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CFTC Considers Niederhoffer Rule

Victor Niederhoffer, the famous trader and author of The Education of a Speculator, has reached yet another milestone in his fascinating career. The meltdown of his $130 million hedge fund last October raised more than a few eyebrows at the Commodity Futures Trading Association, and regulators have decided to change their segregated fund disclosure rules to make sure that Niederhoffer's experience is not repeated in the future.

In the volatile market of October 1997, Niederhoffer sold puts on the Standard & Poor's 500 in size with the expectation that the market would rebound. It eventually did, but not before dropping 7 percent on October 27. Niederhoffer's 20,000 S&P puts obliterated his fund.

The problem in the eyes of the CFTC was that Niederhoffer financed his final moves with a margin call for some $50 million from his futures commission merchant, Refco Inc.

Current regulations require FCMs to keep money in segregated funds in order to guarantee liquidity in the event of a selling stampede. The depletion of $50 million dollars—which Niederhoffer promptly lost and thus owed to Refco—threatened Refco's liquidity and could have prevented the firm from paying all its investors if they had decided to get out of their positions. Niederhoffer reportedly owed Refco more than $40 million of the loan, though it appears as though he has since paid back all of his debt.

The CFTC was concerned that it had no way of knowing of the loss until the following afternoon, because FCMs are not required to disclose such information until the next business day.

For this reason, it has proposed a measure, put before its commissioners in January, that requires FCMs to notify regulators immediately when segregated fund accounts slip below a certain threshold. CFTC commissioners could vote as soon as early March.

Fed Defends New Capital Regs

When the Federal Reserve decided last year to change bank capital requirements to account for what it calls "market risk,” many risk managers and compliance officers viewed the plan as an attempt to sock it to banks with high risk exposures in equity markets.

Not so, says the Fed in a defense of its plan entitled "Bank Capital Requirements for Market Risk: The Internal Models Approach,” published in the New York Fed's December 1997 Economic Policy Review. "The [new] approach will lead to regulatory capital charges that conform more closely to banks' true risk exposures…[and] the information generated…will allow supervisors and financial market participants to compare risk exposures over time and across institutions,” it explains. The requirements took full effect on New Year's Day, impacting 15 U.S. banks.

The plan was an outgrowth of the Basel Committee on Banking Supervision's 1996 proposal, which called for an adjustment of capital requirements for international banks based on a set of value-at-risk calculations measuring market risk exposures.

It differed from the Basel Committee's proposal in one important respect: While the Basel plan called for a standardized approach to VAR measurement, the Fed's plan called for an internal models approach, in which banks use their own VAR models to produce compliance data. The Fed's plan, it argued, was more precise than a standardized measure and easier to administer. Yet many U.S. banks complained that the requirements of the Fed's plan were too stringent and would lead to underperformance. Bankers Trust was the only bank to begin implementing the new requirements during the voluntary compliance period, which lasted until January 1.

The requirements call for a 10-day, 99th percentile VAR estimate, meaning a particular bank would expect to lose more than a certain amount of money on only one day in 100 10-day periods. The VAR estimates, moreover, are to be calculated on a daily basis using at least a one-year historical observation period. The capital charge takes the average VAR estimate over the previous 60 trading days and multiplies this by a "scaling factor” of three.

In addition, the new plan differs in its treatment of specific risk, or the risk of negative price movements of a security as a result of specific events affecting the issuer of the security (unrelated to general risk factors, such as interest rate moves and so on). Under the old capital requirements, long-term debt and equity positions were subject to capital charges that ranged from 0 percent for government securities to 8 percent for corporate debt and equity. The new plan allows banks to measure their specific risk using their VAR models, and the results are scaled by a factor of four until banks can show that their specific risk VAR estimates adequately account for "idiosyncratic” market behavior.

To deter banks from intentionally cooking their VAR numbers to lower their capital requirements, the Fed imposes stiff penalties for inaccurate modeling. The Fed confirms bank-provided data by a process of backtesting, in which it compares a bank's VAR numbers with its actual trading outcomes—that is, the number of days that a bank's losses actually exceeded the targeted amount. Banks with five or more discrepancies between the VAR data and actual trading results during the previous 250 trading days are subject to a higher scaling factor. The scaling factor increases to a maximum of four for banks with 10 or more exceptions.

Critics complained that the 10-day holding period is too conservative, that the year-long observation period is much too long and that the scaling factor undermines the benefits of the internal approach for banks with accurate VAR measures. By scaling the results, they argued, banks that provide accurate VAR figures are unfairly penalized.

The Fed has dismissed these arguments, asserting that the changes in capital requirements for the banks affected by the new rules are "likely to be quite small.” It estimates that banks' capital requirements would increase by only 1.5 percent to 7.5 percent. And when specific risk is included in the mix, the overall increase may even be smaller than that. "Given the significant positions that some institutions hold in instruments that will become subject to the specific risk capital requirements,” it says, "the [specific risk] carve out may well result in a net reduction in required capital levels for some institutions.”

Even under this rosy scenario, banks likely won't reap the benefits of the new plan for long. Evidently the Fed isn't through tinkering with capital requirement procedures just yet. When it unveiled the new plan in 1996, chairman Alan Greenspan said it was already "on the verge of obsolescence,” and that a "precommitment approach” will be the wave of the future.

To get a copy of the publication, call the Federal Reserve Bank of New York at 212-720-6134.

New CBOT Book

The Chicago Board of Trade has ventured into the choppy waters of the publishing industry with Treasury Options for Institutional Investors, a book and interactive software package geared toward corporates, pension fund managers, mortgage bankers and traders, that sells for a retail-like price of $25. The book explores theoretical pricing models, option behavior in dynamic markets and analysis of volatility in trading strategies. Special focus is given to put/call parity, risk analysis using the Greeks, dynamic hedging, volatility skew and cones, and parsing the returns to a volatility trade.

For more information on the package, see the CBOT's web site at www.cbot.com.

Credit 101

Attention senior bank managers, insurance company managers and anyone else intimately involved with the credit market: its time to sharpen your pencils, grab your calculators and polish your apples. CIBC World Markets, the creator of the School of Financial Products, has built another school on wheels—the Credit Products Institute—and it's coming soon to a city near you.

CIBC created the Credit Products Institute to help clients understand the increasingly complicated credit market, from credit derivatives to portfolio management and credit risk measurement tools such as CreditMetrics and Credit Risk Plus, to the increase in collateralized loan obligation (CLO) and collateralized bond obligation (CBO) transactions in the last few years. "The credit markets are in a period of rapid, revolutionary change,” says Sean Rai, head of credit derivatives at CIBC, "which encompasses a number of areas that traditionally have be thought of as separate and unrelated.”

The school will focus not on particulars such as credit derivatives or CLOs, but on the entire spectrum of credit. "Credit portfolios have unique characteristics that make applying traditional modern portfolio theory difficult,” says Rai. "We'll provide a good foundation of modern portfolio theory—concepts like efficient frontiers, Sharpe ratios and RAROC [risk-adjusted return on capital]—and then talk about the things unique to credit portfolios, such as fat-tailed distributions of return and the difficulties in getting historical data.”

The courses are free of charge. For more information, e-mail Liz Young of CIBC Oppenheimer at YOUNGELI@CIBC.com.