In spelling out more than a dozen guidelines that the besieged Bankers Trust New York Corp. now has to follow in its leveraged derivatives business, the Federal Reserve Bank of New York may have set the stage for costly regulation of the derivatives industry at large.
Industry observers said the guidelines, announced Monday as a result of an inquiry into the bank's sales practices, should act as a warning that the Fed will take action to correct any irregularities it perceives.
Of particular concern was a requirement that Bankers Trust provide clients with costly computer models showing how a derivatives contract will perform under a variety of scenarios.
"The Fed is clearly trying to send a message to the rest of the industry about the standards it expects the industry to follow on leveraged derivatives transactions," said Raphael Soifer of Brown Brothers Harriman & Co.
The outcome, said Mr. Soifer, could be that the leveraged derivatives market becomes more expensive for both dealers and end users. If that happens, he said, the business could be driven overseas, virtually eliminating a U.S. leveraged derivatives market.
"The sheer act of compliance is costly," he said. "That cost probably will be passed on to the client."
Derivatives are volatile financial contracts whose value is tied to currencies, interest rates, or other benchmarks.
The agreement addresses leveraged transactions in which the contract multiplies the rewards -- and risks -- of changes in the benchmarks.
In a statement, Bankers Trust chairman Charles S. Sanford Jr. said leveraged transactions contributed only about 5% of the bank's trading revenue over the past seven quarters. They "have never been a core business," he said.
Mr. Sanford also said that the bank had undertaken a review of its leveraged derivatives business before the agreement was reached, and that many of the recommendations in the Fed guidelines already have been implemented.
"Our review made clear that certain changes were needed, and we have made them," he said.
Although leveraged transactions are not a major part of the business for most players, experts were urging other dealers of leveraged and plain-vanilla transactions alike to read the agreement closely.
"It's a road map of how the Fed thinks certain issues should be dealt with," said Robert W. Viets, a partner in the New York law firm of Emmet, Marvin & Martin, which specializes in derivatives issues. "Any bank that is a big player should get a copy."
The two main themes of the agreement are increased disclosure and stress testing -- computer modeling that can simulate virtually any change in market interest rates.
According to the agreement, Bankers Trust must conduct its leveraged derivatives business "in a manner which seeks to reasonably ensure that each [leveraged derivative transaction] customer has the capability to understand the nature and material terms, conditions, and risks."
The Fed also requires that upon entering into a leveraged transaction, Bankers Trust deliver to its clients "sensitivity analyses designed to illustrate a broad range of outcomes and distribution of risks at maturity." The bank must also provide these computer models -- popularly known as stress tests -- at the client's request.
Derivatives Road Map
Bankers Trust must ensure that:
* Clients understand nature of risks
* They provide sufficient disclosure
* A special counsel reviews employee conduct
* Pricing information is clear to client
Source: Federal Reserve Bank of New York
In a lawsuit filed against Bankers Trust in October by Procter & Gamble Co., two of the company's main contentions were that Bankers Trust failed to fully disclose the risks of its derivatives contracts and that it failed to deliver a stress test of the instrument involved. P&G is seeking $130 million in damages.
P&G said in its lawsuit that Bankers Trust had an "unwind" model that would have detailed the soap giant's possible losses, but refused to produce it to P&G.
"Bankers Trust said it was calculating the lock-in interest rate by a secret, complex, multi-variable 'unwind' model which was proprietary to Bankers Trust, ran on Bankers Trust computers and absolutely would not be shared with outsiders, even with its client," the P&G lawsuit said.
Bankers Trust denied this, saying in an answer to the complaint that "...contrary to the allegations in the complaint, Bankers Trust offered to bring its computer model to P&G's Cincinnati offices in early March, but that P&G canceled that visit because P&G stated that it was not necessary."
Regardless of what actually occurred between the bank and P&G, under the Fed's written agreement with Bankers Trust, it would be banned from keeping such models secret.
"Written communications to a customer after execution of an LDT shall include a notice to the customer that an updated sensitivity analysis is available upon request," the Fed agreement states.
Bankers Trust also is expected to reach consent decrees soon with the Securities and Exchange Commission and the Commodity Futures Trading Commission relating to its derivatives sales to Gibson Greetings Inc.
The Cincinnati-based Gibson Greetings settled a lawsuit with the bank last month after taking a $23 million pretax loss from derivatives contracts.
The consent decrees are expected to accuse Bankers Trust of misleading Gibson about the risks involved in its derivatives contracts. Bankers Trust is not expected to admit fault, but probably will have to pay a fine or make restitution, sources said, confirming a report in The Wall Street Journal.
While not in favor of additional regulation, the banking industry generally looks on the agreement as a positive step.
Alistair W.J. Fyfe, vice president and manager of interest rate derivatives at Cleveland-based Keycorp, said anything that stresses more disclosure is good for the industry. "If you want to establish a long-term relationship with a client, they had better understand what's happening.
"With the leveraged stuff, stress testing becomes more critical," he added. "With a $5 [million] to $10 million plain-vanilla swap, if interest rates go up or down a couple of percentage points you know what will happen. With the leveraged stuff, it becomes more difficult."
Though some business may be driven overseas if costly regulations ensue, Mr. Soifer said he thinks the agreement will serve to educate the market about leveraged derivatives.
If clients are more knowledgeable, the opportunity for misuse drops, he said. "Abuse will be more easily detected. Raising the profile is good."