After taking a broadside last month from the General Accounting Office, the derivatives industry fired back last week.

The International Swaps and Derivatives Association released a 15-page position paper disputing recommendations made by the GAO in its two-year study of the market.

The GAO, in a report released May 18, warned that derivatives are not sufficiently regulated and pose risks to the financial system that could require federal intervention. The report also noted that derivatives have helped users better manage financial risks.

While agreeing with some of the GAO's findings the industry group said that the government's report overstated the risks from proliferating derivatives use. The group also rejected the GAO's call for new capital requirements, regulation of end users, and mark-to-market accounting.

"While the report provides a wealth of good information, unfortunately many of its conclusions are not supported by, or are at odds with, the data gathered by the authors," Frederick Medero, executive director of the ISDA, said in a letter accompanying the brief.

The position paper warns that if the GAO's recommendations are adopted, "they will reduce the availability and increase the cost of critically important risk management transactions."

In some cases, the two sides do not even agree on the basic facts. In the complex world of derivatives, there can be multiple methods of measuring risks and they may provide contradictory conclusions.

For example, the GAO report warned that derivatives holdings are highly concentrated among a few major dealers, primarily commercial and investment banks.

The report, citing previous research, said that eight U.S. banks account for 56% of the worldwide notional amount of all interest rate and currency swaps, that seven U.S. banks account for 90% of all U.S. banks' derivatives holdings, and that five U.S. securities firms account for 87% of all derivatives activity by domestic securities firms.

The report then goes on to warn that "concerned regulators and market participants said that the size and concentration of derivatives activity, combined with derivatives-related linkages, could cause any financial disruption to spread faster and be harder to contain."

The industry paper, however, asserts that concentration is not excessive. Instead of relying on notional amounts, the paper cites the GAO's own survey of U.S. derivatives dealers' "total net credit exposure" to each other.

Notional amount measures the principal amount that swaps are based on. A $100 million swap usually involves exchanges of payments of only a few million dollars. Notional amount also double-counts total volume, since both sides of a transaction report the full notional value.

Net credit exposure attempts to measure the losses a dealer would suffer if all of its counterparties defaulted at the same time.

U.S. dealers' net credit exposure to other U.S. dealers from over-the-counter derivatives, which includes all types of swaps, was 11% of the dealers' total net credit exposure, the ISDA paper reported. In other words, almost 90% of the credit exposure of derivatives held by U.S. derivatives dealers arises from transactions with non-dealers, from corporations to pension funds to municipalities.

This is in part because of netting arrangements among the dealers. Using a netting arrangement, two dealers agree to offset their various derivatives transactions. If the dealers have entered two identical swaps, each taking the opposite side, the net effect is to virtually eliminate any credit exposure between the two dealers.

After disagreeing about the evidence, the two sides go on to dispute the importance of concentration in the first place.

The ISDA paper concludes that "concentration among derivatives dealers is not nearly so great as to raise any serious questions about the ability of the interdealer market to absorb the problems arising from the failure or withdrawal from the market of a derivatives dealer."

The two sides split on the value of mark-to-market accounting which would require derivatives holders to value the products, along with all other financial instruments, on their balance sheets at the latest market value.

The GAO said that current accounting practices are "likely to result in inappropriate and inconsistent financial reporting of derivatives activities, especially reporting of hedging activities by end-users." The report recommended that the Financial Accounting Standards Board adopt market value accounting as an "ultimate objective."

The ISDA, while conceding that more disclosure about derivatives is needed, said that market value accounting would "introduce artificial volatility into the financial statements of commercial and industrial companies who use commodity or currency derivatives to hedge inventory ... or to hedge other exposures which do not arise from financial instruments."

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