WASHINGTON -- Documents released this week by the Commodity Futures Trading Commission provide a wide-ranging look at the derivatives market -- including its scope, major defaults, and the specialized derivatives product companies that dealers have set up.
The documents are the working papers upon which the commission's recent derivatives report was based. While they deal mostly with taxable derivatives, they provide insights for the municipal market as well.
One working paper, for example, details the defaults of five major players in the derivatives market and how they unwound their swaps portfolios. The five firms are Drexel Burnham Lambert Products Corp., Bank of New England, British and Commonwealth Merchant Bank, Development Finance Corporation of New Zealand, and Olympia and York Development Ltd.
The five firms defaulted because of the financial difficulties of their parent firms or affiliates and not because of their derivatives activities, the commission said.
The commission concludes that none of the defaults adversely affected the derivatives market or other financial markets. However, Helen Blechman, assistant general counsel to the commission, said at a recent conference that one cannot assume there would be no market effects from a default today because firms' derivatives portfolios have become much larger.
The commission found that most swaps transactions of these failed firms were settled even though many had "walk-away clauses" in their swaps agreements allowing the other parties to avoid their obligations once such a default occurred.
Drexel Burnham Lambert Products Corp., whose parent company, the Drexel Burnham Lambert Group Inc., filed for bankruptcy in February 1990, effectively strong-armed some of its counterparties to settle "with great success," the commission said.
The products group was intentionally not included in the parent company's bankruptcy filing so that it could dispose of its portfolio. It had entered into more than 1,500 swaps and other derivatives deals with more than 200 counterparties. When firms that owed Drexel money in a swap transaction threatened to walk away from their obligation, Drexel warned it would legally challenge the enforceability of the agreements' walk-away clause.
When firms that were owed money in swap transactions threatened to walk away with the windfall payments that Drexel made to them, Drexel warned it might file for bankruptcy protection, thereby tying up the recovery of any such funds.
Another working paper provides details about the special-purpose derivatives product companies set up by Merrill Lynch & Co., Goldman Sachs Group L.P., Salomon Brothers Holding Co., and Compagnie Financiere de Paribas, the parent company of Banque Paribas.
Merrill Lynch Derivatives Products Inc., which recently started backing swaps for some municipal derivative products, was created to conduct derivatives transactions in interest rate swaps, currency swaps, caps, floors, and swap options, the commission said. The products company serves as an intermediary between Merrill Lynch Capital Services and counterparties on derivatives deals.
As of June 25, the company's portfolio consisted of 1, 140 derivative transactions with 181 counterparties, the commission said. The notional principal value of these transactions was $42.5 billion, with 59% of that amount in interest rate swaps, 32% in currency swaps, and 9% in interest rate options, the commission said.
The average maturity of the product company's contracts was five years, with only 3% of the notional amount of the portfolio having more than 10 years to maturity, the commission said. The total positive net exposure to third parties was valued at $628 million as of the end of the second quarter of 1993. At that time, the market value of the product company's portfolio with Merrill Lynch Capital Services was $37 million. The products company held $580 million in collateral to cover the direct and potential exposure to Merrill Lynch Capital Services and other counterparties.
These product companies have been structured, in part, to achieve the highest credit ratings possible and to avoid federal capital requirements for registered broker-dealers that many market observers believe are unfairly onerous for derivatives transactions.
Another working paper dealt with the scope and size of the derivatives market worldwide and in the United States. As of the end of 1991, there were 39 dealers in interest rate and currency swaps that each had notional principal exceeding $10 billion. Of these, 20 were in the United States, five in Canada, 10 in Europe, and four in Asia. The commission was not able to get information from either Japan or Germany. In the United States, commercial banks' positions in interest rates swaps are larger than those of nonbanks and U.S. branches of foreign dealers, the paper says.
At the end of 1991, 25% of the U.S. end-users of interest rate swaps were financial institutions, 20% were corporations, 18% were regional banks, and 16% were non-dealer foreign banks and agencies. Thrifts and insurance companies accounted for little of the end-user market, the commission said.
Other working papers released by the commission focused on the activities of the federal agencies overseeing derivatives and on accounting issues.