORY AND COMMON
LAW CLAIMS WOULD BE ASSERTED
IN DISPUTES INVOLVING OTC
DERIVATIVES THAT ARE NOT
SUBJECT TO FEDERAL LAWS
-------------------------------------------------------- Chapter 2:1.3
To the extent that OTC derivatives are not covered by either the
federal securities or commodities laws, an end-user alleging sales
practice misconduct by a dealer would need to seek relief by
asserting primarily state statutory or common law claims, such as
fraud or breach of fiduciary duty.\19 These claims, which are
typically advanced in suits against dealers, are either tort\20 or
contract based. Although similar in certain respects, tort claims
are based upon the existence of a special relationship that creates a
duty owed by the dealer to the end-user, while contract claims are
based upon the contractual relationship between the dealer and
end-user. Tort-based claims that are typically asserted by end-users
include claims of fraud and fraudulent concealment against dealers.
End-users may also assert a claim of breach of fiduciary duty. For
such claims, a derivatives dealer may have a duty to disclose
material information to an end-user if the court finds that an
explicit or de facto fiduciary relationship exists. End-users may
also assert a claim that the dealer's alleged misstatements or
omissions constitute a negligent misrepresentation. In addition,
other state law claims may be asserted. For example, under New York
law, the judge in the Procter & Gamble case found that an implied
contractual duty to disclose in business negotiations exists when one
party has superior knowledge not known to the other and the party
with superior knowledge knows that the other party is acting on the
basis of mistaken knowledge.\21 In resolving these cases, the nature
of the relationship between the parties to the transaction is
critical to determining the duties that the dealer owes the end-user.
Contract-based claims do not require the existence of a special duty
between the dealer and end-user. For example, an end-user may
advance a contract-based claim for rescission due to
misrepresentation. This claim would restore the parties to the
positions they held before they entered into the contract. If the
end-user is a governmental entity, it may assert an ultra vires
claim.\22 To support this claim, the end-user may argue that the
transaction at issue is unenforceable because it violates a provision
in its charter. An end-user may also claim that the contract is
voidable because the end-user was a victim of economic duress and,
therefore, did not enter into the contract of its own free will.
Finally, an end-user may assert that the contract is unenforceable
under the applicable statute of frauds. Although the specifics may
vary from jurisdiction to jurisdiction, the statute of frauds
generally states that contracts in excess of a certain dollar amount
that cannot be performed within 1 year are unenforceable unless in
writing and signed by the party against whom the contract is being
enforced. To reduce the likelihood of the success of this claim, New
York amended this statute in 1994 to improve the enforceability of
oral OTC derivatives transactions.
--------------------
\19 End-users could also seek redress under the federal Racketeer
Influenced and Corrupt Organizations Act. In addition, dealers may
be subject to federal criminal enforcement actions under applicable
mail fraud or wire fraud statutes.
\20 A tort is a wrongful act (except for those involving a breach of
contract) for which damages are imposed.
\21 925 F. Supp. at 1290. The judge concluded that Bankers Trust
"had a duty to disclose material information to plaintiff before both
the parties entered into the swap transactions . . . and also had
a duty to deal fairly and in good faith during the performance of the
swap transactions." Id. at 1291.
\22 This claim would likely be advanced only by governmental entities
because corporations typically may not rely on this doctrine to
invalidate a contract.
MBS AND STRUCTURED NOTES ARE
TYPICALLY SUBJECT TO THE
SECURITIES LAWS
-------------------------------------------------------- Chapter 2:1.4
MBS and structured notes are typically considered to be securities
and subject to the federal securities laws,\23 except when exempted
from specific provisions. In the United States, these products are
marketed by broker-dealers who are required to register with SEC and
become subject to various regulations, such as those requiring
minimum levels of capital. When corporations issue these securities,
they are subject to the full range of requirements applicable to
other corporate securities issued to the public. These requirements
include the need to file a prospectus that describes the financial
condition of the issuer and explains the risks of investing in the
securities. In addition, the marketing of MBS and structured notes
is subject to the antifraud provisions of the securities laws
previously discussed, as well as the sales practices provisions of
SRO rules.
Many MBS and structured notes are issued by GSEs and are considered
to be government securities under the federal securities laws.
Although dealers marketing these products must comply with the
antifraud provisions of the securities laws, just as they would for
other securities activities, issuers of government securities are
generally exempted from the registration and issuance disclosure
provisions of the laws that apply to corporate-issued securities. As
a result, GSEs are not generally required to obtain SEC approval
before offering securities publicly, and such issuances need not be
accompanied by prospectuses that identify the issuer and describe its
business operations and financial condition.\24 Nevertheless, GSEs
have chosen to voluntarily follow the same practices that corporate
securities issuers are required to follow. For example, GSE
securities issuances are accompanied by prospectuses that contain the
same type of disclosures as would be required for other company
securities that are registered with SEC. GSE security issuances also
typically include a discussion of the structure and risks of the
securities being offered.
As previously discussed, dealers marketing securities, including MBS
and structured notes, must comply with the requirements of the
securities industry SROs of which they are members. NYSE and NASD
supervise the majority of dealers offering MBS and structured notes,
and both place similar requirements on their members, including
requiring firms to determine the suitability of products before
recommending them to their customers. Although NASD's suitability
rule had long applied to stocks and other securities, the provisions
of this rule were not extended to its members' marketing of
government securities, including GSE-issued MBS and structured notes,
until August 1996.\25
In recognition of the significant institutional participation in the
markets for these securities, NASD also implemented an interpretation
of its suitability rule to clarify the responsibilities that dealers
have to institutional end-users.\26
Such users are defined by the rule to include any entity other than a
natural person.\27 This interpretation provides that a dealer must,
on the basis of information either supplied by the end-user or
otherwise known to the dealer, determine whether the end-user is
capable of evaluating the risk of the specific transaction and
whether the end-user is making an independent investment decision.
The interpretation includes a number of factors that are relevant to
making this determination, including the end-user's employment of
outside consultants or advisors, the end-user's general level of
sophistication and level of sophistication with respect to the
particular product, the complexity of the product, and the end-user's
ability to understand and independently assess the product. Other
relevant information might include whether the end-user had
established a pattern of accepting the dealer's recommendations, had
access to investment suggestions from other sources, and had supplied
information about its investment portfolio to the dealer. If a
dealer determines that the end-user is capable of independently
evaluating investment risk and making its own decision about the
transaction, the dealer's obligation regarding the end-user's
suitability is to be considered fulfilled. The interpretation
stresses that the determination can only be made on the basis of the
particular facts and circumstances of the transaction, including the
particular relationship between the dealer and end-user.
--------------------
\23 As noted in chapter 1, we are assuming for the purpose of this
report that structured notes meet the conditions of CFTC's hybrid
instrument exemption and are securities, not futures.
\24 The Federal Agricultural Mortgage Corporation, commonly known as
Farmer Mac, is an exception; its security issuances are registered
with SEC.
\25 NASD had been prohibited from applying its full complement of
sales practice rules to the marketing of government securities by a
longstanding statutory restriction that was removed by subsequent
legislation. On August 22, 1996, SEC approved NASD's proposed
extension of its rules to these securities with an associated
interpretation for applying them to institutional end-users. (This
restriction and its impact on NASD's operations are discussed in ch.
6.) Because this restriction applied only to government securities,
NASD was able to apply its full complement of sales practice rules to
the marketing of corporate-issued CMOs.
\26 Self-Regulatory Organizations; National Association of Securities
Dealers, Inc; Order Granting Approval to Proposed Rule Change and
Notice of Filing and Order Granting Accelerated Approval to Amendment
Nos. 4 and 5 to Proposed Rule Change Relating to Application of the
Rules of Fair Practice to Transactions in Exempted Securities (Except
Municipals) and an Interpretation of its Suitability Rule, 61 Fed.
Reg. 44100 (Aug. 27, 1996).
\27 The interpretation indicates that its tenets are most
appropriately applied to institutional customers with more than $10
million in securities holdings.
SALES PRACTICE REQUIREMENTS
VARY, DEPENDING ON THE
REGULATOR OF THE DEALERS'
ACTIVITIES
---------------------------------------------------------- Chapter 2:2
Sales practice requirements also vary, depending on which regulator,
if any, oversees the dealers' activities. Bank OTC derivatives
activities are subject to requirements of the federal banking
regulators as a part of their oversight of all bank activities.
Banks marketing MBS and structured notes are now expected to comply
with suitability rules similar to those that apply to securities
firms offering such products. Banks marketing OTC derivatives, MBS,
and structured notes may also be subject to oversight by different
regulators, depending on which legal entity within their corporate
structure conducts these activities. Securities, futures, and
insurance firms typically conduct their nonsecurities and nonfutures
OTC derivatives marketing in affiliates not subject to direct federal
oversight, although some individual transactions may be subject to
oversight. Members of the President's Working Group on Financial
Markets have stated that the scope of SEC and CFTC authority and
existing sales practice requirements are currently adequate to
protect the end-users of derivatives and the markets.
BANK ACTIVITIES ARE
REGULATED TO PROTECT THEIR
FINANCIAL CONDITION
-------------------------------------------------------- Chapter 2:2.1
All of the activities of banks are subject to oversight by at least
one federal regulatory agency--either the Federal Deposit Insurance
Corporation, the Federal Reserve, or OCC. These regulators are
responsible for ensuring the safety and soundness of banks to protect
depositors and the federally administered Bank Insurance Fund. The
regulators address this responsibility by placing various
requirements on banks, including periodic reports of financial
condition, maintenance of minimum capital levels, and periodic bank
examinations. Almost all of the banks actively marketing OTC
derivatives, MBS, and structured notes are overseen by either the
Federal Reserve or OCC.
In response to the large increase in the volume of bank activity in
OTC derivatives and other financial products over the last decade,
bank regulators revised and expanded the guidance provided to
examiners and banks to more specifically address the risks that these
activities pose, including those risks related to sales practices.
Previously, according to bank regulatory officials, the only bank
sales practice-related guidance was "know your customer" rules under
which regulators expected banks to obtain sufficient information
about customers' financial condition and business activities to
prudently extend credit or engage in other financial transactions
with them.
In 1993 and 1994, OCC and the Federal Reserve each issued new
guidance that more specifically addresses sales practice issues as a
part of a bank's overall responsibilities for managing the risks of
its financial activities, including OTC derivatives. Both sets of
guidance place generally the same requirements on examiners and
banks. OCC's October 1993 guidance\28 directs the banks it oversees
to assess and document the appropriateness of transactions, as a part
of managing the credit risk arising from these transactions. In a
follow-up 1994 OCC interpretation,\29 OCC states that consistent with
safe and sound practices, banks should not recommend transactions
that they know, or have reason to know, would be inappropriate for
counterparties on the basis of available information. According to
the interpretation, banks should also determine whether proposed
transactions are consistent with counterparties' policies and
procedures, as these are known to them. Specifically, banks should
understand the risks that counterparties are trying to manage or
assume through the use of derivative products. The interpretation
also requires that banks ensure counterparties understand the general
market risk of transactions and explain, particularly for those
counterparties that they determine lack sophistication, how
transactions will achieve the counterparties' objectives.\30
The Federal Reserve's December 1993 guidance\31 to the banks it
oversees states that sound business practices require member banks to
take steps to ascertain the sophistication of derivatives
counterparties, including whether counterparties understand the
nature and risks of transactions. If a bank determines that its
counterparty is unsophisticated, either generally or with respect to
a specific transaction, the guidance directs it to educate the
counterparty about the risks associated with the proposed
transaction. Furthermore, the guidance provides that when a bank
recommends a derivatives transaction to an unsophisticated
counterparty, it should ensure that it has adequate information about
the counterparty on which to base its recommendation. In the
guidance issued to examiners,\32 the Federal Reserve indicates that
banks should have established standards for complex products to
ensure that counterparties are not entering into transactions where
they fail to understand the risks. The guidance also notes that bank
management should be cognizant of the potential for activities in
these products to result in financial losses and harm the bank's
reputation.
The goal of the guidance applicable to OTC derivatives issued by the
Federal Reserve and OCC is primarily to protect the safety and
soundness of banks rather than their counterparties or the end-users
of the products banks offer.\33 The requirements banks are to follow
when marketing such products are designed to reduce their exposure to
risk of loss from end-user default or transaction disputes.\34
Although the Federal Reserve's guidance places additional sales
practice requirements on banks, its guidance also states that
end-users are ultimately responsible for their own transactions.
Regarding OCC's guidance, a senior OCC official explained that it
does not task banks with determining the suitability of OTC
derivatives transactions for their customers, but the guidance is
meant to ensure that the activities are being conducted in a safe and
sound manner. According to the official, a suitability rule would
represent a fundamental change in the relationship between a bank and
its customers because certain transactions, such as loans, deposits,
and letters of credit, are entered into on a principal-to-principal
basis. Although intended primarily to protect banks, bank regulator
officials told us that the interests of end-users would indirectly be
protected by banks complying with the prudent practices recommended
in bank guidance.
--------------------
\28 Banking Circular 277: Risk Management of Financial Derivatives,
OCC (Washington, D.C.: Oct. 1993).
\29 Risk Management of Financial Derivatives: Questions and Answers
Re: BC-277 (OCC Bulletin 94-31), OCC (Washington, D.C.: May 1994).
\30 As discussed in chapter 6, OCC subsequently issued more detailed
guidance in 1996 and 1997 with additional sales practice-related
expectations for the banks it oversees; however, this additional
guidance does not change the requirements described in this chapter.
\31 Examining Risk Management and Internal Controls for Trading
Activities of Banking Organizations, [SR 93-69 (FIS)], Division of
Banking Supervision and Regulation, Board of Governors of the Federal
Reserve System (Washington, D.C.: Dec. 1993).
\32 Trading Activities Manual, Division of Banking Supervision and
Regulation, Board of Governors of the Federal Reserve System
(Washington, D.C.: Mar. 1994).
\33 Bank regulatory officials indicated that bank dealers' compliance
with these requirements should have the indirect effect of protecting
counterparties and end-users from abusive practices.
\34 Under federal banking laws, aggrieved end-users have no right of
private action or redress similar to that provided by federal
securities or commodities laws. As a result, aggrieved end-users
must seek redress under state statutory and common law.
BANK REGULATORS ADOPTED
ADDITIONAL REQUIREMENTS FOR
DEALERS MARKETING SECURITIES
-------------------------------------------------------- Chapter 2:2.2
Bank regulators have placed additional requirements on banks that
market securities. Banks marketing securities must now comply with
substantially the same suitability rule as securities firms that
market such products. In 1994, the Federal Deposit Insurance
Corporation, the Federal Reserve, OCC, and the Office of Thrift
Supervision issued a joint statement applicable to banks and thrifts
marketing nondeposit investment products, including mutual funds and
annuities, to retail customers.\35 This joint statement also applied
to banks marketing government securities, including GSE-issued MBS
and structured notes to retail customers. Although securities
products have always been subject to the antifraud provisions of the
securities laws, the interagency statement tasks banks offering
nondeposit investment products--some of which are not
securities--with determining the suitability of such products before
recommending them to retail customers.
Bank regulators have also recently approved additional sales practice
rules for banks that deal in government securities. As authorized by
the Government Securities Act Amendments of 1993, the three federal
bank regulatory agencies--the Federal Reserve, the Federal Deposit
Insurance Corporation, and OCC--issued a March 1997 joint rule on
bank sales of government securities, including GSE-issued MBS and
structured notes.\36 In addressing dealers' obligations to determine
suitability before making a recommendation to institutional
end-users, the rule uses language similar to the recently approved
NASD rule, as previously discussed. As of July 1, 1997, which was
the effective date of the banking regulators' rule, banks and
securities firms marketing these securities became subject to
essentially the same rules regarding determining suitability before
recommending purchase of GSE-issued MBS and structured notes.
--------------------
\35 Interagency Statement on Retail Sales of Nondeposit Investment
Products, Board of Governors of the Federal Reserve System, Federal
Deposit Insurance Corporation, OCC, and Office of Thrift Supervision
(Washington, D.C.: Feb. 15, 1994).
\36 Government Securities Sales Practices, Board of Governors of the
Federal Reserve System, Federal Deposit Insurance Corporation, OCC,
and Office of Thrift Supervision (Washington, D.C.: Mar. 12, 1997).
BANKS MARKET PRODUCTS FROM
VARIOUS LEGAL ENTITIES THAT
MAY BE SUBJECT TO OVERSIGHT
BY DIFFERENT REGULATORS
-------------------------------------------------------- Chapter 2:2.3
Banks market OTC derivatives, MBS, and structured notes from various
legal entities within their organizational structures, and this
affects which regulators, if any, oversee these activities.
Regulators indicated that most banks use bank employees to market OTC
derivatives. However, some also use their securities affiliates'
staffs to market them, depending on corporate preferences or the
extent to which securities are also being offered to their customers.
Nevertheless, any OTC derivative marketing activities by such
securities affiliate staff would not be subject to the securities
laws unless the product being marketed is a security. A bank
examiner explained that banks' use of the same staff to market both
securities and nonsecurities OTC derivatives may reflect an effort to
have marketing staff be able to select the most appropriate product
for the specific risk management needs or investment objectives of an
end-user, regardless of the regulatory status of the individual
products.
The corporate entities used by banks to market MBS and structured
notes also vary. The Banking Act of 1933, commonly known as the
Glass-Steagall Act, allows banks and their affiliates to underwrite
and deal in certain types of securities known as bank-eligible
securities. These include GSE-issued MBS and structured notes. The
act generally prohibits banks from underwriting and dealing in
bank-ineligible securities, such as those issued by corporations,
including MBS\37 and structured notes. Federal regulators have
provided banks with limited authority to underwrite and deal in
ineligible securities through affiliates of their holding company.
These affiliates--called Section 20 affiliates after the relevant
section of the act--are permitted to engage in securities
underwriting and dealing as long as the affiliate generates no more
than 25 percent of its gross revenues from ineligible securities.\38
Regulators told us that most banks with such affiliates market MBS
and structured notes exclusively from these entities to provide as
large a revenue base as possible for conducting activities in
ineligible securities. Because these Section 20 affiliates are also
registered as broker-dealers with SEC, they are also subject to
examinations by SEC and securities industry SROs to ensure that they
comply with the sales practice requirements of the federal securities
laws when selling securities.
--------------------
\37 To distinguish them from GSE-issued securities, MBS issued by
corporations are called "private label."
\38 The previous limit on revenues derived from ineligible securities
activities for Section 20 affiliates was 10 percent, but the Federal
Reserve raised the percentage to 25 percent, effective March 6, 1997.
However, national banks may sell their own assets in a securitized
form and, therefore, may be deemed underwriters for purposes of the
securities laws, but not for purposes of the Glass-Steagall Act.
UNREGULATED AFFILIATES ARE
NOT SUBJECT TO DIRECT
FEDERAL OVERSIGHT, BUT
REGULATORS MAY ASSERT
JURISDICTION OVER SPECIFIC
PRODUCTS
-------------------------------------------------------- Chapter 2:2.4
Affiliates of securities, futures, and insurance firms that market
nonsecurities or nonfutures OTC derivatives are not directly
regulated by SEC or CFTC.\39 Securities and futures firms are allowed
to conduct activities in nonsecurities and nonfutures products
outside of the entities that are subject to direct SEC or CFTC
oversight, respectively. Some securities firms have established one
or more separate affiliates that conduct OTC derivatives activities.
For example, because counterparties are sensitive to the credit risk
inherent in most OTC derivatives contracts, several securities firms
have created separately capitalized subsidiaries to conduct
activities in these products. These affiliates were specifically
structured to receive the highest credit ratings by rating agencies
to increase their attractiveness as counterparties to end-users of
these products. SEC officials told us that firms generally cite the
stringent treatment that OTC derivatives receive under SEC and CFTC
capital requirements as the reason firms do not conduct such
activities in regulated entities, rather than a desire to avoid sales
practice requirements.
Some insurance firms also market OTC derivatives to end-users.
However, unless the products involved are subject to SEC or CFTC
jurisdiction, the OTC derivatives marketing activities of these firms
are not subject to federal regulatory oversight. The regulation of
the insurance industry is primarily a state responsibility.\40
However, officials from the state insurance regulatory commissions of
the states with major insurance company dealers of OTC derivatives,
including New York, New Jersey, and Delaware, told us that they did
not directly oversee insurance firms' marketing of these products
because such activities were conducted in noninsurance affiliates.
As previously discussed, to the extent that nonsecurities OTC
derivatives activities are legally conducted outside of a regulated
firm, they are not subject to direct SEC or CFTC oversight. By
offering these products from affiliates, dealers have, in effect,
determined that these products are not subject to the securities laws
or most provisions of the CEA. However, SEC, CFTC, or a court could
determine that a product offered by an unregulated affiliate is
subject to the provisions of the federal securities or commodities
laws, respectively, and take action against the dealer when they find
violations of these laws.
--------------------
\39 As discussed in chapter 6, the affiliates of securities and
futures firms that market OTC derivatives are subject to indirect SEC
and CFTC oversight under the risk assessment authority Congress
granted to these agencies in 1990 and 1992, respectively. Also, as
discussed in chapter 6, SEC and CFTC worked with the firms most
active in the OTC derivatives markets to establish a set of voluntary
guidance for participating firms to follow. The guidance presents a
framework of management controls and risk measurement practices.
\40 Congress has strictly limited the extent to which federal law
preempts state insurance law.
THE WORKING GROUP CONCLUDED
THAT THE SCOPE OF
REGULATORS' AUTHORITY AND
SALES PRACTICE REQUIREMENTS
ARE ADEQUATE
-------------------------------------------------------- Chapter 2:2.5
According to SEC and CFTC officials, the President's Working Group on
Financial Markets has discussed the need to expand SEC and CFTC
authority over and sales practice requirements for OTC derivatives.
On the basis of these discussions and information collected on an ad
hoc basis by various members, the officials comprising the Working
Group concluded that no changes requiring legislation are currently
needed to protect the financial markets or end-users of derivatives.
SEC and CFTC officials also told us that their agencies have been
able to take appropriate actions under their existing authorities
when problems have arisen. For example, as previously discussed in
this chapter, SEC and CFTC took a cooperative action against Bankers
Trust for its conduct in OTC derivatives transactions with Gibson
Greetings. The legal entity cited was BT Securities, which is a
subsidiary of Bankers Trust.\41
SEC and CFTC officials told us that if they believed their authority
was insufficient, they would ask Congress to address the issue.\42
One member of the Working Group, the Chairman of the Federal Reserve,
indicated in a February 1997 speech that institutional end-users of
OTC derivatives have demonstrated their ability to protect themselves
from fraud. He noted that when dealers have engaged in deceptive
practices, end-users have been able to obtain restitution either by
taking legal action or threatening to do so. He indicated that,
while the threat of legal action by end-users may deter misconduct,
dealers are motivated by the need to stay competitive, which requires
that they maintain a good reputation.
Officials familiar with the operations of the Working Group indicated
that the various members have shared information relating to OTC
derivatives sales practice issues. The members obtained this
information through special study efforts or otherwise collected it
during their routine oversight activities. However, Federal Reserve
and SEC officials indicated that data on market characteristics
relevant to sales practice issues, such as increased market
participation by new dealers, more widespread use of complex
products, or increased marketing to or product use by less
sophisticated end-users, was not routinely collected by their
agencies. Furthermore, they said that no formal mechanism or
expectation existed for the members to continue collecting and
sharing such information on a periodic basis.
--------------------
\41 BT Securities is an affiliate of Bankers Trust Company and is
authorized to conduct securities activities under section 20 of the
Federal Reserve Act. Both are subsidiaries of Bankers Trust New York
Corp., which is a bank holding company.
\42 CFTC has offered Congress legislative amendments to address
technical issues to clarify its authority under the CEA in several
respects. As of , Congress had not enacted these amendments.
SATISFACTION WITH SALES PRACTICES
WAS HIGH AND DISPUTES WERE
LIMITED, BUT WHEN DISPUTES
OCCURRED LOSSES WERE OFTEN LARGE
============================================================ Chapter 3
According to our 1995 survey, end-users were generally satisfied with
the sales practices of dealers offering OTC derivatives, MBS, and
structured notes. Product use varied with end-users reporting less
use of OTC derivatives than of MBS and structured notes, and larger
organizations generally reporting more use of all of the products
than smaller organizations. Review of regulatory and other data
indicated that cases involving sales practice disputes were not
widespread. However, when disputes did arise, the losses were often
large, with dealers and end-users generally experiencing other
financial impacts. These included direct costs from litigation or
regulatory fines and indirect costs, such as reduced revenues and
income.
MOST END-USERS WERE GENERALLY
SATISFIED WITH DEALER SALES
PRACTICES
---------------------------------------------------------- Chapter 3:1
According to our 1995 survey of a wide range of U.S. organizations,
most end-users were generally satisfied with the sales practices of
the dealers that marketed OTC derivatives, MBS, and structured notes
to them. The rates of reported overall dissatisfaction with the
sales practices of dealers used ranged from as low as 2 percent to as
high as 13 percent across the products. End-users reported lower
rates of dissatisfaction with the sales practices of dealers they had
used than for dealers that made presentations to them but were not
used. Finally, the respondents to our survey provided generally
consistent reasons for any dissatisfaction with specific elements of
dealer practices.
FEW END-USERS REPORTED
DISSATISFACTION WITH DEALERS
USED
-------------------------------------------------------- Chapter 3:1.1
When asked to rate the sales practices of the dealers with whom they
had entered into transactions, few end-users of OTC derivatives, MBS,
or structured notes reported dissatisfaction. To obtain information
on how satisfied organizations who had heard proposals were with
these dealers' sales practices, we asked the organizations we
surveyed to indicate whether they were "very satisfied," "somewhat
satisfied," "neither satisfied nor dissatisfied," "somewhat
dissatisfied," or "very dissatisfied" for each of the products
included in this review.\1 They were asked to provide these ratings
for the following six individual elements of sales practices: (1)
disclosure of downside risks, (2) quality of transaction
documentation provided, (3) suitability of products proposed, (4)
competitiveness of pricing and fees, (5) provision of accurate
mark-to-market pricing information, and (6) assistance in unwinding
transactions. Respondents were also asked to provide a rating of
their overall level of satisfaction or dissatisfaction with dealer
sales practices. In addition, survey respondents were asked to
provide ratings in these categories for (1) dealers they used for
transactions involving OTC derivatives, MBS, or structured notes and
(2) dealers that made product proposals to them but whom they did not
use for a particular product.
As shown in figure 3.1, 2 percent of the organizations across the
industries we surveyed reported being "somewhat" or "very
dissatisfied" with the overall sales practices of the dealers they
used for plain vanilla OTC derivatives contracts. For MBS dealers
used, 7 percent\2 of users reported being similarly dissatisfied; for
structured note dealers used, 13 percent reported being similarly
dissatisfied.
Figure 3.1: Overall Sales
Practice Ratings Reported for
Dealers Used and Dealers Not
Used, by Product
(See figure in printed
edition.)
Note 1: The categories of satisfied and dissatisfied in this figure
represent the total of those respondents that reported being somewhat
or very satisfied or somewhat or very dissatisfied, respectively,
with dealers' overall sales practices. The neutral category
represents those that reported being neither satisfied nor
dissatisfied.
Note 2: Ratings may not add to 100 percent due to rounding.
\a The satisfaction ratings for dealers used relate to MBS only, but
ratings for dealers not used include other asset-backed securities
because we were unable to separate out such products from these
responses.
\b The sampling error for the percentage of structured notes users
who reported being satisfied (64 percent) was plus or minus 11
percent.
\c Dealers not used were those that made product proposals to
end-users but were not used for a particular product.
Source: GAO survey.
Our survey indicated that 79 percent\3 of the end-users of more
complex OTC derivatives were somewhat or very satisfied with the
dealers with whom they did business, which was comparable to the
levels of satisfaction reported for dealers of the three product
types shown in figure 3.1. Because of the small number of end-users
of more complex OTC derivatives and the even smaller number who
reported being dissatisfied with the dealers they used, we could not
make a reliable estimate of the extent of dissatisfaction with
overall dealer sales practices for more complex products. Similarly,
the small number of end-users reporting dissatisfaction with other
products among our survey respondents precluded a statistically valid
analysis of dissatisfaction by the size of organization or by
industry subgroups.
As shown in figure 3.1, an analysis of our survey results indicated
that organizations reported less satisfaction with the overall sales
practices of dealers they heard presentations from but with whom they
did not do business. The percentages of organizations that were
either somewhat or very dissatisfied with the overall sales practices
of dealers that they did not use could be at least twice as high as
the comparable percentages for dealers that were used.\4 The overall
level of dissatisfaction with dealers not used was 17 percent for
plain vanilla OTC derivatives, 26 percent for more complex
derivatives,\5 27 percent for MBS and/or asset-backed securities, and
29 percent for structured notes.
Between 4 and 8 percent of the organizations not using a particular
product were contacted by at least one dealer offering that product
during the survey period. Furthermore, some evidence exists that the
extent to which dealers contacted nonusers is somewhat higher than
these percentages suggest because some nonusers contacted chose not
to rate the dealers' presentations. These respondents reported that
they generally did not listen to the dealers' complete presentations
or thoroughly evaluate them because they did not find the products
appropriate for their organization or for their investment
objectives.
For those end-users and nonusers who rated dealers they did not do
business with, the higher level of dissatisfaction reported with the
dealers not used suggests that potential end-users may have chosen
not to do business with dealers whose sales practices were
objectionable or appeared questionable for particular transactions.\6
Comments by some end-users were consistent with this interpretation,
as some respondents indicated that they refused to do business with
some dealers. Also, some respondents noted that their satisfaction
with dealer sales practices varied by product at some dealers or
depended on which member of a dealer's sales staff presented a
transaction.
--------------------
\1 Respondents were also able to indicate that they either "did not
know" or had "no opinion."
\2 All the population estimates from our survey have sampling errors
of plus or minus 10 percentage points, or less, at the 95-percent
confidence level, unless otherwise noted. This means that a 95-
percent probability exists that if we were to survey all of the
organizations in this population, the actual result obtained would
fall within a range above and below the estimate cited of no more
than the amount of the sampling error for that particular estimate.
See appendix I for the exact sampling errors for each estimate in the
report and more information about the various errors that may affect
survey estimates. For example, survey respondents may intentionally
or accidentally misreport their organizations' product usage.
\3 Subject to a plus or minus 19-percent sampling error.
\4 The differences in dissatisfaction levels between dealers used and
not used were statistically significant for plain vanilla OTC
derivatives and MBS, while the differences for more complex OTC
derivatives and structured notes were not statistically significant
due to the small numbers of dissatisfied end-users of these products
in our sample.
\5 Subject to a plus or minus 12-percent sampling error.
\6 In some cases, respondents might have rated the same firm as a
dealer used and as a dealer not used because an end-user may have
entered into a transaction for a product with a dealer on one
occasion but may have chosen not to do so on another occasion.
RESPONDENTS PROVIDED
CONSISTENT REASONS FOR THEIR
DISSATISFACTION WITH
SPECIFIC ELEMENTS OF DEALER
SALES PRACTICES
-------------------------------------------------------- Chapter 3:1.2
Respondents who were dissatisfied with dealer sales practices
provided similar reasons for their dissatisfaction with two
individual elements of sales practices--disclosure of downside risk
and suitability of products proposed.\7 In addition to providing
ratings on their overall satisfaction with dealers' sales practices
(as shown in fig. 3.1), survey respondents also provided ratings of
individual sales practice elements. For disclosure of downside risk,
none of the estimates for the rate of dissatisfaction with dealers
used exceeded 20 percent for any of the products. End-users of
structured notes reported the highest rate of dissatisfaction--17
percent--with thks element. However, for dealers not used, these
rates of dissatisfaction were higher. Twenty percent of the
organizations in our population reported dissatisfaciton with the
risk disclosure practices of dealers not used that offered plain
vanilla OTC derivatives, while 38 percent\8 reported dissatisfaction
with the risk disclosure practices of dealers not used that offered
more complex OTC derivatives. In addition, 27 percent of the
organizations reported dissatisfaction with the risk disclosure
practices of dealers they had not used for MBS, and 31 percent
reported dissatisfaction with the risk disclosure practices of
dealers they had not used for structured notes.
In follow-up conversations or in their written comments, some
respondents explained why they were dissatisfied with dealer risk
disclosures. Officials at 19 of the 50 judgmentally selected
organizations with which we followed up told us that they were
dissatisfied in some way with the amount of information dealers had
provided.\9 For example, an official of a money management firm said
that risk disclosure was the primary problem with dealer sales
practices. For MBS and structured notes, he said that dealers had
not provided sufficient information about the reduced market
liquidity of some products and that end-users could not rely on
commercially available pricing information to determine the market
liquidity or prices that could be received for products.
Some officials at these 19 organizations commented that even dealer
personnel did not appear to understand the potential downside risks
of the products. For example, an official at a mutual fund told us
that dealer staff often provided written materials on how product use
could be beneficial, but the dealer staff could not always answer
questions about how the value of the products would change as
interest rates changed. An insurance company official wrote on the
survey form that his firm's dissatisfaction rating reflected
experiences with some of the smaller dealers that contacted the firm.
The official believed that the larger dealers generally did a good
job of explaining the merits and risks of products.
According to our survey results for another individual sales practice
element that we asked questionnaire recipients to rate, organizations
were not always satisfied with the suitability of the products
dealers proposed, and this dissatisfaction was again more significant
for dealers they did not use.\10 For this particular element, all of
our estimates of dissatisfaction with dealers used fell below 10
percent. However, for dealers not used, the estimates of
dissatisfaction were higher--18 percent of end-users reported being
somewhat or very dissatisfied with the suitability of plain vanilla
OTC derivatives proposed by dealers that were not used, while 42
percent\11 reported dissatisfaction with the suitability of more
complex OTC derivatives transactions proposed by dealers that were
not used. Thirty-six percent reported dissatisfaction with the
suitability of MBS that were offered but not purchased, and 39
percent reported dissatisfaction with the suitability of structured
notes that were offered but not purchased.
Officials at 16 of the 50 organizations with which we followed up
indicated that dealers were not sufficiently considering end-user
circumstances when proposing transactions. For example, an official
at a money market mutual fund said that, although such funds should
maintain fixed net asset values, many of the transactions dealers
proposed to his organization were for products that could cause large
declines in the value of the fund. A credit union official described
mixed experiences. He said some dealers seemed interested in selling
a product regardless of the credit union's needs and requirements,
but others were more willing to describe products and attempt to
understand the organization's needs. Officials of at least three
organizations were concerned that dealers were marketing GSE-issued
structured notes by portraying them as safe, government-backed
investments, even though the values of such products could be quite
volatile.
Although some organizations were concerned about the suitability of
products that dealers offered, other organizations generally welcomed
receiving proposals even if the product was not currently appropriate
or suitable for them. For example, officials at a hardware products
manufacturer that exported worldwide explained that their firm used
OTC derivatives for managing its foreign currency exposures and for
altering the mix of fixed and floating interest rate obligations used
to finance its operations. Although the firm had specific guidelines
related to its use of these products, it was still interested in
hearing ideas that could lead to alternative ways of meeting its
needs. Similarly, officials at three large multinational firms told
us that, even though their firms receive numerous proposals from
dealers, they explore only those they considered appropriate for
them. However, they appreciated receiving the other proposals so
that they could better evaluate their own risk management activities.
--------------------
\7 Because of the relatively few end-users of OTC derivatives that
existed and the even fewer number that were dissatisfied, we could
not make (1) precise estimates of the extent of dissatisfaction with
these two elements of sales practices and (2) any estimates of the
extent of dissatisfaction with the other four elements of sales
practices that we asked survey respondents to rate.
\8 Subject to a plus or minus 13-percent sampling error.
\9 We conducted follow-up telephone interviews with 50 judgmentally
selected organizations that had responded to the survey--about
one-half of which had expressed dissatisfaction and one-half of which
were generally satisfied with dealer sales practices. See appendix I
for more information on our methodology.
\10 When rating this aspect of dealer sales practices, survey
respondents were not asked to rate whether dealers had complied with
any legal requirement to determine the suitability of a
recommendation.
\11 Subject to a plus or minus 13-percent sampling error.
REPORTED PRODUCT USAGE VARIED
ACROSS PRODUCTS AND BY
ORGANIZATION SIZE AND TYPE
---------------------------------------------------------- Chapter 3:2
Our survey revealed that the extent of OTC derivatives, MBS, and
structured notes usage varied, with fewer organizations reporting use
of OTC derivatives than of MBS and structured notes. In general,
larger organizations were more likely than smaller ones to report
using any of these products, although smaller organizations were
active users in some industries, such as banking. The extent of
reported product usage also varied across industries and
organizations, with more financial organizations reporting use of the
products than nonfinancial organizations, such as state and local
governments. Surveys conducted by other organizations covering
periods after that of our survey indicated that rates of usage showed
little change, with some showing slight declines.
FEW ORGANIZATIONS REPORTED
USING OTC DERIVATIVES, MORE
REPORTED USING MBS AND
STRUCTURED NOTES
-------------------------------------------------------- Chapter 3:2.1
Our end-user survey measured the usage of OTC derivatives, MBS, and
structured notes over a broad population of U.S. organizations. The
survey results indicated that relatively few public and private
organizations used an OTC derivative product, with an estimated 11
percent\12 of such organizations reporting using such a product in
the 12 months before our survey was received, beginning for most
organizations in the spring of 1995. Some of these organizations had
reported using either plain vanilla or more complex OTC derivatives,
and others had reported using both. We estimated that in the period
defined by our survey, approximately 5,200 end-users of OTC
derivatives (plain vanilla, more complex, or both) existed in the
population of approximately 49,000 potential end-users from which we
drew our sample.\13
As shown in figure 3.2, 10 percent of these organizations reported
using plain vanilla OTC derivatives, and 2 percent reported using
more complex OTC derivatives. Reported usage of other products was
somewhat more widespread--approximately 24 percent of such
organizations reported holding at least one MBS, and 16 percent
reported holding at least one structured note during the study
period. We estimated the number of end-users for these products to
be approximately 11,500 for MBS and 7,700 for structured notes.
Although we did not survey individual investors, regulators and
exchange officials told us that few individuals used OTC derivatives
and their usage of MBS and structured notes was small. For example,
NYSE officials estimated that individual investors accounted for
about 5 percent of the volume in the MBS market.
Figure 3.2: Extent of Reported
Product Usage Across the
Potential User Population
(See figure in printed
edition.)
\a Includes securities OTC derivatives.
Source: GAO survey.
--------------------
\12 Subject to a plus or minus 2-percent sampling error.
\13 See appendix I for a detailed description of how we defined this
population and drew our survey sample.
LARGER ORGANIZATIONS WERE
MORE LIKELY TO BE END-USERS
-------------------------------------------------------- Chapter 3:2.2
As shown in figure 3.3, the larger organizations were more likely to
indicate that they were users of OTC derivatives, MBS, and structured
notes.\14
Figure 3.3: Extent of Reported
Product Usage, by Organization
Size
(See figure in printed
edition.)
Note: See appendix I for a description of how we defined large and
small organizations across industry strata.
\a Includes securities OTC derivatives.
Source: GAO survey.
Even though large organizations were more likely to be end-users of
these products, some types of small organizations, which were
aggregated in the survey analysis because of the small sample sizes
involved, reported using MBS at higher rates. For example, small
banks, credit unions, and insurance companies--aggregated in the
survey analysis because of the small sample sizes involved--reported
using MBS at a combined rate of 40 percent,\15
which was about twice the estimated 21-percent usage rate across all
other organizations. In addition, 35 percent\16 of the small bank,
credit union, and insurance company subgroup reported using
structured notes, while overall 12 percent of all other organizations
reported use of such products. Similarly, OCC reported that, as of
March 31, 1996, 41 percent of the approximately 8,600 banks with less
than $250 million in assets had invested in structured notes that had
a total market value of about $6.2 billion. According to OCC, the
percentage of small banks using structured notes was equal to that of
the other 1,274 banks with assets exceeding $250 million.
--------------------
\14 We grouped the organizations in each industry into one or more
substrata by asset size, investment portfolio size, revenue, sales,
population, or other relevant indicators of financial size, depending
on the type of industry and the information available. However, for
banks and credit unions, we obtained additional information on past
usage of certain OTC derivative products and MBS that was used to
improve the accuracy of our groupings for these firms, not just in
terms of financial size, but also in terms of the likelihood of
current product usage. Therefore, the criteria for division between
larger and smaller organizations vary across industries, and although
the larger subgroups are typically comprised of the top 10 percent of
the population, from 1 percent to about 33 percent of some industries
may be apportioned to the largest subgroups. See appendix I for a
more thorough description of how we defined large and small industry
subgroups.
\15 Subject to a plus or minus 11-percent sampling error.
\16 Subject to a plus or minus 13-percent sampling error.
PRODUCT USAGE VARIED BY
INDUSTRY
-------------------------------------------------------- Chapter 3:2.3
Our survey results indicated that usage of OTC derivatives, MBS, and
structured notes was generally higher among the more specialized and
perhaps more sophisticated financial services and investment
management industries.\17 As shown in figure 3.4, among the various
industries we surveyed, reported use by GSEs indicated that they were
the most active users of all three of these product types. On the
basis of information provided by the 31 GSEs that responded to our
survey, 71 percent of these large and generally financially
sophisticated institutions reported using OTC derivatives. About the
same percentage also reported using MBS, while 57 percent of GSEs
reported using structured notes. A group we classified as "other
financial corporations"--which included large credit-financing
organizations, mortgage brokers and lenders, and leasing
agencies--also reported being active users of OTC derivatives. In
contrast, banks, credit unions, and insurance companies reported
active use of MBS and structured notes but comparatively less use of
OTC derivatives.
Figure 3.4: Extent of Reported
Product Usage, by Industry
(See figure in printed
edition.)
Note 1: Because of the small number of respondents in some
industries, small differences in usage percentages may not be
statistically significant.
Note 2: Appendix I describes the organizations that are included in
the groupings in this figure.
\a Pension funds include both private and public (governmental)
pension funds.
Source: GAO survey.
In addition, the survey results from the pension fund industry
indicated differing levels of usage within certain subgroups.
Although the average usage rates reported across the overall universe
of large and small public and private pension funds were not above
average, the large public pension fund subgroup reported relatively
higher usage rates. Forty-one percent of the large public pension
funds reported using plain vanilla OTC derivatives, 33 percent
reported using structured notes, and 74 percent reported using MBS.
Our survey also showed that nonfinancial corporations (service and
manufacturing firms), endowments and colleges, and state and local
governmental entities\18 did not make extensive use of any of the
products. Among nonfinancial corporations, overall reported usage
rates were average or below average for all of the products.
However, the "larger organization" subgroup of nonfinancial
corporations\19 did report using plain vanilla OTC derivatives to a
great extent. We estimated that 66 percent\20 of the population of
large U.S. nonfinancial firms used plain vanilla OTC derivatives
during the survey period. This estimate is comparable to those of
other surveys of similar organizations, many of which reported usage
rates of over 50 percent.
Although higher proportions of firms in the specialized,
sophisticated financial industries may be using OTC derivatives, MBS,
and structured notes, they often represented a smaller total number
compared to the actual number of reported end-users among some of the
more populous nonfinancial industries. For example, even though 71
percent of GSEs reported using OTC derivatives, they made up less
than 1 percent of the entire number of estimated end-users. However,
nonfinancial corporations made up an estimated 22 percent of the
total population of end-users of OTC derivatives, even though only 10
percent of the firms in this industry grouping reported using these
products. Similarly, while 27 percent of the aggregated industry
group of mutual funds, money market funds, and commodity pools
reported using OTC derivatives, the number of such organizations
represented 39 percent of the total number of end-users for this
product type.
--------------------
\17 Statistics on the rates of usage by all industry substrata are
shown in appendix I, tables I.5 through I.8.
\18 Local governmental entities included state treasuries, local
school districts, special districts, cities, and counties (see app.
I, table I.2).
\19 For publicly held corporations, we drew our sample of large
organizations from the top 10 percent (annual sales over $1.4
million) of our population of approximately 5,600 firms. For
privately held nonfinancial corporations, we designated the top 200
firms on the basis of their assets (2.5 percent of our universe of
8,000) as large corporations.
\20 Subject to a plus or minus 12-percent sampling error.
MORE RECENT STUDIES
GENERALLY SHOWED LITTLE
CHANGE IN PRODUCT USAGE
-------------------------------------------------------- Chapter 3:2.4
A number of publicly reported studies conducted after our survey
generally showed either no change or slight declines in the
proportion of organizations in various industries that use OTC and
other derivatives. To assess the magnitude and direction of any
change in usage that may have taken place after our survey closed in
October of 1995, we reviewed studies conducted by three external
organizations that measured usage among specific industries over a
period extending to October 1995 or beyond.\21
Two of the three studies concluded that a slight decrease in
derivative product usage had occurred among certain organizations
after 1995. A series of surveys conducted by Greenwich Associates
estimated that 68 percent of a selected sample of public and private
nonfinancial corporations used derivatives in 1995, while 59 percent
of such corporations used derivatives in 1996.\22 The Greenwich
Associates' surveys suggest that for nonfinancial corporations, usage
reached a high point in 1995, after having increased somewhat in the
preceding years. Surveys of public and private pension plans
conducted for the September 1995 and March 1997 issues of
Institutional Investor Magazine concluded that derivatives usage had
declined from 52 percent to 48 percent.\23 However, another set of
surveys of publicly held U.S. nonfinancial corporations in 1994 and
1995 found an increase in the proportion of derivative product users.
The Wharton School of Business estimated that 41 percent of these
organizations used derivatives in October 1995, an increase from
November 1994.\24
--------------------
\21 Although we attempted to confirm that the industry populations
surveyed and products specified in these other studies were generally
similar to those discussed in this report, the estimates of usage
from these other studies are usually not directly comparable to those
from our survey because of the variability of the samples selected
and questions asked. Most of the recent studies we reviewed rely on
small, nonprobability convenience samples that usually represent a
self-selected subset of only the larger organizations within any
particular industry. We did not assess the quality or verify the
results of any of these external studies.
\22 North American Treasury Services, 1996 Report, Greenwich
Associates (Greenwich, CT: July 1996). This survey obtained 588
personal interviews with senior treasury managers at a judgmental
sample of multinational corporations, large domestic companies,
foreign subsidiaries, regional banks, and government agencies in May
through July of 1995 and 457 interviews in May through July of 1996.
\23 "Pensionforum Survey," Institutional Investor Magazine (New York,
NY: Sept. 1995 and Mar. 1997). This survey received an unknown
number of responses from a judgmental sample survey of 800 corporate
and 250 public pension plan sponsors, conducted quarterly.
\24 1995 Survey of Derivatives Usage By U.S. Non-Financial Firms,
Wharton School of Business/Canadian Imperial Bank of Commerce/Wood
Gundy (Philadelphia, PA: Apr. 1996). This survey received 530
responses in 1994 and 350 in 1995 from a sample of over 2,000 U.S.
nonfinancial firms listed on Standard & Poor's Compustat database.
The 1995 sample also included an undetermined number of additional
Fortune 500 firms that had not been included in the 1994 sample.
SALES PRACTICE CONCERNS DID NOT
APPEAR TO BE WIDESPREAD BUT
INVOLVED MANY LARGE LOSSES
---------------------------------------------------------- Chapter 3:3
Concerns about dealer sales practices have been raised in many of the
publicized losses incurred by end-users of OTC derivatives, MBS, and
structured notes. Although many of the losses were large, sales
practice concerns related to OTC derivatives involved primarily one
dealer. More sales practice concerns were raised for transactions
involving MBS and structured notes. However, such losses involved a
relatively limited number of dealers.
CONCERNS ABOUT DEALER SALES
PRACTICES WERE RAISED IN
MANY PUBLICIZED LOSSES
-------------------------------------------------------- Chapter 3:3.1
Combining publicly available information and regulatory data, we
compiled a list of U.S. and foreign end-users that experienced
losses from OTC derivatives, MBS, or structured note transactions
with U.S. dealers.\25 From this list and with the information used
to compile it, we identified losses in which sales practice concerns
were raised by end-users or regulators. Through this effort, we
identified 360 end-user losses involving OTC derivatives, MBS, and
structured notes, with the earliest loss occurring in April 1987 and
the latest loss occurring in March 1997.\26 These end-user losses
totaled an estimated $11.4 billion. Sales practice concerns were
raised in 209, or 58 percent,\27 of these losses and were associated
with an estimated $3.2 billion in losses. However, since many
disputes were associated with a relatively limited number of dealers,
and given the many thousands of transactions in OTC derivatives, MBS,
and structured notes and the hundreds of billions of dollars at risk
in these transactions over the period we reviewed,\28 we found that
sales practice concerns were not widespread.
As indicated above, not all OTC derivatives, MBS, and structured note
losses involved sales practice disputes. For example, 42 percent of
the publicly reported losses were not accompanied by sales practice
disputes, and for OTC derivatives, 59 percent of the reported losses
were not associated with such disputes. End-users that incurred
losses may not have raised sales practice concerns if the products
were used to hedge other positions that had offsetting gains. EUDA
confirmed that some end-users suffering large derivatives losses had
been using the products as hedges. In such instances, the losses
were not unexpected because the derivatives operated as anticipated
and were offset by gains in the underlying hedged items.
Alternatively, when derivatives performed differently than the way
the dealer had represented they would perform, EUDA said disputes
have arisen.
--------------------
\25 Our list of end-user losses was compiled from publicly available
information and regulatory data. To identify losses, we conducted
searches of periodicals, industry publications, special studies, and
litigation reporting service data. We also reviewed regulatory case
data and discussed such cases and related matters with banking,
securities, and futures regulators. We limited our list to end-user
losses directly involving OTC derivatives (forwards, options, and
swaps), MBS, or structured notes. We excluded losses that dealers
incurred and that foreign end-users transacting with foreign dealers
incurred. We also excluded derivatives-related losses involving the
sale of mutual funds or OTC contracts that CFTC or a court found to
be illegal, off-exchange futures contracts. Although many of the
losses are supported by multiple sources, we generally did not
confirm the accuracy of the information provided by such sources.
\26 The number of losses and the total amount of losses may be
overstated by including losses involving products not covered in this
report and unrealized losses. The number of losses and the total
amount of losses may also be understated to the extent that all
losses were not publicly reported. In this regard, we have included
in the number of losses instances where the entity was reported as
having a loss, even when the loss amount was not reported and,
therefore, could not be included in the total loss amount.
\27 This percentage, as with similar percentages reported in this
section, is not a statistically valid estimate of the actual extent
to which sales practice concerns have been raised in connection with
OTC derivatives, MBS, and structured note transactions. It is based
on a compilation of losses that is not necessarily representative of
the population of transactions involving OTC derivatives, MBS, and
structured notes.
\28 According to the Federal Reserve, the amount at risk, as measured
by the gross market value of OTC derivatives outstanding, was $328
billion for U.S. entities, as of March 1995, or about 3 percent of
the notional/contract amount.
OTC DERIVATIVES LOSSES WITH
SALES PRACTICE CONCERNS
INVOLVED PRIMARILY ONE
DEALER
-------------------------------------------------------- Chapter 3:3.2
Our review identified 44 end-user losses that involved OTC
derivatives transactions with U.S. dealers. These losses totaled an
estimated $5.4 billion. Sales practice concerns were raised in 18 of
these losses, accounting for about 41 percent of the total OTC
derivatives losses and covering an estimated $1.7 billion in losses.
The losses with sales practice concerns involved 9 dealers; however 1
dealer, Bankers Trust, was involved in 9 of the 18 end-user losses.
Sales practice allegations against Bankers Trust have been among the
most widely publicized and have resulted in lawsuits and regulatory
action. As noted in our 1994 report on OTC derivatives, Bankers
Trust is a major U.S. OTC derivatives dealer,\29 and it had a
reputation for offering some of the most sophisticated derivatives
products. In April 1994, two of its customers, Procter & Gamble and
Gibson Greetings, Inc., announced that they faced losses on certain
complex OTC derivatives transactions with Bankers Trust. Procter &
Gamble announced after-tax losses of about $102 million on two
complex swaps transactions, and Gibson Greetings reported after-tax
losses of almost $20 million in a series of complex swaps and options
transactions. Both corporations, as well as several other Bankers
Trust customers that suffered losses, filed suit against Bankers
Trust alleging, among other things, fraudulent sales practices. As
discussed on page 78, Bankers Trust has settled with Procter & Gamble
and Gibson Greetings as well as with other customers.
SEC, CFTC, and the Federal Reserve investigated Bankers Trust's
conduct, and each regulator reached a settlement or similar agreement
with Bankers Trust (the SEC and CFTC actions were discussed in ch.
2, and the Federal Reserve's action is discussed in ch. 6). In
December 1994, SEC and CFTC concluded their investigations with a
joint settlement addressing Bankers Trust's dealings with Gibson
Greetings. Without admitting or denying SEC's and CFTC's findings,
Bankers Trust agreed to the issuance of SEC and CFTC orders finding
that the bank violated antifraud provisions of the federal securities
and commodities laws and agreed to pay a $10 million fine. During
the same period, the Federal Reserve entered into an agreement with
Bankers Trust that required it to establish, among other things, new
marketing and sales practice policies that were consistent with safe
and sound banking practices.
The eight dealers involved in the remaining nine end-user losses with
sales practice concerns were largely major U.S. securities firms;\30
however, unlike the losses associated with Bankers Trust, these
losses generally involved instances where only one end-user had
raised concerns about a dealer's conduct. The end-users incurring
the losses were foreign firms, individuals, and a state, and their
losses ranged from an estimated $8 million to $371 million. In these
losses, many of which involved lawsuits, the end-users alleged, among
other things, that the dealers had misrepresented the risks of the
products or induced the end-user to enter into unsuitable or
unauthorized derivatives transactions.
Regulatory staff at SEC, NASD, and NYSE told us that they have
received few, if any, other complaints against securities firms
involving OTC derivatives. Notwithstanding the limited number of
complaints and publicized OTC derivatives losses involving sales
practice concerns, the extent to which such concerns exist may not be
fully apparent. Speaking at an industry conference, an OCC official
said that the agency's examiners identified instances in which banks
agreed to settle certain OTC derivatives transactions for less than
the amounts due after their customers expressed concerns about the
practices that the banks used to market the products. The OCC
official was not able to estimate the total number of such
occurrences or the dollar amounts involved. Furthermore, an official
from a financial markets consulting firm also indicated that some of
its clients have settled transactions for amounts less than due under
circumstances similar to those described by the OCC official. In
addition, EUDA expressed the view that more sales practice disputes
between end-users and dealers have arisen than were aired publicly,
many of which it said probably involved modest losses.
--------------------
\29 See GAO/GGD-94-133.
\30 According to press accounts and other sources, five of these
cases have been settled and the other four cases are ongoing.
MORE SALES PRACTICE CONCERNS
WERE RAISED IN MBS AND
STRUCTURED NOTE
TRANSACTIONS, BUT SUCH
CONCERNS GENERALLY INVOLVED
FEW DEALERS
-------------------------------------------------------- Chapter 3:3.3
MBS and structured notes were used more often than OTC derivatives,
and a greater number of sales practice concerns were raised with
these products than with OTC derivatives. Our review identified 285
end-user losses connected with MBS and/or structured note
transactions. These losses totaled an estimated $5.6 billion. Sales
practice concerns were raised in 190 of these losses, accounting for
67 percent of the total losses and covering an estimated $1.6
billion. The losses associated with sales practice concerns involved
56 dealers, ranging from major national securities firms to smaller
regional firms. However, 8 dealers were involved in 148 of these
losses. According to press accounts and similar articles, common
sales practice allegations included the dealers misrepresenting the
risks of the products and/or omitting material information about
them.
Our review of regulatory efforts to enforce securities laws
applicable to MBS and structured notes also indicated that cases in
which sales practice concerns were raised involved a limited number
of firms, with an even smaller number of firms accounting for large
numbers of disputes with individual end-users. To assess the extent
to which sales practice concerns were associated with MBS or
structured note transactions, we collected data on investigations by
securities regulators and on complaints these organizations received
in the 4-year period from January 1993 through December 1996. The
regulatory organizations included were SEC, NASD, and NYSE.\31 In
total, we found that these organizations had conducted 55 dealer
investigations during this 4-year period. However, some of these
investigations involved several personnel at individual firms, and
some dealers had been investigated by more than one regulator. Table
3.1 summarizes the status of these investigations.
Table 3.1
Status of Investigations of Dealers by
SEC, NASD, and NYSE From 1993 Through
1996 for Cases Involving MBS and
Structured Notes
Number of dealers
----------------------
Investigation status SEC NASD NYSE
---------------------------------------------- ------ ------ ------
Dealers still under investigation 10 6 4
Dealer investigations resulting in formal 0 6 8
sanctions against a firm or selected
personnel
Cases closed with no action taken 9 3 2
Cases not pursued:
----------------------------------------------------------------------
Dealer out of business (e.g., bankrupt) 1 0 0
Case referred to another regulator 0 1 1
Dealers investigated for nonsales practice 4 0 0
violations instead
======================================================================
Total of cases not pursued 5 1 1
======================================================================
Total 24 16 15
----------------------------------------------------------------------
Note: Forty-four dealers were subject to investigation by these
regulators during this period. The table totals to 55 as some
dealers were being investigated by more than 1 regulator.
Sources: GAO analysis of data from SEC, NASD, and NYSE.
Overall, SEC, NASD, and NYSE investigated a total of 44 different
dealers. However, just a few firms accounted for a large number of
the losses in which individual end-users had raised sales practice
concerns. For example, 6 Houston firms were being investigated or
considered for investigation across more than 78 end-users. SEC and
NASD staff were investigating 1 of these dealers for its dealings
with as many as 30 customers in several states. This firm consented
to a regulatory settlement, stating that it had committed various
sales practice-related violations, including making material
misrepresentations of MBS risks, failing to adequately supervise its
sales representatives, and lacking procedures to ensure that product
risks were disclosed to end-users. SEC was also investigating at
least 3 other dealers for activities involving numerous end-users,
ranging from 10 to 23 end-users at each firm.
Typically, these cases involved dealers marketing GSE-issued MBS,
including some of the more volatile variations, to municipal and
county governments and colleges. For example, an end-user in one of
these cases--City Colleges of Chicago--had estimated losses of around
$38 million, as of March 1996, after purchasing about $110 million in
volatile MBS from one dealer. In at least two of the cases that SEC
or the SRO staff were investigating, the end-users had accused dealer
personnel of marketing high-risk securities by characterizing them as
safe, federally insured investments.
Although the bulk of these cases involved a few smaller securities
firms, some of the largest securities firms were involved in the MBS
case that had the largest loss. In this case, Askin Capital
Management, a New York-based investment management firm, reportedly
lost over $660 million after the declines it experienced from adverse
market movements led to the April 1994 liquidation of several funds
it managed. These funds had been invested in some of the most
volatile CMO tranches. Some of the fund investors sued Askin Capital
Management and at least three large securities firms that sold Askin
the volatile products.\32 The investors alleged that Askin promised
them high returns without large risks, but instead purchased high
risk securities. The suit claims that the three large securities
dealers abetted Askin in these fraudulent sales because they needed
Askin and others to buy the higher risk CMO tranches before the lower
risk tranches could also be sold, thereby ensuring the profitability
of the entire issuance of securities.
Other than these cases, regulators reported that a limited number of
allegations of deficient dealer sales practices involving MBS and
structured notes were identified. Table 3.2 shows the number of
complaints received by securities industry regulatory bodies from
1993 through 1996 for MBS. These data indicate that the total
complaints involving MBS was about 1 percent of the total number of
complaints received. These regulatory bodies did not separately
track complaints, if any, they had received involving structured
notes.
Table 3.2
Complaints Received by Regulators From
1993 Through 1996 Involving MBS Sales
Practices and Total Complaints for All
Products
Complaints involving MBS sales
practices
---------------------------------
Total
complaints
for all
products
(1993-
Regulator 1993 1994 1995 1996 Total 1996)\a
--------------------- ----- ----- ----- ----- ===== ------------
SEC 42 112 50 30 234 49,869
NASD 51 69 57 29 206 18,345
NYSE 71 300 405 122 898 3,984
----------------------------------------------------------------------
\a Includes all products for which these regulators received
complaints (including stocks, corporate bonds, etc.). The volume of
stocks, bonds, and other products being traded likely exceeds the
volumes attributable to MBS, but we did not attempt to standardize
complaint information, such as by calculating the ratio of complaints
to volume traded, across products due to the lack of data on trading
volumes for all products.
Source: GAO analysis of data from NASD, NYSE, and SEC.
The bulk of the sales practice cases being reviewed by regulators
involved MBS; however, one case involving structured notes has been
widely reported by the press. In 1994, Orange County, CA, filed for
bankruptcy after incurring over $1.7 billion in losses in its
investment portfolio that included GSE-issued structured notes.
While about $970 million of the losses were attributed to structured
notes, the county had also used other nonderivative products and had
borrowed heavily to make additional investments. Alleging deficient
sales practices, the county filed suit against two dealers--Merrill
Lynch and Morgan Stanley--that sold it structured notes. Other cases
involving losses on structured notes have been made public, but they
did not involve allegations of deficient sales practices.
--------------------
\31 As discussed in chapter 2, NASD and NYSE together oversee most of
the securities firms marketing MBS or structured notes in the United
States.
\32 The three large securities dealers were Kidder Peabody; Bear
Stearns; and Donaldson, Lufkin & Jenrette.
WHEN THEY OCCURRED, SALES
PRACTICE-RELATED DISPUTES WERE
OFTEN COSTLY TO DEALERS AND
END-USERS
---------------------------------------------------------- Chapter 3:4
Transactions in OTC derivatives, MBS, and structured notes can
present significant risks to dealers and end-users. In addition to
the familiar risks arising from adverse market movements or
counterparty default, dealers with inadequate sales practices expose
themselves to significant compliance and reputation risks. We found
that, in the recent losses involving sales practice disputes, the
associated dealers and end-users frequently experienced significant
costs related to these risks.
COMPLIANCE AND REPUTATION
RISK LOSSES CAN ARISE FROM
SALES ACTIVITIES
-------------------------------------------------------- Chapter 3:4.1
Although the potential for OTC derivatives and related financial
products to produce losses from adverse market movements or
counterparty default has been widely discussed, parties to
transactions in these products are also subject to losses arising
from compliance and reputation risks. These risks are defined by OCC
in December 1995 guidance and appear to aptly describe the various
potential losses and costs that can arise from sales practice
disputes.\33 OCC describes compliance risk as the potential for
losses that result when an entity violates or does not comply with
existing laws, rules, regulations, prescribed practices, or ethical
standards. The OCC guidance also indicates that this risk is present
when the laws or rules governing certain products or customer
activities are ambiguous or untested--the situation that seems to
have applied to the rapidly growing markets for OTC derivatives. The
actual types of losses that result from the failure to adequately
manage activities posing compliance risk include regulatory fines,
civil lawsuit penalties and damages, legal fees, and voided
contracts.
Entities entering transactions in OTC derivatives, MBS, and
structured notes without sound sales practices or adequate controls
also subject themselves to a second major risk--reputation risk. OCC
defines this risk as the potential for reduced earnings and firm
value when negative public opinion affects an institution's ability
to establish new customer relationships or maintain existing ones.
Such losses can also arise if the shareholders of a public
corporation or the investors in an investment company or mutual fund
file suit or reduce their investments in the affected institution.
--------------------
\33 Comptroller's Handbook: Large Bank Supervision--Bank Supervision
and Examination Process, OCC (Washington, D.C.: Dec. 1995).
SOME DEALERS EXPERIENCED
SIGNIFICANT COSTS ASSOCIATED
WITH SALES PRACTICE DISPUTES
-------------------------------------------------------- Chapter 3:4.2
The Bankers Trust case exemplifies the serious compliance and
reputation risks that deficient marketing of OTC derivatives, MBS,
and structured notes can pose. Bankers Trust's OTC derivatives sales
practice disputes have already resulted in significant costs, and
additional compliance and reputation risk losses are possible.
Regarding compliance risk, press accounts reported that Bankers Trust
forgave as much as $150 million of the amount owed to it by Procter &
Gamble and forgave $14 million of the amount owed to it by Gibson
Greetings to settle these customers' suits. Bankers Trust also
settled with several other firms. In addition, it was required to
pay a $10 million fine to settle a joint SEC and CFTC investigation
of its dealings with Gibson Greetings and retain an independent
consultant to review and make recommendations concerning its OTC
derivatives activities. Overall, Bankers Trust reserved $423 million
to absorb losses and other payments relating to these
derivative-related disputes. Press accounts also indicated that
Bankers Trust faced litigation with at least one other derivatives
customer--an Italian publishing firm that reported losses on
derivatives transactions with the bank in 1994. Furthermore, Bankers
Trust has likely incurred significant legal expenses in defending
itself against these and other lawsuits, including one by a
shareholder.
In addition to these costs, Bankers Trust experienced effects on its
reputation or operations that are more difficult to directly measure.
It reported sharply lower revenues and profits for 1994--the year the
disputes came to light, and its stock price declined around the time
its customers were announcing losses. Analysts attributed much of
this reduced performance to Bankers Trust's ongoing derivatives
problems. Also, according to press reports, Bankers Trust's credit
rating was downgraded by the major credit rating services, which was
expected to increase its future borrowing costs. Finally, Bankers
Trust's chairman resigned and was replaced by an executive from
outside of the company.
Another major dealer--Merrill Lynch--was sued by Orange County. The
county alleged that Merrill Lynch employed deficient sales practices
in marketing structured notes and other financial products and has
sought over $2 billion in civil damages. In June 1997, without
admitting wrongdoing, Merrill Lynch agreed to pay Orange County $27
million and to reimburse the county and California $3 million to end
a criminal probe into the firm's role in the county's bankruptcy.
Under the agreement, Merrill Lynch will also implement changes in its
procedures and training. The agreement will not affect the county's
$2 billion civil damage lawsuit against Merrill Lynch. The county
also filed suit against a second major securities dealer--Morgan
Stanley--from whom it purchased structured notes. Since initiating
an investigation of this case, SEC has taken action against the
county's treasurer and assistant treasurer.
As of June 6, 1997, SEC had not taken action against any of the
dealers involved for their conduct in marketing structured notes to
Orange County, and SEC officials advised us they do not discuss
ongoing investigations.\34 However, a press account indicated that
some Merrill Lynch staff had earlier raised concerns with its
management about the potential risks involved with both marketing
securities to and underwriting the debt of Orange County, but that
management had not adequately addressed these concerns. If so,
Merrill Lynch may have failed to adequately consider the potentially
serious compliance and reputation risks of its sales practices and
other dealings with Orange County.
A number of other dealers also face potential regulatory action or
are involved in litigation as a result of their sales of MBS and
structured notes. For example, Askin Capital's loss of as much as
$660 million on MBS in 1994 resulted in an SEC investigation of its
fund's activities and of the dealers that sold it these investments.
As previously discussed, investors in its funds have also filed suit
against these dealers in a New York state court. These investors are
seeking almost $700 million in restitution and an additional $1
billion for damages from each of the three dealers named in the suit.
Some smaller securities firms have also incurred and continue to face
additional costs from their dealings in MBS and structured notes. As
previously indicated, as many as 44 dealers are being investigated by
regulators for their sales of MBS and some have already been assessed
monetary sanctions by federal and state securities regulators or
their designated SRO. For example, Westcap Securities of Houston,
TX, entered into a consent settlement with SEC in February 1996 in
which SEC found that sales representatives had made false or
misleading statements to customers in marketing CMOs and had
excessively traded customer accounts to maximize sales commissions.
SEC found that supervision of sales personnel had been deficient.
SEC revoked the firm's registration as a broker-dealer and ordered it
to pay over $800,000 in regulatory penalties and customer
restitution. The firm declared bankruptcy in April 1996.
Other smaller securities firms under regulatory investigation also
incurred additional losses and costs as a result of their sales
practice-related problems. For example, another Houston securities
firm--Government Securities Corporation--was fined $400,000 by NASD
and has paid more than $11 million in restitution and other costs as
part of its activities with over 30 local government and other public
fund customers. The firm was also suspended from selling certain
securities to such customers for 2 years. Other end-user suits
against dealers included one involving Escambia County, FL, which
sued in U.S. district court four of the dealers that sold it
volatile MBS that had declined in value by $21 million. In another
action, Odessa College of Texas settled legal proceedings under terms
that were not publicly disclosed against four dealers that had sold
it similar securities.
--------------------
\34 However, SEC has filed complaints against one securities firm--CS
First Boston--and two individuals employed by that firm for their
role in underwriting the debt securities Orange County used to fund
its investment portfolio. These complaints allege that the financial
condition of the county at the time of these issuances was not
adequately disclosed to investors in these securities.
SOME END-USERS ALSO
EXPERIENCED SIGNIFICANT
COSTS FROM SALES PRACTICE
DISPUTES
-------------------------------------------------------- Chapter 3:4.3
In addition to the losses that end-users suffered when adverse market
movements reduced the value of their OTC derivatives, MBS, and
structured note holdings, some end-users have experienced additional
costs and losses similar to the compliance and reputation risk losses
incurred by dealers. The widely publicized case of Orange County is
a primary illustration of the additional adverse financial impacts
that an end-user can experience beyond the original investment loss.
In December 1994, the county filed for bankruptcy--the largest
reported occurrence of a governmental insolvency in the United
States, according to a 1995 statement to Congress by the SEC
Chairman--as a result of losses on the portfolio of investments it
managed for itself and 187 other local government participants. As
indicated in the Chairman's statement, the subsequent liquidation of
this portfolio produced at least a $1.7 billion loss.\35 His
statement also elaborates that, as a result of the bankruptcy filing,
two major rating services downgraded Orange County's debt to
speculative grade status.
According to information reported by one of the rating services, when
the county issued $275 million in 30-year bonds in June 1995, it paid
$10 million to buy insurance guaranteeing repayment--4 times the
normal rate for such issues--and an additional .25 percent in
interest to investors. Later that same month, the county issued an
additional $155 million in bonds; this issuance carried interest
payments that were more than 1 percent above comparably rated
municipal bonds, according to this rating service account. We
calculated that the higher rates of interest paid on these bond
issues mean that the county will pay as much as $2.2 million more in
interest each year that these bonds are outstanding.
According to testimony by an Orange County official, the county also
laid off employees, reduced its operating budget, and is using
revenue from other sources to pay off its debt. This official stated
that various other California municipalities and public entities also
made service cutbacks and reduced planned expenditures as a result of
the losses incurred on the funds they invested with the county.
The experiences of other end-users that incurred investment losses
and had subsequent sales practice disputes also illustrate the
potential for additional compliance and reputation risk losses. For
example, both City Colleges of Chicago and Odessa College of Texas
have faced additional financial impacts beyond their initial losses
on MBS investments. According to a City Colleges' official, the
college reduced services and borrowed additional money to cover its
liquidity problem. Similarly, Odessa College officials indicated
that their MBS losses were a contributing factor in raising student
tuition, borrowing from reserves, and restructuring the college's
debt.
The case of Gibson Greetings illustrates other compliance and
reputation risk impacts. After announcing losses on various
derivatives transactions with Bankers Trust, Gibson Greetings was
investigated by and subsequently settled the proceeding with SEC for
filing financial statements that materially misstated its derivatives
positions. Although SEC did not assess a monetary penalty, the
regulator ordered the company to cease and desist any additional
violation of reporting and recordkeeping, which will likely require
that it improve its internal controls and accounting practices for
such products. Gibson Greetings also faced at least four shareholder
lawsuits that claimed that the company's disclosures about its
derivatives activities and other operations were misleading.
--------------------
\35 Although $1.7 billion was initially reported as the amount of the
loss, some estimates indicated that total losses exceeded $2 billion.
DISAGREEMENT OVER COUNTERPARTY
RESPONSIBILITIES INCREASES THE
POTENTIAL FOR DISPUTES
============================================================ Chapter 4
Some end-user losses involving OTC derivatives, MBS, and structured
notes have been accompanied by disputes over counterparty
responsibilities that reflect differences in dealer and end-user
views on the nature of their relationship. These differences in
views could contribute to costly sales practice disputes when
end-users incur losses. However, reconciling these differences could
be difficult given the reaction of end-users to aspects of
dealer-issued guidance that address the nature of counterparty
relationships. Also, decisions about the specific responsibilities
of end-users and dealers can affect the costs of the transaction to
each party. In addition to the dealer-issued guidance, steps taken
by other dealer groups as well as judicial decisions related to sales
practice issues have not completely resolved the differences in
end-user and dealer views. As a result, some market participants
have indicated that the involvement of federal financial market
regulators may be useful.
DISPUTES HAVE CENTERED ON
COUNTERPARTY RESPONSIBILITIES
---------------------------------------------------------- Chapter 4:1
Some of the widely publicized losses on OTC derivatives, MBS, and
structured notes have resulted in disputes between the end-users and
dealers involved over the specific roles and responsibilities that
each envisioned for the other, including whether a fiduciary
relationship existed.\1 An institution acting as a fiduciary to an
end-user, whether established by law or fact, must act in good faith
and with loyalty and honesty towards the end-user and disclose to the
end-user all material facts relevant to actions it takes within the
context of the fiduciary relationship. In one lawsuit, Procter &
Gamble accused Bankers Trust of misusing the trust and confidence it
had placed in the bank by inducing the firm to enter into swaps that
were represented as being safe investments, when instead the
transactions entailed considerable undisclosed risk. Bankers Trust
countered that it acted solely as a principal by dealing with and not
on behalf of Procter & Gamble--that is, by dealing with the firm on
an arm's-length basis. The bank also indicated that Procter &
Gamble, as with other counterparties, was responsible for making its
own assessment of the likely rewards and risks of the transactions,
although the bank contended that it had responded to any questions
posed and had provided reasonable and accurate information. The
resolution of this case is discussed on pages 102 and 103.
In another publicized case, the treasurer of Orange County asserted
that he relied on the advice of various large securities firms when
purchasing structured notes that later incurred losses and
contributed to the county's bankruptcy. The dealers denied having
any advisory responsibilities and stated that county officials had
responsibility for the investments they made. The lawsuit brought
against various large securities firms over their dealings in MBS
with Askin Capital (see discussion in ch. 3) also alleged that the
dealers had breached their fiduciary responsibilities and failed to
act in the interests of Askin's investors. In January 1997, the
judge in this case reduced the counts against these firms to those
pertaining to fraud, according to press accounts.
As these cases indicate, determining whether a formal fiduciary
relationship exists can be difficult. In some instances, fiduciary
duties are clearly placed on a financial institution by law when the
institution agrees to act as an agent in performing certain services.
Such fiduciary duties arise, for example, when a bank's trust
department manages the assets of an estate or when an investment
advisor manages the investments of a pension fund. In other
instances, courts have found fiduciary duties applied to a financial
institution that had not formally agreed to provide fiduciary
services, but whose past relationship with a customer showed a
pattern of reliance by the customer on the institution's advice. The
factors that courts have considered to establish such a pattern of
reliance include the extent to which a customer followed the
institution's recommendations, statements by the customer indicating
reliance or dependence on the institution, and the customer's general
level of sophistication. Generally, courts have ruled that the
larger and more sophisticated the customer, the greater its
responsibility to independently assess the value and risks of a
transaction and the lesser the dealer's responsibility to determine
the suitability of a security and to fully disclose product risks and
valuations. No specific standards distinguish between sophisticated
and unsophisticated customers or degrees of sophistication.
Even when no special relationship exists between a financial
institution and an end-user, the institution may have an obligation
to disclose to the end-user information regarding a transaction about
which it has superior knowledge. Under principles defining common
law fraud, superior knowledge or access to the means of knowledge can
give rise to an affirmative duty to disclose material information,
particularly when the information is not within reasonable reach of
the other party. Applying this principle to the securities markets,
federal courts have held that securities firms have a special duty
not to take advantage of customers' lack of knowledge and, therefore,
firms must disclose certain material information--such as the amount
of the markup they are charging--even when executing a transaction on
a principal-to-principal basis.
--------------------
\1 In general, a fiduciary relationship is a relationship in which
one party owes a duty of trust, loyalty, and confidence to another.
These relationships include, but are not limited to, those
specifically imposed by law. The party that owes the duty of trust,
loyalty, and confidence is a fiduciary and thus may not deal at arm's
length (or on equal terms) with the other party but has a duty to
provide full disclosure of all relevant facts about transactions,
including any financial benefits it receives. A fiduciary's loyalty
must be undivided in that it has a duty not to act on behalf of a
competitor and not to advance self-interests at the expense of the
other party. A fiduciary is entitled to compensation for duties
performed unless it is waived by prior agreement.
THE POTENTIAL FOR ADDITIONAL
DISPUTES ARISES FROM THE
DIFFERING VIEWS OF END-USERS
AND DEALERS
---------------------------------------------------------- Chapter 4:2
Differences between end-users and dealers in the way they view their
responsibilities in transactions involving OTC derivatives, MBS, and
structured notes indicate that costly disputes may continue to
accompany end-user losses. Our survey indicated that a large
percentage of end-users believed that a fiduciary relationship exists
when they engage in transactions involving these products. However,
additional follow-up contacts with respondents revealed that, when
end-users indicated a fiduciary relationship existed, they were
expecting dealers to accurately describe product features,
performance, and material risks. Our survey also indicated that a
significant percentage of end-users relied on dealers for investment
advice.
However, end-users' views on counterparty relationships differed from
those reflected in voluntary guidance issued by two groups of dealer
representatives. In the guidance, transactions in OTC derivatives
are presumed to be on an arm's-length basis--with no special
responsibilities or reliance expected of either party--unless
otherwise agreed to or provided by law. While the dealer-issued
guidance is voluntary and intended only to supplement any existing
responsibilities that parties to these transactions may have, the
approaches to the nature of the relationship, degree of reliance, and
expectations for risk disclosure between parties differed in some,
but not all, respects from the way that such issues are addressed in
existing U.S. and U.K. regulatory requirements applicable to
securities, futures, and other financial products.
END-USERS ATTRIBUTED SOME
FIDUCIARY RESPONSIBILITIES
TO DEALERS
-------------------------------------------------------- Chapter 4:2.1
In our survey, we asked end-users to indicate the extent to which
they believed a fiduciary relationship existed between them and
dealers offering OTC derivatives, MBS, and structured notes.
However, we did not define the term fiduciary. The responses
revealed that a significant number of end-users attributed
fiduciary-like responsibilities to dealers in at least some
transactions involving these financial products. On the basis of
responses to our survey, we estimated that 53 percent of end-users
believed dealers had a fiduciary relationship in some or all
transactions involving plain vanilla OTC derivatives, and that 48
percent\2 attributed such responsibilities to dealers in some or all
transactions involving more complex OTC derivatives, as shown in
figure 4.1.
Figure 4.1: Extent to Which
End-Users Believed Dealers Had
a Fiduciary Relationship
(See figure in printed
edition.)
Note: Percentages of end-users indicating no opinion are not shown.
\a Subject to a plus or minus 16-percent (or less) sampling error.
\b Includes securities OTC derivatives.
Source: GAO survey.
To better understand survey responses indicating that a fiduciary
relationship existed, we reviewed comments on returned questionnaires
and conducted follow-up telephone interviews with 50 judgmentally
selected respondents, including those that were both satisfied and
dissatisfied with dealer sales practices. In explaining their
response that a fiduciary relationship existed, most end-users told
us that this meant dealers had a duty to disclose adequate
information about the products and their risks. Many end-users also
commented that dealers should be truthful and provide accurate
information. In addition, some end-users indicated that dealers
should generally have the end-users' best interests in mind. For
example, an official at a GSE that used OTC derivatives, MBS, and
structured notes told us that, although a legal fiduciary
relationship did not exist, his organization expected dealers to be
open and forthcoming with information, and that this expectation
creates responsibilities for dealers similar to those of a fiduciary.
The percentage of end-users that believed fiduciary relationships
existed as part of transactions in these products was generally
similar across OTC derivatives, MBS, and structured notes. As
discussed in chapter 1, no specific federal sales practice
requirements apply to OTC derivatives that are not securities or
subject to the CEA antifraud provisions. However, MBS and structured
notes are subject to the antifraud provisions of federal securities
laws, which require dealers to disclose risks and assess the
suitability of transactions involving such products for end-users.
Because the percentages of end-users indicating that a fiduciary
relationship existed for transactions involving OTC derivatives were
not significantly different from the percentages for securities
products, it does not appear that the different requirements afforded
these products greatly influenced the degree of responsibility that
end-users placed on dealers.
However, our analysis of survey responses revealed some differences
by type of industry. Officials of state and local governments were
more likely than those from most other organizations to report
believing that a fiduciary relationship existed in some or all
transactions involving OTC derivatives, MBS, and structured notes.
In contrast, GSEs were significantly less likely than organizations
in some other industries to report that such a relationship existed
between them and their dealers. Because of the small number of
respondents within some industry groups, statistically valid
comparisons between most industries could not be made. However,
overall, the responses across industries generally indicated that
entities whose primary function included operating or managing
portfolios of financial assets--such as GSEs, mutual funds, commodity
pools, and money managers--were least likely to believe that a
fiduciary relationship existed. Entities whose use of these products
was generally more limited, such as state and local governments and
nonfinancial corporations, were correspondingly more likely to
believe a fiduciary relationship existed.
--------------------
\2 Subject to a plus or minus 16-percent sampling error. See
footnote 2 in chapter 3 for an explanation of sampling errors related
to estimates from our survey analysis.
END-USERS ALSO INDICATED
RELIANCE ON DEALERS FOR
INVESTMENT ADVICE
-------------------------------------------------------- Chapter 4:2.2
In addition to views regarding fiduciary responsibilities, end-users
indicated that they relied to some extent on dealers to provide
investment advice as part of these transactions. As shown in figure
4.2, the percentage of end-users that indicated they relied on
dealers to provide investment advice from some to a very great extent
ranged from 59 percent for plain vanilla OTC derivatives to 84
percent for structured notes.
Figure 4.2: Extent to Which
End-Users Relied on Dealers for
Investment Advice
(See figure in printed
edition.)
Note: The percentages of end-users indicating no opinion are not
shown.
\a Subject to a plus or minus 15-percent sampling error.
\b Includes securities OTC derivatives.
Source: GAO survey.
DEALER-ISSUED GUIDANCE
ASSERTS AN ARM'S-LENGTH
RELATIONSHIP
-------------------------------------------------------- Chapter 4:2.3
In 1995, two dealer groups each issued guidance that addresses sales
practices, including the nature of the relationship and the specific
responsibilities of parties to transactions involving OTC
derivatives. The first set of guidance, the Framework for Voluntary
Oversight (the Framework), was issued by the Derivatives Policy Group
in March 1995. This group consists of six securities firms whose
affiliates did approximately 90 percent of all U.S. securities
firm-related business in nonsecurities OTC derivatives.\3
The Framework was issued in response to concerns by Congress and
others that the nonsecurities OTC derivatives activities of these
firms were conducted in affiliates not subject to any direct U.S.
regulation.\4 The Framework contains procedures the participating
firms have agreed to voluntarily follow in four major areas related
to OTC derivatives, including counterparty relationships, which
address dealer sales practices.\5 Specifically, the counterparty
relationships section consists of guidelines for professional
intermediaries to follow in dealing with nonprofessional
counterparties. Currently, the Framework applies only to the six
firms and only to their nonsecurities OTC derivatives activities.\6
In August 1995, six financial industry groups,\7 in coordination with
the Federal Reserve Bank of New York, released the Principles and
Practices for Wholesale Financial Market Transactions (the
Principles). The purpose of the Principles is to define the
relationship between institutional participants and to set out sound
practices to be followed as part of transactions in OTC financial
products, including OTC derivatives, MBS, and structured notes. This
guidance does not purport to apply to transactions involving retail
customers. The Principles resulted from an invitation by a senior
official at the New York Federal Reserve Bank to representatives of
the six groups to develop a code of conduct for U.S. financial
markets.\8 In contrast to the Framework, the Principles was promoted
for use by all institutional market participants and does not make
distinctions in its recommended practices on the basis of any
differences in the professional or nonprofessional nature of the
parties to a transaction.
Although differences between the two sets of dealer-issued guidance
exist, we did not find these differences to be material. One of the
members of the Principles drafting committee, whose firm also served
on the committee that developed the Framework, reached the same
general conclusion. At an April 5, 1995, public meeting at which the
Principles drafting committee discussed the provisions of Principles,
he stated that the spirit of the two documents is the same and that
it would be unfair to contrast them simply because they use different
language in some sections.
Overall, we found that the two sets of dealer-issued guidance
advocate a similar approach to counterparty relationships. Both
assert that the relationship between counterparties--unless otherwise
agreed to by the parties or provided by law--is arm's length with
neither party relying on the other, even if information is exchanged.
Also, neither set of guidance requires risk disclosure on specific
transactions by either party, although each states that the parties
should consider exchanging such information when the transaction is
more complex or involves leverage. The summary introducing the
Framework also indicates that the six participating firms have agreed
to provide a generic risk disclosure document to new
counterparties.\9 In addition, both sets of guidance recommend
similar procedures for exchanging pricing information and controlling
and supervising personnel. Furthermore, both state that they are not
intended to create legally enforceable obligations; however, courts
could find the guidance useful in evaluating counterparty
relationships and defining counterparties' respective common law
responsibilities. Table 4.1 compares the major sales practice
provisions of the two sets of guidance.
Table 4.1
Key Sales Practice Elements of the
Dealer-Issued Guidance
Element The Framework The Principles
-------------- ------------------------------- -------------------------------
Nature of the Transactions are predominantly Transactions are arm's length
relationship arm's length in which each and both parties should have
party has the responsibility to the capability to understand
review and evaluate the terms, and make independent decisions
risks, and benefits of the about transactions.
transaction.
Reliance on A dealer should not create the Absent any written agreement or
the dealer impression that it is acting in applicable law or regulation,
an advisory capacity and should information passed between the
take steps to clarify the parties should not be construed
relationship if the as investment advice or
counterparty indicates that it recommendations upon which the
believes the dealer is acting other party may rely.
in such a role.
Disclosure of No disclosure is required on No disclosure is required, and,
risk specific transactions, but the if none is requested, the
summary indicates participating counterparties are to assume
firms have agreed to provide a that each has sufficient
generic risk disclosure information about transaction
statement that describes risks and terms for its
principal OTC derivatives risks decisionmaking process. A
and that clarifies the nature written outline of the material
of the counterparties' terms of the transaction is
relationship. Also, when considered helpful. If a
specifically requested, transaction is particularly
particularly for more complex complex or has significant
or leveraged transactions, leverage, counterparties are
dealers should provide advised that they may wish to
additional information that share more information, such as
accurately presents the scenario analyses.
potential transaction's risks
and benefits, such as scenario
analyses (which shows how a
product's value may change
under different market
circumstances).
Disclosure of When provided, such information Counterparties are not
valuation or should be prepared in good obligated to provide valuations
pricing faith and should not be but should have policies to
information misleading. Dealers should take address the specific
steps to ensure that their methodology used for
counterparties understand the calculating such information.
type of price quote or If unable to internally value
valuation they are receiving transactions, counterparties
(i.e., indicative price, firm should seek external valuations
price, or mid-market and clearly indicate the
valuation). desired type of valuation
information being sought.
Internal Dealers should adopt internal Counterparties should have
controls policies and procedures to board or senior management-
foster strong relationships approved policies covering
with counterparties. Mechanisms their use of financial products
should be in place for and should maintain and enforce
supervising activities of controls and compliance
personnel engaged in OTC procedures, including those
derivatives transactions. relating to supervising
personnel, to ensure that such
transactions are conducted in
accordance with applicable
legal and regulatory
requirements, internal
policies, and other
requirements.
--------------------------------------------------------------------------------
Sources: GAO analyses of the Framework for Voluntary Oversight and
the Principles and Practices for Wholesale Financial Market
Transactions.
As a part of stating that neither counterparty should rely on the
other, both the Framework and the Principles advocate that each party
should be capable of independently analyzing prospective
transactions. This expectation is generally consistent with existing
risk management guidance, such as that issued by the Group of
Thirty\10 and others, for entities engaging in transactions in OTC
derivatives, MBS, and structured notes. This other risk management
guidance typically recommends that such entities have adequate risk
management systems in place, including the ability to measure and
control the risks associated with using these products. The
Framework and the Principles echo this advice by maintaining that
each party is responsible for assessing the risks of a transaction
and its own risk tolerance or capability for managing such risks.
While stating that the relationship between parties is arm's length,
both sets of guidance advocate that parties clarify their
relationship or obligations in writing. For example, the Principles
states that any changes in the assumed relationship from one of arm's
length should be agreed to in writing.
Although the two sets of dealer guidance indicate that entities
wishing to adhere to them should implement certain practices or
controls, neither establishes any minimum responsibility for
disclosing the risks of specific transactions--although this is an
area where problems and disputes have arisen. Nonetheless, when such
information is shared, both sets of guidance offer advice on the
types of disclosure that could be made and provide suggestions for
making certain kinds of disclosures. For example, both discuss
providing scenario analyses that are not misleading and that
adequately explain any assumptions made.
Both sets of guidance also indicate that all dealings should be
conducted fairly and accurately. For example, the Framework states
that dealers should conduct their OTC derivatives activities
honestly, in good faith, and in a manner consistent with the
promotion of public confidence in the integrity of the markets. It
also indicates that all materials should be accurate and reasonable
and that professional intermediaries "should consider including
legends with those materials that identify various assumptions
underlying the analyses presented, describe market factors that may
affect the analysis, and/or inform the party receiving the materials
that a variety of assumptions and market factors may affect the
analysis." Similarly, the Principles indicates that "a Participant
should act honestly and in good faith when marketing, entering into,
executing and administering Transactions." It subsequently indicates
that any communications between the parties, either oral or written,
should be accurate and not intentionally misleading. The Framework
and the Principles also urge that any assumptions used in scenario
analyses be reasonable and that the unique market terminology and
conventions of particular transactions not be used in a misleading
way.
The Framework and the Principles also note that participants must be
mindful of the potential for transactions to result in disputes as
well as to expose them to compliance risk--the risk of loss from
counterparty or shareholder lawsuits, regulatory fines, and voided
contracts--and reputation risk--the risk of loss from reduced
revenues and firm value. Both sets of dealer guidance acknowledge
that certain transactions pose greater levels of these risks, such as
when the transaction is more complex or involves leverage, or when
the counterparty lacks sophistication or the capability to
independently analyze the transaction. In such cases, both indicate
that participants may wish to increase the amount of information they
exchange, involve additional internal personnel or external advisors
in negotiating the transactions, or take other steps, including
avoiding the transaction. Both sets of guidance also advocate that
counterparties establish policies and procedures to assess and
mitigate the extent to which these transactions create compliance and
reputation risks for each party, such as when counterparties appear
to believe that the dealer has assumed an advisory role.
--------------------
\3 The six firms include CS First Boston, Goldman Sachs, Lehman
Brothers, Merrill Lynch, Morgan Stanley, and Salomon Brothers.
\4 See chapter 2 for more detail on the regulatory structure under
which these firms operate and chapter 6 for a discussion of SEC and
CFTC monitoring of these firms.
\5 The other three areas are management controls, reporting, and
evaluation of risk in relationship to capital.
\6 The Framework enumerates the products it covers. SEC officials
told us that, in general, it addresses OTC derivatives not otherwise
subject to regulation under the securities laws.
\7 The six groups included the Emerging Markets Traders Association,
the Foreign Exchange Committee of the Federal Reserve of New York,
ISDA, the New York Clearing House Association, the Public Securities
Association, and the Securities Industry Association. Since being
issued in August 1995, the Principles has been endorsed by two
additional associations, the Institute of International Bankers and
the Bankers Roundtable.
\8 Several such codes existed for foreign market participants, but no
code existed for U.S. market participants.
\9 The counterparty relationships section of the Framework states
that firms "should consider providing" these generic risk disclosure
documents.
\10 The Group of Thirty is an international financial policy
organization whose members include representatives of central banks,
international banks and securities firms, and academia.
THE DEALER-ISSUED GUIDANCE
DIFFERS IN SOME, BUT NOT
ALL, RESPECTS FROM
REGULATORY STANDARDS
APPLICABLE TO OTHER
ACTIVITIES
-------------------------------------------------------- Chapter 4:2.4
To identify any significant differences between the dealer-issued
voluntary guidance\11 and other existing sales practice standards, we
compared the major tenets of the dealer guidance to the approaches
embodied in bank supervisory guidance, a foreign code of conduct, and
U.S. commodities and securities laws.\12
Differences between the dealer-issued guidance and these other
standards could generally be attributed to differences in their
purpose and intent, products covered, or entities subject to them.
The sales practice requirements placed on banks that market OTC
derivatives are largely consistent with the dealer-issued guidance,
although certain differences exist. Similar to the dealer-issued
guidance, OCC and Federal Reserve guidance each indicates that bank
counterparties are ultimately responsible for ensuring the
appropriateness of transactions with bank dealers. Similar to the
dealer-issued guidance, OCC guidance does not specifically require
risk disclosure on individual transactions. The Federal Reserve
guidance appears to require risk disclosure as it expects banks, if
they determine that a counterparty is unsophisticated, to take steps
to ensure that the counterparty is made aware of transaction risks.
The goal of bank supervisory guidance as it relates to OTC
derivatives is to promote the safety and soundness of regulated
institutions; it is not specifically intended to protect those who
engage in financial transactions with these institutions.
The expectations for dealers set out in the dealer-issued guidance
are also similar in some, but not all, respects to the requirements
applicable to futures trading in the United States. Similar to the
dealer guidance, U.S. commodities laws do not require entities
marketing futures and exchange-traded options to determine whether
such products are suitable for their customers. However, in contrast
to the Principles, U.S. commodities laws require that the customer
be apprised of the significant risks of buying and selling these
products, including disclosing that the prices of futures and options
can be volatile and that the customer may incur losses that are
larger than the amount originally invested.
The dealer-issued guidance is most similar to regulatory requirements
issued in one of the major foreign markets for OTC derivatives and
foreign exchange. In July 1995, the Bank of England issued an update
to The London Code of Conduct,\13 which was developed in conjunction
with U.K. market participants. Similar to the U.S. dealer-issued
guidance, the U.K. code establishes that the nature of the
relationship for products in institutional markets involves
transactions between principals, with end-users assumed to be capable
of independently evaluating the transaction. In addition, the U.K.
code states that if the end-user wishes to retain the other party as
an adviser, it should do so in writing.\14 Just as with the U.S.
dealer-issued guidance, the U.K. code also states that participants
share an interest in maintaining high standards of business conduct
and fair dealing. However, whereas compliance with the U.S.
dealer-issued guidance is voluntary, compliance with the U.K. code
is mandatory. The code indicates that the U.K. central bank--the
Bank of England--will view breaches of its provisions seriously, will
investigate complaints, and may employ a range of sanctions against
violators.
The responsibilities envisioned by the dealer-issued guidance
contrast most with the SEC requirements imposed on dealers marketing
securities in the United States. Although the Framework and the
Principles do not supersede existing regulatory requirements, they
vary in several major respects from U.S. securities law
requirements. Whereas the dealer-issued guidance asserts that an
arm's-length relationship exists between counterparties, dealers
marketing securities are expected to ensure that transactions they
recommend are suitable, given the investment objectives, financial
condition, and sophistication of the end-user. Disclosure of
transaction risk, which the dealer-issued guidance makes optional for
specific transactions, is generally expected as part of securities
transactions.
The differences between the dealer-issued guidance and U.S.
securities laws may stem, in part, from differences in the types of
entities to which each applies. The dealer-issued guidance addresses
transactions between participants who tend to be large financial and
commercial entities and tend to be financially sophisticated. In
addition, the dealer-issued guidance does not apply to individual
investors. In contrast, the antifraud provisions of the U.S.
securities laws apply equally to all investors and do not distinguish
between institutional and individual end-users.\15 Furthermore, the
required disclosures that must be made as part of corporate
securities issuances are designed to ensure that any superior
knowledge about the financial condition and risks associated with the
entity issuing the securities are made known to prospective
investors.
--------------------
\11 The drafters of the Principles intended that their guidance be
applicable to all institutional financial market transactions, not
just to those involving OTC derivatives. Nonetheless, they have
acknowledged that entities adhering to the guidance are not relieved
of any obligations under existing law.
\12 We were aware when doing these comparisons that the dealer-issued
guidance is most relevant to transactions involving nonsecurities OTC
derivatives, which currently lack a specific body of law relevant to
sales practices.
\13 The London Code of Conduct: For Principals and Broking Firms in
the Wholesale Markets, Bank of England (London: July 1995).
\14 The U.K. code classifies securities firms, banks, and other
financial institutions as "core" principals and considers other
institutions, companies, and governments as "noncore" principals
active in these markets. Core principals are expected to adhere to
this code in their dealings and noncore principals are expected to
understand these institutions' roles and responsibilities.
\15 In some cases, U.S. securities laws make distinctions between
types of investors, such as the reduced disclosure requirements
pertaining to private placements of securities. NASD's recent
suitability interpretation also addresses dealers' responsibilities
to institutional versus other end-users.
RECONCILING THE VIEWS OF
END-USERS AND DEALERS COULD BE
DIFFICULT
---------------------------------------------------------- Chapter 4:3
End-user and dealer reactions to the specific tenets of the Framework
and the Principles have been mixed. Such reactions may reflect the
parties' differing interests when it comes to defining the nature of
their relationship in transactions involving OTC derivatives. Part
of the difficulty arises because altering the nature of the
relationship between end-users and dealers affects the costs of the
transaction to each party. In addition to the dealer-issued
guidance, actions by a dealer group to standardize contract language
as well as judicial decisions related to sales practice issues have
not completely resolved the differences in end-user and dealer views.
Therefore, various market participants have recognized the need to
resolve these differences, and some have acknowledged that the
involvement of federal financial market regulators might be
necessary.
REACTIONS TO THE TENETS OF
THE DEALER-ISSUED GUIDANCE
HAVE BEEN MIXED
-------------------------------------------------------- Chapter 4:3.1
End-user representatives, including EUDA, GFOA, the National
Association of State Treasurers (NAST),\16 the North American
Securities Administrators Association (NASAA),\17 and the Department
of Labor have criticized the tenets of the dealer guidance.\18
Others, including legal experts, have also voiced concerns about
specific provisions of the guidance. In contrast, representatives of
dealers and certain other organizations have supported the guidance.
Although public comments were not sought on the Framework, the
drafting committee of the Principles solicited comments before
finalizing the guidance. We analyzed the comment letters to identify
the views of end-users and others on the specific tenets of the
dealer-issued guidance, many of which were common to both the
Principals and the Framework. Of the 21 organizations that
commented, we spoke with 9 that provided substantive criticisms of
the Principles. These nine organizations told us that their primary
criticisms had not been addressed in the final version of this
guidance.
One of the primary objections raised by commenting organizations was
that the dealer-issued guidance inappropriately assumes that an
arm's-length relationship should prevail for all transactions. Those
citing this issue argued that the dealer guidance thus imposes a
"one-size-fits-all" model on end-users despite their varying levels
of financial sophistication. For example, in their joint comments on
the final draft of the Principles, three associations representing
governmental entities\19 stated that because the guidance uses the
term "participant" to refer to both dealers and end-users, no
distinction is made between their respective roles and
responsibilities. As a result, they believe that the value of most
of the document is negated. Additionally, the associations stated
that end-users are a diverse group and that assuming they all have
equivalent levels of expertise, responsibility, and access to
information is erroneous.
Another criticism has been that the Principles may reduce end-users'
legal protections. In a May 3, 1996, letter to the Federal Reserve
Bank of New York, EUDA noted that Bankers Trust offered the
Principles as documentation of common practices for OTC derivatives
transactions in support of its litigation with Procter & Gamble.
EUDA indicated that Bankers Trust's action affirmed the association's
original concerns that the Principles would be used by dealers to
reduce the legal protections afforded end-users. EUDA characterized
the Principles as "essentially a unilateral effort on the part of the
dealer community to shift responsibilities from the dealers to
end-users and to buttress the position of the dealers in pending and
possible future litigation." Some have argued that adherence to the
dealer guidance may negatively affect the ability of end-users to
claim reliance on dealer representations. GFOA, NASACT, and NAST
stated in a joint issuance to their members that they might
inadvertently waive existing legal rights if they agreed to be bound
by the Principles without careful prior review.\20 In their letter
commenting on the draft of the Principles, these organizations also
indicated that the attempt by the guidance to preclude reliance on a
dealer was not realistic because potential investors should be able
to, and often do, rely on representations made by dealers about
products. However, the organizations stated that the guidance would
require written acknowledgement by the dealer before any such
reliance could occur.
Some of the commenting organizations also objected to the guidance
because it does not place any responsibilities on dealers to disclose
transaction risks or valuations. For example, in its November 1995
newsletter, EUDA stated that the Principles drafting committee had
"philosophically rejected the idea that dealers should have any
affirmative obligation to disclose material risks of OTC derivative
transactions to end-users, irrespective of the complexity or novelty
of the transactions." Later in that newsletter, EUDA stated that "the
final Principles make it clear that a dealer is not obligated to
provide periodic valuations to its end-user counterparty, regardless
of whether the instrument sold is a proprietary product of the dealer
for which market valuations are neither publicly available nor
readily ascertainable." The associations representing governments
stated that the guidance should recognize a dealer's affirmative
obligation to provide information material to a transaction instead
of requiring an end-user to request it. They believe that failing to
do so inappropriately assumes that both sides have equal information.
They also objected to the Principles' assumption that any additional
transaction information, if not specifically requested, is considered
unnecessary.
In commenting on the Principles, various associations representing
governmental entities stated that the Federal Reserve's agreement
with Bankers Trust\21 would be a better model for disclosing risk and
ensuring that end-users understand transactions.\22 Such a model
would require dealers to (1) provide every counterparty with
information about the material terms and risks of any applicable
proposed transactions, (2) ensure that every counterparty could
understand such terms and risks, and (3) ensure that the means by
which product prices and values are determined are reasonably clear
to counterparties. Dealers would also be required to meet specific
disclosure obligations for proposed transactions.
Another criticism of the guidance was that end-users were
insufficiently involved in their development. For example, the
Department of Labor stated in its comment letter on the draft
Principles that "entities which had no involvement in the creation of
the Principles, had not agreed to adhere to the Principles, or may
not even have known of its existence could be viewed as subject to
the Principles." The agency also stated that the Principles should
only apply to entities that subscribe to them in writing. According
to EUDA, "the process followed in developing the Principles and
Practices was fundamentally flawed" because representatives of the
end-user community were excluded from the Principles Drafting
Committee. The treasurer of a major utility, who is an EUDA board
member, was quoted in an industry publication as stating that "this
is probably the only area in the finance world where a group of
dealers have shaped both the products and all of the surrounding
rules and regulations, with no input from those who are not
dealers."\23
Finally, in a May 1995, letter to the Principles drafting committee,
GFOA contrasted the Framework with the Principles by stating that the
Framework "takes limited steps in advising professional
intermediaries to OTC transactions to disclose information regarding
risks, clarify valuation questions, and provide training regarding
counterparty relationships." A GFOA official told us that, although
these documents call for largely the same practices, GFOA believed
that the Framework was more balanced in tone.
Representatives of dealers and other organizations have viewed the
Principles more positively. A member of the ISDA board told us that
the greater use of OTC derivatives has increased the need for dealers
to formally explain their products and activities, including the
risks associated with product use and the nature of their
responsibilities in these transactions. A managing director at a
large U.S. securities firm said that he disapproved of end-users
who, when faced with losses, decide that they were not fully informed
about the transactions. Therefore, he saw the guidance as valuable
for describing the customary way the institutional markets work and
for clarifying that dealers, unless otherwise agreed to, do not have
fiduciary obligations as part of these transactions. An official
from the New York Federal Reserve Bank indicated that the Principles
provides a sound basis for relationships between parties conducting
activities in financial products. He said that it assumes an
arm's-length relationship unless otherwise agreed to and acknowledged
that parties can agree to alter this assumption in writing if it does
not fit their circumstances. He also stated that the United Kingdom
makes the same assumption about the nature of counterparty
relationships, and it would be problematic for U.S. practices to be
inconsistent with those of other major markets.
--------------------
\16 NAST is a 75-member association of state and territorial
treasurers, deputies, and staff.
\17 NASAA members are the securities regulators of the 50 states, the
District of Columbia, Puerto Rico, the Canadian provinces and
territories, and Mexico. It develops model codes and guidelines,
facilitates cooperative enforcement efforts, fosters
information-sharing, and provides training.
\18 As well as reviewing journal articles and conference proceedings,
we also obtained copies of critical letters that various
organizations sent to the drafting committee of the Principles.
These organizations included the Treasury Management Association, the
Financial Executives Institute, NASACT, and the New York State Bar
Association.
\19 The three associations were GFOA, NAST, and NASAA.
\20 State and Local Government Investor Protection ALERT, GFOA, NAST,
and NASACT (Washington, D.C.: Oct. 16, 1995).
\21 The Bankers Trust-Federal Reserve agreement applied these
heightened requirements only to those transactions involving
significant leverage. The agreement is discussed more fully in
chapter 6.
\22 Comments on Principles and Practices for Wholesale Market
Transactions, GFOA, NAST, and NASAA (Washington, D.C.: May 19,
1995).
\23 "Resolving the Dealer-User Conflict," Derivatives Strategy, May
1996, Vol. 1, No. 6, page 17.
THE INTERESTS OF END-USERS
AND DEALERS CONFLICT WHEN IT
COMES TO DEFINING THEIR
RELATIONSHIP
-------------------------------------------------------- Chapter 4:3.2
Difficult issues remain to be resolved before the differing interests
of end-users and dealers over the nature of their relationship can be
reconciled. To date, attempts to address these differences have not
been successful. The primary areas of disagreement and uncertainty
between end-users and dealers, and among the most difficult to
resolve, are the nature of their relationships in transactions
involving OTC derivatives that are not securities or futures and
whether or not each party can rely on the statements made by the
other. Under the securities laws, an implied standard of fair
dealing allows end-users to rely on dealer statements and advice
about a security. Although both sets of dealer-issued guidance
indicate that neither party is presumed to be relying on the other,
these documents contain language stating that transactions and
communications between parties are expected to be accurate and made
in good faith. According to the New York Federal Reserve Bank
official who sponsored the development of the Principles, this
language means that misstatements are not permissible. An official
of a U.S. securities firm that participated in drafting the
Principles said that, although neither party has the duty to advise
the other about the risks of the transaction, a "buyer beware"
philosophy is not assumed because the Principles calls for honest
dealings between the parties.
Some dealer officials explained that allowing counterparties to view
their firms' statements as investment advice as a part of these
transactions can be problematic. They said that to provide
investment advice, dealers need to understand the complete financial
position of their counterparties; however, end-users are not always
willing to provide this information. A managing director at one of
the major dealer banks, who also sits on ISDA's board, told us that
OTC derivatives contracts require performance by both parties. As a
result, it is not reasonable to hold dealers totally responsible for
the actions of the end-user.
Dealers also explained that the information they provide is not
advice, rather it describes and explains the products. Dealers told
us that they offer useful products that can meet the needs of
end-users seeking to hedge risks or to obtain an investment return.
In explaining how they marketed these products, dealers said they
take time to learn end-users needs, assess end-users' current
financial condition, and provide end-users education or explanations
about products. For example, officials at one U.S. securities firm
provided us with a sample of a presentation given to an end-user.
The 26-page document included a detailed analysis of the end-user's
exposure to changes in interest and currency exchange rates.
However, officials representing end-users and other organizations
indicated that when the complexity or other features of some products
render their risk characteristics less obvious, then reliance on
dealer statements is sometimes necessary. An official working in the
treasury of a large end-user commented at an April 1996 conference
that, although his firm was financially sophisticated, the effort
required to fully analyze the performance of certain complex products
was beyond his firm's capabilities. Therefore, the firm needed to be
able to rely on dealer statements about how the products would
perform as market rates changed. He said that, although the dealers'
marketing staff who explain complex transactions are willing to allow
his firm to rely on their representations, the dealers' legal staff
advised his firm that no such reliance can be made because such firms
are seeking to avoid the resulting legal liability. An attorney
representing EUDA at a July 1996 forum on these issues said that
dealers have superior knowledge about the proprietary products they
develop and end-users find replicating the valuations of some
products very difficult. During an address to an industry
conference, an SEC commissioner said that dealers sometimes are
tempted to describe products in sophisticated terms to increase their
proprietary value.
Although comments on a draft of the Principles were solicited in a
public session, few meetings between end-user and dealer groups have
been held. A representative of GFOA said that members of the
Principles drafting committee met with their organization and other
governmental end-user associations just before issuing the final
draft of that document. A representative from another end-user
organization told us that his organization had been approached in
early 1996 about working on a committee to revise the Principles, but
they had declined to participate at that time because, according to
this official, participation was made contingent on endorsing the
Principles. As of August 1997, no additional meetings for the
purpose of reconciling dealer and end-user views on the nature of
their relationship as part of OTC derivatives transactions had been
held.
THE FINANCIAL IMPACT OF
ALTERING THE NATURE OF
RELATIONSHIPS MAY MAKE
RESOLVING DISAGREEMENTS MORE
DIFFICULT
-------------------------------------------------------- Chapter 4:3.3
Resolving disagreements about the nature of the relationship between
end-users and dealers may be more difficult because the resolution
can affect who bears what costs in transactions involving OTC
derivatives, MBS, and structured notes. As our survey and other
information indicated, end-users believe they should be able to rely
on the information that dealers provide. However, dealers and others
told us that, if end-users want to rely on the information provided,
then it would be considered investment advice and the dealers would
have to increase transaction prices or arrange separate compensation
to reflect the increased legal risk in providing such advice. A
former securities regulatory official said that reconciling the
opposing views of the parties will be difficult because neither wants
to assume the likely increased costs of the transactions. He noted
that dealers, despite providing sometimes voluminous information
about a product and its function, do not wish this information to be
considered a recommendation or investment advice that can be relied
upon because they do not want to assume any related legal liability.
Conversely, he said that end-users want to obtain information from a
dealer at no cost, secure competitive price quotes from a number of
dealers, and then retain the right to sue the dealer used if the
transaction loses money.
In January 1995 testimony before Congress, the Chairman of the Board
of Governors of the Federal Reserve System also discussed how
altering dealer responsibilities could create additional costs that
are detrimental to the markets.\24 The Chairman testified that
dealers in financial transactions sometimes assume a role beyond that
of a mere counterparty, such as when they provide advisory services.
However, if dealers are required to ensure that an end-user's use of
a product is appropriate, such requirements may serve as a means for
end-users to shift a transaction's risk back to the dealer through
legal actions. If such legal risks are exacerbated, dealers may
begin charging a premium to cover uncertain future legal claims, and
some dealers could move their activities overseas or withdraw from
the market altogether. He said that such an outcome would present
considerable costs to the economy because of the resulting
interference in liquid and efficient markets.
--------------------
\24 Testimony by Alan Greenspan, Chairman, Board of Governors of the
Federal Reserve System: Committee on Banking, Housing, and Urban
Affairs; United States Senate (Washington, D.C.: Jan. 5, 1995).
A DEALER GROUP PROPOSED
CONTRACT LANGUAGE TO ADDRESS
THE NATURE OF COUNTERPARTY
RELATIONSHIPS
-------------------------------------------------------- Chapter 4:3.4
ISDA proposed standardized language that describes the nature of the
relationship between counterparties to OTC derivatives transactions
and that could be incorporated into OTC derivative contracts. ISDA
suggests that this language be added to the ISDA master
agreement--the standardized contract used to document the obligations
of parties to OTC derivatives transactions.\25 If included as part of
such contracts, each party would be representing that
-- it was not relying on the other party and was making its own
decisions about the transaction,
-- it was capable on its own (or with independent professional
advice) of understanding the terms of the transaction and its
risks, and
-- it was not acting as a fiduciary or an advisor in the
transaction.
An official from a large U.S. corporation indicated that his firm
refused to sign contracts with this provision. He said that,
although his firm did not expect dealers to act as fiduciaries, it
wanted to be able to rely on statements of fact made by the dealers
about product performance under different market conditions. He
noted that, although his firm was large enough to refuse to sign
contracts that included language such as that suggested by ISDA,
smaller end-users might not have the same clout and thus might sign
as a condition of completing a transaction.
An attorney speaking on behalf of EUDA at a July 1996 industry forum
said that the organization was cautioning end-users about signing
contracts with this language in the event that doing so waived rights
they might otherwise have, such as the ability to claim fraud on the
basis of misrepresentations or omissions of fact. Although ISDA had
amended the representation in an attempt to address this concern, the
attorney told us that she was aware of the amendment when she spoke
at the conference and that EUDA's reservations about the
representation's language persist.
--------------------
\25 Representation Regarding Relationship Between Parties, ISDA (New
York, N.Y.: Mar. 6, 1996).
RECENT COURT DECISIONS HAVE
FOUND THAT OTC DERIVATIVES
DEALERS HAVE SOME
RESPONSIBILITIES, BUT THEY
HAVE NOT RESOLVED KEY ISSUES
-------------------------------------------------------- Chapter 4:3.5
In two cases resolved since 1995, courts have indicated that,
although OTC derivatives dealers were not acting as fiduciaries, they
were held responsible for being accurate when disclosing transaction
risks. The first case, decided in the English Commercial Court in
December 1995, was decided in the dealer's favor. Although a U.K.
case, the decision is relevant to U.S. OTC derivatives
counterparties because many of their swaps personnel are located in
London, and the ISDA master agreement used to document OTC
derivatives contracts offers the choice of either New York or U.K.
law as the governing jurisdiction for disputes. The case concerned
two swaps transactions executed between Bankers Trust and an
Indonesian business conglomerate. The Indonesian firm claimed, among
other things, that the bank had made fraudulent misrepresentations
and had a "duty of care" to fully explain the transactions and their
risks. The judge found that Bankers Trust had not made a complete
disclosure of the risks as part of these transactions. However, he
stated that "the parties' respective skill and knowledge in the field
is a very relevant, though not by itself, decisive factor." He also
noted that officials at the Indonesian firm had held themselves out
as being financially sophisticated and had demonstrated their ability
to determine the transaction risks, even though the bank had not
fully disclosed them. Therefore, the judge determined that Bankers
Trust did not have a duty greater than the duty to present fairly and
accurately any facts and matters in the representations it made.
Another suit--filed in U.S. District Court by Procter & Gamble
against Bankers Trust--may have aided in clarifying the
responsibilities of dealers in OTC derivatives transactions, but its
early settlement has left opinions divided on its implications.
Procter & Gamble filed this suit in October 1994, but the two parties
settled in May 1996 before the case was presented to a jury. Under
the settlement, Bankers Trust agreed to forgive as much as $150
million that Procter & Gamble owed. On the day of the settlement,
the presiding judge responded to an earlier motion for summary
judgment by dismissing or ruling in Bankers Trust's favor on all the
counts against it except one count alleging fraud and two counts
requesting that the contracts be voided. The judge would have
allowed these three counts to proceed to trial. Bankers Trust had
argued that the transactions in question had been conducted at an
arm's length. In the ruling, the judge concluded that Bankers Trust
had not been acting for or on behalf of Procter & Gamble as in a
typical customer-broker context, but instead the two were principals
to a contract and, therefore, no fiduciary duties were imposed.
However, he did find that, under New York law, Bankers Trust had a
duty to disclose material information about the transaction, both
before and during the transactions, and also had a duty to deal
fairly and in good faith during the performance of the transactions.
The judge's ruling in the Procter & Gamble case did not definitively
settle the extent to which dealers, in general, have responsibilities
to disclose material information about transaction risks or the other
requirements that may apply to dealers' marketing activities. Since
the ruling was made, several journal articles have provided
conflicting views on the implications of the judge's ruling on
dealers' obligations. At a July 1996 conference in Washington, D.C.,
representatives of dealers and end-users as well as legal experts
also offered conflicting views on the conclusions that could be drawn
from the ruling. Furthermore, in its announced settlement with an
individual Bankers Trust employee who had marketed these products to
Gibson Greetings, SEC stated that it disagreed with the Ohio judge's
ruling in the Procter & Gamble case regarding the inapplicability of
federal securities laws to certain OTC derivative products.
THE NEED TO ADDRESS
CONFLICTING VIEWS ON THE
NATURE OF COUNTERPARTY
RELATIONSHIPS HAS BEEN
RECOGNIZED
-------------------------------------------------------- Chapter 4:3.6
Representatives of regulators, end-users, and dealers have recognized
the need to reach agreement on the specific responsibilities of
dealers as a part of transactions in OTC derivatives, MBS, and
structured notes. While speaking at a forum for end-users about the
relationship that should prevail between end-users and dealers in
institutional market transactions, a New York Federal Reserve Bank
official said that activities in these products are important to the
economy. Therefore, he said that too much uncertainty is created by
leaving these matters to be decided by the courts on the basis of
individual case facts and circumstances. Another speaker, an SEC
commissioner, called on dealers and end-users to come to common
agreement on each party's responsibilities and duties. He cited the
inefficiency of having dealers face potentially large legal
liabilities over disputes decided by individual courts on the basis
of what is usually a brief interaction between the end-user and
dealer. He said that such uncertainty would not be tolerated in
other areas of business and should not be tolerated in the markets
for these products. Thus, he concluded that clarifying the
relationship between end-users and dealers could enhance market
efficiency and reduce dealers' legal liability. Furthermore, he said
that having dealers agree on the rules regarding their
responsibilities was better than having thousands of end-users
attempting to individually negotiate the nature of their relationship
with dealers. However, he also acknowledged that when the nuances of
relationships do not fit within the generally agreed-upon framework,
then changes could still be individually negotiated.
Others have also recognized a need for end-users and dealers to agree
on the nature of their relationship. A former securities regulator
said that end-users and dealers need to agree on a set of common
terms so that each side understands what type of information the
other is providing and which statements can be relied on and which
cannot. End-users and dealers should also discuss when and how
scenario analyses should be provided. Coming to such agreement could
reduce the number of instances where legal disputes occur. In
response to an end-user's concerns over the need to rely on the
information dealers provide about product features and performance,
ISDA's legal counsel agreed that the parties need to discuss these
issues with the goal of reaching a consensus. In a May 1996 article,
an EUDA board member remarked that the organization hoped to continue
to work with dealers to develop mutually acceptable practices for
these products.
Some market participants have observed that the involvement of one or
more federal financial market regulators may be needed to assist
end-users and dealers in resolving disagreements about dealer
responsibilities. Speaking at a June 1996 risk management forum,
representatives of a large dealer bank and a securities firm
indicated that financial regulators had a role to play in assisting
the end-user and dealer communities in reaching agreement on their
responsibilities. At an industry forum in July 1996, an attorney
with futures regulatory expertise commented that the existence of
different regulatory requirements and dealer-issued guidance creates
confusion over what standards apply or should apply to transactions
in these products. He expressed the desire that end-users and
dealers jointly come to agreement and suggested that the standards
proposed by bank regulators would be a good starting point for
considering what form such agreements could take. He and other forum
participants indicated that financial market regulators, especially
SEC and CFTC, could assist in clarifying the legal standards that are
applicable to these transactions. EUDA has also acknowledged that
federal financial market regulators could play a role in this
process. In a May 3, 1996, letter to the New York Federal Reserve
Bank, the end-user association called for guidelines that
". . . could be endorsed and implemented by both dealers and
end-users. This would require, however, that all sides and
views be invited to the drafting table without preconditions.
If the Federal Reserve Bank of New York does not want to
facilitate such a dialogue under its auspices, we feel certain
that other interested persons or government agencies would do
so."
Although not calling for federal involvement, the Chairman of the
Federal Reserve Board provided some criteria for appropriate
regulatory intervention in the markets. In the previously cited
January 1995 congressional testimony, the Chairman stated that
markets function most efficiently when both parties are free to enter
transactions at their own discretion and are unhampered by the need
to serve the interests of their counterparties. He emphasized that
any consideration of regulation in this area should adhere to the
principle that parties to financial transactions are responsible for
their own decisions. However, he noted that misrepresentation and
fraud could not be tolerated. He also said that, in some cases,
end-users may not reasonably be expected to understand the risks
involved in certain complex products, and that dealers in financial
transactions sometimes act as more than just a counterparty by
providing advisory services. According to the Chairman, addressing
the situation may require limiting the use of some products to only
certain organizations, providing guidance to end-users for investment
and risk management, encouraging them to obtain independent advice,
or encouraging them to diversify their portfolios. However, he
cautioned against approaches that would allow end-users to shift a
transaction's risk back to the dealer through legal actions, because
such approaches would likely increase transaction costs, discourage
dealers from offering these products, and interfere with currently
liquid and efficient markets.
DEALERS AND END-USERS ACTED TO
REDUCE THE POTENTIAL FOR SALES
PRACTICE DISPUTES, BUT WEAKNESSES
REMAIN
============================================================ Chapter 5
Regardless of whether end-users and dealers collectively reach
agreement on the nature of their relationship, they can individually
protect themselves against sales practice disputes by having in place
strong corporate governance systems,\1 including internal controls
and related practices. In discussions with us, dealers described
implementing internal controls and sales practices that were
consistent with those advocated by the two sets of dealer-issued
voluntary guidance analyzed in chapter 4. Nonetheless, regulators
identified weaknesses in sales practices that exposed dealers to the
risk of loss. Similarly, end-users described a range of procedures
for controlling investment risk; however, some lacked basic controls.
Also, reviewing organizations identified specific weaknesses in
end-user controls that contributed to losses. To help end-users
better manage their activities, professional associations have issued
guidance for their members to use in strengthening their corporate
governance systems, including their internal controls and related
practices. Actions have also been taken by various state governments
to reduce the risk of loss associated with the use of OTC
derivatives, MBS, and structured notes.
--------------------
\1 Governance systems are concerned with transactions and
relationships within an organization, including who controls which
activities, who makes decisions, and who has what responsibilities
for which claims against the revenues and assets of a company.
Although we refer to these systems as corporate governance, they also
apply generally to governmental entities.
CORPORATE GOVERNANCE SYSTEMS
CAN ADDRESS SALES PRACTICE
ISSUES
---------------------------------------------------------- Chapter 5:1
In our previous reports on derivatives, we stressed the importance of
organizations having strong corporate governance systems to ensure
that risk management and internal control systems are in place and
functioning as anticipated. Under an effective corporate governance
system, the board of directors approves policies and oversees the
organization's activities in financial products, including OTC
derivatives, MBS, and structured notes. In addition to losses
arising from adverse market movements or counterparty defaults, the
marketing and use of these products can expose dealers and end-users
to risks that can be similarly costly. Various entities, such as the
Federal Reserve, OCC,\2 and the Group of Thirty,\3 have issued
guidance that emphasizes the need for sound corporate governance
systems to address the risks posed by dealing in and using these
products. These sets of guidance are applicable to dealer marketing
and end-user investment activities. As discussed at the end of this
chapter, various end-user groups have also issued guidance that is
specifically targeted to their members' investment activities and
that addresses the importance of a strong corporate governance
system.
--------------------
\2 In addition to guidance for banks acting as dealers, the Federal
Reserve and OCC have issued guidance for banks that use OTC
derivatives and other financial products primarily as end-users. See
Evaluating the Risk Management and Internal Controls of Securities
and Derivative Contracts Used in Nontrading Activities, Federal
Reserve Board (SR 95-17) (Washington, D.C.: Mar. 28, 1995) and
Comptrollers Handbook: Risk Management for Derivatives, OCC
(Washington, D.C.: Oct. 1994).
\3 Derivatives: Practices and Principles, Global Derivatives Study
Group, Group of Thirty (Washington D.C.: July 1993).
DEALERS DESCRIBED SALES
PRACTICE POLICIES AND
PROCEDURES THAT WERE CONSISTENT
WITH THE DEALER-ISSUED GUIDANCE
---------------------------------------------------------- Chapter 5:2
The dealers we contacted described sales practice policies and
procedures for marketing OTC derivatives, MBS, and structured notes
that we found to be consistent with the Framework and the Principles
that were discussed in chapter 4.\4 Dealers indicated that the extent
to which they disclosed transaction risks depended on the product and
the needs of the end-user. In general, they explained that the
amount and type of information they disclosed about the risks of
transactions in OTC derivatives, MBS, and structured notes varied
depending on the complexity of the product. For more complex
products, dealers generally indicated that they would provide more
detailed descriptions, explanations, and materials about the
product's performance and risks. The firms also indicated that
scenario analyses were sometimes provided, particularly for more
complex transactions. The dealers explained that the amount of
information they provided also varied depending on the sophistication
of the end-user. For example, officials at one of the large
securities firms told us that end-user sophistication was key to
determining how much information was included in proposals--that is,
the less sophisticated the end-user, the more information they would
include.
Although dealers of OTC derivatives, MBS, and structured notes told
us that they considered the circumstances of end-users when marketing
these products, they did not view this as necessary for all
transactions. At least four of the dealers we contacted explicitly
stated that they were not responsible for assessing the suitability
of OTC derivatives transactions for end-users. However, all of the
dealers said that their firms' policy is to tailor transactions to
end-user objectives and sophistication. For example, officials at a
major bank and a major securities firm indicated that, although
suitability determinations are not legally required for OTC
derivatives, their staff are generally protective of their
relationships with end-users and would not knowingly enter into
transactions that were inappropriate for end-users. However,
officials at another major securities firm told us that they would
enter into a transaction they believed was inappropriate for an
end-user if the end-user insisted on proceeding even after hearing
the dealer's advice against such action. Dealers also generally did
not view themselves as acting as fiduciaries in these
transactions--most dealers emphasized that the end-users with whom
they transacted were generally sophisticated. Officials at one of
the large securities firms explained that, as a way of reducing their
firm's exposure to compliance and reputation risks, sales staff are
required to be alert to indications that an end-user might be viewing
the relationship as one involving fiduciary responsibilities for the
firm. Such indications could result from observing that the end-user
generally entered into all or most of the transactions the firm
proposed, or appeared to be doing so, without independent analysis.
In such cases, firm policy was for sales staff to ensure that
transactions conformed to the end-user's objectives and to discuss
the situation with other levels of management within the firm.
Dealers of OTC derivatives, MBS, and structured notes described
having similar controls and supervision processes to oversee their
marketing of these products and to reduce the likelihood of sales
practice disputes. They told us that their primary means of
overseeing the firm's marketing activities was by establishing
multiple points of review for the transactions. The dealers
described requiring staff other than the marketing personnel--such as
trading supervisors--to review transactions daily as well as at
weekly or monthly intervals. At least four firms had relationship
managers who acted as central points of contact for the dealers'
activities with individual end-users. In this capacity, such staff
were to review the appropriateness of all activity between the dealer
and end-users, regardless of which business line within the firm
originated the transaction. Furthermore, most of the dealers
indicated that their internal audit staff performed reviews of their
marketing activities in these products. However, one firm indicated
that its internal audit staff had never reviewed these activities.
Most of the dealers of OTC derivatives, MBS, and structured notes
told us that they had also made at least some changes to their sales
practices or oversight activities within the last few years,
primarily in response to publicized sales practice disputes. Five of
the dealers indicated that they had revised policies applicable to
their marketing of these products. For example, two firms said that
they were creating more formal written policies to better document
the specific practices they expected their staff to follow. Two
other dealers said that they had made improvements to the information
they provided to end-users including, in one case, expanding the
range of possible market moves used in scenario analyses. Two of the
dealers also indicated that they had formed new groups within their
firms to review transactions and marketing of these products. One of
the firms explained that a new committee within the firm would focus
on assessing the compliance and reputation risks of the firm's
activities, including how products would be marketed and what type of
end-user would be approached.
Dealer compensation practices was another area relevant to the
quality of sales practices. The findings of regulators and others
indicate that the structure of such compensation can be influential
in determining how marketing personnel conduct their activities. For
example, to the extent that staff receive higher compensation for
more risky transactions that bring the firm greater profits, they
have greater incentives to market these types of transactions, even
if they are not in the end-user's best interests. One dealer told us
that more complex derivatives tend to offer the potential for greater
bonuses than plain vanilla OTC derivatives because of their higher
profit margin.
In general, dealers told us that their marketing staffs were not
compensated solely by commissions on individual transactions.
However, we could not determine the extent to which such commissions
determined compensation. One dealer told us that its compensation is
not a commission system tied to sales volume but a salary and bonus
system that is based on the value of business brought into the firm.
The dealer explained that, in calculating individual bonuses, overall
firm profitability and the relative performance of other departments
within the firm might be weighed more heavily than individual
performance. The dealer said that the system was designed to reduce
incentives for individuals to market high margin, risky products that
are not in the end-user's best interests. Some firms told us that
deferring portions of the compensation of their personnel was one way
they were attempting to align their marketing staffs' interests with
those of end-users. Other firms told us that maintaining quality
end-user relationships was important to determining compensation.
--------------------
\4 We interviewed or obtained written responses from 14 dealers,
including 5 large U.S. securities firms, 3 large U.S. banks, and 1
foreign bank--all of which marketed OTC derivatives, MBS, or
structured notes. In addition, we obtained information from two
smaller banks and three smaller securities firms that almost
exclusively marketed MBS and structured notes.
REGULATORY EXAMINATIONS
SURFACED DEALER WEAKNESSES
---------------------------------------------------------- Chapter 5:3
Although dealers described following sales practices that were
consistent with the dealer-issued voluntary guidance, regulatory
examinations indicated that most dealers had some areas where
improvements were warranted. As noted in chapter 3, we did not find
that a large number of dealers had deficient sales practices. In
addition, in examinations conducted from mid-1994 to mid-1995, the
Federal Reserve and OCC generally found that large bank derivatives
dealers had made efforts to implement appropriate policies,
procedures, and internal controls related to sales practices. OCC
concluded that the banks it examined were in substantial compliance
with its guidance and, in many cases, had developed policies and
procedures that went beyond its minimum requirements.
However, both regulators identified weaknesses in sales
practice-related areas at these banks that could expose them to
compliance and reputation risks. Among the weaknesses identified in
internal controls were inadequacies in the risk disclosure materials
provided to potential counterparties. For example, some banks' risk
disclosure materials did not show how a product would perform across
a sufficiently wide range of market conditions.
Regulators also identified weaknesses in the supervision of marketing
personnel, including failure to provide for supervisory approvals of
the prices quoted by marketing personnel to end-users. Some banks
also lacked comprehensive, written policies and failed to adequately
document transactions. Finally, OCC found that, in some cases, bank
communications to end-users could be construed as advisory, which
could expose banks to litigation if the transactions resulted in
losses.
Banks may continue to have such weaknesses in their sales practice
policies and controls. According to a bank regulatory official who
oversees some of the major dealer banks, the examinations they have
conducted since 1995 have continued to find weaknesses like those
identified above. This official noted that banks have made
improvements to their policies and controls relating to sales
practices since 1994 and 1995, but that additional improvements are
needed.
END-USERS DESCRIBED A RANGE OF
CONTROLS, BUT SOME LACKED BASIC
CONTROLS
---------------------------------------------------------- Chapter 5:4
Our review found that the policies and controls varied widely at the
organizations we contacted that used OTC derivatives, MBS, and
structured notes. From a judgmentally selected sample of respondents
to our survey, we obtained information through telephone interviews
about the practices and controls in place at 50 organizations that
had used OTC derivatives, MBS, or structured notes or that had only
heard dealer presentations on these products. The organizations we
contacted described a range of policies and practices governing the
use of these products.\5 Some described very sophisticated and
involved processes, whereas others acknowledged that very few formal
policies or practices existed. For example, one end-user reported
having an extensive set of policies that it updated every quarter.
Twenty-eight respondents said that they had their own investment
guidelines. Officials of four organizations said they followed
guidelines provided by their regulator or local governmental
authority. Officials at three organizations said they did not have
formal investment policies because of their small size or lack of
investment activity.
Restrictions on using particular products also varied across the
organizations we interviewed. Although we did not obtain complete
information for all organizations, at least 30 respondents said that
they limited purchases to specific products or had formal
prohibitions against investing in certain products. However, five
entities had no restrictions on which products they could use. In
addition, 22 of the organizations described limiting their use of
these products to certain situations or for specific purposes. For
example, some of these organizations said they limited their use of
OTC derivatives to adjusting exposure to changes in interest rates.
The ability to independently price or stress test the values of
products held and the existence of a robust process for reviewing and
approving transactions are important controls over investment
activities. Of the 26 organizations that provided information on
their ability to price or stress-test their holdings, 12 indicated
they could independently do so. Six others indicated that they
relied on assistance from dealers or other parties to conduct such
activity. Four indicated that they did not attempt to stress test
their portfolios.
The processes respondents used to approve or review transactions also
varied. Although 31 respondents said that they required some sort of
approval before purchasing a product, the levels of review and
authorizing parties varied greatly. In some cases, portfolio
managers or treasurers approved transactions; whereas in other cases,
approval was required by an investment committee or by the company
president. Twenty-two respondents reported controlling their use of
these products by entering into transactions only with dealers that
had been previously approved. To become an approved dealer, these
organizations evaluated dealers' credit ratings and other factors,
such as their reputation. Two respondents reported that they only
approved dealers that sign an agreement acknowledging that they
understood and would follow the end-users' investment guidelines.
Five other end-users, which said they did not conduct such
evaluations, indicated that they would only use dealers with high
credit ratings.
Consistent with the descriptions of the practices followed by
respondents we contacted, surveys by other organizations also found
that end-user practices and controls varied across firms.\6 For
example, a 1995 survey by the Wharton School of Business found that
while 76 percent of respondents had policies addressing their use of
these products, only 3 percent reported results monthly to their
boards, 25 percent reported results quarterly, 20 percent reported
results annually, and 51 percent reported results on an as-needed
basis.\7 This survey and one other\8 also found that just under
one-half of the respondents conducted stress-testing or scenario
analyses on their portfolios to determine how they could be affected
by severe market changes. A 1995 survey of 75 large, multinational
corporations found that their ability to internally determine the
value of their holdings varied widely across these organizations,
depending on the products involved. Seventy-six percent reported
being capable of pricing forwards and futures contracts, but only 38
percent of the corporations reported that they could independently
price swaps and swaptions,\9 and 14 percent reported such
capabilities for complex options.\10
Other surveys also found that the controls employed by end-users
varied. Separate surveys by two financial journals of between 150
and 200 large U.S. firms reported that the authority for entering
into transactions in OTC derivatives and similar products resided
mainly with senior managers who were responsible for the
organizations' finances, but that some firms had recently begun
requiring additional levels of approval.\11 Similarly, an accounting
firm's survey of U.S. and international investment fund companies
reported that one-third of those surveyed who had used derivatives
had a supervisory board or risk management committee that established
limits on the use of derivatives and similar products.\12
A more recent survey that addressed the practices of end-users also
showed that practices varied across organizations. In November 1996,
one of the large public accounting firms issued a survey of almost
700 financial and nonfinancial organizations that used
exchange-traded and OTC derivatives.\13 According to this survey,
although these organizations followed generally consistent practices
in accounting for these transactions, a range of practices existed
for how they defined and evaluated the risks of these activities.
--------------------
\5 We did not obtain complete information from every organization we
contacted, therefore, totals for individual policies or controls do
not add to the total number of organizations contacted.
\6 We attempted to confirm that the organizations and products
examined in these other surveys were generally comparable to those
discussed in this report; however, we did not otherwise assess the
quality or verify the results of these surveys.
\7 1995 Survey of Derivatives Usage by U.S. Non-Financial Firms,
Wharton School of Business/Canadian Imperial Bank of Commerce/Wood
Gundy. (Philadelphia, PA: Oct. 1995). This survey received 142
responses from end-users in a random sample of U.S. publicly held
nonfinancial firms.
\8 "Survey of CFOs," Institutional Investor Magazine (June 1995).
This survey received 150 responses from chief financial officers from
a judgmentally selected sample of large U.S. public and private
corporations.
\9 A swaption is an option that grants the holder the right to enter
into a swap with predetermined terms.
\10 Emcor Fax Survey, Emcor Risk Management Consulting, Inc. (Nov.
1995). This survey received 75 responses from finance officers from
a judgmentally selected sample of large, multinational corporations.
\11 "Reader Survey" and "1995 Derivatives Survey," Treasury and Risk
Management Magazine (Spr. 1993 and July-Aug. 1995). This survey
received 95 responses in 1993 and 201 responses in 1995 from finance
officers from a judgmentally selected sample of U.S. public and
private nonfinancial corporations. "Survey of CFOs," Institutional
Investor Magazine (June 1995).
\12 Derivatives Usage by Investment Funds, Ernst & Young, LLP (Oct.
1995). Ernst & Young surveyed a judgmentally selected sample of 143
U.S. and foreign investment fund companies in 1995.
\13 Survey on Current Accounting for Risk Management Activities, KPMG
Peat Marwick (Nov. 1996). This survey received 139 responses from
officials at a judgmentally selected sample of 700 financial and
nonfinancial organizations that used forwards, futures, swaps, and
options.
REVIEWING ORGANIZATIONS FOUND
THAT WEAKNESSES AT END-USERS
CONTRIBUTED TO LOSSES
---------------------------------------------------------- Chapter 5:5
Although concerns over dealer sales practices have arisen in a number
of recent losses, in some of these cases, weaknesses in the
end-user's internal controls and practices contributed to the
end-user's losses. Various groups have called for end-users to
improve their management of and controls over the use of products
like OTC derivatives, MBS, and structured notes to reduce the
potential for losses and resulting sales practice disputes. The
types of controls advocated by these groups are intended to reduce
end-user dependence on the information provided by dealers and the
resulting vulnerability to deficient dealer sales practices. Federal
and state regulators, state audit departments, and other reviewing
organizations that examined end-user losses where sales practice
disputes existed found that the end-users involved had multiple
weaknesses in their internal controls and practices that contributed
to their losses. We reviewed the reports and findings of these
organizations for nine cases where an end-user incurred a loss and
subsequently alleged deficient dealer sales practices. Among the
weaknesses identified at these end-users were inadequacies related to
investment policies, oversight of investment activities, separation
of duties, staff training and qualifications, and internal audits.
Regarding investment policies, regulators and others have frequently
recommended that, at a minimum, entities using OTC derivatives or
investing in financial instruments, such as MBS and structured notes,
identify their objectives for using such products, the type of
products approved for use, and the extent to which the products will
be used. However, in five of the nine cases we reviewed, the
reviewing organization found that end-users had material weaknesses
in their policies addressing product use and, in some cases, lacked
formal written policies. For example, a State of California report
on Orange County's losses noted that the county did not have a
written investment plan against which its activities could have been
compared before the losses occurred. Also, its investment policies
did not establish limits on the level of risk allowed for the
county's investments. In 1994, a Texas community college incurred a
$3-million loss when it sold part of its portfolio of highly volatile
CMO tranches. The college had also experienced an $11-million
decline in the market value of its remaining portfolio, which
originally had a book value of over $31 million. The state auditor
found that the college had no policies related to controlling the
risk of its investments, their desired level of liquidity, or the
extent to which they should be diversified.
Regarding oversight of investments, a key control identified by most
reports and other guidance on the use of OTC derivatives and products
with similar characteristics is the need to supervise the activities
of staff engaging in such transactions to ensure that guidelines are
followed and activities are prudent. Seven of the nine audit reports
of end-users incurring losses identified lack of controls for
monitoring investment activity and personnel as contributing to these
losses. For example, the treasurer at one Texas county was allowed
to enter into transactions without prior approval. He invested over
65 percent of the county's investment funds in long-term, high-risk
CMOs. The value of the $12.7-million portfolio later declined by as
much as $4.5 million.
A related control is to adequately separate officials' duties and
responsibilities. Internal control standards generally require that
internal auditors report to officials other than those that directly
oversee the activities they are auditing. This control was absent in
one county that experienced losses because the comptroller was
responsible for making the county's investments and for approving any
internal audit of his activities--approval which he had never
granted. An official of another county was responsible for both
executing investment transactions and preparing the accounting
records that reported their value. Because these two duties were not
assigned to separate staff, the official was able to falsify the
accounting records to hide the full extent of the losses that
resulted from transactions he executed.
Federal and state regulators and state auditors also criticized some
end-users for lacking staff that were adequately trained or that
possessed sufficient understanding of the risks involved in using
complex financial products. Six of the nine audits we reviewed
indicated that investment personnel or supervisory staff did not
sufficiently understand the risks involved with the products
purchased or lacked the expertise to properly monitor complex
investments. This lack of understanding is not surprising because
the treasurers of some local entities are elected officials who may
have no experience investing in sophisticated financial instruments.
In these situations, external oversight assumes even greater
importance because, as some of the reviewing authorities noted, the
lack of expertise on the part of end-user personnel led them to rely
heavily on dealers for advice.
Finally, some end-users lacked adequate internal audits. Thorough
internal audits can lead to corrective action when investment
policies and procedures are deficient or not being followed. At
three end-users, the reviewing organizations noted that audits of
investment activities either were not being done frequently enough or
were not sufficiently addressing whether investment activities were
in compliance with policies or other guidance. State auditors noted
that the investment activities at one community college had not been
reviewed by county audit staff in at least 5 years.
VARIOUS ORGANIZATIONS ISSUED
GUIDANCE FOR END-USERS
---------------------------------------------------------- Chapter 5:6
In response to recent reported losses, various organizations issued
guidance on recommended practices for reducing the risks of engaging
in OTC derivatives, MBS, and structured note transactions. Although
most of the recommended practices we reviewed addressed issues faced
primarily by dealers, we identified four sets of guidance issued by
professional associations or groups that address issues faced by
end-users. In June 1994, GFOA issued guidance to its members on the
policies and practices that governmental entities should have in
place before using derivatives.\14 About 1 year later, NAST issued
revised guidance\15 that focuses on preferred practices for
government-administered investment pools in which smaller state and
local government funds are pooled and invested centrally. That same
year, the Treasury Management Association (TMA)\16 issued guidelines
on internal controls and appropriate disclosures for end-users of
derivatives.\17 Finally, in November 1996, the Risk Standards Working
Group (RSWG)\18 issued 20 standards for managing and measuring
risks.\19 The GFOA and TMA guidance is written specifically for
derivatives use, while NAST and RSWG guidance is intended for all
investment products. All four sets of guidance favor explicitly
written policies and objectives that have been approved by executive
management or the board of directors.
As shown in table 5.1, the four sets of guidance also call for
similar practices, which, if not followed, can leave an end-user more
vulnerable to sales practice disputes. However, each set of guidance
has a different emphasis. The GFOA guidance emphasizes the
importance of internal controls in reducing risks, such as
establishing written investment guidelines, reporting requirements,
and oversight systems. The NAST guidance focuses on the importance
of communicating with pool participants, establishing the
authorization to invest in certain types of products, and ensuring
that investment policies exist--including borrowing and
diversification policies. The RSWG guidance stresses the importance
of risk management--including setting overall risk management
objectives, valuing investments, and measuring risk-adjusted rates of
return.
The TMA guidance pays particular attention to end-user management
controls, calls for end-users to obtain any necessary independent
expertise, and provides an extensive list of disclosure standards and
practices. Overall, RSWG and TMA provide the most detail on
implementing their guidance.
Table 5.1
Key Elements of Various Organizations'
Investment Guidance for End-Users
Issuing organizations
------------------------------------------------------------------
Element GFOA NAST RSWG TMA
------------ --------------- --------------- --------------- ---------------
Authority to An analysis The end-user Fiduciary Policies should
use products should be should prepare responsibilitie conform with
conducted to a written s of internal regulations.
ensure that statement that and external The Procedures
constitutional provides legal investment should address
and statutory authority for managers should risks arising
authority to the investment be specified in from
execute pool and that writing and derivatives
derivatives establishes the describe their use. Personnel
contracts relationship authority to authorized to
exists. End- between pool make investment enter
users should managers and decisions and transactions
also ensure participants. capacity to should be
that provisions enter designated in
against agreements. writing.
indebtedness
and procurement
statutes are
not violated.
Written Purpose and Written Written and End-users
investment objectives of policies should approved should have
policies derivatives use address policies should written, board-
should be in investment address established
writing. objectives and investment policies and
Policies should risks--with philosophy, objectives
mandate sound safety, risk tolerance, related to
asset and liquidity, and and investment investment
liability yield as guidelines. strategies,
management and priorities. Technical terms risk
adequately Policies should should be tolerances, and
consider describe defined in risk
safety, eligible writing and philosophy.
liquidity, and products and risk limits Acceptable
yield. The risk strategies and should be derivative
characteristics any stated in products and
of products restrictions on concrete terms strategies
that might make such. They and updated as along with
them should also necessary. their
inappropriate specify desired Back-up plans objectives and
for use should product and in the event of goals should be
be considered, overall physical specified.
including their portfolio emergencies or
price maturities, financial
volatility, limits on crisis should
liquidity, amounts be in writing.
leverage, and invested in Risk policies
valuation each type of should be
difficulty. security, and consistently
extent to which applied.
borrowing can
be used.
Suitability Written Dealers should In determining Discussions
of acknowledgement follow the same the should be held
investments should be standards of appropriateness to ensure that
obtained from conduct as of investment employees
dealers that required for strategies and involved with
they have treasurers, and instruments (1) derivatives
received, read, treasurers investment activities
and understood should obtain strategies clearly
the end-user's signed should be understand
debt and agreements of compared to the applicable
investment understanding intent of policies and
policies, from dealers compensation procedures. In
including that the incentives and conducting
whether investment to written daily
derivatives are alternatives investment operations, a
authorized and being offered strategies; (2) transaction's
the recommended are suitable contemplated potential to
product is for the end- activities harm
suitable for users' should be counterparty
the end-user. objectives. compared to relations
Entities should risk and return should be
also be aware goals; (3) the evaluated.
of when dealers impact of
are acting as relevant risks
agents or are on each
taking a instrument and
proprietary the overall
position and portfolio
should evaluate should be
potential identified,
conflicts of measured, and
interest before understood; and
entering (4) returns
transactions. should be
adjusted for
risk to
determine an
instrument's
relative
performance.
Reports on End-users End-users Requirements Relevant risks
activities should should disclose for routine as well as risk
regularly to all pool reporting and management and
report participants deviation other reporting
derivatives use and prospective reporting policies and
to governing participants should be procedures
bodies and make their defined. Also, should be
appropriate investment procedures for established and
disclosures in objectives, reporting to should provide
official pool liquidity, higher useful and
statements and and potential management relevant
other access limits levels when information.
documents. End- to invested deviations Financial
users should funds. continue should statement
also follow Participants be defined. disclosures and
generally should also Risk policies accounting
accepted receive should be should comply
accounting statements that consistently with industry
principles to assess and applied and regulations and
report on account for supported by standards.
derivatives pool management. Disclosures
use, hold early activities, should, at a
discussions including minimum,
with public detailed discuss the
accounting reports of types of
organizations portfolio derivative
on derivatives holdings, products used,
use, and use market values, the goals and
special and maturity as objectives of
reporting well as the their use, and
procedures, if independent the way their
necessary. auditor's use is
report and controlled.
opinion.
Oversight Procedures An independent Oversight of Systems and
and should be advisory board line investment procedures for
monitoring established for should monitor activities oversight
of periodic investment should be should be
transactions monitoring of activities of independent established to
derivatives the investment from oversight (1) review
use. manager for of compliance legal
Recordkeeping compliance with with risk relationships
systems should written policies using between
be sufficiently objectives. An updated counterparties
detailed to external audit guidelines and to derivatives
allow governing of the control transactions
bodies, investment procedures. and the
auditors, and function and Roles, lines of derivatives
examiners to treasury should responsibility, transaction
determine if be completed at and reporting process, (2)
use is in least annually. should be periodically
accordance with clearly review
established written. compliance with
objectives. Separation of policies and
responsibilitie procedures, (3)
s and adequate identify and
checks and review policy
balances should changes, (4)
be in place. identify
Evaluations of deviations from
the validity written
and policies and
appropriateness procedures, (5)
of strategies, ensure
valuation compliance with
methodologies, accounting
models, and disclosure
systems should standards, and
be conducted by (6) review
an independent internal
third party. controls.
Pricing and Competitive The portfolio Products should Procedures and
valuation of price should be be priced methods of
transactions comparisons marked-to- daily, weekly, valuing
should be market at least or whenever derivatives
obtained before monthly. Values feasible as exposure and
entering a should also be well as measuring
transaction. determined by whenever current,
End-users an independent material events potential, and
should be aware pricing service occur, using underlying
that little or or by using consistent and exposures;
no standardized multiple documented marking-to-
pricing assessments to mechanisms and market;
information is formulate an methodologies. dictating the
available for average. The More than one frequency of
some products. method of external source valuing
valuation for pricing derivatives;
should be information and ensuring
disclosed. should exist compliance with
and internal valuation
pricing should procedures
be should be
independently approved and
verified. established.
Sources of End-users
valuation should not rely
should be solely on one
evaluated for counterparty
incentives to for valuation
inflate or information but
deflate prices. should have
Material access to
differences in adequate
pricing between internal or
internal or external
external expertise.
sources should
be reconciled
and the reasons
reported and
monitored.
--------------------------------------------------------------------------------
Sources: GFOA, NAST, RSWG, and TMA.
--------------------
\14 GFOA's primary risk management guidance for end-users of
derivatives was presented in GFOA Recommended Practice: Use of
Derivatives by State and Local Governments (Washington, D.C.: June
7, 1994). GFOA also released other guidance related to these issues,
including GFOA Recommended Practice: Diversification of Investments
in a Portfolio (Washington, D.C.: 1997), and GFOA Recommended
Practice: Sale of Derivative Instruments by State and Local
Governments (Washington, D.C.: 1995).
\15 Guidelines for Local Government Investment Pools, NAST
(Washington, D.C.: July 27, 1995).
\16 TMA was founded in 1979 and represents 7,000 members, consisting
of cash management professionals, such as treasurers from the private
sector. TMA seeks to educate, communicate, and recognize the
treasury management profession.
\17 Voluntary Principles and Practices Guidelines for End-Users of
Derivatives, TMA (Bethesda, MD: Oct. 1995).
\18 RSWG was established by 11 individuals from the institutional
investment community to create a set of risk standards for
institutional investment managers and institutional investors.
\19 Risk Standards for Institutional Investment Managers and
Institutional Investors, RSWG (New York, NY: Nov. 1996).
SOME STATE GOVERNMENTS ACTED TO
REDUCE THE RISK OF LOSS
---------------------------------------------------------- Chapter 5:7
Between 1994 and 1996, at least 14 states made changes that address
the use of OTC derivatives, MBS, and structured notes by governmental
entities within their states.\20 These actions--which included 11
states\21 enacting legislation and 3 states\22 making executive
branch policy changes--were taken after governmental entities in some
of these states incurred unanticipated losses from derivatives use.
These actions were taken to minimize the risk of loss that product
use poses to governments in at least one of three ways--by improving
end-users' policies, procedures, and controls; limiting the use of
certain types of products; or placing additional requirements on
dealers.
One way that state governments have sought to decrease the likelihood
of losses arising from the use of OTC derivatives, MBS, and
structured notes was by requiring governmental entities to revise
their own investment policies, procedures, and controls. Thirteen
states took actions that place additional requirements on the
investing entities within their states. For example, legislative
bodies in Florida and Texas placed a similar new requirement on
governmental units within their respective states to adopt investment
plans that make the safety of investment funds a primary objective of
government investment strategies. California and Florida now require
their treasurer or unit carrying out the state's investment
activities to follow the prudent investor/person standard.\23 Eleven
states imposed requirements for strengthening internal controls on
local governments. For example, Ohio now requires treasurers in
local governments to establish and file written investment policies
with the state, prepare quarterly investment reports, and provide
monthly portfolio updates.
Several states also placed restrictions on the types of products that
governmental entities could use. Ten of the 14 states now prohibit
or restrict the use of OTC derivatives, MBS, and/or structured notes.
For example, New Mexico now prohibits governmental entities in that
state from using complex financial products, including structured
notes. Wisconsin's legislation allows its state investment board to
use derivatives only for reducing risk. In Florida, local entities
can invest in derivatives if the entity's investment policy
authorizes derivatives and if the entity's financial officers have
sufficient expertise in managing derivatives investments.
Finally, four states also sought to place additional responsibilities
on dealers marketing OTC derivatives, MBS, or structured notes to
governmental entities in their jurisdictions as well as to impose
punitive measures when violations are found. The four
states--Colorado, Minnesota, Ohio, and Texas--require dealers to
ensure that the products they offer are acceptable under the
governmental entities' statutes or investment policies. For example,
Texas requires broker-dealers to sign a statement acknowledging that
they reviewed the entity's investment policy and implemented
reasonable procedures and controls in an effort to preclude imprudent
investment activities arising out of the subject transaction. Taking
a different approach, Colorado law requires that dealers repurchase
investments, for at least the original face value plus any accrued
interest, if the investments are found to be impermissible for the
governmental entity.
--------------------
\20 In this section, we did not attempt to obtain comparable
information from all states on any actions that may have been taken
to improve investment policies, procedures, and practices. Instead,
we summarized those that received broader public attention.
\21 These states were California, Colorado, Florida, Illinois,
Kansas, Louisiana, Minnesota, Maryland, Ohio, Texas, and Wisconsin.
\22 These states were New Mexico and Oklahoma.
\23 The prudent person standard requires those investing on behalf of
the governmental entity to act as a prudent person would be expected
to act--with discretion and intelligence to seek reasonable income,
to preserve capital, and in general, to avoid speculative
investments.
REGULATORS HAVE IMPROVED SALES
PRACTICE OVERSIGHT OF REGULATED
FIRMS, BUT SOME WEAKNESSES REMAIN
============================================================ Chapter 6
Federal financial market regulators have improved their oversight of
dealer sales practices, but have not taken certain steps that would
better ensure dealers follow sound practices when marketing OTC
derivatives, MBS, and structured notes. To limit the risks that
these activities pose to regulated institutions, bank regulators have
promulgated specific requirements for the marketing of financial
products and conducted examinations to monitor the extent to which
banks comply with them. As a result, bank supervisory guidance
addresses sales practices more extensively than in the past. We also
found that these regulators' examinations were generally thorough in
addressing issues related to banks' sales practices for OTC
derivatives, MBS, and structured notes. However, the Federal
Reserve's guidance does not yet adequately address areas where
weaknesses in a bank's practices could lead to sales practice-related
losses, although agency officials told us the Federal Reserve plans
to address these areas in updated guidance that the agency expects to
issue by the end of 1997.
In contrast to banking regulators, the regulatory authority of SEC
and CFTC does not extend to the unregulated affiliates of the firms
they otherwise regulate. To address concerns about the risks these
activities pose to the regulated entity, SEC and CFTC worked with the
six U.S. securities firms whose affiliates did approximately 90
percent of all U.S. securities firm-related business in these
products on the Framework for Voluntary Oversight. Under the
Framework, the participating firms are to provide SEC and CFTC with
more information about their unregulated activities; however, the two
regulators are not to receive information that could be used to
determine the extent to which the firms are following the sales
practice provisions of the Framework. Finally, SEC relies primarily
on the securities SROs to oversee the sales practices of MBS and
structured note dealers. Although certain jurisdictional and other
factors affected SROs' ability to fully assess dealers' sales
practices, recent changes in the law and corresponding rules removed
the most serious limitation affecting one SRO.
BANK REGULATORS' EFFORTS TO
OVERSEE SALES PRACTICES HAVE
INCREASED, BUT UPDATED FEDERAL
RESERVE GUIDANCE HAS NOT YET
BEEN ISSUED
---------------------------------------------------------- Chapter 6:1
Both the Federal Reserve and OCC have taken various actions to
address sales practice issues. Both regulators issued guidance to
their examiners and the banks they oversee that address the risks of
marketing OTC derivatives, MBS, and structured notes. They
subsequently conducted targeted examinations of bank sales practices
for these products, including reviewing areas not adequately
addressed in each agency's guidance. To ensure that subsequent
examinations would also adequately review these areas, OCC issued
additional guidance to address these weaknesses, but the Federal
Reserve has not yet issued updated guidance. Federal Reserve
officials told us they expect to issue revised guidance that will
address the sales practice areas not specifically covered in their
existing guidance by the end of 1997. In addition, the Federal
Reserve placed specific sales practice-related requirements on one
bank's transactions in certain types of complex OTC derivatives
transactions as part of a 1994 enforcement action.
BANK REGULATORS EXPANDED
SALES PRACTICE REQUIREMENTS
FOR BANKS
-------------------------------------------------------- Chapter 6:1.1
In 1993 and 1994, OCC and the Federal Reserve issued guidance to the
banks they regulate. This guidance was also used by their examiners
to review banks' activities. The two sets of supervisory guidance
were designed to address the risks associated with the increasing
volume of banks' activities in OTC derivatives and other financial
products. According to OCC and Federal Reserve officials, before
these issuances, sales practice-related guidance generally consisted
of requirements that banks obtain sufficient information about a
customer's financial condition and business activities before
extending credit to or engaging in other financial transactions with
the customer--referred to as the "know your customer" rule.
In expanding the treatment of sales practice issues, OCC and Federal
Reserve guidance generally contained the same requirements to be
followed by banks and used by bank examiners. Specifically, OCC
guidance required that banks not recommend transactions that they
know, or have reason to know, would be inappropriate for their
customers on the basis of available information about the end-user.
The Federal Reserve required banks to determine the sophistication of
derivatives counterparties, including whether counterparties
understood the nature and risks of transactions. In separate
guidance to its examiners,\1 the Federal Reserve indicated that banks
should establish standards to ensure that counterparties are not
entering into transactions in complex products where they do not
understand the risks. The guidance also noted that bank management
should be cognizant of the risks to the bank's reputation arising
from its activities in these products. In December 1995, OCC issued
additional guidance that more extensively discussed the
risks--including compliance and reputation risks--that are associated
with marketing financial products. This guidance also provided
extensive criteria to help examiners evaluate the degree to which a
bank was exposed to these risks and how well they were being managed.
--------------------
\1 Trading Activities Manual, Division of Banking Supervision and
Regulation, Board of Governors of the Federal Reserve System
(Washington, D.C.: Mar. 1994).
BANK REGULATORS GENERALLY
CONDUCTED THOROUGH
EXAMINATIONS AFTER SALES
PRACTICE PROBLEMS SURFACED
-------------------------------------------------------- Chapter 6:1.2
In response to publicized sales practice disputes, OCC and the
Federal Reserve conducted focused examinations of the largest bank
dealers that addressed sales practices associated with OTC
derivatives, MBS, and structured notes. In 1995, OCC conducted
targeted examinations of several large bank dealers to assess their
practices. OCC also published a summary of the results of these
reviews, including identifying a list of best practices followed by
the banks they reviewed. Similarly, the Federal Reserve targeted
sales practices in examinations of major bank dealers conducted from
mid-1994, when Bankers Trust's sales practice-related problems became
public, to mid-1995. The scope of both regulators' examinations was
broader than required by their existing supervisory guidance.
We reviewed the examination reports and supporting workpapers for
seven of the targeted examinations that the two bank regulators
conducted and found that these examinations were generally thorough
in addressing key areas related to sales practices. As part of our
review, we searched various sources for information applicable to
sales practices--including securities regulators' examination
materials, private risk management guidance, and case studies of
end-user losses--and identified six elements that could comprise a
thorough examination of an institution's sales practices. These
elements include the existence of sales practice policies and
procedures, management oversight and controls over marketing
personnel, management oversight and controls over price quotes and
valuation information, management supervision of restructured
transactions,\2 policies and procedures for assessing counterparty
sophistication and appropriateness, and adequacy of disclosures to
counterparties. We found that OCC and Federal Reserve examiners had
reviewed at least five of these six elements at each of the banks
they examined. The element examiners most commonly omitted from
review involved management supervision of restructured transactions.
Also, the Federal Reserve's efforts focused primarily on more complex
OTC derivatives transactions because agency officials believed that
such transactions were harder for end-users to understand and value
and thus were more prone to sales practice disputes.
--------------------
\2 Restructured transactions are those in which the terms or
conditions of an existing contract have been changed.
OCC ADDRESSED WEAKNESSES IN
ITS GUIDANCE, BUT UPDATED
FEDERAL RESERVE GUIDANCE HAS
NOT YET BEEN ISSUED
-------------------------------------------------------- Chapter 6:1.3
Although the guidance OCC and the Federal Reserve issued through 1996
expanded sales practice-related requirements, our analysis revealed
that they did not address several sales practice areas related to
compliance and reputation risks. These areas had been noted by
regulators and dealers as among those in which sales practice
disputes were likely to arise. For example, the guidance did not
task examiners with assessing whether a bank's marketing practices
might inadvertently create an advisory relationship with an end-user
where none was intended. In addition, neither regulator directed its
examiners to ensure that the banks had adequate internal controls in
place related to supervisory review of the price quotations and
position valuation information provided to end-users. The importance
of assessing this aspect of a dealer's sales practices was
illustrated by the Bankers Trust case, where providing incorrect
price quotations and valuation information was the primary misconduct
SEC and CFTC cited in their settlements with the bank. Finally,
neither regulator's guidance required examiners to assess the
accuracy of banks' marketing materials and product risk disclosures
to end-users. Yet, both regulators reviewed such materials during
the targeted examinations and found weaknesses.
In January 1997, OCC issued guidance to its examiners and the banks
it oversees that expanded its coverage of sales practice issues into
the areas where past problems were identified, thereby addressing
these weaknesses. For example, the guidance directs OCC examiners to
review any risk disclosure materials banks provide to customers and
ensure that bank policies define the types of disclosures, if any,
that should be made. Examiners are also to determine whether banks'
internal audit staff ensure that sales presentations are clear,
balanced, and reasonable. The guidance also raises expectations for
banks' internal controls and supervision of marketing personnel,
including requiring independent reviews of counterparty positions by
other departments within the bank. Banks' policies must also provide
guidance on avoiding the implication that an advisory relationship
exists. Finally, the new guidance more specifically addresses the
way transactions are to be documented, including directing that bank
policies require the maintenance of financial statements, investment
policies, and profiles of counterparties.
As of June 20, 1997, the Federal Reserve had not yet issued updated
guidance, but agency officials told us that the agency expected to do
so by the end of 1997. Federal Reserve staff provided us with a
draft of the updated guidance to review. The planned revisions to
the guidance would address the elements we identified as missing in
the existing guidance.
THE FEDERAL RESERVE PLACED
HIGHER SALES PRACTICE
REQUIREMENTS ON ONE BANK
-------------------------------------------------------- Chapter 6:1.4
Separately from the guidance issued to all of the banks that it
oversees, the Federal Reserve tasked at least one bank with more
stringent requirements as a part of a 1994 supervisory agreement. As
discussed in chapter 3, some Banker's Trust counterparties raised
concerns about the bank's marketing of OTC derivatives, which
prompted regulatory investigations. As a result of its
investigation, the Federal Reserve entered into a supervisory
agreement with Bankers Trust that imposed extensive new requirements
on some of the bank's activities in more complex OTC derivatives to
increase the amount of information the bank provided on product risks
as well as price and valuation calculations.
Specifically, the agreement included required practices for the
bank's marketing of leveraged derivative transactions (LDT), whose
payment flows and values are highly sensitive to changes in relevant
market rates, prices, or indexes to which they are linked.\3 The
agreement required Bankers Trust to (1) provide every counterparty
with sufficient information about the terms and risks of any LDT it
entered, (2) reasonably ensure that every counterparty has the
ability to understand this information, and (3) conduct its LDT
business in a manner that ensured reasonable price and valuation
transparency to its counterparties.
The supervisory agreement also imposed specific disclosure
obligations on the bank for proposed LDT transactions, including
providing a written term sheet setting out material terms, explaining
the risks, and preparing sensitivity analyses that show a broad range
of potential outcomes. Both the term sheet and sensitivity analyses
were to describe the various assumptions Bankers Trust used to
evaluate transaction risks. To achieve reasonable price
transparency, Bankers Trust was also to provide LDT counterparties
with indicative (approximate) price quotes, which were to be updated
daily for highly market sensitive LDTs and monthly for other LDTs.
Bankers Trust's procedures for achieving minimum risk disclosure and
price transparency were to be subject to Federal Reserve review.
In addition to implementing these sales practice-related changes,
Bankers Trust was subjected to a review of the conduct of its
employees' LDT activities by a special counsel and was restricted
from initiating any new LDT business until the Federal Reserve
determined that it had complied with the provisions of the written
agreement. On December 9, 1996, the Federal Reserve announced that
it had terminated the written agreement, thus ending the heightened
requirements and oversight placed on the bank. According to a press
account, a Bankers Trust official responded by noting that the bank
had implemented numerous policies and procedures over the prior 2
years that increased the transparency and controls related to
activities with its derivatives customers.
Although the sales practice requirements outlined in this agreement
were binding only on Bankers Trust, some industry participants,
including legal experts and professional association officials,
indicated that the agreement may have effectively set the standard
for all derivatives dealers. However, a senior Federal Reserve
official cautioned that requirements such as those placed on Bankers
Trust for its LDT activities may not be appropriate for other OTC
derivative products. This official told us that the detailed
disclosures required of Bankers Trust for its LDT customers would be
unnecessary for more experienced end-users of plain vanilla
derivatives. However, she said that as the complexity of products
increase, similar disclosures may become necessary.
--------------------
\3 See Written Agreement By and Among Bankers Trust New York
Corporation, and Bankers Trust Company, and BT Securities
Corporation, and Federal Reserve Bank of New York (FRB Docket No.
94-082), (Dec. 4, 1994). The agreement defines LDTs to include
transactions where a market move of two standard deviations in the
first month would reduce the value of a counterparty's position by
the lower of 15 percent of the notional amount or $10 million,
transactions where the counterparty's final principal payment is at
risk, coupon swaps where the coupon can drop to zero or exceed twice
the market rate, and transactions applying leverage (i.e., a
multiplier) to rates or a spread between rates.
JURISDICTIONAL AND OTHER
LIMITATIONS HAVE AFFECTED
OVERSIGHT OF SECURITIES FIRMS'
SALES PRACTICES
---------------------------------------------------------- Chapter 6:2
SEC, CFTC, and the various industry SROs have increased their sales
practice oversight of firms that deal in OTC derivatives, MBS, and
structured notes. However, the approaches used to conduct this
oversight were sometimes affected by these organizations' lack of
authority over the full range of firms' marketing activities. Under
legislation passed in the early 1990s, the firms under SEC and CFTC
jurisdiction must provide SEC and CFTC, respectively, with
information to be used in assessing the risks that such firms'
unregulated activities, including those in nonsecurities and
nonfutures OTC derivatives, pose to the regulated entity. To
supplement this information, SEC and CFTC worked with the securities
firms whose affiliates are most active in the OTC derivatives markets
to develop guidance that includes actions these firms will
voluntarily implement to manage their OTC derivatives risks,
including those related to sales practices. By adopting the
guidance, participating firms also agreed to provide additional
information about their OTC derivatives activities. However, SEC and
CFTC are not to receive information about the extent to which these
firms are following the sales practice provisions of the guidance.
In contrast to nonsecurities OTC derivatives, SEC has jurisdiction
over the marketing of MBS and structured notes\4 and has conducted
examinations of dealers and taken enforcement actions against them
for violations of the securities laws. SROs, such as NASD and NYSE,
provide most of the routine oversight of dealers marketing these
products and also have conducted examinations of and taken
enforcement actions against dealers of these products. However, SRO
efforts have sometimes been made more difficult by limits to their
authority over particular firms or products. NASD faced the most
serious restrictions, but recent changes to the law and applicable
rules have removed these restrictions.
--------------------
\4 As previously discussed, we assume for the purposes of this report
that structured notes meet the terms and conditions of CFTC's hybrid
exemption.
SEC AND CFTC JURISDICTION IS
LIMITED, BUT THE REGULATORS
RECEIVE INFORMATION ON
AFFILIATES' ACTIVITIES
-------------------------------------------------------- Chapter 6:2.1
As discussed in chapter 2, SEC and CFTC direct regulatory authority
is limited to products defined as securities or futures (including
certain options), respectively, and to the firms registered with
these regulators to conduct such activities. Because nonsecurities
and nonfutures OTC derivatives activities are usually conducted in
affiliates outside of the direct oversight of these two regulators,
neither regulator conducts examinations of these firms' sales of OTC
derivatives.
To better assess the risk posed by the activities of these affiliates
on the financial condition of a regulated broker-dealer, SEC was
granted authority under the Market Reform Act of 1990 to collect
certain types of information from the entities it regulates about
their unregulated activities. CFTC was provided similar authority by
the Futures Trading Practices Act of 1992. Both regulators
subsequently issued risk assessment rules that require the firms
subject to their regulation to submit additional information about
their unregulated activities. For example, firms overseen by both
SEC and CFTC provide these regulators with information on the total
notional/contract amounts, aggregated credit risk exposure, and
credit exposures concentrated by industry or counterparty arising
from their OTC derivatives activities. The two regulators were to
receive information from the regulated entities subject to these
rules on a quarterly basis beginning in 1995. Firms regulated by
both SEC and CFTC were to provide these regulators with descriptions
of the systems they use to manage the risks associated with
transactions in nonsecurities OTC derivatives. SEC and CFTC
officials confirmed that, in general, they have been receiving the
information required under their rules.
SEC AND CFTC LACK
INFORMATION TO ASSESS THE
SALES PRACTICES OF
UNREGULATED AFFILIATES
-------------------------------------------------------- Chapter 6:2.2
The rapid growth of the OTC derivatives market and some highly
publicized losses by end-users raised concerns by Congress and others
about the potential risks that OTC derivatives use by unregulated
affiliates might pose to the regulated entity and the financial
system. SEC and CFTC responded by working with the six securities
firms whose affiliates are most active in the OTC derivatives markets
to develop the Framework, which includes a sales practice-related
section (the provisions of which are discussed ch. 3). According to
an SEC official, the affiliates of these six firms accounted for
about 90 percent of the OTC derivatives activity done by securities
firm affiliates.
To supplement the responsibilities that securities firms have under
the risk assessment rules, the Framework expands the participating
firms' commitment to taking additional voluntary steps related to
their unregulated activities. These steps include reporting
additional information to SEC and CFTC on their market and credit
risk management systems and controls, risk in relation to the capital
reserved against these activities, and credit concentrations and
revenues from these activities. The Framework also outlines
management controls that the firms are to follow. In addition, the
firms have agreed to annual external audits whose purpose is to
verify their adherence to the management control provisions of the
Framework.\5
Unlike the other aspects of the Framework, the provisions relating to
sales practices are less prescriptive and do not call for SEC and
CFTC to receive additional information on the firms' activities.
These provisions suggest that participating firms (1) provide generic
risk disclosure forms to new counterparties, (2) prepare accurate
marketing materials that fairly present a transaction's benefits and
risks, and (3) adopt internal controls sufficient to ensure that
strong counterparty relationships are maintained. SEC officials told
us that the agency had worked with the participating firms to ensure
that the counterparty relationships section was included in the
Framework because they believed that fair treatment of end-users is a
prerequisite to the growth and evolution of the OTC derivatives
market. In a speech to end-users, an SEC commissioner said that the
financial integrity of the OTC derivatives markets would be harmed if
participants perceived them as unfair or rampant with abuse, thus,
regulators have an interest in the sales practices used to market
these products.
Although the firms agreed to external audits addressing their
adherence to certain provisions of the Framework, as planned, these
audits will not address the sales practices provisions. The
Framework also does not stipulate that the participating firms report
on the extent to which they are implementing the sales practice
provisions of the Framework. For example, the participating firms
have not provided copies of their sales practice policies--as they
did as part of SEC's risk assessment process for their risk
management systems--and descriptions of the internal controls they
have established to ensure that such policies are being followed. In
addition, the firms are not expected to periodically provide the
regulators with internal audit reports that document adherence to
these policies and controls. Without a mechanism to collect such
information, SEC and CFTC will lack sufficient data to indicate
whether these firms are conducting their OTC derivatives marketing
activities in ways that foster the fairness and integrity of these
markets as was envisioned by the agencies when the sales practice
provisions were included in the Framework.
--------------------
\5 Because its OTC derivatives affiliate is subject to oversight in
the United Kingdom, CS First Boston is not subject to the additional
reporting requirements but has committed to adhering to the other
elements of the Framework. SEC officials told us that under SEC risk
assessment rules, the agency receives copies of quarterly financial
reports that the affiliate files with its U.K. regulator.
SEC RELIES PRIMARILY ON SROS
TO OVERSEE MBS AND
STRUCTURED NOTE DEALERS, BUT
ALSO CONDUCTS EXAMINATIONS
AND TAKES ENFORCEMENT
ACTIONS
-------------------------------------------------------- Chapter 6:2.3
Although SEC relies primarily on SROs to oversee the activities of
MBS and structured note dealers, including their sales practices, it
has an active regulatory program under which it receives reports on
dealers' financial condition, examines broker-dealers and evaluates
their compliance with laws and regulations, and conducts
investigations of possible violations of the securities laws. The
goals of its oversight are to (1) ensure the quality of SRO
activities and (2) provide additional oversight of securities firms'
marketing activities. For example, SEC conducted 645 examinations of
securities firms in 1996, about 50 percent of which were to assess
the quality of examinations performed by the relevant SRO. The
remaining 50 percent of SEC examinations were initiated on the basis
of a specific cause, such as a complaint by an end-user. SEC
officials advised us that almost all of these examinations include
some sales practice component. In conducting the 1996 examinations,
the officials said that six examinations identified material sales
practice deficiencies involving MBS or structured notes that were
subsequently referred to SEC's Enforcement Division for
investigation.
SEC is also expanding its examination procedures to address sales
practice issues. According to officials in SEC's Office of
Compliance Inspections and Examinations, new examination modules have
been created to facilitate their examiners' review of products such
as MBS and structured notes. Routine sales practice modules include
updated steps to address current rules and case law regarding markups
and confirmation disclosures, and specialized modules are being
created for government securities. SEC is to use these specialized
modules to review NASD's implementation of its new government
securities rule (as discussed on p. 133).
Although SROs also conduct enforcement activities, SEC considers
enforcing the securities laws to be one of its most important
missions.\6 As discussed in chapter 3, SEC officials had initiated
investigations against 24 dealers from 1993 through 1996 for
deficiencies related to the sale of MBS and structured notes. In
some of these cases, SEC has taken action against the dealer
involved, including assessing monetary penalties, imposing operating
restrictions, or revoking a dealer's license to conduct business. In
several cases, both SEC and an SRO were investigating the conduct of
the same dealer. A senior SEC Enforcement Division official
explained that, when an SRO either has an investigation under way or
has sanctioned a firm, SEC usually avoids initiating a parallel
effort but sometimes will seek additional penalties for egregious
cases. Decisions to pursue such actions also depend on the size and
frequency of the violations and the dollar value involved. (See ch.
3 for a discussion of the results of SEC enforcement actions.)
--------------------
\6 Similarly, CFTC considers enforcing the CEA to be one of its most
important missions. Except for the Bankers Trust case previously
discussed, we do not address CFTC enforcement actions in the OTC
markets because they typically involved the illegal marketing of
off-exchange futures, which is generally outside the scope of this
report.
VARIOUS FACTORS ALSO
AFFECTED SROS' ABILITY TO
FULLY ASSESS DEALER SALES
PRACTICES
-------------------------------------------------------- Chapter 6:2.4
Securities industry SROs, particularly NASD and NYSE, are an integral
part of the oversight of firms marketing MBS and structured notes.
However, these organizations were not always able to review all of a
dealer's sales activities. SROs can only review the sales activities
of their members and not the sales activities of those firms'
unregulated affiliates that are not also members. The way that
certain customers use dealers of MBS and structured notes also
reduced the SRO staffs' ability to fully assess sales practices for
some transactions.
As part of their activities, NASD and NYSE have conducted
examinations of securities firms. In 1996, NASD conducted 2,359
examinations and NYSE conducted 326 examinations that addressed sales
practices, according to each SRO's statistics. SRO officials told us
that the examinations generally reviewed firms' sales practice
policies, procedures, and controls over marketing personnel. These
organizations also had conducted enforcement investigations of
possible sales practice violations, with NASD having performed
investigations of 16 dealers and NYSE having performed investigations
of 15 dealers from January 1993 through December 1996. (See ch. 3
for additional discussion of SRO enforcement action results.)
The way in which securities industry SROs conducted their sales
practice oversight differed from the way they met their other
responsibilities. According to a NYSE official, these SROs obtain
reports and conduct examinations to ensure that their members are
financially sound and in compliance with SRO rules and relevant
federal securities law requirements. To facilitate these
examinations and reduce the overlap of SRO jurisdiction over
securities firms that conduct activities on multiple exchanges,
usually just one SRO is designated to review the financial condition
of such firms.\7 However, the NYSE official said that the individual
SROs remain responsible for conducting their own examinations for
sales practice purposes, unless they contract with another SRO to
have such examinations conducted on their behalf.
Dealers' sales practice activities relating to OTC derivatives, MBS,
and structured notes were not always subject to review by securities
industry SROs. As previously discussed, the largest securities firms
generally conduct their nonsecurities OTC derivatives activities in
affiliates that are not registered with SEC. Although a dealer
conducting activities in securities is required to join and submit to
oversight by at least one securities industry SRO, its other
nonsecurities affiliates, such as those conducting nonsecurities OTC
derivatives activities, are not subject to SRO oversight.
The way that certain end-users conduct their activities in MBS and
structured notes also affected SROs' ability to fully assess sales
practices. NYSE officials told us that assessing the adequacy of
their members' sales practices for MBS and structured notes could
generally only be done when the customers involved are retail
end-users. However, they estimated that such end-users account for
only about 5 percent of the purchases of MBS. The remainder of such
securities are purchased by institutional end-users that do not
always maintain their holdings in accounts at NYSE-member securities
firms. Instead, some transfer their purchases to custodial accounts
at banks or other money managers. According to NYSE officials,
reviewing an end-user's portfolio is an important way for them to
determine the appropriateness and suitability of transactions for the
particular end-user. However, the transfer of purchases by some
institutional end-users to other accounts generally precluded NYSE
staff from determining the appropriateness and suitability of
transactions for such end-users.
--------------------
\7 The SRO with responsibility for conducting the financial condition
examination of a securities firm is known as its designated examining
authority.
REMOVAL OF RESTRICTIONS ON
NASD OVERSIGHT SHOULD
IMPROVE SALES PRACTICE
OVERSIGHT
-------------------------------------------------------- Chapter 6:2.5
The most serious limitation on an SRO's ability to assess sales
practices was faced by NASD. Before August 1996, NASD could not
fully assess and take appropriate actions against certain
deficiencies in the sales practices of dealers marketing GSE-issued
MBS and structured notes, which accounted for the bulk of those
securities issued.\8 As noted in chapter 2, NASD had been prohibited
from applying its full complement of sales practice rules to the
marketing of government securities by a long-standing provision in
the Securities Exchange Act of 1934.\9 This restriction was removed
by the Government Securities Act Amendments of 1993, and, after
several rounds of public comment and revision, NASD obtained SEC
approval to implement the rules and an associated interpretation on
August 22, 1996.
While in effect, this restriction on NASD's authority affected its
enforcement activities. In cases where NASD determined that dealers'
sales practices warranted disciplinary action, the SRO was unable to
pursue such cases as violations of its Rules of Fair Practice because
GSE-issued securities were exempt from these rules.\10 Instead, it
had to pursue the enforcement cases under the antifraud provisions of
the securities laws. However, the burden of proof for fraud
violations was harder to meet than that for noncompliance with SRO
rules. The removal of restrictions on NASD authority will allow the
SRO to pursue cases as violations of its own rules and should improve
its ability to oversee sales practices for MBS and structured notes.
--------------------
\8 NASD officials could not determine how many of their 5,000 members
marketed GSE-issued securities; however, the officials indicated that
in 1994 over 300 of the firms they oversaw held such securities and
that most were probably offering them to end-users.
\9 This restriction did not extend to NYSE.
\10 As indicated in chapter 2, these rules are now known as Conduct
Rules.
CONCLUSIONS AND RECOMMENDATIONS
============================================================ Chapter 7
CONCLUSIONS
---------------------------------------------------------- Chapter 7:1
Although OTC derivatives are subject to sales practice requirements
that vary, depending on the dealer or specific product involved, our
survey found that most end-users of these products were generally
satisfied with the sales practices of dealers with whom they did
business. In addition, federal financial market regulators found
that few dealers in these contracts were involved in sales practice
disputes.
Certain characteristics of the OTC derivatives markets may explain
the high level of end-user satisfaction and the relatively limited
number of disputes. Specifically, our 1995 survey found that about
10 percent of a broad range of U.S. organizations had entered into
plain vanilla OTC derivatives contracts and only 2 percent had
entered into more complex OTC derivatives contracts. In addition,
product use was concentrated among generally large, financially
oriented organizations, with GSEs, finance companies, mutual funds,
and money managers reporting the highest rates of usage.
Nonetheless, some regulators and market participants have responded
to concerns about the losses and costly disputes that can arise when
OTC derivatives sales practices are inadequate or when roles and
responsibilities are unclear. Their responses have included issuing
guidance on recommended practices and controls; strengthening sales
practice or investment policies, procedures, and practices; and
increasing internal reviews of these activities.
Although the President's Working Group on Financial Markets has
concluded that legislation containing additional sales practice
requirements is not currently needed for OTC derivatives, the market
characteristics that contributed to the high level of end-user
satisfaction and the limited number of sales practice disputes
experienced to date could change as the markets evolve. These
changes could include increased market participation by new dealers,
more widespread use of complex products, or increased marketing to or
product use by less sophisticated end-users. Such changes in market
characteristics could cause the Working Group to reconsider whether
current requirements are adequate to protect end-users of OTC
derivatives or the financial markets.
However, the federal financial market regulators that participate in
the Working Group do not routinely collect information related to
changes in market characteristics. These regulators monitor the OTC
derivatives activities of the firms subject to their respective
oversight, and they discuss any developments of which they become
aware through their joint participation in the Working Group.
However, the regulators do not routinely collect the information
necessary to ensure that they are able to systematically detect
changes in market characteristics. Thus, the Working Group lacks a
formal mechanism for obtaining the necessary information for
monitoring market developments related to sales practices. Such a
mechanism is important because it could alert the Working Group to
the need for reassessing the adequacy of existing sales practice laws
and regulations applicable to OTC derivatives.
Regarding MBS and structured notes, our survey found that end-user
satisfaction with dealer sales practices was somewhat lower than for
OTC derivatives. In addition, regulators identified more cases of
potential sales practice abuse for these products than for OTC
derivatives. However, SEC and the securities industry SROs have been
investigating and, when deemed necessary, taking enforcement actions
against the dealers involved in these cases. In addition, recently
enacted rules subject dealers marketing GSE-issued MBS and structured
notes--which account for the bulk of such securities--to all of
NASD's sales practice requirements. The implementation of these
rules should close what has been a major gap in regulatory oversight
of these products and improve NASD's ability to ensure that dealer
practices in these markets are appropriate.
Although the number of cases in which sales practice concerns were
raised was relatively limited, the disputes that accompanied some of
these cases resulted in both the end-user and dealer incurring
significant costs. These costs included legal expenses, regulatory
fines, reduced income, and even bankruptcy as well as other costs
related to the failure to manage the compliance and reputation risks
associated with these transactions. Although expanded sales practice
requirements to protect end-users may not be necessary at this time
due to the market characteristics previously discussed, the
seriousness of these risks justify additional action by federal
financial market regulators to better ensure the sound financial
condition of regulated institutions and the fairness and integrity of
the markets. Even actions that focus primarily on the risks posed to
dealers can help improve dealer sales practices, benefit end-users,
and enhance the overall integrity of the markets.
The Working Group could provide regulators a forum for assisting
end-users and dealers in reconciling their differing views on the
nature of their responsibilities in transactions involving OTC
derivatives. According to our survey, over 50 percent of the
end-users of plain vanilla OTC derivatives believed that dealers had
certain fiduciary responsibilities to them in some or all cases. As
reflected in the two sets of dealer-issued voluntary guidance--the
Framework and the Principles--dealers have generally considered such
transactions to be conducted at arm's length, with minimal
responsibilities existing for either party beyond those of honest and
fair dealing. To the extent that the differing views of end-users
and dealers increase the likelihood of sales practice disputes that
expose regulated institutions to material losses or that otherwise
could prove disruptive to the markets, federal regulators have an
interest in the reconciliation of these differences. The
reconciliation of such differences does not entail federal regulators
imposing a resolution on the markets. Rather, the type of
relationship and accompanying responsibilities that should prevail in
OTC derivatives transactions should be agreed upon by market
participants.
A clearer understanding of the nature of end-user and dealer
responsibilities may also be necessary for the voluntary standards to
receive more widespread acceptance among end-users. In addition,
these standards may be the only ones applicable to some unregulated
market participants, such as insurance company affiliates.
Therefore, by assisting market participants in reaching a clearer
understanding of their responsibilities, federal financial market
regulators may enhance the overall integrity of the markets.
Reaching a clearer understanding may also encourage product use,
where appropriate, by organizations that have limited their use
because of concerns about transaction risks and uncertainty about the
roles and responsibilities of dealers and end-users. Finally,
reaching such an understanding could result in greater diligence by
both end-users and dealers in ensuring that they comprehend product
risks before entering into transactions.
Notwithstanding the potential benefits of an improved understanding
between dealers and end-users, the issues surrounding their
relationships are complex and federal involvement may not necessarily
result in an agreement that is widely accepted. Even if an increased
level of understanding between these groups could be reached, the
likelihood of legal disputes when large losses occur might not
decrease. However, federal financial market regulators would be
justified in considering whether they can help end-users and dealers
reach a mutually acceptable agreement because of the importance of
these products to the financial markets and the U.S. economy.
Consultation with market participants on this subject might assist
regulators in assessing whether they should assume such a role.
Regardless of whether they decide to assist end-users and dealers in
resolving their differences, federal financial regulators can take
other specific actions to address the risks to dealers that market
OTC derivatives, MBS, and structured notes. Although the Federal
Reserve has conducted examinations of banks' activities and issued
guidance on the responsibilities of banks that market these products,
its guidance remains incomplete. Specifically, it does not direct
bank examiners to assess the adequacy of bank policies and controls
related to disclosing risk, acting in a fiduciary or advisory
capacity, or supervising marketing personnel. Weaknesses in these
areas existed in some cases where sales practice disputes have
arisen. Although we found both bank regulators' examinations to be
generally thorough, specifically addressing these areas in the
Federal Reserve's guidance would better ensure that such areas
receive similar attention in future examinations. Federal Reserve
officials have efforts under way to update this guidance, and our
review of a draft of this updated guidance indicates that it would
address the elements we identified as missing in the existing
guidance.
SEC and CFTC participation in the development of the Framework
reflects their concern with the risks posed by the sales practices
and other activities of the largely unregulated dealers in these
markets. In lieu of additional regulation of this market, the
Framework is to result in SEC and CFTC periodically receiving
additional information, including the results of external audits, on
some aspects of participating dealers' OTC derivatives activities.
This information should improve the ability of SEC and CFTC to
conduct the legislatively mandated risk assessments of the entities
they regulate. However, information on these dealers' adherence to
the sales practice provisions of the Framework is not included in the
information these regulators are to receive. Adherence to these
provisions is important for ensuring market fairness and integrity.
In the absence of a mechanism for ensuring such adherence, SEC and
CFTC cannot be sure that these firms' commitment to voluntarily
follow the sales practice provisions of the Framework is being
fulfilled, casting doubt on whether a voluntary arrangement is an
adequate substitute for direct federal oversight.
RECOMMENDATIONS TO THE
PRESIDENT'S WORKING GROUP ON
FINANCIAL MARKETS
---------------------------------------------------------- Chapter 7:2
We recommend that the Secretary of the Treasury, as Chairman of the
President's Working Group on Financial Markets, take the following
actions:
-- Ensure that the members of the Working Group establish a
mechanism for systematically monitoring developments in the OTC
derivatives markets to assess whether developments warrant
introducing specific federal sales practice requirements.
-- Lead the members of the Working Group in considering the extent
to which it should assist end-users and dealers in reaching
agreement on the nature of their relationship in transactions
involving OTC derivatives.
RECOMMENDATION TO THE FEDERAL
RESERVE
---------------------------------------------------------- Chapter 7:3
We recommend that the Chairman of the Federal Reserve Board implement
planned revisions to the Federal Reserve examination guidance, which
are to more specifically address the need to assess the adequacy of
banks' policies and controls related to disclosing risks, creating
advisory relationships, and supervising marketing personnel.
RECOMMENDATION TO SEC AND CFTC
---------------------------------------------------------- Chapter 7:4
We recommend that the Chairpersons of SEC and CFTC establish a
mechanism for determining that participating firms are following the
sales practice provisions of the Framework for Voluntary Oversight.
AGENCY AND INDUSTRY COMMENTS
AND OUR EVALUATION
---------------------------------------------------------- Chapter 7:5
We requested comments on a draft of this report from the heads, or
their designees, of CFTC, the Federal Reserve Board, OCC, SEC, and
Treasury. We also requested comments from two securities industry
SROs (NASD and NYSE) and four industry associations (EUDA, GFOA,
ISDA, and NASACT). Each of these agencies/associations provided us
with written comments except CFTC, Treasury, and NASD. The Director
of Treasury's Office of Federal Finance Policy Analysis provided oral
comments on our recommendations. Officials from CFTC provided oral,
technical comments. Our additional responses to written,
nontechnical comments are contained in appendixes III through IX.
Technical comments provided by CFTC, the Federal Reserve Board, OCC,
SEC, Treasury, NASD, NYSE, EUDA, GFOA, and ISDA were incorporated
into this report as appropriate.
Overall, no consensus emerged on the benefits of implementing our
recommendations. The banking regulators and the associations that
represent primarily end-users generally concurred with our findings
and/or recommendations. The Federal Reserve also stated that this
report makes a useful contribution to assessing the current state of
financial market sales practices. OCC commented that the report is
comprehensive in evaluating sales practices from the perspectives of
dealers, end-users, and regulators. GFOA said this report will be an
extremely helpful reference on derivatives, and NASACT stated that it
provides an excellent study of sales practice issues facing the OTC
derivatives market. In contrast, Treasury and ISDA generally
objected to our recommendations, with both opposing additional
federal involvement in the OTC derivatives markets to address sales
practice issues. SEC's views were mixed.
SEC, Treasury, and ISDA objected to our recommendation that the
Working Group establish a mechanism for systematically monitoring
developments in the OTC derivatives markets. Specifically, SEC and
Treasury officials commented that the Working Group's current
efforts, which generally include the principals meeting every 6 weeks
and the staff meeting every 2 weeks, are adequate to address market
developments. Similarly, ISDA commented that it is not readily
apparent that a formal monitoring mechanism would be any more
effective than the existing structure. In contrast, EUDA, GFOA, and
NASACT supported this recommendation. EUDA indicated that taking the
recommended steps--as they relate to this and our other
recommendation to the Working Group--will lead to greater market
safety and soundness, particularly concerning new dealers or
end-users entering the markets. We continue to believe that the
Working Group needs a formal mechanism for monitoring the OTC
derivatives markets. As discussed in this report, the market
characteristics that contributed to the relatively high level of
end-user satisfaction and the relatively limited number of sales
practice disputes could change as the markets evolve. This report
recognizes that the federal financial market regulators monitor the
OTC derivatives activities of the firms subject to their respective
oversight, and they discuss market developments of which they become
aware through their joint participation in the Working Group.
However, this report also observes that the agencies that participate
in the Working Group do not routinely collect the information
necessary to ensure that they are able to systematically detect
changes in market characteristics. Thus, the Working Group lacks a
formal mechanism for obtaining the necessary information for
monitoring developments related to sales practices. Such a mechanism
is important because it could alert the Working Group to the need for
reassessing the adequacy of existing sales practice requirements
applicable to OTC derivatives. The information to be assessed could
include the number and types of new dealers and end-users entering
the markets, the types of complex new products being introduced, and
changes in the types or sophistication of end-users to whom products
are being marketed.
Treasury and ISDA also objected to our recommendation that the
Working Group consider the extent to which it should assist end-users
and dealers in reaching agreement on the nature of their relationship
in transactions involving OTC derivatives. Treasury was concerned
that, because such relationships are contractual, no single model may
be appropriate. ISDA commented that no need exists for the Working
Group to involve itself in mediating between dealers and end-users,
that the involvement of market participants and regulators to date
has been sufficient, and that the issues involved are complex and
federal involvement may not result in an agreement that is widely
accepted. In addition, ISDA stated that the draft report offered no
evidence suggesting that disputes among privately negotiated
derivatives contracts (that is, OTC derivatives contracts) are more
frequent than in other commercial dealings, that these markets have
been largely free of sales practice abuses, and that courts and
regulators have not had difficulty in finding remedies when
necessary. For these reasons, ISDA indicated that it did not support
expanded regulatory activity. ISDA also commented that the report
does not substantiate that the OTC derivatives market is "in any way
broken and needs fixing," that our recommendations do not follow
logically from the facts or conclusions in the report, and that our
recommendations contradict the views of market participants and
regulators.
SEC commented that in its efforts to address financial market issues,
the Working Group has had discussions with end-users and professional
counterparties (dealers) and that it believes the Working Group would
be willing to continue this dialogue. However, SEC stated that it is
not necessary for the government to intervene and define contractual
obligations for professional and sophisticated counterparties. The
Federal Reserve noted that it has recognized the importance of and
encouraged voluntary industry efforts in this area, and the three
end-user associations supported our recommendation.
We continue to support our recommendation that the Working Group
consider assisting market participants in reaching agreement on the
nature of their relationship in OTC derivatives transactions. This
report acknowledges that the issues involved in reaching agreement
between dealers and end-users are complex and may not lend themselves
to a single, widely accepted solution. For this reason, we do not
intend that the Working Group impose a model that defines
counterparty relationships in OTC derivatives transactions. In
addition, we do not base our recommendation to the Working Group on a
finding that a high frequency of sales practice abuses exists or that
courts and regulators have had difficulty in finding remedies when
abuses occur. Instead, we present evidence that end-users and
dealers do not always agree on the nature of their relationship,
including their responsibilities, in OTC derivatives transactions.
Although the dealer-issued voluntary guidance asserts that the nature
of the relationship is arm's length, our survey found that a majority
of end-users believed that dealers had fiduciary responsibilities in
some or all OTC derivatives transactions, and that a majority
indicated they relied on dealers from some to a very great extent as
part of these transactions. To the extent that the differing views
of end-users and dealers increase the likelihood of sales practice
disputes that expose regulated institutions to material losses or
that otherwise effect the sound financial condition of regulated
institutions and the fairness and integrity of the markets, we
concluded that the federal financial market regulators have an
interest in the reconciliation of these differences.
Regarding ISDA's objection to additional regulatory activity, our
report concludes that no legislation or regulation is currently
needed. Nonetheless, our views on the benefits of federal regulatory
involvement in the OTC derivatives markets differ from those of ISDA.
In this regard, our recommendations address the need for the federal
financial markets to fulfill their responsibilities related to
ensuring the sound financial condition of regulated institutions and
the fairness and integrity of the markets, without creating
unnecessary or costly burdens for them. We do not recommend that the
federal financial market regulators resolve the differences between
dealers and end-users by defining the nature of their relationship
for them. Rather, we recommend that they consider, as participants
in the Working Group, whether the benefits of assisting market
participants are sufficient to warrant their involvement and whether
their involvement is likely to achieve the desired result. The
Working Group's assistance could involve facilitating discussions
between dealers and end-users that lead to agreement in key areas
where they now disagree. Regarding ISDA's comment that our
recommendations contradict the views of market participants and
regulators, this report recognizes the varying support of these
parties for our recommendations.
Treasury officials commented that the draft report appeared to be
critical of establishing an arm's-length relationship as the default
model for OTC derivatives transactions. ISDA officials supported the
arm's-length relationship as the default model, noting that it is the
appropriate starting place for institutional market participants.
This report does not reach a conclusion on the appropriate default
model for counterparty relationships. It presents the views of both
those who support and oppose an arm's-length relationship as the
default model. As clarified in chapter 7, we conclude that the type
of relationship and accompanying responsibilities that should prevail
in OTC derivatives transactions should be agreed upon by market
participants, and we recommend that the Working Group consider
assisting market participants in reaching agreement on these issues.
The Federal Reserve commented favorably on our recommendation to its
chairman. That is, the agency indicated that it has efforts under
way that would fully respond to our recommendation that the agency
revise its examination guidance to more specifically address the need
to assess the adequacy of banks' policies and controls related to
disclosing risk, creating advisory relationships, and supervising
marketing personnel.
In addressing our recommendation that SEC and CFTC establish a
mechanism for determining that participating firms are following the
sales practice provisions of the Framework, SEC indicated that it is
willing to discuss with the affected parties the feasibility of
extending the external auditor's role to incorporate a review of
sales practice procedures. This appears to be an appropriate first
step towards implementing our recommendation. As indicated in
chapter 6, SEC and CFTC could also request that the participating
firms provide copies of their sales practice policies--as was done
for these firms' risk management systems as part of SEC's risk
assessment process--and descriptions of the internal controls these
firms have established to ensure that such policies are being
followed. CFTC did not comment on this recommendation.
However, NASACT opposed this recommendation to SEC and CFTC,
contending that these agencies' participation in a compliance program
would be recognized as an endorsement of the Framework and would
present new legal obligations without first being subject to the due
process associated with a new regulation. In place of our
recommendation, NASACT proposed that the drafters of the Framework
and end-users work with SEC and CFTC to further clarify counterparty
relationships. GFOA also expressed concern that the dealer-issued
voluntary guidance could establish legal obligations, noting that
Bankers Trust cited the Principles as support in legal actions
involving Procter & Gamble.
Our recommendation is not intended to create new legal obligations
for dealers or end-users. Regarding NASACT's concern that SEC and
CFTC participation in a compliance program related to the Framework
would present new legal obligations (presumably for end-users), this
report notes that the Framework is not intended to apply to
end-users. Instead, the Framework specifically states that it
applies only to the participating firms and only to their
nonsecurities OTC derivatives activities. Although the Framework
indicates that it is not intended to create legally enforceable
obligations, this report acknowledges that the courts could find the
guidance useful in evaluating counterparty relationships and defining
common law responsibilities. To the extent that market participants
find this potential outcome objectionable, they can individually take
steps to clarify their relationship with counterparties in each
transaction they enter.
We believe that a more effective approach would be for end-users and
dealers to participate in a joint effort to reach agreement on the
nature of their relationship in OTC derivatives transactions, and we
have recommended that the Working Group consider assisting the
parties in this process. We make our recommendation to the Working
Group in the belief that a coordinated effort by the federal market
regulators would be a more effective means of reaching agreement on
the nature of counterparty relationships, including the
responsibilities of counterparties to OTC derivatives transactions.
An additional advantage to this approach is that the resulting
agreement would not make distinctions between types of dealers and
end-users. That is, it would not distinguish between dealers that
are banks and dealers that are securities firm affiliates or their
end-user counterparties. As a result, should the Working Group
assist dealers and end-users in reaching an agreement on the nature
of their relationship, the resulting agreement would be applicable to
all dealers and end-users of OTC derivatives.
This report also notes that, in lieu of additional regulation, SEC
and CFTC are already participating with the drafters of the Framework
in a voluntary program that includes monitoring the nonsales practice
provisions of the Framework by external auditors. We are merely
recommending that such monitoring be extended to the sales practice
provisions of the Framework. As we conclude in this chapter,
adherence to these provisions is important for ensuring market
fairness and integrity. In the absence of a mechanism for ensuring
such adherence, SEC and CFTC cannot be sure that a participating
firm's commitment to voluntarily follow the sales practice provisions
of the Framework is being fulfilled, thereby casting doubt on whether
a voluntary arrangement is an adequate substitute for direct federal
oversight.
METHODOLOGY FOR GAO SURVEY OF
END-USERS
=========================================================== Appendix I
Beginning in March 1995, we sent questionnaires to 2,381 randomly
selected organizations drawn from a wide range of U.S. public and
private industries, representing a universe of approximately 49,000
organizations that were potential end-users of plain vanilla
over-the-counter (OTC) derivatives, complex OTC derivatives,
structured notes, and asset-backed securities.\1 Our objectives in
conducting the survey were to estimate for these four product types
(1) the extent of end-user satisfaction with dealer sales practices
and (2) the extent of product use.
The questionnaire requested data on the usage of specific products
within the 12 months preceding receipt of the survey. It also asked
respondents to rate the sales practices of any dealers with whom they
engaged in transactions across six dimensions: (1) disclosure of
downside risks, (2) quality of transaction documentation provided,
(3) suitability of products proposed, (4) competitiveness of pricing
and fees, (5) provision of accurate mark-to-market pricing
information, and (6) assistance in unwinding transactions. In
addition, it asked the organizations to separately rate the sales
practices of dealers that proposed contracts, but who they did not
use, over the three applicable dimensions listed above--(1), (3), and
(4). We developed these sales practice dimensions on the basis of
reviews of regulatory and dealer documents and discussions with
regulators, dealers, and end-users. Lastly, the questionnaire asked
organizations to provide overall ratings of sales practices both for
dealers with whom the organizations entered into contracts as well as
dealers that proposed contracts but who they did not use.
From the returned surveys, we selected a judgmental sample of 70 of
the respondents, drawn from a wide spectrum of large and small
organizations across all of the industries surveyed. Some were
end-users and others were nonusers of the four types of products;
some were satisfied with dealer sales practices, while others were
dissatisfied. We completed telephone follow-up interviews with 50 of
these respondents to learn more about the reasons for their
satisfaction or dissatisfaction with dealer sales practices, their
opinions on fiduciary relationships, and the range of end-user sales
practice-related policies, procedures, and practices. Although the
results of these follow-up interviews are not generalizable to any
larger population of potential end-users, the 50 organizations
contacted generally reflect the range of organization types and
sizes, product usage, and satisfaction levels.
--------------------
\1 We included mortgage-backed securities as a subset of asset-backed
securities in the questionnaire.
DESIGN OF THE SURVEY SAMPLE
--------------------------------------------------------- Appendix I:1
To respond to a request made by the former Chairman of the
Subcommittee on Telecommunications and Finance, House Committee
Energy and Commerce, we set out to determine the extent of end-user
satisfaction with the sales practices of dealers offering OTC
derivatives, mortgage-backed securities (MBS), and structured notes
across a wide universe of U.S. public and private organizations that
might be using these products, including not only the organizations
with the largest finances, but also the smaller organizations in each
industry. The former Chairman also asked us to determine the extent
of product use.
To obtain a statistically precise estimate (one with a low sampling
error) of the level of satisfaction with dealer sales practices, we
needed to collect as many survey responses as possible from current
end-users, which are more likely to have experienced sales practice
presentations. Our prior work and that of other organizations
indicated that larger organizations tend to be end-users of these
products more often than smaller organizations.
However, we were concerned that smaller organizations, which might
use these products less often and have fewer resources for managing
their financial activities, might have different sales practice
experiences than larger organizations. Any such differences would
not be reflected by our estimate of the level of satisfaction, if
small organizations were excluded from the survey. Also, we did not
want to exclude from our estimate of usage a significant number of
smaller organizations that had at least some, if limited, potential
for being end-users. Therefore, to obtain unbiased estimates of
satisfaction and usage, we included proportionately more large
organizations in our sample, while still selecting some organizations
that would represent the smaller entities in the population under
study.
We began by defining the populations we would survey. We identified
19 public and private industries that we concluded would thoroughly
cover potential end-users. For each of the 19 survey strata
representing these industries, we had to compile a frame, or a
listing of all known organizations in a population, ideally without
duplicates or omissions. The frames had to include mailing
addresses, relevant contact names, and enough information about the
organizations to allow classification by industry and financial size
and to allow the assignment of a unique identification number. In
several of the industries we surveyed, our frames did not cover all
of the known organizations, but were restricted to organizations
above a minimum financial size, determined by the availability of
data in the lists we used. Nevertheless, the scope of each frame
covered a significant proportion of the smaller organizations in that
industry and adequately comprised the population of organizations
that would have a reasonable probability of derivative product usage
and experience with dealer sales practices. See table I.1 for a
description of the 19 industry strata, the scope of organizations
included in those strata, and the sources for the sample frames we
developed to represent those populations.
Table I.1
Design of Potential End-User Sample
Frame
Indicators of Size/Usage
Population size and/or substratificatio
Strata (19) definition Frame used usage n criteria
------------ ---------------- -------------- -------------- ----------------
Cities and All 38,995 local Directory of Population Large substratum
counties governments, Governments, counts from defined as
such as 1988: Name and 1990 decennial organizations in
counties, Address File census. top 5 percent,
municipalities, (U.S. Bureau representing 70
and townships, of the percent of total
that were Census). population
identified in a count. Small
1987 census and substratum
updated by consists of all
subsequent other
annual surveys organizations.
(excludes
states).
Special All 32,838 local Directory of Population Large substratum
districts government Governments, counts of defined as the
special 1988: Name and cities in special
districts or Address File which the districts
authorities, (U.S. Bureau districts are (except sewerage
such as of the located, from and water supply
airports, Census). 1990 decennial districts
hospitals, census. nationwide and
utilities, other
ports, and multifunction
terminals. districts in
Texas) with
addresses in the
30 most populous
cities. Small
substratum
consists of all
other
organizations.
Local All 14,222 Directory of School Large substratum
school school districts Governments, enrollments defined as
districts and systems. 1988: Name and from the 1992- organizations in
Address File 93 school the top 10
(U.S. Bureau year. percent,
of the representing 60
Census). percent of total
school
enrollment.
Small substratum
consists of all
other
organizations.
State Offices of all Various Not No
treasuries 50 state government applicable. substratificatio
treasurers and directories. n.
the District of
Columbia.
Private All 46,795 1995 Money Total pension Large substratum
pension corporate and Market assets. defined as
funds and union Directory organizations
union funds (headquarters Pensionscope with $20 million
and local) Database in pension
pension funds (Money Market assets and over,
with investment Directories, representing
assets of $1 Inc.). approximately
million and over the top 10
that were percent of
identified in a organizations.
periodic review Small substratum
of Department of consists of all
Labor Form 5500 other
filings (Annual organizations.
Return/Report of
Employee Benefit
Plan) and a
proprietary
survey conducted
by Money Market
Directories,
Inc.
Public All 1,167 1995 Money Total pension Large substratum
pension pension funds Market assets. defined as
funds and and retirement Directory organizations
retirement systems Pensionscope with $1 billion
systems sponsored by Database in pension
state, county, (Money Market assets and over,
and municipal Directories, representing
governments with Inc.). approximately
investment the top 10
assets of $1 percent of
million or more, organizations.
identified and Small substratum
updated consists of all
periodically by other
Money Market organizations.
Directories,
Inc.
Endowments All 4,855 1995 Money Total assets. Large substratum
and private Market defined as
foundations educational and Directory organizations
museum funds; Pensionscope with $100
private and Database million in total
public (Money Market assets and over,
charitable Directories, representing
endowments; and Inc.). approximately
foundations with the top 10
assets of $1 percent of
million or more, organizations.
identified and Small substratum
updated consists of all
periodically by other
Money Market organizations.
Directories,
Inc.
College and All 3,667 2- Digest of Current-fund Large substratum
university year and 4-year Education revenues, as defined as
operating U.S. colleges, Statistics, reported for organizations
funds universities, 1994 (National the 1991-92 with $80 million
technical Center for period. and over in
institutes, and Education current-fund
vocational Statistics). revenue for the
programs, 1991-92
identified by reporting
Department of period,
Education representing
surveys, approximately
conducted the top 10
annually. percent of
organizations.
Small substratum
consists of all
other
organizations.
Institutiona All 1,759 1995 Money Total managed Large substratum
l money registered U.S. Market assets. defined as
managers investment Directory organizations
advisor firms, Pensionscope with $1 billion
bank and trust Database in managed
departments, and (Money Market assets and over,
insurance Directories, representing
companies Inc.). approximately
managing various the top 36
assets of at percent of
least $1 organizations.
million, Small substratum
identified and consists of all
updated other
periodically by organizations.
Money Market
Directories,
Inc.
Government- All 33 GSEs and Ward's Not No
sponsored GSE-like Business applicable. substratificatio
enterprises organizations Directory, n.
(GSE) that we (1994
identified as edition);
being in previously
existence in published GAO
March of 1995, products, and
including major consultation
credit with GAO
organizations, experts.
such as the
Federal National
Mortgage
Association and
the Federal Home
Loan Mortgage
Association,
regional Federal
Home Loan Banks,
Farm Credit
Banks, and other
organizations
with the
Standard
Industrial Code
(SIC)
classification
of 6111
("Federal and
Federally
Sponsored
Credit").
Excludes
approximately
238 Farm Credit
Associations
whose day-to-
day asset or
liability
management is
generally
carried out at
the bank level
or higher.
Commodity Includes 844 National Net asset Large substratum
pools commodity pools Futures value of pool, defined as
with U.S. Association. as of January organizations
operators, with 1995. with $31.5
total net asset million net
value of $1 asset value and
million or more, over,
as of January representing
1995, according approximately
to National the top 33
Futures percent of
Association organizations.
records. Small substratum
consists of all
other
organizations.
Mutual funds All 6,358 Lipper Total net Large substratum
individual Analytical assets under defined as
equity and bond Services, Inc. management. organizations
mutual funds with $450
(except for million in total
municipal bond net asset value
funds), and over,
identified by representing
Lipper approximately
Analytical the top 10
Services, Inc., percent of
as of January organizations.
1995. Small substratum
consists of all
other
organizations.
Money market All 1,237 Lipper Total net Large substratum
funds taxable and tax- Analytical assets under defined as
exempt money Services, Inc. management. organizations
market mutual with $1.15
funds, including billion net
municipal bond asset value and
funds, over,
identified by representing
Lipper approximately
Analytical the top 10
Services, Inc., percent of
as of January organizations.
1995. Small substratum
consists of all
other
organizations.
Publicly The 5,581 U.S. Compact Total annual Large substratum
held parent companies Disclosure sales figure defined as
nonfinancial with at least (Disclosure, most recently organizations
corporations 500 stockholders Inc.) and the reported in with $1.4
of one class of March 14, Compact billion annual
stock, at least 1995, Pink Disclosure sales and over,
$5 million in Sheets records. representing
assets, and (National approximately
filing reports Quotation the top 10
with the Bureau, Inc.). percent of
Securities and organizations.
Exchange Small substratum
Commission in consists of all
the 18 months other
before the 1994 organizations.
review by
Compact
Disclosure.
Excludes
companies listed
in Compact
Disclosure on
the basis of a
debt issue and
not traded on a
national or
regional
exchange, or on
the National
Association of
Securities
Dealers
Automated
Quotation
system, and
which had sales
of less than $25
million. Also
excludes
companies with a
primary SIC in
the financial
industry and
foreign-based
companies with
American
Depository
Receipts listed
on U.S. stock
exchanges.
Privately The 8,204 U.S.- 1994 Directory Total sales as Large substratum
held based of Corporate reported in defined as the
nonfinancial nonfinancial Affiliations, Ward's 1995 top 200
corporations privately held Volume 5-- Business corporations in
ultimate parent U.S. Private Directory of total 1994
companies with Companies U.S. Private sales,
annual revenues (National and Public representing
of at least $10 Register Companies. approximately
million or a Publishing) the top 2
workforce of at and Ward's percent of
least 300 people 1995 Business organizations in
as listed in the Directory of the population.
1994 Directory U.S. Private Small substratum
of Corporate and Public consists of all
Affiliations, Companies other
Volume 5--U.S. (Gale organizations.
Private Research,
Companies. Inc.).
Excludes public
organizations
and companies
with a primary
SIC in the
financial
industry.
Largest The largest 120 Ward's 1995 Total assets No
nonbank firms with Business as reported in substratificatio
financial assets over $100 Directory of Ward's 1995 n.
corporations million, as U.S. Private Business
identified by and Public Directory of
Ward's 1995 Companies U.S. Private
Business (Gale and Public
Directory. Research, Companies.
Includes Inc.).
financial
companies other
than banks,
insurance
companies, and
securities
firms. Includes
firms classified
under the
following SICs:
6141, personal
credit
institutions;
6153, short-
term business
credit firms;
6159,
miscellaneous
business credit
firms;
6162, mortgage
bankers and
correspondents;
and 6163, loan
brokers. Does
not include
subsidiaries of
banks or thrifts
but may include
subsidiaries of
insurance or
nonfinancial
companies.
Banks and All 9,816 U.S. Holding Total assets Largest
thrifts thrifts and company, bank, as reported in substratum
single-bank and and thrift June 1994 Call defined as those
multibank data files in Reports and institutions
holding June 1994 total dollar with total
companies or (#188) Call amount of assets of $225
lead banks with Report assets and million or more
national or (Federal liabilities and reporting
state charters. Financial reported in $300 million or
Does not include Institutions all categories more in holdings
New York Examination of MBS, either of MBS and
Investment Council). held to notional amounts
Companies or maturity, of forwards,
trust companies. available for options, and
Branches, sale, or held swaps (3 percent
subsidiaries, or in trading of the
individual banks accounts plus population).
that are members total off- Middle
of larger balance sheet substratum
families of notional value defined as
banks are also dollar amounts institutions
excluded. of various with total
interest rate assets of less
and foreign than $225
exchange million and
forwards, reporting $300
options, and million or more
swaps. in holdings of
MBS and notional
amounts of
forwards,
options, and
swaps and
institutions of
any asset size
and reporting up
to $300 million
in holdings of
MBS and notional
amounts of
forwards,
options, and
swaps (33
percent of the
population).
Smallest
substratum
defined as
institutions of
any asset size
reporting no
holdings of
these products
(64 percent of
the population).
Insurance The 2,523 Best's Total assets Large substratum
companies ultimate parent Insurance as reported in defined as
property/ Reports, 1994 1994 edition organizations
casualty and edition (A.M. of Best's with $700
life/health Best, Inc.). Insurance million in
insurance Reports. assets and over,
companies representing
identified in approximately
the 1994 edition the top 12
of Best's percent of
Insurance organizations.
Reports. Small substratum
Includes consists of all
foreign-owned other
U.S. organizations.
subsidiaries or
divisions that
list their U.S.
executive
management in
Best's Insurance
Reports. Also
includes
insurance
companies owned
by holding
companies
outside of the
insurance
industry. Does
not include
subsidiaries or
divisions of
other U.S.
insurance
companies.
Credit All 13,380 Data tapes Total assets Largest
unions federally from the in 1994. Also, substratum
insured National total holdings defined as all
corporate and Credit Union of 45 of the
natural person Administration collateralized corporate credit
credit unions in . mortgage associations, 25
the United obligations of which
States. Includes (CMO) and real reported holding
the U.S. Central estate CMOs or REMICs
Credit Union. management as of December
Natural person investment 1994 (less than
credit unions conduits 1 percent of the
primarily serve (REMIC) in population).
individuals who June 1994. Second
are their substratum
member-owners. defined as the
Corporate credit 1,147 natural
unions are person credit
cooperatively unions with any
owned by the CMO or REMIC
natural person holdings as of
credit unions June 1994
and serve them (approximately 9
by investing a percent of the
portion of their population).
assets or Third substratum
loaning them defined as the
funds for 1,204 natural
liquidity person credit
purposes. unions with no
CMO or REMIC
holdings as of
June 1994, but
with $50 million
or more in
assets
(approximately 9
percent of the
population).
Fourth
substratum
defined as the
10,984 natural
person credit
unions with no
CMO or REMIC
holdings as of
June 1994 and
less than $50
million in
assets
(approximately
82 percent of
the
population).\a
--------------------------------------------------------------------------------
\a Totals do not sum to 100 percent due to rounding.
Source: GAO.
After identifying the 19 strata representing broad industries, we
then subdivided 16 strata into 2 or more substrata on the basis of
financial size and, if available, the extent of past product usage.
We did not subdivide three strata--state treasuries, GSEs, and the
largest nonbank financial corporations--because they were already
narrow industries with too few organizations to subdivide by size.
We substratified to group organizations on the basis of how likely
they were to be current end-users of OTC derivatives, MBS, and
structured notes so that we could sample them at different rates. In
each of the industry strata, we chose indicators of financial size,
such as annual revenues, assets under management, or population in
the governmental jurisdiction served. For the bank and credit union
strata, additional information identifying past users of certain
kinds of products was available from financial reports.
Typically, we defined the larger substrata in each industry as the
top 10 percent of the number of organizations in the population when
ranked by size, although the cutpoints defining the large substrata
varied from approximately the top 1 percent to 33 percent of some
populations, depending on our knowledge of that particular industry
or the characteristics of the sampling frames (see table I.1). For
example, we defined the large credit union substratum as only the
corporate credit unions, which covered less than 1 percent of all
credit unions. Corporate credit unions, which tend to be large,
differ in structure and function from smaller "natural person" credit
unions. In addition, we defined a cutpoint of $1 billion in assets
under management for money managers, resulting in the large
substratum covering 36 percent of the organizations in the
population, because that asset level was the highest available in the
computerized list that we used. Organizations known to have recently
used certain MBS and derivatives were included in the larger
substrata of banks, thrifts, and credit unions.
The sample was drawn from each substratum at different
rates--proportionately more organizations were drawn from the
substrata of large entities and recent users, which we expected to
yield a relatively high proportion of current users, and fewer from
the substrata of smaller entities, which we expected to yield fewer
end-users. This differential rate of sampling was necessary to
obtain a sample that would meet both the objectives of developing an
acceptable estimate of overall usage and an acceptable estimate of
users' opinions. See table I.2 for the exact allocation of the
original survey sample of 2,422 organizations\2 across the substrata
and the aggregation of the 19 strata into the 9 industry groups that
we used to present our findings throughout this report.
--------------------
\2 Of the 2,422 organizations in the original sample, 41 were
determined to be ineligible (out of business, wrong industry,
duplicate listing, and similar dispositions) before mailout. From
the 2,381 questionnaires mailed out, we determined that an additional
177 organizations were ineligible during the course of the survey.
The final working sample size was 2,204 organizations.
QUESTIONNAIRE DESIGN
--------------------------------------------------------- Appendix I:2
To develop our questionnaire, we consulted representatives of the
dealer community, groups representing end-users, financial
regulators, and other finance experts. We also conducted many
in-depth interviews with finance officers from state and local
governmental entities and private corporations on subjects to be
included in the questionnaire. After drafting a questionnaire and
receiving comments from the aforementioned groups, we conducted five
pretests of the questionnaire with a variety of likely respondents
drawn from several of the survey populations. The information
gathered during such tests was used to improve the structure of the
questionnaire as well as the phrasing of specific questions.
SURVEY ADMINISTRATION
--------------------------------------------------------- Appendix I:3
The mailout of questionnaires began during the last week of March
1995. Follow-up mailings with replacement questionnaires and a
renewed appeal encouraging response were sent to nonrespondents
beginning in the last week of May 1995. In the second week of July
1995, we began to make telephone follow-up calls to a sample of
organizations that had not yet responded to either the first or
second questionnaire mailing. A random sample of approximately 50
percent of the nonrespondents was drawn from across all of the
strata, and we administered a short telephone interview questionnaire
to that sample of 365. The follow-up interviews determined the
reason for nonresponse, prompted the return of the full
questionnaire, or collected basic data from the organization if a
mail questionnaire would not be returned by the respondent. The
survey was closed out at the end of October 1995, after which no
additional responses were included in our results. Because the
questionnaire asked for product usage and sales practice experience
for the 12 months preceding the survey, and given that respondents
were filling out and returning questionnaires from April 1995 through
October 1995, the maximum possible period of financial activity
covered by the survey was from April 1994 through October 1995.
SURVEY RESPONSE
--------------------------------------------------------- Appendix I:4
We attempted to collect data from every one of the organizations
chosen in our random sample. However, for a variety of reasons, such
as refusals, we did not receive usable responses from a number of
entities. After sending a replacement questionnaire to
nonrespondents and following up by telephone with a random sample of
the remaining nonrespondents, we determined the final status of our
entire sample (see table I.2). We received 1,755 usable responses,
for an overall response rate of 80 percent. Although some of the
survey strata exhibited higher or lower rates of response than
others, the response rates did not vary systematically by size of
stratum. Because we hypothesized that large and small organizations
would differ on key variables, a large difference in response rates
between large and small substrata could have introduced bias into the
overall survey results.
Table I.2
Disposition of Survey Sample Across All
Strata
Follow-
Follow- up Follow-up Follow-up Total Response
Original Original Ineligib Responden Nonresponde up ineligib respondent nonresponde response rate
Industry Strata (19) Substrata (38) population sample le ts nts sample le s nts s (percent)
groups (9) ------------------ ---------------------- ----------- -------- -------- --------- ----------- -------- -------- ---------- ----------- -------- ----------
State and Cities and Large: population � 1,932 100 1 67 32 10 6 4 0 71 76
local counties 37,000
government
Small: population < 37,104 50 5 45 0 0 0 0 0 45 100
37,000
State and local Large: top 30 urban 489 50 5 23 22 7 5 2 0 25 63
special districts areas
Small: all other 32,349 50 4 29 17 14 5 8 1 37 90
districts
Local school Large: enrollment � 1,426 50 0 34 16 7 0 6 1 40 80
districts 5,250
Small: enrollment < 12,796 50 0 34 16 6 1 4 1 38 78
5,250
State treasuries All states and 51 51 0 32 19 5 1 4 0 36 72
District of Columbia
Pension Private pension/ Large: assets � $20 4,407 100 3 54 43 17 3 11 3 65 69
funds Union funds million
Small: assets < $20 41,349 100 5 63 32 18 4 11 3 74 81
million
Public pension Large: assets � $1 123 75 1 60 14 8 2 5 1 65 90
funds/Retirement billion
systems
Small: assets < $1 1,044 25 0 16 9 4 2 2 0 18 78
billion
Endowment Endowments and Large: assets � $100 507 50 3 32 15 10 3 4 3 36 82
and college foundations million
funds
Small: assets < $100 4,348 50 1 38 11 7 1 5 1 43 90
million
College and Large: revenue � $80 366 50 3 37 10 6 1 5 0 42 91
university million
operating funds
Small: revenue < $80 3,301 50 1 35 14 10 4 2 4 37 82
million
Money Institutional Large: assets � $1 637 122 0 70 52 32 12 11 9 81 74
managers money managers billion
Small: assets < $1 1,122 72 3 64 5 0 0 0 0 64 93
billion
GSE GSE All 33 33 1 31 1 0 0 0 0 31 97
Investment Commodity pools Large: net asset value 286 29 7 18 4 0 0 0 0 18 82
funds � $31.5 million
Small: net asset value 558 26 0 13 13 7 4 2 1 15 68
< $31.5 million
Mutual funds Large: assets � $450 636 125 3 58 64 22 5 12 5 70 60
million
Small: assets < $450 5,722 75 1 36 38 27 3 21 3 57 80
million
Money market Large: assets � $1.2 124 75 0 36 39 17 0 14 3 50 67
mutual funds billion
Small: assets < $1.2 1,113 75 5 28 42 32 15 10 7 38 69
billion
Nonfinancial Publicly held Large: sales � $1.4 506 75 0 46 29 12 3 7 2 53 74
corporations nonfinancial billion
corporations
Small: sales < $1.4 5,075 74 1 42 31 12 2 9 1 51 72
billion
Privately held Large: top 200, by 200 50 3 33 14 7 5 2 0 35 83
nonfinancial sales
corporations
Small: all others 8,004 121 16 70 35 11 4 7 0 77 76
Other Largest nonbank Top 120, by assets 120 120 7 71 42 19 7 12 0 83 78
financial financial
corporations corporations
Banks/ Banks and thrifts Large/Past users: MBS 309 75 2 59 14 7 4 2 1 61 88
Credit and derivative usage �
unions/ $300 million and
Insurance assets � $225 million
companies
Medium/Past users: (1) 3,194 75 1 55 19 7 1 5 1 60 82
usage < $300 million
or (2) usage � $300
million and assets <
$225 million
Small/No past usage: 6,313 50 10 30 10 6 2 3 1 33 87
$0 usage, any asset
size
Insurance Large: assets � $700 299 50 3 33 14 10 2 6 2 39 87
companies million
Small: assets < $700 2,224 50 13 27 10 5 0 3 2 30 81
million
Credit unions 45 corporate credit 45 45 0 38 7 3 1 2 0 40 91
unions
Natural person credit 1,147 54 2 50 2 0 0 0 0 50 96
unions, past users of
MBS
Natural person credit 1,204 25 0 25 0 0 0 0 0 25 100
unions, no past usage,
assets � $50 million
Natural person credit 10,984 25 0 22 3 0 0 0 0 22 88
unions, no past usage,
assets < $50 million
====================================================================================================================================================================================
Total N/A N/A 191,447 2,422 110 1,554 758 365 108 201 56 1,755 80
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Source: GAO.
CALCULATION OF SURVEY ESTIMATES
--------------------------------------------------------- Appendix I:5
The overall survey statistics appearing in this report represent
estimates of the entire population of U.S. private industry and
state and local governmental entities from which the sample was
drawn. To be able to make an estimate of the entire population, each
questionnaire we received was statistically adjusted, or "weighted,"
so that its influence in determining the overall survey result was
proportional to the number of other, nonsampled entities it had to
represent in its industry. Specific weights were calculated for
returned questionnaires within each of the substrata formed by the
cross-classification of industry with organizational size and/or past
usage. The weights were also adjusted to represent different sample
selection rates within substrata for the initial sample and the
follow-up sample of nonrespondents.
Not all of the sample substrata are included in the overall survey
results. Five of the "smallest" substrata were removed from the
overall survey estimates made in this report and analyzed separately.
They were: small cities and counties, small special districts, small
school districts, small private pension and union funds, and small
nonuser credit unions. These five substrata represent populations
that are very numerous, yet very low in financial assets and
activity. We discovered a very low rate of product usage among these
entities and, therefore, decided to separate them from the rest of
the sample. See tables I.3 and tables I.5 through I.8 for the
estimates of usage of the various products by these very small
organizations. Although the size of the entire original population,
including the 5 smallest strata, is approximately 191,000, the
population to which we project our overall survey estimates in this
report, after removing the very small organization strata and
adjusting the population for ineligibles, is approximately 49,000
organizations.
In addition to the overall estimates that are projectable to the
entire population of U.S. public and private industry from which the
sample was drawn, this report contains some estimates for more
specific industry groupings. Because the number of sampled
organizations falling within any 1 of the 19 industries was usually
too small to yield precise estimates for that individual industry, we
aggregated responses from several comparable industries to form 9
industry groups (see table I.2). For example, we combined
questionnaires received from mutual funds, money market funds, and
commodity pools into one analytical group. Although the individual
industries combined in a group generally exhibit the same
characteristics on most survey items, a great deal of variation may
exist in rates of usage and satisfaction among some of the combined
industries.
This report also breaks down survey results by the size of
organization and/or past usage of certain MBS and derivative products
across the entire sample and within each industry group. As
previously described, we separated the industries into as many as
four substrata. The cutpoints separating these substrata of "larger"
from "smaller" organizations in each of the 19 industries are
somewhat arbitrary and are based on different measures across each
industry. As a result, "larger" organizations in one industry are
not necessarily similar to those in another industry.
Beyond the limited breakdowns of the survey results by broad
categories of industry and size, it is not possible to make any
estimates of acceptable precision. Because the survey sample was
designed to make overall estimates across a large number of
industries, an insufficient number of sampled institutions exists
within the fine categories of industry, size, geographical location,
or other subgroups. Some subgroup estimates that are made in this
report are accompanied by a note to the reader that the small number
of observations involved make calculation of sampling error
unfeasible and heighten the likelihood of significant nonsampling
error. The concept of sampling errors and other survey errors is
discussed in the following sections.
SAMPLING ERROR
--------------------------------------------------------- Appendix I:6
Because we reviewed a statistical sample of organizations, each
estimate developed from the sample has a measurable precision, or
sampling error. The sampling error is the maximum amount by which
the estimate obtained from a statistical sample can be expected to
differ from the true population value we are estimating. Sampling
errors are stated at a certain confidence level--in this case 95
percent. This means that the chances are 19 out of 20 that if we
surveyed all of the organizations in the population, the true value
obtained for a question on this survey would differ from the estimate
obtained from our sample by less than the sampling error for that
question. The sampling errors for all of the survey estimates made
in this report are listed in tables I.3 through I.14. For the state
treasury, GSE, and other financial institution strata, we selected
all known organizations in the population as defined, so there is
technically no sampling error associated with those estimates.
However, missing observations due to the nonresponse of some of the
sampled organizations in those strata creates statistical uncertainty
similar to sampling error.
NONSAMPLING ERRORS
--------------------------------------------------------- Appendix I:7
In addition to the reported sampling errors, the practical
difficulties of conducting any survey may introduce other types of
errors, commonly referred to as nonsampling errors. For example,
intentional or accidental misreporting, differences in how a
particular question is interpreted, the level of effort a respondent
makes to answer the questions accurately, or the types of people who
do not respond can introduce unwanted variability into the survey
results.
We included steps in the questionnaire design, data collection, and
data analysis stages for the purpose of reducing such nonsampling
errors. While designing the questionnaire, we solicited expert
opinions on the wording and structure of our questions and their
answer categories, we received feedback on our questions and answers
during a focus group with end-users, and we pretested the survey
instrument with five organizations from our sample.
During data collection, we checked whether some answers respondents
gave on their questionnaires were logically consistent with other
answers. While conducting an in-depth telephone follow-up with a
sample of respondents who were particularly satisfied or dissatisfied
with sales practices, we attempted to verify some of their previous
answers and thus gauge the reliability of a subset of the questions.
To reduce nonresponse bias, we attempted to convert a sample of 50
percent of the nonrespondents to respondents through telephone
follow-ups. To assess the potential impact of nonresponse on our
estimates, we examined a group of respondents who may be similar to
nonrespondents in terms of characteristics that determine
questionnaire responses--those organizations that were initially
nonrespondents but were converted through telephone follow-up. When
we compared the answers of those converted nonrespondents to
organizations that responded without follow-up, we found the only
material difference to be that a smaller proportion of the converted
nonrespondents used MBS and fewer were dissatisfied with the sales
practices of dealers offering MBS. Finally, in processing and
tabulating the survey data, we employed a number of procedures to
reduce errors that arise from these activities.
SAMPLING ERRORS ASSOCIATED WITH
THE KEY SURVEY ESTIMATES CITED
IN THIS REPORT
--------------------------------------------------------- Appendix I:8
Table I.3
Proportion of Organizations Using OTC
Derivatives (Plain Vanilla or More
Complex) in the 12 Months Preceding
Receipt of Survey, by Size Category and
Industry Group
Sampling
Organizations, by size category and industry Estimate error (�)
group (percent) (percent)
---------------------------------------------- ---------- ----------
Size category:
All organizations in the population, excluding 11% 2%
the five smallest strata
Large organizations 14 2
Small organizations, excluding the five 9 3
smallest strata
Smallest five strata (smallest local <1 \a
governmental entities, smallest credit
unions, and smallest private pension funds)
Industry group:
Banks and thrifts, credit unions, and 5 3
insurance companies
Endowments, foundations, and college and 7 5
university operating funds
Other financial corporations (credit financing 54 6
firms, mortgage brokers and lenders, and
leasing agencies)
GSEs 71 3
Money managers 10 5
Mutual funds, money market funds, and 27 9
commodity pools
Public and private pension funds and 10 5
retirement systems
Publicly and privately held nonfinancial 10 5
corporations
State and local governmental entities 4 \a
----------------------------------------------------------------------
\a Number of cases insufficient to make an estimate.
Source: GAO.
Table I.4
Proportion of Estimated Total Users
Represented by Each Industry Group
Sampling
Estimate error (�)
Industry group (percent) (percent)
---------------------------------------------- ---------- ----------
Banks and thrifts, credit unions, and 12% 7%
insurance companies
Endowments, foundations, and college and 11 7
university
operating funds
Other financial corporations 1 <1
GSEs <1 <1
Money managers 3 2
Mutual funds, money market funds, and 39 10
commodity pools
Public and private pension funds and 9 5
retirement systems
Publicly and privately held nonfinancial 22 10
corporations
State and local governmental entities 2 \a
======================================================================
Total 100% N/A
----------------------------------------------------------------------
\a Number of cases insufficient to make an estimate.
Source: GAO.
Table I.5
Proportion of Organizations Using Plain
Vanilla OTC Derivatives, by Size
Category and Industry Group
Sampling
Organizations, by size category and industry Estimate error (�)
group (percent) (percent)
---------------------------------------------- ---------- ----------
Size category:
All organizations in the population, excluding 10% 2%
the five smallest strata
Large organizations 14 2
Small organizations, excluding the five 9 3
smallest strata
Smallest five strata (smallest local <1 \a
governmental entities, smallest credit
unions, and smallest private pension funds)
Industry group:
Banks and thrifts, credit unions, and 5 3
insurance companies
Endowments, foundations, and college and 6 5
university operating funds
Other financial corporations (credit financing 54 6
firms, mortgage brokers and lenders, and
leasing agencies)
GSEs 68 3
Money managers 10 5
Mutual funds, money market funds, and 27 9
commodity pools
Public and private pension funds and 10 5
retirement systems
Publicly and privately held nonfinancial 10 5
corporations
State and local governmental entities 3 \a
Other subgroups:
Large publicly and privately held nonfinancial 66 12
corporations
Large public pension funds and retirement 41 9
systems
Proportion of organizations that have not used 8 2
plain vanilla OTC derivatives, but have
received a proposal to enter into such a
contract in the last 12 months
----------------------------------------------------------------------
\a Number of cases insufficient to make an estimate.
Source: GAO.
Table I.6
Proportion of Organizations Using More
Complex OTC Derivatives, by Size
Category and Industry Group
Sampling
Organizations, by size category and industry Estimate error (�)
group (percent) (percent)
---------------------------------------------- ---------- ----------
Size category:
All organizations in the population, excluding 2% 1%
the five smallest strata
Large organizations 4 1
Small organizations, excluding the five 1 \a
smallest strata
Smallest five strata (smallest local 0 0
governmental entities, smallest credit
unions, and smallest private pension funds)
Other subgroups:
Proportion of organizations that have not 6 2
used, but have received a proposal for more
complex OTC derivatives
----------------------------------------------------------------------
\a Number of cases insufficient to make an estimate.
Source: GAO.
Table I.7
Proportion of Organizations Using MBS,
by Size Category and Industry Group
Sampling
Organizations, by size category and industry Estimate error (�)
group (percent) (percent)
---------------------------------------------- ---------- ----------
Size category:
All organizations in the population, excluding 24% 3%
the five smallest strata
Large organizations 37 4
Small organizations, excluding the five 19 4
smallest strata
Smallest five strata (smallest local 3 \a
governmental entities, smallest credit
unions, and smallest private pension funds)
Industry group:
Banks and thrifts, credit unions, and 55 8
insurance companies
Endowments, foundations, and college and 16 7
university operating funds
Other financial corporations (credit financing 23 4
firms, mortgage brokers and lenders, and
leasing agencies)
GSEs 73 3
Money managers 33 8
Mutual funds, money market funds, and 25 9
commodity pools
Public and private pension funds and 24 7
retirement systems
Publicly and privately held nonfinancial 2 \a
corporations
State and local governmental entities 7 5
Other subgroups:
Small banks and thrifts, credit unions, and 40 11
insurance companies
All other organizations except for small banks 21 2
and thrifts, credit unions, and insurance
companies
Large public pension funds and retirement 74 9
systems
Proportion of organizations that have not used 4 2
MBS, but have received a proposal to enter
into such a contract in the last 12 months
----------------------------------------------------------------------
\a Number of cases insufficient to make an estimate.
Source: GAO.
Table I.8
Proportion of Organizations Using
Structured Notes, by Size Category and
Industry Group
Organizations, by size Sampling
category and industry error (�)
group Estimate (percent) (percent)
---------------------- ---------------------- ----------------------
Size category:
All organizations in 16% 3%
the population,
excluding the five
smallest strata
Large organizations 22 3
Small organizations, 13 4
excluding the five
smallest strata
Smallest five strata 2 \a
(smallest local
governmental
entities, smallest
credit unions, and
smallest private
pension funds)
Industry group:
Banks and thrifts, 40 8
credit unions, and
insurance companies
Endowments, 11 6
foundations, and
college and
university operating
funds
Other financial 6 <1
corporations (credit
financing firms,
mortgage brokers and
lenders, and leasing
agencies)
GSEs 57 3
Money managers 20 7
Mutual funds, money 12 6
market funds, and
commodity pools
Public and private 5 4
pension funds and
retirement systems
Publicly and privately 3 \a
held nonfinancial
corporations
State and local 9 6
governmental entities
Other subgroups:
Small banks and 35 13
thrifts, credit
unions, and insurance
companies
All organizations 12 2
except for small
banks and thrifts,
credit unions, and
insurance companies
Large public pension 33 9
funds and retirement
systems
Proportion of 5 1
organizations which
have not used
structured notes, but
have received a
proposal to enter
into such a contract
in the last 12 months
----------------------------------------------------------------------
\a Number of cases insufficient to make an estimate.
Source: GAO.
Table I.9
Proportion of Organizations Rating
Overall Sales Practices for Dealers
Used, by Product Offered
Neither
Somewhat or very satisfied nor Somewhat or very
satisfied dissatisfied dissatisfied No opinion
---------------- ---------------- ---------------- ----------------
Samplin Samplin Samplin Samplin
Estimat g error Estimat g error Estimat g error Estimat g error
e (�) e (�) e (�) e (�)
(percen (percen (percen (percen (percen (percen (percen (percen
Product t) t) t) t) t) t) t) t)
-------- ------- ------- ------- ------- ------- ------- ------- -------
Plain 85% 8% 13% 8% 2% \a <1% \a
vanilla
OTC
derivat
ives
More 79 19 \a \a \a \a \a \a
complex
OTC
derivat
ives
MBS 71 8 20 8 7 4 2 \a
Structur 64 11 20 9 13 9 4 \a
ed
notes
--------------------------------------------------------------------------------
\a Number of cases insufficient to make an estimate.
Source: GAO.
Table I.10
Proportion of Organizations Rating
Overall Sales Practices for Dealers Not
Used, by Product Offered
Neither
Somewhat or very satisfied nor Somewhat or very
satisfied dissatisfied dissatisfied No opinion
---------------- ---------------- ---------------- ----------------
Samplin Samplin Samplin Samplin
Estimat g error Estimat g error Estimat g error Estimat g error
e (�) e (�) e (�) e (�)
(percen (percen (percen (percen (percen (percen (percen (percen
Product t) t) t) t) t) t) t) t)
-------- ------- ------- ------- ------- ------- ------- ------- -------
Plain 29% 9% 33% 9% 17% 7% 21% 10%
vanilla
OTC
derivat
ives
More 16 9 51 14 26 12 7 \a
complex
OTC
derivat
ives
MBS 20 8 46 10 27 8 8 7
Structur 15 7 48 12 29 10 8 \a
ed
notes
--------------------------------------------------------------------------------
\a Number of cases insufficient to make an estimate.
Source: GAO.
Table I.11
Proportion of Organizations Somewhat or
Very Dissatisfied With Disclosure of
Downside Risks or Suitability of
Products Proposed, by Dealers Used and
Not Used
Dealers used Dealers not used
---------------------------------- ----------------------------------
Suitability of Suitability of
Disclosure of products Disclosure of products
downside risks proposed downside risks proposed
---------------- ---------------- ---------------- ----------------
Samplin Samplin Samplin Samplin
Estimat g error Estimat g error Estimat g error Estimat g error
e (�) e (�) e (�) e (�)
(percen (percen (percen (percen (percen (percen (percen (percen
Product t) t) t) t) t) t) t) t)
-------- ------- ------- ------- ------- ------- ------- ------- -------
Plain 6% \a <1% \a 20% 8% 18% 7%
vanilla
OTC
derivat
ives
More 12 \a 3 \a 38 13 42 13
complex
OTC
derivat
ives
MBS 5 3 4 3 27 8 36 9
Structur 17 9 7 \a 31 10 39 10
ed
notes
--------------------------------------------------------------------------------
\a Number of cases insufficient to make an estimate.
Source: GAO.
Table I.12
Proportion of End-Users of a Product Who
Believed a Fiduciary Relationship Exists
Total of some and all cases In all cases In some cases Never No opinion
--------------------------- --------------------- --------------------- --------------------- --------------------
Sampling Sampling Sampling Sampling Estimate Sampling
Estimate error (�) Estimate error (�) Estimate error (�) Estimate error (�) (percent error (�)
Product percent (percent) (percent) (percent) (percent) (percent) (percent) (percent) ) (percent)
----------------------------- ------------ ------------- --------- ---------- --------- ---------- --------- ---------- -------- ----------
Plain vanilla OTC derivatives 53% 10% 35% 10% 18% 7% 31% 9% 16% 8%
More complex OTC derivatives 48 16 28 15 19 10 36 16 16 15
MBS 60 7 37 7 23 6 25 6 15 6
Structured notes 58 9 36 9 22 7 26 9 16 6
-----------------------------------------------------------------------------------------------------------------------------------------------------
Source: GAO.
Table I.13
Proportion of End-Users of a Product Who
Believed a Fiduciary Relationship Exists
in Some or All Cases, by Industry Group
Plain vanilla
OTC Structured
derivatives MBS notes
-------------- -------------- --------------
Sampli Sampli Sampli
ng ng ng
Estima error Estima error Estima error
te (�) te (�) te (�)
(perce (perce (perce (perce (perce (perce
Industry group nt) nt) nt) nt) nt) nt)
-------------------------------- ------ ------ ------ ------ ------ ------
Aggregated subgroup of large and 58% 24% 63% 10% 63% 13%
small banks and thrifts, credit
unions, and insurance companies
Endowments, foundations, and 31 \a 58 24 34 \a
college and university
operating funds
Other financial corporations 54 6 75 4 73 \a
(credit financing firms,
mortgage brokers and lenders,
leasing agencies)
GSEs 27 4 38 4 41 5
Money managers 39 24 52 15 49 20
Mutual funds, money market 42 18 52 24 47 23
funds, and commodity pools
Public and private pension funds 78 \a 51 20 69 \a
and retirement systems
Publicly and privately held 73 19 63 \a 86 \a
nonfinancial corporations
State and local governmental 81 \a 87 \a 84 \a
entities
--------------------------------------------------------------------------------
\a Number of cases insufficient to make an estimate.
Source: GAO.
Table I.14
Proportion of all End-Users of a Product
That Relied on the Dealer for Investment
Advice
To some, moderate, great, To a great or very To some or a moderate To little or no
or very great extent great extent extent extent No opinion
-------------------------- --------------------- --------------------- --------------------- --------------------
Sampling Sampling Sampling Sampling Estimate Sampling
Estimate error (�) Estimate error (�) Estimate error (�) Estimate error (�) (percent error (�)
Product (percent) (percent) (percent) (percent) (percent) (percent) (percent) (percent) ) (percent)
------------------------------ ------------ ------------ --------- ---------- --------- ---------- --------- ---------- -------- ----------
Plain vanilla OTC derivatives 59% 10% 28% 10% 31% 9% 36% 10% 5% 3%
More complex OTC derivatives 64 15 28 18 36 16 32 15 4 \a
MBS 73 6 36 7 37 7 20 6 7 3
Structured notes 84 6 42 9 42 9 10 5 6 4
-----------------------------------------------------------------------------------------------------------------------------------------------------
\a Number of cases insufficient to make an estimate.
Source: GAO.
(See figure in printed edition.)Appendix II
GAO SURVEY OF SALES PRACTICES FOR
OTC DERIVATIVES, STRUCTURED NOTES,
AND ASSET-BACKED SECURITIES
=========================================================== Appendix I
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)Appendix III
COMMENTS FROM THE BOARD OF
GOVERNORS OF THE FEDERAL RESERVE
SYSTEM
=========================================================== Appendix I
(See figure in printed edition.)
(See figure in printed edition.)
The following is GAO's comment on the July 30, 1997, letter from the
Board of Governors of the Federal Reserve System.
GAO COMMENT
--------------------------------------------------------- Appendix I:9
The Federal Reserve commented that its guidance on the investment and
end-user activities of banking institutions may be helpful to
end-users generally. We agree and have added a specific citation to
this guidance as well as Office of the Comptroller of the Currency
guidance for institutions acting as end-users of OTC derivatives and
other financial products.
(See figure in printed edition.)Appendix IV
COMMENTS FROM THE OFFICE OF THE
COMPTROLLER OF THE CURRENCY
=========================================================== Appendix I
(See figure in printed edition.)Appendix V
COMMENTS FROM THE SECURITIES AND
EXCHANGE COMMISSION
=========================================================== Appendix I
(See figure in printed edition.)
(See figure in printed edition.)
The following are GAO's comments on the Securities and Exchange
Commission's (SEC) August 15, 1997, letter.
GAO COMMENTS
-------------------------------------------------------- Appendix I:10
1. SEC commented that our draft report did not adequately discuss
the differences between the two sets of dealer-issued guidance--the
Framework for Voluntary Oversight and the Principles and Practices
for Wholesale Financial Market Transactions. First, SEC stated that,
while our draft report noted that both sets of guidance assert the
relationship between parties to nonsecurities over-the-counter (OTC)
derivatives transactions is one of arm's length, the report provides
no additional discussion of the affirmative responsibility, under the
Framework, for a dealer to clarify the nature of the relationship
when it becomes aware that the nonprofessional counterparty
(end-user) mistakenly believes that the dealer has assumed advisory
obligations. Second, SEC stated that our draft report alluded in
table 4.1, but did not discuss, that, while the Principles recommends
that policies regarding the use of financial products be maintained,
the Framework goes further by expressly recommending that controls be
established to reduce the risk of misunderstandings and contractual
disputes between parties.
Although differences between the two sets of dealer-issued guidance
exist, we did not find these differences to be material, and we did
not find them to exist in the two respects that SEC cited. Our
overall analysis of the key provisions of each set of guidance
indicates that they are consistent in the following: type of
relationship they assert; the degree to which the parties should rely
on each other; and the specific responsibilities of parties regarding
the disclosure of risk, the exchange of pricing and valuation
information, and the controls that should be in place. Also, given
that adherence to each set of guidance is voluntary, the difference
in terminology used is not material. This report now notes that a
member of the Principles drafting committee, whose firm also served
on the committee that developed the Framework, reached the same
general conclusion. He stated that the spirit of the two documents
is the same and that it would be unfair to contrast them simply
because they use different language in some sections.
Regarding the first difference between the Framework and Principles
that SEC cited, table 4.1 of this report provides our summary of the
key sales practice provisions of these two sets of guidance. In this
table, we state that the Framework indicates that professional
intermediaries (dealers) should take steps to clarify the
relationship if its counterparty appears to believe that the dealer
has assumed an advisory role. However, this responsibility is not
unique to the Framework, as the Principles, in section 5.2, similarly
states that participants may wish to maintain policies and procedures
for identifying and addressing exceptional situations that pose
relationship, reputational, or litigation (compliance) risks,
including those in which the counterparty appears to assume
incorrectly that it may rely on the participant for recommendations
or investment advice. This section of the Principles also represents
the provision related to controls that SEC cited as a second
difference between the two sets of dealer-issued guidance. The draft
report summarized this aspect of both sets of guidance.
In addition, we added text in chapter 4 that cites a situation posing
compliance and reputation risks for which both documents call for
policies and procedures--that is, when counterparties incorrectly
assume an advisory relationship exists. In summary, our report
indicates that both sets of guidance contain similar expectations for
participants regarding the need to establish controls to address the
risk arising from misunderstandings and contractual disputes between
parties.
2. In identifying another difference between the two sets of
dealer-issued guidance, SEC stated that the Principles may be
implemented in whole or in part, whereas the Framework should be
implemented in its entirety. We found that this difference between
the two sets of guidance results because the firms that have agreed
to voluntarily adhere to the Framework have done so to avoid direct
federal regulation. Notwithstanding this difference, our discussion
of the key provisions of the two sets of guidance focuses primarily
on the nature of the relationship and types of the responsibilities
they advocate. Differences in the extent to which each set of
voluntary guidance may be implemented is not material to this
discussion; therefore, we did not modify the report.
3. SEC stated that while our draft report correctly indicated that
the Framework applies only to six firms and only to their
nonsecurities OTC derivatives activities, this implies that a large
number of firms as well as a large amount of activity may be
operating outside of the Framework. SEC stated that the six firms
that have agreed to implement the Framework are responsible for more
than 90 percent of the nonsecurities OTC derivatives business
conducted by unregistered affiliates of broker-dealers, and that
these affiliates do not conduct securities OTC derivatives
activities, as these must be conducted through an SEC registered and
regulated broker-dealer.
By describing the specific firms and activities covered by the
Framework, we did not intend to imply that large amounts of
securities firms' OTC derivatives activities are not addressed by the
Framework or by some other regulatory regime. We acknowledged in the
draft report that the participating firms account for 90 percent of
the OTC derivatives activities of security firm affiliates. We
revised this text to indicate that such activities involve
nonsecurities OTC derivatives. Although we indicate in chapter 1 of
this report that firms conducting securities activities must do so in
affiliates registered with and subject to regulation by SEC, we have
also added text to that effect in chapter 2.
4. SEC commented that our draft report did not always clearly
distinguish between OTC derivatives that are securities and those
that are not. We revised the text of this report and the figures
appearing in chapters 3 and 4, as appropriate, to make this
distinction. We also added text in chapter 2, explaining that OTC
derivatives that are considered to be securities represent a small
percentage of the overall volume of OTC derivatives.
(See figure in printed edition.)Appendix VI
COMMENTS FROM THE END-USERS OF
DERIVATIVES ASSOCIATION
=========================================================== Appendix I
(See figure in printed edition.)
The following is GAO's comment on the End-Users of Derivatives
Association's August 1, 1997, letter.
GAO COMMENT
-------------------------------------------------------- Appendix I:11
The association commented that the draft report might give the
impression that sales practice disputes are largely the result of
end-users suffering large financial losses. It elaborated that
end-users have suffered large losses without objecting to dealer
conduct when derivatives that were used as hedges operated as dealers
represented. In such cases, derivatives losses were offset by gains
in the underlying hedged items.
We did not intend to imply that end-users routinely blame dealers
when they incur losses. In chapter 3, we presented estimates of the
percentage of reported losses in which sales practice concerns were
raised. While we could not determine if the products were used for
hedging, the data (which are not statistically valid) show that about
59 percent of publicized over-the-counter derivatives losses did not
result in sales practice disputes. Nonetheless, we revised the
report to further clarify that end-users do not routinely raise sales
practice concerns when they incur losses and to describe the
circumstances under which they might raise such concerns.
(See figure in printed edition.)Appendix VII
COMMENTS FROM THE GOVERNMENT
FINANCE OFFICERS ASSOCIATION
=========================================================== Appendix I
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
The following are GAO's comments on the Government Finance Officers
Association's July 30, 1997, letter.
GAO COMMENTS
-------------------------------------------------------- Appendix I:12
1. The association commented that we should recognize the role and
importance of state securities regulators in enforcing the securities
laws. We added a footnote to the executive summary and to chapter 1
to clarify that state agencies also oversee banking and securities
activities but that this report does not assess their oversight in
detail.
2. The association commented that the presentation in the draft
report of survey statistics by financially oriented organizations and
other nonfinancial organizations could be misleading. The
association was particularly concerned about the treatment of public
pension funds and state and local governments because pension funds
(both public and private) were included in the financially oriented
category, while state and local governments were included among other
organizations. We clarified this report by adding footnotes to the
related text that explain the types of organizations within each
grouping. We also added a note to figure 3.4, indicating that
appendix I describes the organizations included in the groupings.
3. The association commented that our draft report erred in relying
on the Principles and Practices for Wholesale Financial Market
Transactions when describing the participants in transactions covered
by the dealer-issued guidance. The association elaborated that
participants, including end-users, are not only large financial and
commercial entities that are more likely to be financially
sophisticated, but they also include state and local governments,
churches, schools, charities, and others who, although holding large
portfolios, would not be construed as commercial entities or would
not necessarily be financially sophisticated.
The association correctly points out that participants may include
end-users that are not large or financially sophisticated. However,
our point was that the dealer-issued guidance was designed to apply
to larger entities that tend to be financially sophisticated. In
addition, our discussions with regulators and dealers as well as the
results of our survey confirmed that the predominant users of
over-the-counter (OTC) derivatives, mortgage-backed securities, and
structured notes are larger organizations, most of which are in
financially oriented industries and most of which tend to be more
financially sophisticated.
4. The association commented that the draft report is technically
correct in stating that the U.S. securities laws "generally" apply
equally to all investors, but noted that these laws sometimes
distinguish between institutional and individual customers. We added
a footnote to chapter 4 that recognizes the securities laws and
regulatory guidance that make distinctions between institutional and
individual customers and modified the text to clarify that the
antifraud provisions of U.S. securities laws do not make such
distinctions.
5. The association commented that our report should clarify that the
association's concern regarding the ability of an end-user to rely on
dealer statements only when acknowledged in writing by the dealer was
not based on the association's analysis of the Principles but was
drawn directly from the document itself. Our draft report quoted
from the letter the association sent to the Principles drafting
committee, and that letter correctly interprets the Principles as
requiring written agreement between the parties before one can rely
on the other.
6. The association commented that the individual cited in the draft
report as asserting that dealers, unless otherwise agreed to, do not
have fiduciary obligations in OTC derivatives transactions was
expressing his opinion or that of his employer. (We referred to this
individual as the managing director of a large securities firm and
the association referred to him as an International Swaps and
Derivatives Association board member.) The association stated that
this assertion has not been settled by law. We attributed the
statement in question to the official who made it, and by doing so,
indicated that it represents his opinion.
7. The association noted that an executive branch action in
Connecticut was taken between 1994 and 1996 to institute changes to
investment policies and controls in that state. We revised chapter 5
of this report to incorporate Connecticut's action. We also added a
footnote in chapter 5 to clarify that we did not attempt to obtain
comparable information on all state actions to improve investment
policies, procedures, and practices.
8. Although generally endorsing the recommendations in our report,
the association asked that we recommend that the Federal Reserve, the
Securities and Exchange Commission, and the Commodity Futures Trading
Commission ensure that the process for coordinating the issuance of
dealer-issued guidance in any form outside of the federal regulatory
process be more inclusive of affected market participants. As the
draft report indicated in chapter 7, we envisioned that the
President's Working Group on Financial Markets might facilitate a
process under which market participants could reach agreement on the
nature of their relationship, including their responsibilities in
transactions involving OTC derivatives. Implicit in our related
recommendation is that a common set of mutually agreed-upon guidance
would be issued for dealers and end-users. We make our
recommendation to the Working Group, whose membership includes the
Federal Reserve, the Securities and Exchange Commission, and the
Commodity Futures Trading Commission, in the belief that a
coordinated effort by the federal market regulators would be more
effective than individual efforts in addressing the need for
end-users and dealers to reach agreement on the nature of
counterparty relationships.
(See figure in printed edition.)Appendix VIII
COMMENTS FROM THE INTERNATIONAL
SWAPS AND DERIVATIVES ASSOCIATION
=========================================================== Appendix I
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
The following are GAO's comments on the International Swaps and
Derivatives Association's August 15, 1997, letter.
GAO COMMENTS
-------------------------------------------------------- Appendix I:13
1. The association commented that the report's consideration of
sales practice issues for mortgage-backed securities (MBS) and
structured notes in the same context as those for over-the-counter
(OTC) derivatives is intellectually and practically inappropriate,
and that the report is confusing and incomplete in differentiating
between these transaction types. The association also noted that the
report found that greater losses and more dissatisfaction existed for
MBS and structured notes than for OTC derivatives, even though the
former are subject to the securities laws--suggesting that regulation
is not necessarily effective in reducing problems.
We attempted to ensure that this report distinguishes, as
appropriate, among OTC derivatives, MBS, and structured notes. As
our report states, it addresses sales practices for the three product
categories because losses associated with each of them were receiving
public and regulatory attention at the time we began our review.
Furthermore, although we agree with the association that significant
differences in the products and their regulatory schemes exist, the
products share many risk characteristics and are frequently marketed
by the same dealers and used by many of the same market participants.
As a result, by including all three product categories, our report
provides useful information to those trying to understand the
similarities and differences among the sales practice requirements
for the OTC markets.
The association's conclusion that the higher level of disputes and
dissatisfaction associated with MBS and structured notes indicates
that the regulatory regime is not fully effective is open to
question. First, the bulk of MBS and structured notes are government
securities that are issued by government-sponsored enterprises (GSE)
and marketed by broker-dealers. However, as our report notes, the
National Association of Securities Dealers (NASD), a self-regulatory
organization with oversight responsibilities for a significant number
of MBS and structured note dealers, was limited in its ability to
assess the marketing of GSE-issued securities against its full
complement of sales practice rules by a long-standing statutory
restriction. This restriction was removed by the Government
Securities Act Amendments of 1993. Nonetheless, NASD rules governing
GSE-issued securities were not approved until August 1996. As this
report states, the removal of this restriction and implementation of
these rules should improve the oversight of this products, which may,
over time, lead to a reduction in sales practice-related complaints.
Second, the higher level of sales practice-related disputes and
dissatisfaction associated with MBS relative to OTC derivatives may
be partly attributable to the lower level of sophistication of MBS
end-users compared to that of OTC derivatives end-users. Also,
because MBS involve the transfer of ownership, the dealer and
end-user do not have an ongoing relationship vis-a-vis a specific
transaction. As a result, an unethical dealer may find MBS end-users
more vulnerable targets when contemplating committing fraud.
2. The association commented that the definition of losses as
discussed in the draft report may be flawed. The association noted
that loss totals included in the report were compiled from public
information and depended on end-user self-reporting. It also noted
that steps to confirm their accuracy had not always been taken.
Furthermore, it noted that actual losses may be significantly lower
than those reported because of the inclusion of unrealized losses,
which may have been mitigated by offsetting hedging transactions.
Our report now acknowledges not only the limitations and weaknesses
that exist in the loss totals but also the potential that losses may
be overstated by including unrealized losses and understated by
omitting losses that were not publicly reported. Because of these
limitations, we used this information only as one indicator of the
extent of sales practice concerns and supplemented it with data from
regulators, our survey of end-users, and discussions with market
participants and regulators.
3. The association commented that while the draft report attempts to
put the level of losses in context, it obscures how small the losses
are relative to total market activity. The association provided
calculations comparing the losses we reported to the gross market
value of OTC derivatives outstanding in the United States, as of
March 1995. The association concluded that we should have emphasized
the resulting relatively small loss percentage when explaining that
sales practice-related losses did not appear to be widespread.
We added text to the loss discussion in chapter 3 that recognizes
sales practice concerns are not widespread relative to the limited
number of dealers involved in the losses that have been reported, the
thousands of transactions that have occurred over the period
discussed, and the hundreds of billions of dollars at risk in these
transactions. We did not use the loss data that we developed to
perform calculations such as those the association presented due to
its limitations. Doing so would have suggested greater precision in
and validity to the statistical results than is otherwise warranted.
Notwithstanding this objection, comparing the cumulative loss total
for multiple years to the amounts outstanding as of a single later
year, as the association did, is not appropriate. Because losses on
transactions initiated in one year may not be incurred until several
years later, a more relevant analysis would be to compare losses on
transactions initiated in a single year to the amount at risk in
transactions initiated during that same year. However, data to make
such calculations were not generally available.
4. The association commented that the two sets of dealer-issued
guidance served as the basis for productive discussions between
dealers and end-users for clarifying counterparty relationships and
noted that the only appropriate starting place for institutional
participants in derivatives is an arm's-length relationship. The
association stated that the parties are free to alter such a
relationship if they agree to do so, but such variations should occur
on a privately negotiated basis. Furthermore, the association stated
that the federal government does not have a role to play in bilateral
negotiations between "parties that can take care of themselves," and
that additional regulation and the increased potential for litigation
would only result in higher transaction costs with little offsetting
benefits.
We agree that the dealer-issued guidance has provided opportunities
for discussion between dealers and end-users. However, our survey
results show that end-users attribute fiduciary responsibilities to
and rely on dealers as part of OTC derivatives transactions. Also,
end-users and others have objected to the presumption of an
arm's-length relationship as evidenced in the formal comments these
groups submitted on one set of guidance--the Principles and Practices
for Wholesale Financial Market Transactions. This evidence indicates
a lack of acceptance and/or understanding of the specific
responsibilities the dealer-issued guidance asserts for OTC
derivatives transactions. Our recommendation calls for the federal
regulators that participate in the Working Group to consider whether
they can assist in bridging this lack of agreement or understanding.
We do not anticipate that the Working Group would dictate the nature
of the relationship that should prevail because this would fail to
account for the inevitable and appropriate differences in the actual
relationships between parties. Instead, the Working Group could
facilitate discussions between dealers and end-users that might lead
to agreement in key areas where they now disagree.
5. The association asserted that in many instances our support for
proposing regulatory intervention is anecdotal. We do not rely on
anecdotal information to support our recommendations. Rather, such
information is used primarily to illustrate the results provided by
our survey and to provide insights into other data we obtained--such
as end-users' formal comments on the Principles.
6. The association commented that the draft report should have
emphasized in its recommendations the need for universal
implementation of and adherence to the internal control and risk
management recommendations in the Group of Thirty report published in
July 1993. We recognized the importance of internal controls in two
previous reports on derivatives.\3
The May 1994 report makes three recommendations to one or more of the
federal financial market regulators on this subject. The inclusion
of chapter 5 in this report--discussing guidance to dealers and
end-users related to sales practice issues and describing dealer and
end-user efforts to implement related internal controls--reflects our
continued concern about the adequacy of market participants' internal
controls and our support for efforts to improve them. Implementing
controls such as those advocated by the Group of Thirty and others
could significantly reduce dealer and end-user exposure to the type
of compliance and reputation risk losses that can arise from engaging
in transactions involving OTC derivatives and other financial
products.
(See figure in printed edition.)Appendix IX
--------------------
\3 See Financial Derivatives: Actions Needed to Protect the
Financial System (GAO/GGD-94-133, May 18, 1994) and Financial
Derivatives: Actions Taken or Proposed Since May 1994
(GAO/GGD/AIMD-97-8, Nov. 1, 1996.
COMMENTS FROM THE NATIONAL
ASSOCIATION OF STATE AUDITORS,
COMPTROLLERS AND TREASURERS
=========================================================== Appendix I
(See figure in printed edition.)
(See figure in printed edition.)
The following is GAO's comment on the National Association of State
Auditors, Comptrollers and Treasurers' July 28, 1997, letter.
GAO COMMENT
-------------------------------------------------------- Appendix I:14
The association commented that end-users who were generally satisfied
with dealer sales practices at the time of our 1995 survey may not be
satisfied with them today due to the promulgation of the Framework
for Voluntary Oversight and the Principles and Practices for
Wholesale Financial Market Transactions. The association elaborated
that no end-users were included in the Derivatives Policy Group that
issued the Framework, and no substantive revisions were made to the
Principles as a result of the association's input.
End-user comments on the provisions of these documents, including
those that the association discusses in its letter, are discussed in
this report. Our report also recognizes that the market
characteristics that contributed to the relatively high level of
end-user satisfaction and the relatively limited number of sales
practice disputes could change as the markets evolve. For this
reason, we recommend that the President's Working Group on Financial
Markets establish a mechanism for systematically monitoring
developments in the over-the-counter derivatives markets to assess
whether developments warrant introducing specific federal sales
practice requirements.
MAJOR CONTRIBUTORS TO THIS REPORT
=========================================================== Appendix X
GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C.
--------------------------------------------------------- Appendix X:1
Cecile O. Trop, Assistant Director
Cody J. Goebel, Co-project Manager
James R. Black, Senior Evaluator
Frederick T. Evans, Senior Evaluator
Rosemary Healy, Attorney
Christine J. Kuduk, Evaluator
Carl M. Ramirez, Senior Social Science Analyst
Desiree W. Whipple, Communications Analyst
CHICAGO FIELD OFFICE
--------------------------------------------------------- Appendix X:2
David J. Diersen, Co-project Manager
Melvin Thomas, Sub-project Manager
Daniel K. Lee, Evaluator
Cristine M. Marik, Evaluator
Angela Pun, Evaluator
Richard S. Tsuhara, Senior Evaluator
Francis M. Zbylski, Senior Operations Research Analyst (Retired)
OFFICE OF SPECIAL
INVESTIGATIONS
--------------------------------------------------------- Appendix X:3
Donald F. Fulwider, Deputy Director
*** End of document. ***