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AustraliaRisk Supplement
New era for risk managers - Comment There is no doubt that Australia’s bankers and treasurers are among the most sophisticated in the world when it comes to risk management. But the performance of the floundering Australian dollar over the past 18 months has changed the landscape considerably. Now, many of the country’s leading export-based corporates are staring in the face of hundreds of millions of dollars in losses. Shareholders, expecting juicy windfalls, are up in arms at poor earnings results, and the press are mercilessly hounding corporates guilty of nothing more than locking in forward revenues. And now with BHP, one of Australia’s largest hedgers, deciding to abandon its derivatives programme, it seems everything is up for grabs. Certainly, a number of corporates are re-evaluating their strategy in the face of BHP’s decision, and, aided by a gaggle of consultants, are questioning the link between hedging and shareholder value. The upshot of this questioning is by no means clear, and companies differing in size, scale and industry sector may reach opposite conclusions. Indeed, a number of outcomes are possible, ranging from a drop in derivatives volumes at the worst case, to a temporary shift to plain vanilla products. Similarly, things haven’t gone to plan in the energy market. Ten years after the Australian government announced plans to restructure the power industry, it has to be said that the energy derivatives market has not really lived up to its full potential. Add in a worrying supply problem and massive price volatility, and you have all the makings of a California-style power crisis. And then, of course, there’s the latest consultative document from the Swiss-based Basel Committee. Certainly, Australia’s banks have been active critics of some areas of the Accord, and there are real fears that bloated risk weightings for residential mortgages stand to impact many banks’ portfolios, traditionally skewed towards the housing and mortgage market. But there are plenty of upbeat elements too. Certainly, the securitisation market is experiencing something of a renaissance, with nearly everyone forecasting a bumper year. The only disagreement, however, is which asset class will come out on top. And credit derivatives have recorded marked growth over the past two years. While still an infant market, the desire for portfolio diversity, coupled with a shortage of supply in the corporate bond market, could well lead to explosive growth in the coming years. But whichever way the market shifts, Australia is sure to retain its reputation for good risk management. Indeed, a constant questioning of hedging policy can only be a positive step forward. Your comments are welcome by the editor (nsawyer@riskwaters.com).
--------------------------------------------------------------------------------- AustraliaRisk Supplement The Basel Accord A
mountain to climb he deluge and ferocity of responses to the Basel Committee on Banking Supervision’s new proposals on capital adequacy clearly indicate that there is still some way to go before the new Accord is actually put into practice. Most bankers agree that there is a genuine need for greater sensitivity in measuring risk, but the devil appears to be in the detail, with all 250-odd responses that swamped the Committee’s Switzerland headquarters at the end of May screaming for adjustments and modifications. Certainly, Australia’s financial institutions were vociferous in their opposition to some aspects of the Accord, led by the country’s regulatory body – the Australian Prudential Regulation Authority (APRA). With the exception of National Australia Bank (NAB), most of the major Australian banks contributed to the APRA response, with all agreeing that elements of the proposal need to be re-examined. Conceptually, I think the new Accord is the way to go,” says Morris Batty, head of policy and portfolio management at ANZ in Melbourne. “It’s making the whole framework more risk sensitive. But when you get into the detail, you find there are a lot of areas requiring more work.” Even the Basel Committee now realises some of the drawbacks of the January 16 proposal, and recently delayed the implementation date for the new Accord from 2004 to 2005, with another round of consultation pencilled in for 2002. It also agreed to revisit some of the specific proposals, in particular the controversial 20% charge for operational risk. The new proposal itself is aimed at making the Accord more risk-sensitive, while at the same time retaining the same levels of regulatory capital in the banking system. Central to the proposal is the introduction of a so-called three-pillar framework. Pillar one outlines the minimum capital requirements, while pillars two and three sketch out proposals for a more stringent supervisory regime and increased levels of market discipline. Simply put, there are effectively three different approaches for measuring credit risk in pillar one, depending on the levels of sophistication of the banks. At the most simple end of the scale is the standardised approach, where risk weightings for sovereign, bank and corporate exposures are based on ratings from external credit agencies, such as Moody’s and Standard & Poor’s. Meanwhile, financial institutions meeting tough regulatory require- ments can move to the internal ratings-based (IRB) approach, which effectively allows banks to calculate their own capital charges. The IRB methodology is divided into two components, the foundation and advanced approaches. The first allows banks to estimate the probability of default for each issuer, while loss-given default (LGD) data is set by the regulator. Meanwhile, the most sophisticated banks approved by national regulators will be able to use LGD data derived from their own internal models, as part of the advanced approach. Under the proposals, it is envisaged that the standardised approach will result in broadly unchanged capital levels for banks, with the IRB approach resulting in a 2–3% reduction in risk capital, effectively acting as an incentive for banks to invest in risk management systems. However, Wayne Byres, general manager, risk analysis and research at APRA in Sydney, believes that the calibration of these levels as they currently stand mean that banks using the standardised approach will, in fact, experience increases in capital, while those banks using the advanced approach will encounter far greater reductions than had been envisaged. “Under the standardised approach, these institutions face a substantial increase in their minimum capital requirements in the order of 20–30%,” he says. The reason, he continues, is that there are very few savings in the new framework for those banks using the standardised approach, and with the additional operational risk charge, capital ratios will increase significantly. Meanwhile, under the foundation IRB approach, any reductions in risk weightings will be offset by the operational risk charge, leaving overall capital levels broadly unchanged. “But the advanced IRB would produce possible declines in regulatory capital in the order of 30%, even after taking into account the new operational risk charge,” he adds. The reason for this misalignment is that the LGD assumptions for the foundation IRB approach are too conservative, continues Byres, leading to significantly higher risk weightings than would be the case under the advanced approach. The Accord effectively proposes a 50% LGD for unsecured loans under the foundation approach, and this is reduced by only 10% for loans secured by physical collateral, such as real estate. But using the Accord’s 90-day definition of default, the average LGD for Australian banks is considerably lower, meaning there will be a sizeable jump from the foundation to advanced approach. “Once you move on to the advanced approach, banks take into account their own LGDs, and for most Australian banks it is considerably less than the 40–50% that is assumed within the foundation approach,” says Byres. Arthur Wassink, senior manager, portfolio management, group risk management at Westpac in Sydney, agrees, noting that the LGD for the foundation approach should be around 24%, according to Westpac’s own internal models. Using this LGD data in the advanced approach will therefore result in a substantial fall in risk-weighted assets. “You get quite a lot of relief if you move to the advanced approach,” says Wassink. “I’m not sure that the regulators actually intend that there be such a big difference between the foundation and advanced. Depending on how you actually define our loss-given default, we can actually get quite a big reduction moving to advanced.” sink also points to the treatment of collateral as overly restrictive, and impacting the amount of capital banks have to hold under the foundation approach. Under the current proposals, collateral worthy of capital relief is restricted to commercial and residential real estate, with emphasis on financial collateral, such as cash and government securities. This effectively benefits US investment banks that hold this type of collateral, and disadvantages commercial banks with large retail portfolios. ANZ’s Batty says: “The whole framework seems to be a little US investment bank-centric at the moment, and really hasn’t catered for the large complex commercial banks, such as ourselves.” Under the standardised approach, however, the classification of collateral is even more irksome, and a huge issue for the retail-dominated Australian banks. There is no recognition for physical collateral, and consequently, banks using this approach will have to apply a 50% risk weighting for housing loans, compared with actual losses of around 5–10% per annum. In addition, residential real estate is not recognised as collateral for past due assets, meaning that housing loans, if overdue, will be liable to a 150% risk weighting. This effectively means that more sophisticated banks using their own LGD will have a significant advantage in the mortgage market in Australia, and contradicts the Basel Committee’s stated aim of creating a level playing field. “The standardised approach has a risk weighting of 50%, which we have previously said was too high, and which now gets an operational charge on top of that,” says Byres. “When you get to the IRB approaches and you look at loss rates for Australian banks, they are negligible, and the end result is an effective credit risk weight of around 5–10%. So some institutions are going to get significant capital savings, which in turn might lead to significant pricing advantages.” APRA proposes supervisory discretion in the setting of this standardised rate, and suggests a level of 20%, a figure ANZ’s Batty still believes is too high. “APRA wants to have it at 20% under the standardised approach, which is still well above what we’d expect.” While the risk weightings outlined in the standardised approach will certainly impact the smaller regional banks, building societies and credit unions in Australia, whose portfolios are, for the most part, secured by residential real estate (see table overleaf), the four major banks – NAB, ANZ, Commonwealth Bank of Australia and Westpac – are all expecting to move to the IRB approach immediately after proposed implementation in 2005. “Certainly the large Australian banks will be able to move quickly into the IRB approach. Whether that’s the advanced or foundation approach remains to be seen,” says Ken McLay, managing director, risk solutions at Standard & Poor’s in Melbourne. But one potential obstacle is the “all or nothing” clause, whereby banks have to apply the IRB approach to their entire portfolio in order to take advantage of the reduced capital levels. However, while most of the major Australian banks have sophisticated systems and a history of LGD data when it comes to home loans and other retail activities, the data may not be up to scratch right across the board, in particular for some of those banks with international operations, such as NAB and ANZ. McLay says: “Going to the advanced approach requires a lot more loss-given default data, not only in your home market but also in your global market. Some of these banks with a more global operation, whether they’ve got adequate loss-given default data in all their markets remains to be seen.” Indeed, ANZ raises the issue of a scarcity of data in its overseas operations, stating that the national supervisor should consider granting IRB status in the bank’s home market, even if the data overseas is not yet up to scratch. Meanwhile, Westpac’s Wassink concedes that the LGD data isn’t exactly in the form specified by the Accord. “We would expect the regulators to have a pragmatic approach to implementation,” he says. “We wouldn’t comply if everything had to be strictly broken down, but we’ve got nine years worth of LGD data. We can certainly support observations that we make, even if it isn’t in exactly the right form as specified in the Accord.” Certainly, the move to advanced IRB is likely to take a great deal of investment, in terms of training, systems and disclosure. In their responses, a number of banks noted that the capital benefits gained in moving to the advanced approach may not be worth the potential investments. “The cost of going to the advanced approach is likely to be severe,” says one Melbourne-based internal risk manager of a major bank, who asked not to be named. “The capital savings are not enough to get there. There are issues of data, training people and infrastructure, so there is a sizeable capital cost up front. A number of software companies will be licking their lips at the prospect.” But while the major banks need to address a number of issues before the implementation date, the regulator itself also has some issues to resolve. While the banks need to achieve high levels of systems and data collection, APRA will need to be able to evaluate and monitor the banks’ progress to be able to grant IRB status to them. “We intend to be ready, although I certainly think it’s going to require us to get some additional resources and some additional skills that we might not have now, or we might have, but don’t have enough individuals to tackle every bank,” says Byres. “Just how much more we will need will depend on how many banks we have to tackle, but it’s certainly not beyond us to implement any of this.” The increased levels of disclosure outlined in pillar three is also likely to lead to increased costs. The Accord proposes that the banks disclose comprehensive internal methodologies used to calculate capital adequacy, along with detailed accounts of all risk exposures, on a half-year or quarterly basis. While APRA and the banks broadly support increased levels of disclosure, there are some concerns about the costs and level of information required. “With pillar three, we will have to include a whole lot of extra information in our annual reports,” says Wassink. “The mandates in disclosure seem to be excessive, and, potentially, if we have to go and get external auditors to sign off on it, then that involves an additional cost for us as well, and that could be significant.” Meanwhile, ANZ’s Batty feels the costs will not be as significant as first feared, mainly due to the fact that much of the internal infrastructure will already have been implemented in a move to the IRB approach. However, there is some concern that the detail involved will put the banks at a competitive disadvantage compared to other institutions not subject to the same regulations. “Where you have entities that are not controlled by the same disclosure requirements, they will know a lot more about our business than we know about theirs,” says Batty. “There may be some competitive disadvantage.” In fact, there are a number of other criticisms that Australian banks feel need to be addressed. In particular, many feel the treatment of securitisation in the Accord may halt this booming asset class in its tracks. As it currently stands, the proposal recommends different treatment for sponsoring, originating and investor banks. The intention is to apply extra capital to banks with exposures to schemes they have sponsored or originated, due to concerns about association or reputational risks. According to APRA, risk weightings for credit enhancements could be as high as 1250% if provided by an originating or sponsor bank, but as low as 20% for an investor bank. “We would prefer to see risks of association dealt with by ensuring appropriate separation between the bank and any securitisation vehicle, and through disclosure to potential investors,” says Byres. Even more controversial is the decision to impose a LGD of 100% on securitised transactions as part of the IRB approach, a figure many in the industry feel will be punitive to securitisation. With the new Accord allowing banks under the IRB approach to use their own LGDs for residential mortgages, potentially reducing the risk weighting to as low as 5%, it could potentially be disadvantageous for a bank to choose the securitisation path. “There are a number of problems with the proposed framework – its differential treatment of sponsoring and originating banks is unnecessary, as is its very conservative LGD assumption of 100% in the IRB framework,” says Batty. “A lot of the things that they are suggesting would make securitisation quite unattractive.” But, as with the US and Europe, the proposed charge for operational risk is proving to be one of the most contentious elements. Certainly, even the definition of operational risk has been questioned by a number of players. In its response to the Accord, Westpac questions Basel’s definition - “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events” – as potentially double counting charges already implicitly included in the pricing structure of the bank’s products. Instead, it suggests that the definition should be amended to reflect unexpected losses only. APRA, on the other hand, believes the definition should be extended to include reputational risk issues – especially with the growth of third party outsourcing. “We thought the definition should have been a bit wider,” Byres notes. “Having said that, if they are going to stick with that definition, we felt the 20% figure was a bit high.” While the Basel Committee has agreed to go back to the drawing board to draft another consultation document, there are hopes that it may address some of the key concerns. Certainly, the Committee has conceded that the seemingly arbitrary 20% charge for operational risk be reduced. The Committee has also hinted that it will reconsider the processes for collating data other than the internal measurement approach, a methodology that many in Australia have criticised as backward-looking and not taking into account improvements made to internal systems. Byres says: “Once you get to the internal measures approach, it essentially only looks backwards. Whenever a bank has a big loss, the first reaction of management is usually to tighten up the control framework. But in the internal measures approach, you’ll just have that big loss in the data set, but you get no recognition for any improvements made to the control environment.” However, if the Basel document does not address these concerns, Byres hints that APRA may tweak the Accord to adequately represent the risks in the market-place and to make sure that Australia’s banks are not disadvantaged. “Our preference is always to operate within an international framework. But given some of the disparities that are going to exist, we do need to be prepared to say, if the Committee doesn’t make some sensible adjustments, then we need to look at what we can do ourselves.” --------------------------------------------------------------------------------- AustraliaRisk Supplement Cover Story Hedging goes back to basics BHP's decision last December to stop hedging has prompted a number of Australian corporates to take stock of their own risk management strategies. Will they follow in BHP’s footsteps? Nick Sawyer writes from Melbourne and Sydney BHP's decision last December to stop hedging has prompted a number of Australian corporates to take stock of their own risk management strategies. Will they follow in BHP’s footsteps? Nick Sawyer writes from Melbourne and Sydney ustralia’s resource-based corporates seem to have been under constant attack from virtually all quarters over the last year. They have taken a battering from the country’s press, with headlines screaming for the blood of board members accused of poor management, while investors have been incensed at often dwindling profits. But the reason for this storm of indignation is curious, following the carnage of the Asian crisis. Simply put, it comes down to the fact that many Australian companies have fully-hedged currency risk, at a time when the Australian dollar has plummeted to record levels and shareholders are expecting to benefit with hefty profits. In fact, so intense is the change in attitude towards hedging, that many of Australia’s mining and resource companies are questioning the value of their hedging strategies. The decision by one of Australia’s largest companies, Melbourne- based BHP, now BHP Billiton following the recent merger with a South African mining company, to stop hedging last December, has upped the stakes even more and a string of corporates are now weighing up their options. Following the BHP decision, the question of whether to hedge or not has become a huge issue,” says John Martin, partner, global risk management solutions at PricewaterhouseCoopers (PwC) in Sydney. “In Australia, there is a tradition of active risk management especially among the commodity companies, and if you look at the statistics, they are big users of derivatives. But a lot of people are asking themselves why they are doing this and has it been a waste of time?” Corporate Australia has long carved a reputation for sophistication and innovation in risk management, having been active users of derivative instruments for a number of years. While a desire to manage risk undoubtedly played a large part in this, there was sometimes an opportunistic element involved as well – forward points were often in the favour of corporates looking to lock in revenue, therefore making it financially beneficial to use derivatives. Bob Davies, treasurer of WMC, a minerals producer based in Melbourne says: “The forward points went in the favour of anyone putting on a forward currency position. If the currency was US$0.75 today, you could hedge US$0.72 or US$0.71 a couple of years out, so there was quite a lot of advantage in doing that.” However, the flailing Australian dollar, which reached a record low of $0.4775 in April, has turned all that on its head. Those corporates that locked in revenues several years ago have not benefited from the currency’s decline, and have suffered sizeable losses over the last year. In the worst cases, financial institutions are now unwilling to extend credit lines any further. “Most of these companies have had term hedge books, which at one time or another have been absolutely under the water,” says Simon Wright, executive director, foreign exchange division, treasury and commodities group at Macquarie Bank in Sydney. As a result of these losses, those corporates are now less inclined to use structured derivative products, and instead are looking for financial institutions willing to grant them credit, he adds. Certainly,
a glut of mining and resource companies reported hefty hedging losses
in their half-year and annual reports. For example, WMC reported losses
on forex hedging to the tune of A$253 million (US$130 million) in the
six months to December 2000; Brisbane-based mining company MIM recorded
a loss of A$91.5 million over the same period; Perth-based petroleum company
Woodside disclosed losses of $24.3 million for 2000; while Melbourne-based
resource company Pamsinco reported losses of A$42 million in the six months
to December 2000. “While [investors] have enjoyed hedging gains in the past, they hate hedging losses even more,” says WMC’s Davies. Consequently, investors do not give firms any credit for the potential benefits of hedging risks, but blame any losses on poor management, he adds. In fact, many of the export-based resource companies are arriving at the conclusion that, far from rewarding risk, both investors and analysts actually expect the volatility inherent in resource companies, be it commodity or currency. Says PwC’s Martin: “We’ve been trying to find a link between shareholder value and whether a company hedges or not. For example, if you look at resource companies from all over the world, can you find a discernable difference in shareholder return over a period of time depending on their hedging practices? Our research says not really.” Instead, Martin argues that risk management needs to be linked to a strong business strategy, and it is this that drives shareholder value. The link between hedging and shareholder value was one of the key issues behind BHP’s decision to stop hedging last December (see Risk March 2001). Following a lengthy period of analysis using cashflow-at-risk (CFaR) techniques – a version of value-at-risk modelling – BHP concluded that, when scrutinised in the context of the overall risk portfolio, there are no clear benefits of hedging to shareholders. Indeed, given the lack of benefits, the huge transaction costs incurred by a rolling hedging programme would actually negatively impact shareholder value. tead, BHP opted for a policy of ‘natural hedging’, using the scale and diversity of its operations to naturally offset currency, commodity and interest rate risks. In other words, it decided to discontinue its sizeable rolling hedging programme and bear the residual market risk on its balance sheet. Using the CFaR model, BHP calculated that the natural diversification of its portfolio effectively halves market risk to A$1.6 billion over a one-year horizon, compared with A$3.1 billion for a similar company with the same revenues but without the same levels of diversification. After conducting a series of investor surveys, BHP decided that shareholders were comfortable with the currency and commodity risk on the A$1.6 billion (A$1.4 billion when the current hedge portfolio is included). At the same time, the company stressed it would continue to monitor the CFaR to ensure risk levels did not breach acceptable levels, and added that it would continue to hedge gold in Australian dollars and would hedge in certain circumstances such as a major acquisition. In short, says John Kidd, partner at Melbourne-based Deloitte Touche Tohmatsu, the analysis conducted to reach this conclusion and the ongoing scrutiny of the CFaR, involves perhaps even more effort than BHP’s previous hedging strategy. “The key point is that you can’t say we’re not going to hedge without doing a lot of work,” he says. “They [BHP] have probably done more work on the implications for them in not hedging than what they may have done with hedging.” Following that decision, a handful of other corporates, particularly in the mining sector, are now weighing up their options. Says Kidd: “The majority of Australian commodity companies have significant hedge books, and so for the biggest company to announce they’re not hedging anymore because it doesn’t add value to the share price, certainly made everyone’s head turn and prompted them to think about whether they should continue what they are doing.” Indeed, mining company WMC also decided to discontinue its hedging operations, following analysis using the CFaR model. “We looked at the cash flow numbers at the extreme end and the extreme downside,” explains Davies. “We took the assessment that we are happy to live with that volatility.” Like BHP, WMC has not ruled out hedging entirely – it will continue to hedge gold in Australian dollars for specific projects, such as acquisitions. However, the company will mostly rely on the diversity of its portfolio and a number of natural correlations – particularly that between currency and commodity prices – to offset risk. This strategy will reduce aggregate market risk by 40%, according to Davies. “There have obviously been some bumps and grinds around that, and they don’t move in tandem, but historically the currency actually provides you with some offset to your commodity exposure,” he explains. However, both consultants and bankers are quick to point out this strategy of diversification depends on the size and scale of the individual companies and that a policy of wearing residual market risk on the balance sheet will not suit all corporates. In fact, different companies that pursue the same analytical processes will probably reach a different set of conclusions. Says PwC’s Martin, “Some companies may have exactly the same underlying business profile, but because they have different strategic drivers and/or risk appetites, you can end up with one not hedging and the other having high hedge levels.” Certainly, not all major exporters are planning to follow the BHP route. The Melbourne-based Australian Wheat Board (AWB), for example, a significant user of currency futures and options, and the largest hedger of wheat in the Chicago Board of Trade, says it will continue to use derivatives products on a year-to-year basis. “We certainly won’t be stopping hedging,” an AWB spokesperson adds. Of course, the question of whether to hedge or not is perhaps most pertinent to resource-based exporters subject to currency and commodity fluctuations. Greg Compton, national manager and head of corporate risk management, Australian markets division at National Australia Bank (NAB) in Sydney, states that there has been little reaction from the majority of corporate Australia. “It’s mostly the commodity companies that are looking at their hedging strategies,” he says. “It’s probably a fair assumption that the shareholders are looking for that commodity risk or forex risk inherent in that investment decision.” But there is some concern that some of the smaller export-based corporates may look at BHP’s approach and decide to follow suit, without necessarily following the same processes of scrutiny and quantitative analysis. “Twelve to 18 months ago, many firms would not be doubting their risk management approach,” says James Moulder, director, financial and commodity risk consulting at Andersen in Melbourne. “But now, based on some adverse hedging results, they are saying, well, if BHP and Rio Tinto have done it, maybe we should follow that example and not hedge.” The decision not to hedge, however, should be based on comprehensive analysis and firm-wide modelling, he adds. Michael Stockley, head of corporate sales, global capital markets, at ANZ Investment Bank in Melbourne, agrees. He says, “There are some mining houses and commodity producers that don’t hedge, and just sort of stick their fingers in the wind and think everything will just work out OK in the long run. That’s not scientific analysis. They end up at the same point, but for different reasons or a lack of reasons.” At the same time, there are still corporates hedging purely for opportunistic reasons, locking in forward rates to derive a better average rate for their hedging portfolio. That means, however, corporates are doing far more hedging than is required, which could have disastrous credit implications if the currency falls further. “What they say is, I’ll lower the average rate on [the hedging portfolio] by increasing the notional volume of the hedging,” says Justin Myatt, director, global risk management solutions at PricewaterhouseCoopers in Sydney. “So, you may have had two years worth of cover last year, now you’ve got four years. Your average rate has improved, but now you’ve got four years worth of cover, so you’re hedged far more than previously.” vertheless, there appears to have been a drop in volumes, particularly in forex derivatives over the last 18 months, with the absence of BHP, a regular hedger, making a significant dent in volumes alone. Says PwC’s Martin. “Commodity companies make up a large proportion of the end-user market, because many of them have significant long-term rolling hedging programmes. Year-on-year, they just kept replacing currency and commodity derivatives, so initially any move to reduce hedging has been viewed as bad news for the banks.” A number of the banks questioned conceded that the loss of BHP would affect their business to varying degrees. “We were certainly a big lender and we would have seen a big chunk of their forex business,” says one Sydney-based banker who requested anonymity. Others are more circumspect and point out that although volumes may be affected by BHP’s absence, the thin margins offered to BHP by banks competing for the business means that banks’ profits will not be hit too badly. “At the end of the day, BHP did big volumes, it was price competitive, so it may make an impact on volumes, but I don’t think it will hit us particularly hard,” says a Sydney-based forex trader who asked not to be named. “BHP talked to many banks, maybe it will affect some of the smaller players.” Along with the decline in volumes there appears to have been an underlying shift in the use of derivatives by Australian corporates towards shorter-dated paper, along with a reluctance to use the more leveraged and structured-type products in favour of plain vanilla swaps. “Over the past 12 months, there has been a noticeable move away from highly leveraged-type structures and from end-users running active long-dated hedge books,” observes Mark Carrodus, director, head of foreign exchange trading, Australia and New Zealand, at Deutsche Bank in Sydney. According to Carrodus, the fortunes of the Australian dollar has been the primary reason for this shift and with many hedge books deeply out of the money, exporters are sceptical of using leveraged products due to credit implications of these trades. Carrodus adds: “This has resulted in a shift to shorter-dated, very vanilla and conservative use of foreign exchange derivatives.” Macquarie’s
Wright agrees, noting that those end-users who locked in revenues too
early are shy of being burned again, and a scarcity of credit has prevented
them from using exotic and highly leveraged products. “What does
this mean for the derivatives market and foreign exchange?”, he asks.
“It means that people become more sceptical of product. There has
been less innovation in products in the last three or four years than
there was in any one year prior to that.” However, a proposed fair value accounting standard in Australia is also playing a part in corporates’ choice of product, according to some consultants. “The P&L and balance sheet recognition effects of the proposed new fair value standard makes the Financial Accounting Standard 133 (FAS 133) look like a garden party,” says Andersen’s Moulder. “It’s three or four years away, but given some portfolios go out to five or ten years, the legacy of hedging decisions today could impact negatively on reported company results under the new standard.” Unlike the US Financial Accounting Standard Board’s (FASB) FAS 133, the proposed fair value accounting standard in Australia will not allow hedge accounting. Instead, all financial instruments will have to be marked-to-market and included as profits or losses on the balance sheet, potentially increasing the volatility of the company’s earnings. The main implications, says Deloitte Touche Tohmatsu’s Kidd, is that many corporates may decide to use only simple vanilla products, due to the complexity of revaluation, or may stop hedging all together. “Either they will go down the BHP route and won’t do any hedging, which will be an option available for some, but not everyone. The other approach is that they will just have to prepare supplemental accounts,” he says. Bankers, meanwhile, predict that volumes in derivatives will slowly pick up, as current loss-making hedge positions roll off and the Australian dollar picks up off its lows. “The average tenor of most hedge books is around three years,” says Macquarie’s Wright. “We’re now coming to the end of that, so a lot of that bad credit will be rolling off. People’s appetite will be freed up and they will start to forget the bad times. The Australian dollar is essentially five points off its lows and is generally looking more buoyish, so there probably is an opportunity for a lot more to be done.” But either way, it is likely that more companies in Australia will begin to closely scrutinise their hedging strategies, and work to understand risk from first principles. The shift to plain vanilla derivatives is one possibility, certainly while the Australian dollar remains in the doldrums, but a large-scale tapering off of derivatives is unlikely. While only a handful of the largest exporters may decide to follow the BHP route, Australia’s sophisticated treasurers are unlikely to abandon risk management altogether. “To hedge or not to hedge is not the right question.” says PwC’s Martin. “It’s really should I manage risk or not.” --------------------------------------------------------------------------------- AustraliaRisk Supplement Credit derivatives Great expectations The credit derivatives market in Australia experienced explosive growth last year, helped by keen interest in the corporate bond market and a mounting need for portfolio diversification. Nick Sawyer reports from Sydney The credit derivatives business stands out in what has otherwise been a steady year for Australia’s derivatives industry, notching up record-breaking volumes in only its second full year of trading. And many in the market are forecasting double-digit growth in 2001 as liquidity improves and regulatory issues are ironed out. Credit is a key issue in the Australian market. The country’s major banks have long been the first port of call for cash-hungry companies eager for funding in the face of a historically moribund and illiquid corporate bond market. But while the four major banks eagerly snapped up the business, the question of how to manage and diversify this risk has been a key concern. fault
swaps Meanwhile, the other side of the trades have been taken on by the US and European investment banks, eager to utilise their trading experience in credit derivatives to profit from the attractive margins in the infant Australian market, and to satisfy demand from global clients for Australian credit exposure. Says Russell Taylor, vice-president at JP Morgan Chase in Sydney, “We’ve got quite a lot of exposures down here to Australian corporates, and credit derivatives are a great way of hedging an exposure, but it’s also an additional security to trade.” The lack of participants has arguably hampered liquidity in Australia in the past, with perhaps only four investment banks willing to make regular two-way markets. Nevertheless, the credit market had a bumper year to June 2000, with trading volumes of A$18.4 billion (US$9.5 billion) according to the Australian Financial Markets Association (AFMA), compared with estimates of A$3–5 billion two years ago. More than 90% of the volume was attributable to credit default swaps, but other products such as total rate of return swaps, credit spread options and credit baskets also recorded marked growth. Market
volume discrepancies Others are not so optimistic, believing the 1999–2000 figures to be something of a blip. Jim Fingleton, associate director of credit trading at SG Australia in Sydney, thinks that a large number of European transactions were passed through Australia to take advantage of tax benefits. “There were a large number of transactions that were being shown to the Australian banks, wherein they were receiving a coupon flow on a portfolio of credits that had a European origin. And they were getting the coupon flow on the portfolio in a very tax efficient way,” he observes. “So what it boiled down to was, yes, those volumes are true, but rather than credit being the sole driver of those transactions, a favourable tax treatment helped get the transactions over the line.” Despite the controversy over levels of volume, most agree that the volumes for this year may match or exceed the A$18 billion figure, fuelled by increased interest from a broad range of domestic end-users eager to diversify credit risk, and global funds looking to gain portfolio diversification by including Australian credits. “What we’ve seen is that Aussie names add value to geographic diversification to a basket of credits,” says Mark Sewell, executive director, derivative trading at UBS Warburg in Sydney. “We are looking at a global basket and there are a few Aussie names in there and so I would expect that sort of trade to continue.” Luring
institutional investment Kevin Kosovich, director and head of global credit derivatives, Australia and New Zealand, at Deutsche Bank in Sydney, agrees that the market has become notably more liquid, with an increasing number of players providing bid/offer prices on a greater number of names. “We think the market is well past the growth phase and is accelerating,” he says. “For example, 12 to 18 months ago, you would have seen around seven names being actively traded with, on average, two to three transactions executed per week. Now, there are around 30 actively traded names, with two to three transactions per day on average. It is possible to obtain quotes on another 40 names on a request basis.” Indeed, all of the four major Australian banks are believed to be in the process of applying for trading book status from the Australian Prudential Regulatory Authority (APRA), which allows the banks to trade credit derivatives rather than merely managing the risk on their balance sheets, and also affords them certain capital advantages over the banking book. Says one executive at one of the major banks, “It’s really an end-user game for us and that’s dependent on getting the trading book up and running and ensuring it is properly established.” n addition, a number of institutional investors and insurance companies are turning their attention to the credit derivatives market, partly due to an increased understanding of the product and partly due to a need to diversify portfolios beyond those bonds physically issued in the corporate market. “It would be fair to say that in the past three to five months there’s been quite a marked change in the way that a lot of institutional investors are looking at products,” says SG’s Fingleton. “They obviously had a change in credit mandate, but they were often a little reserved about the product, but I guess you can now say they’ve embraced it with open arms.” Corporate
bond growth But while the corporate bond market has rocketed, the scaling back of government debt, along with the dominance of offshore ‘kangaroo’ issuers (which have made up around 35% of corporate issuance this year), has led to increased demand for domestic corporate paper. The introduction of compulsory superannuation, which has led to an increase of funds under management of around 16% per annum to the current A$612 billion, has added to the supply problems, prompting asset managers to turn to the credit markets to achieve the required exposure. “I think the reasons for looking at credit derivatives are a function of the limited number of credits available in the traded debt market in Australia,” says Adams. “You can’t get exposure to broad-based corporate Australia through the bond market, so the best way for people to assume risk is via the derivatives market.” Most Australian fund managers have typically preferred to invest high up the credit spectrum due to mandates that prohibit them from investing in securities below double-A, but the shortage of high quality paper in the marketplace has meant that fund managers are increasingly looking further down the credit spectrum to achieve returns. Indeed, there has been a spate of triple-B rated issuance over the last year, and a number of funds have emerged with credit mandates that allow them to invest in this paper. But while the cream of Australian corporates dominate the bond market, often from similar industrial sectors, the credit derivatives markets may be the only way to achieve a wider diversification of credit required by these institutional investors, says Jeremy Colless, global head of securities trading and institutional sales, global capital markets, at ANZ Investment Bank in Sydney. “We’re only seeing the top end of the market issuing in any size. For institutions to get diversification in Australia, they must access the syndicated loan market or the banks’ credit portfolios, because that’s where a great proportion of lower-rated credit sits. The combined assets of the big four banks would dwarf the corporate bond market in Australia.” However, there has also been increased interest from overseas investors looking to diversify into Australian credits. “Australian and New Zealand credit risk is potentially a good diversifier for portfolios offshore, achieving access through efficient formats such as the credit swap or tranche portfolio swaps,” says Kosovich. US and
European comparisons Indeed, Katerdjian believes that this interest from overseas will encourage strong growth in the market by encouraging a greater number of market makers to set up shop in Australia. “If you compare it to the US and European market, which is set to hit US$1 trillion this year, then there’s still some massive upside for the market to grow,” he adds. However, others are not so optimistic, noting that the Australian credit derivatives market has not lived up to its early potential. John Harvey, managing director of financial markets at SG Australia, says: “Two years ago, we believed the Australian market was set for considerable change, but the anticipated growth in credit derivatives has failed to materialise. If we can compare the rate of development and institutional acceptance of product in Europe and the US, we are just miles behind in Australia.” Harvey blames
the conservatism of domestic fund managers for the resistance, and while
acknowledging the emergence of high yield funds and the associated development
of credit analysis skills may change investor appetite, he is sceptical
about prospects for growth. “The institutions are fairly conservative
in terms of new products that they are prepared to look at,” he says.
“Even to the extent where we’ve done structured credit deals
with institutions who have subsequently ceased dealing in the product
for the foreseeable future for reasons ranging from inadequate systems
to preference for generic credit product.” Indeed, Harvey points to the absence of an Australian dollar credit market as evidence of a lack of interest by domestic end-users. “It doesn’t make sense for Australian institutions when you are doing credit derivatives on Australian names in US dollars,” he says. G Australia did attempt to develop an Australian dollar market last year, and completed two deals – one with a US insurance company and one with a European investment house. However, says Fingleton, the lack of liquidity in the Australian dollar market meant that it was far better to trade in US dollars and manage the currency risk. “If you’re looking at a trading book deal where you are looking to get in and out of exposures fairly regularly, then the fact that for a short period of time you have a nicely hedged Aussie dollar bond against Aussie dollar swap to my mind is neither here nor there,” he says. “What you really need is to be able to get in and out of a transaction liquidly, and if I can’t because my default swap is in Australian dollars, then you are really shooting yourself in the foot.” Credit
concerns The w factor places an additional capital floor of 15% to the risk weighting of credit derivatives to take into account legal uncertainties and potential problems with the documentation. While all credit derivatives transactions will be liable for the 15% additional risk weighting, guarantees provided by banks will attract a w factor of zero, potentially putting credit derivatives at a disadvantage. “I’m not sure it will impede the credit derivatives market,” says Wayne Byres, general manager of risk analysis and research at regulator APRA in Sydney. “But the way that the w factor is applied to some products and not others means that the same transactions can be more capital effective using one structure rather than another, which is obviously not ideal if they have the same economic impact.” APRA itself also released guidelines for the treatment of credit derivatives in April 2000, effectively outlining regulatory capital treatment for credit default swaps, credit-linked notes, total rate of return swaps and first to default baskets. However, these too have come under attack from many players in the credit derivatives market as overly conservative. “They [APRA] have been conservative in the way they deal with credit derivatives. They’ve had an initial stab at it, but they really should revisit it,” says Sewell. Of particular concern is the treatment of first to default baskets, which requires an institution that has sold protection to hold capital against every name within the basket, a move that has been criticised as overly restrictive. Even more contentious are the rules for offsetting credit derivatives, which specifies that risk capital charges on two contracts cannot be offset unless they match exactly. If they match in all respects other than tenor, a capital charge is required for one of the positions. However, even APRA’s Byres acknowledges that the guidelines for offsetting are conservative, and emphasises that the regulator will review the rules as the market develops. “[The offsetting of credit derivatives] is something we’ve said we are willing to review when institutions have demonstrated their ability to price these instruments accurately and have evidence to show that the basis risk between different types of products is in fact quite small.” Despite these regulatory issues, it seems that Australian credit derivatives are sure to record further growth as investors become more comfortable with the products. Indeed, Deutsche’s Katerdjian is confident that Australia’s robust legal system will overcome any serious issues, and that the credit derivatives market will continue to flourish. “The market is mature in that obstacles that have come up have tended to be quite well dealt with. If there are documentation problems or regulatory issues, people will get together and deal with it,” he says. --------------------------------------------------------------------------------- AustraliaRisk Supplement Energy Derivatives Running on empty Australia’s energy derivatives market bristled with promise five years ago, but a lack of liquidity continues to impede growth, and market players are beginning to look at alternative ways of managing risk. Lachlan Colquhoun writes from Sydney The Australian energy derivatives market has so far been a story of unfulfilled expectations. After much promise in the early 1990s, repeated cktracking by the government on the pace of electricity deregulation has hampered the use of energy derivatives. The resulting market can at best be described as lacking depth and liquidity; at worst moribund and redundant. In the face of soaring electricity prices, combined with a dearth of liquidity in the energy derivatives market, electricity retailers and generators alike are beginning to turn to other means of managing risk – namely through integration, joint ventures and acquisitions. “If you look back a couple of years, banks were thinking that the market turnover and profitability in this sort of commodity would be like foreign exchange, gold or base metals, and that it would be a widely traded market with both industry participants and intermediaries providing contracts,” says Justin Myatt, a director in the financial risk management group at PricewaterhouseCoopers in Sydney. “But as it turned out, it’s not a market you would describe as having high liquidity, so in general there has been some disappointment.” Of the financial players that entered the market with enthusiasm in the mid-1990s – Macquarie Bank, Rand Merchant Bank and SG – only two remain, with Macquarie closing its desk in 1999. There are currently four firms – Duke Energy, Enron, EdgeCap and Enertrade – acting as traders in the market, but the energy derivatives market is largely left to the 26 generators and retailers who comprise the physical market. “Because of its unique characteristics and basic reliance on the physical market to understand the risks and try to hedge those risks, the energy derivatives market has gone down quite an independent path from other financial and commodity markets,” says Tim Oldham, division director at Macquarie Bank’s risk advisory services team in Sydney. But with New South Wales (NSW) and Victoria moving to full retail contestability, allowing customers to choose their electricity supplier from a choice of vendors, from January 1 next year, to be followed by Western Australia in July and South Australia in 2003, the physical market is likely to become more volatile, potentially necessitating more rigorous risk management. “The energy market is really interesting to corporate treasurers and bankers because it’s like a commodity market hyped up on steroids,” says John Martin, partner, global risk management solutions at PricewaterhouseCoopers in Sydney. “There’s huge volatility, and if you don’t get your risk management right, you’re stuffed.” Although industry players downplay suggestions that Australians could experience a California-style power fiasco, the Australian market has several key similarities to California. Soaring wholesale pool prices and capped retail values pushed Californian utilities to the brink and the worst-case scenario could see something similar happen in Australia. The Australian energy market is currently overseen by the National Electricity Market (NEM), which began operating in December 1998 as part of the deregulation process, and pools all electricity output from NSW, Victoria, South Australia and Queensland for sale to a market of 12 retailers. The generators compete by bidding to supply energy to the pool and electricity is sold to the retailers from there. The spot price is calculated for each half hour period, but these spot prices have been steadily climbing due to a lack of supply in the market, coupled with a change in bidding strategies by the generators following deregulation in some states. “All of a sudden [the generators] are able to change their bidding strategies for power delivered to the pool and you have retailers on the other side who still have all these allocated customers on regulated prices,” observes Myatt. “There has been a real shift in market influence on prices and that has coincided with an increase in spot market prices, with customers now seeing much higher prices in their newly-quoted contracts.” Australia also faces the problem of poor generating capacity and in an environment of full contestability, prices are likely to spike dangerously at peak times in summer and winter. With a question mark hanging over the industry’s capacity to deliver sufficient volume at peak times, retailers and customers are facing the prospect of sharp spikes in prices as caps are removed. This will inevitably prompt a corresponding increase in the need for appropriate hedging and could boost the development of the market for energy futures. Certainly the gradual winding down of NSW government’s Energy Trading Equalisation Fund (ETEF), which operates as a hedge for government-owned generators, could see players in Australia’s most populous state look again to the markets for hedging instruments, a trend which could boost liquidity. “The market is screaming for an appropriate futures contract, and it’s a great opportunity for an innovative product to come in and set the market on fire,” says Dean Price, manager of trading at Duke Energy in Sydney. “But it just hasn’t happened at this stage.” However,
others remain more sceptical about the future for energy derivatives,
noting that liquidity is currently so poor that generators and retailers
are turning to other means of managing risk. “A year or two ago,
firms were advising people on market-linked means to manage price risk,
to use the forwards market, or buy these caps, sell these floors, do option
structures,” says Myatt. “What people have found is that the
liquidity in the market is not good and it is arguably getting worse,
partly because people are now pricing risk more correctly. So people are
now looking for means to manage risk which are not just through derivatives.” th retailers and generators are now considering integration, mergers and alliances. Retailers are developing physical power production capability and generators are setting up desks to market large industrial customers directly, Myatt continues. “The danger is that the more these retailers and generators integrate, the less they will rely on the derivatives market and the worse the derivatives market gets.” Indeed, power contracts issued by the Sydney Futures Exchange (SFE) have largely been ignored by the industry, which has developed a more active over-the-counter market (OTC), where participants are able to tailor relevant contracts to manage their risks. Although participants are able to find more relevant risk cover on the OTC market, emerging problems with credit worthiness have hampered its development. “Credit issues with counterparties have become an issue and a futures contract can supply a mechanism to address that,” says Wendy McTainsh, of Macquarie’s Sydney-based risk advisory team. “But the market has been highly critical of the current contracts and has been reluctant to use them.” Meanwhile, Macquarie’s Oldham says SFE tools are “not bad, fundamentally”, but says it is the physical orientation of the energy market that is limiting liquidity. “It is similar to agricultural markets, where there are a handful of natural sellers of the product and a handful of buyers, most of whom know each other and used to work together,” he says. “There really isn’t much activity in any volume by people outside that physical loop.” Trading volumes on the SFE reached 2,318 contracts last year, compared with 11,412 contracts in 1998. Meanwhile, a report by the electricity committee of the Australian Financial Markets Association’s (AFMA) says that 134 million megawatts of electricity contracts were dealt last year. “There are inherent problems with the SFE contracts as they are listed and they don’t fulfil the hedge requirements of the parties in the market at the moment,” says Duke Energy’s Price. “In my view there’s been no viable futures market to add another tranche of liquidity to the market, but it is quite easy to fix.” The SFE currently provides futures contracts in the peak and base load electricity markets for both Victoria and NSW. However, the contracts currently set the megawatt per hour (MwH) exposure at a constant level of 500 MwH for each month and contract type, regardless of the actual number of hours in the month. Meanwhile, OTC contracts are priced on the specific number of hours in each month, making it arguably better suited to hedge natural forward exposures to the physical market. “[The SFE contracts] haven’t been successful,” says one Melbourne-based energy analyst. “On those contracts, the underlying may be something like the June NSW price. So basically you end up with an average of the half hour for June. But that is not specific enough – most people will want a peak price, an off-peak price or a weekend price in individual components. An average for June is not really helping your overall risk management because there’s too much diversity in that.” The SFE also lacks long-term listed month contracts that go beyond one year and crucially, the contracts do not extend to Queensland and South Australia, two states that have experienced sharp increases in electricity trading volumes over the past 12 months. An SFE spokesperson says the exchange is aware there is “some dissatisfaction” with the structure of its contracts. “There are a number of technological issues for our trading platform that would require addressing in order for us to list contracts that match exactly the requirements of the market,” he says. “We are reviewing these with our market partici- pants, and, at which point, we will make a determination to move forward with the changes or not.” But if the SFE does not act, there is talk in the industry that another player – possibly the Australian Stock Exchange (ASX) – may move in to fill the void. A rival to the SFE, the Australian Derivatives Exchange (ADX), was believed to be on the verge of listing a new product when the exchange failed in March shortly after opening. “The whole market, including the OTC side, would benefit from a new contract and I’m sure we will get one soon,” says a Sydney-based energy trader, who asked not to be named. “Debt-strapped counterparties who find it difficult to find a clean way to trade on an OTC contract are common and their bankers are many of the same counterparties who would be providing clearing services either to them or the SFE, or another potential exchange. It would be in their bankers’ interests to ensure that these counterparties have the ability to trade. After all, if you can’t trade, you can’t mitigate risk, so I think the banks are going to be behind it as well.” At Enron Australia, Raymond Yeow, the Sydney-based director of trading, is less critical of the market’s development. “It may not be as liquid as we’d like, but it’s early days yet and there is a lot of potential and I am not writing it off.” Instead, Yeow points to weather derivatives as a potential means of hedging the risk associated with electricity shortages. Indeed, surging electricity prices in January were driven by a heat wave and a response by generators to set more expensive spot prices. By holding a weather derivative, retailers will be able to hedge against extreme weather conditions and this approach appears to be finding favour with some of the energy traders. “I think we are all looking for innovative ways to hedge risk and these weather hedges help us do that,” said a trader at a Victorian retailer. “We can write these contracts between ourselves, but it would be much better to have a liquid market in an exchange-based product. We haven’t got that yet, but the word is that it is just a matter of time.” --------------------------------------------------------------------------------- AustraliaRisk Supplement New angles Becoming accountable While the derivatives industry gets to grips with the impact of the US Financial Accounting Standard Board’s (FASB) contentious derivatives accounting rule, FAS 133, Australia is mulling over an even more radical proposal, which could create huge volatility on the balance sheets of both banks and corporations alike. And the implications of the proposed standard are leaving many industry players wondering if this could signal drastic changes in risk management strategies. e proposal, drafted last December by the Joint Working Group of Standard Setters (JWG), a body comprising accounting standards bodies in 13 countries including Australia, the UK and the US, plans to abolish special accounting treatment for financial derivatives. Instead, all hedges will have to be marked-to-market and included as profits or losses on the balance sheets of Australian institutions. The proposed measures go further than both the FAS 133 and its international counterpart, the International Accounting Standard Committee’s (IASC) IAS 39, which allow hedge accounting if the hedge proves to be effective at offsetting the hedged item. The Australian Accounting Standards Board (AASB), however, rejected both FAS 133 and IAS 39, in favour of the JWG’s Accounting for Financial Instruments and Similar Items, and published the document for comment in December last year. Although
the proposed standard will increase transparency and will allow greater
comparability of balance sheets, it does not come without headaches. As
with FAS 133, the cost of implementing the new standard, in terms of technology,
expertise and time to transition, is likely to be high. “Only 5%
of Australia’s top corporations have the systems capabilities to
cope with the proposed changes,” says John Kidd, partner in the financial
services group at Deloitte Touche Tohmatsu in Melbourne. “So 95%
of companies will struggle to be able to comply with the standard in line
with their normal accounting reporting cycle,” he adds. The central proposal underpinning the entire document asserts that all financial instruments (both assets and liabilities) must be measured at fair value at each balance date and included in the profit and loss. In addition, institutions will have to provide increased disclosure about financial instruments and financial risk positions. On this issue, Australian corporations, particularly the export-based commodity companies, which are traditionally large users of complex derivatives instruments, are likely to experience serious repercussions. According to Melbourne-based Sally Sinton, director of the financial and commodity risk consulting group at Andersen, one consequence of the proposed standard is that it does not take into account hedges of anticipated events or actions. “In the case of the JWG draft, the anticipated event cannot be recognised on the balance sheet as it is not occurring or contracted currently,” she says. “However, the hedges will be mark-to-market and brought to account, creating a mismatch in terms of the risk and hedge recognition on the balance sheet and profit and loss (P&L).” This ‘mismatch’ may not only distort the true value of the business. John Martin, partner in global risk management solutions at PricewaterhouseCoopers (PwC), based in Sydney, believes it could also lead to changes in companies’ risk management policies: “As much as I don’t want to say this, the proposed changes will have an impact on how corporations implement risk management in Australia.” He adds: “Boards and senior management care about financial reporting and will want to avoid signing off on huge losses – even if these can be viewed as some type of ‘abnormal’.” If the JWG’s
current draft goes ahead, corporate treasurers may question the benefits
of complex derivatives transactions. It is also possible that Australian
companies will increasingly turn to vanilla derivatives in their risk
management. “This is highlighted by the response to FAS 133 in the
US,” says Kidd of Deloitte Touche Tohmatsu. “Vanilla derivatives
are being used as they are easier to value than more complex derivatives,” Another outcome could be the search for and usage of alternative products. “Corporations will still need to hedge, but there will be increased incentive to use products that have limited scope for mark-to-market losses,” says Martin at PwC. “This means greater use of option-based products because losses can be limited and possibly highly structured transactions designed to meet accounting standards. We have already seen some innovative structured transactions offered by banks in response to IAS 39 in Europe and we would expect similar developments locally.” The invitation to comment on the draft expired at the end of June, and while treasury and banking associations such as the Finance and Treasury Association (FTA) in Australia have been vocal, there have been few responses from the corporate sector. Andersen’s Sinton believes this is because “corporations have not fully understood the importance on commenting on the draft”. She adds: “As the discussion document is lengthy and written in ‘accounting speak’, it is taking time to fully comprehend what has been put forward.” At least one reworking of the draft will be issued before it becomes an international standard, and, bearing in mind that each member country and association of the JWG will also be asking its treasurers, accountants and banks for responses, the final measures sanctioned may have no resemblance to the ones currently proposed. So, for Australian corporates, only time will tell whether the standards are for better or for worse. Ausmarkets bucks trend The global multi-bank foreign exchange trading platforms will soon face competition in Australia from a regional player that has unveiled plans to launch a multi-bank, multi-product trading portal tailored specifically for the country’s financial markets. Ausmarkets, a joint venture between four major banks – ANZ, Commonwealth Bank of Australia, National Australia Bank and Westpac – is set to launch in the first quarter of 2002, and plans to offer a suite of money market, fixed income and foreign exchange products. he initiative to produce a customised Australian portal emerged following difficulties accommodating Australian money market and foreign exchange instruments on existing international trading platforms, says Simon Narroway, chief executive of Ausmarkets, based in Sydney. “Some of the products in this country are quite different from international products,” he notes. “So an offering that is customised and tailored for the local markets is more interesting than some of the overseas ones.” Indeed, three of the four banks holding equity in Ausmarkets are already involved in a number of other e-fx ventures. ANZ is a member bank of Atriax, while Westpac is a member of FXall. Meanwhile, National Australia Bank is a member of Atriax and FXall, as well as Currenex and State Street’s Quick FX platform. Shaun Dooley, Melbourne-based head of e-business development for the wholesale financial services division of National Australia Bank, cites Ausmarkets’ focus on Australian financial products as a key reason for the bank’s involvement in the portal. He says, “[Ausmarkets] recognises that the global portals focus mainly on foreign exchange, and there is a broader product need for the regional customers based in Australia.” At launch, the portal will offer Australian money market products, including cash deposits, commercial paper and bank bills. However, it is anticipated that the product range will be extended at six week intervals to incorporate fixed-income products, including domestic government and corporate bonds, as well as asset-backed securities, and foreign exchange products, such as currency swaps and forwards. Other derivative products, such as interest rate swaps, will not be offered initially, but Narroway did not rule out adding them in future. “We need to do the analysis of the revenues versus the costs of doing that type of extra asset class. My current intention is yes, I just need to see the final cost-of-revenue forecast – this is a commercial portal so we don’t want to have to spend A$500,000 if we are only going to make A$100,000,” he says. But while the portal will be targeting active wholesale customers, it expects to lose the larger institutional and corporate clients to the global multi-bank single product portals such as FXall, Currenex and Atriax. “Some of the very, very big companies may choose to use some of the other huge portals such as FXall because they’re doing currency pairs that may not be on Ausmarkets. They might be doing hedging in certain currencies which may not be on Ausmarkets,” says Narroway, adding that its multi-local-product focus, as opposed to multi-global-products, may not be enough for some of the very large companies. Unlike its global multi-bank forex brethren, Ausmarkets may not necessarily be accessible through a public Web browser on the internet. Banks and institutional customers questioned by Ausmarkets demonstrated a preference for dedicated lines, while the corporate investors remain undecided. “The corporate market has mixed views because their trading activity is so little by comparison that possibly public internet with appropriate certificates, appropriate security protocols might be OK for them – it depends on the cost of the private lines,” says Narroway. A pricing schedule will not be decided until the request for proposals – recently sent out to various information technology vendors – return. “That won’t become apparent until probably early or mid-September,” Narroway adds. The portal expects to sign up more banks to act as liquidity providers by the time of launch, and claims to have already received a fair degree of interest from local banks. It also plans to approach international banks through their Sydney- or Melbourne-based treasury and financial markets operations. “We may also look at some price providers and banks from overseas markets, for example, out of Singapore, or Japan, or New Zealand, but the main focus is very much local products for local customers,” says Narroway. Ausmarkets will offer Australian customers with multi-bank relationships a single site through which to conduct all of their online trading, he adds. But with the ever-increasing slew of global portals, Narroway predicts that a process of consolidation is inevitable, and that the various portals will begin to merge or form alliances with each other. Having already approached a number of existing portals, Narroway expects Ausmarkets will eventually establish alliances with overseas platforms, becoming a gateway between Australian customers and the overseas portals. “One of the very key areas of feedback from customers is that they dislike fragmented liquidity pools. They like to have large groups of banks together behind one portal and there will have to be a shake out,” he says. Ausmarkets is currently in talks with the Australian Securities and Investment Commission, seeking regulatory approval, and will be submitting a formal application soon. --------------------------------------------------------------------------------- AustraliaRisk Supplement Securitisation Stoking up the ABS market Everyone agrees that the securitisation market in Australia is set for a bumper year. But there is fierce debate as to which asset type will lead the charge. Ellen Leander reports ions on the potential for development of the Australian securitisation market are as divided as the country’s famous split on the relative merits of Sydney versus Melbourne. While some bankers see potential in commercial mortgage-backed securitisations (CMBS), others guffaw and say that trade finance-based securitisations have much more long-term staying power. Quite a few players see the residential mortgage-backed securities (RMBS) market as the country’s next big asset class, while dissenters believe that the origination of new deals will soon dry up for several years. But one thing that everyone can agree on is that it has been a fantastic year for asset-backed deals in Australia. For the first half of 2001, more than A$16.41 billion (US$8.38 billion) of transactions had been completed, compared with A$18.8 billion for all of 2000 and A$11.8 billion in the first half of 2000, according to Standard & Poor’s. This total does not include asset-backed commercial paper. It also does not include ABN Amro’s record-breaking A$900 million transaction – the biggest RMBS deal in five years, according to the issuer – which came to market in the first week of July. Indeed, this total has been driven by a number of RMBS transactions of exceptional size aimed primarily at foreign investors – more than A$9.9 billion of Standard & Poor’s first-half total was derived from global RMBS issues. With the end of the first half of 2001, all of Australia’s major mortgage-originating banks have now completed an RMBS transaction, as have a good number of the nation’s bigger foreign banks with mortgage operations. Names such as National Australia Bank, St. George Bank, ABN Amro, Bank of Queensland, ANZ, Bendigo Bank, and Commonwealth Bank of Australia have all tapped the RMBS market in the first half of 2001. Large offshore RMBS transactions came into vogue in early 2000, but then fell from favour as the cost of the currency swap that was required to flip the proceeds of the transaction into Australian dollars became prohibitively expensive. Domestic issuance of RMBS securities shot up some 83% in 2000 over the previous year, according to rating agency Fitch IBCA. This situation has since reversed itself, thanks in part to a large number of so-called “kangaroo” issues into Australia, which have helped reduce the cost of the swap. “So long as the economics of the currency swap remains as it is today, the pipeline looks strong,” says Fabienne Michaux, director of structured finance at Standard & Poor’s in Melbourne. Experts from other rating agencies concur. Fitch is predicting an increase of 20–30% in the Australian dollar total for RMBS transactions in 2001, for example. Overseas demand for Australian asset-backed transactions is also growing. Australian RMBS issuers have found strong sources of demand among Hong Kong and Singapore investors, among whom there has been a flight to credit quality, says Peter Taplin, associate director of corporate finance at Westpac in Sydney. Australian RMBS “offers them a bit of yield and diversification, but keeps their funds within the region,” he says. Europe has also proved fertile ground for selling these RMBS deals. Taplin adds that offshore demand for Australian RMBS has made antipodean investors keener on the asset class. Traditionally, Australia’s institutional investor community has been relatively conservative in their asset allocation choices. “As a general rule, most investors are at the conservative end,” says Kevin Lee, division director of debt finance at Macquarie Bank in Sydney. “What we are seeing [domestically] is that some bigger and more sophisticated investors are trying to diversify their portfolios and capture higher yields. The number of investors interested in securitised assets will grow in Australia as they become more sophisticated and build their own credit analysis departments.” Like investors abroad, domestic investors are attracted by the fact that many of the mortgages packaged in the RMBS deals have mortgage insurance for 100% of the principle, so that deals receive higher ratings. Says Ben McCarthy, managing director at rating agency Fitch: “You basically have a guarantee on the loan that says ‘we are going to pay you 100% of the loss.’” But regulatory changes threaten to crimp the flow of new deals into the RMBS market just as investor demand picks up. Basel II, if implemented, would lower the risk weighting on residential mortgages for banks using the internal ratings-based (IRB) approach well below the current 50% (see pages 22–24). The Australian Prudential Regulatory Authority (APRA) also has a proposal to lower risk weightings for banks using the standardised approach. Reducing the risk weighting that needs to be held against those assets would make securitisation less necessary from a regulatory capital perspective. The final shape that these regulatory changes will take will be some time in coming, however. Says one industry participant, “APRA may look to do something completely different for Australian banks, and there is no clarity there, just rumour and innuendo.” The lack of a regulatory driver for RMBS transactions has some bankers thinking that the current rush in activity will be followed by another quiet period. “The only reason to securitise is to manage funding. Banks aren’t securitising for regulatory reasons. The big banks only need to securitise for very specific reasons – to ensure a presence in that market, or to maintain a presence,” says one banker. After the current rush of new issues, he says he expects RMBS issuance from banks to tail off next year, although issuance from Australian non- banks will remain relatively constant. However, Michaux contends that changes in the banking industry – quite similar to changes that are taking place in other countries around the world – will create an environment quite conducive to RMBS transactions. Disintermediation at Australia’s banks – customers choosing to shift time deposits into mutual funds or other non-bank instruments – means that banks will need to consider other ways of funding their balance sheet requirements, and securitisation of mortgage portfolios is an easy way to do this. Glenn McDowell, director of securitisation at Deutsche Bank in Sydney, says that banks will continue to do RMBS transactions to diversify their risks. He says: “This is more about credit risk management than it is about funding.” fter RMBS,
the asset category receiving the most attention is the CMBS sector. The
first half of 2001 saw three deals – two credit lease transactions
and one real estate-backed deal for a listed property trust, Mirvac –
totalling A$678 million. This already far exceeds 2000, which saw two
deals worth just A$373 million. Standard & Poor’s says it has
several transactions in the pipeline for ratings, which the agency expects
to be issued before the end of the year, so this total should be quite
impressive by the end of 2001. “We’ve had a lot of inquiries,”
says Micheux. “This is the first year that I’ve really felt
that it would take hold.” Credit lease transactions have been the most popular so far – these have been for names such as department store retailer David Jones, which securitised the leases on the firm’s stores in 2000, and was viewed in the market-place as more of a play on the retailer’s own creditworthiness. But it is listed property trusts that some say will really help the CMBS market take off. “We expect the volume will come from the listed property trusts,” says Philip McEwan, director of corporate finance at Westpac in Sydney. McEwan says he foresees another three or four of these transactions coming to market over the next 12 months, each worth about A$350 million to A$400 million. But then he says transactions could taper off a bit. The number of listed property trusts, which are large enough to perform these kinds of securitisations and still have not established access to the corporate debt markets, is relatively small. For these trusts, the costs of obtaining a corporate rating is high, but once such a rating is achieved the cost of raising funds in the corporate debt markets is comparable or cheaper than securitisation. Adds one banker from a European firm based in Sydney: “There are going to be a number of one-off deals, and I’d put a question mark on how big that market will be. There will be a flurry of issues, but I’m not sure how sustainable that activity will be, over the long term.” Debate is just as intense over the potential for other types of securitisation, with a number of other structures reaching the market over the past several months. In June, SG Securities launched a first securitisation for CNH Capital Australia of the company’s agricultural and equipment finance leases. The portfolio consisted of $450 million of loans, finance leases, and higher purchase contracts, supported by a mix of both new and used equipment. “I do see more transactions in the field of equipment leasing,” says John Chauvel, head of securitisation at SG Australia in Sydney. He envisions that this sector could grow to three or four transactions each year totalling about A$1 billion. Additional deals could be done in the commercial paper market, adds Macquarie’s Lee. Another field that has also seen its share of deals since the start of the year is trade receivable financing. Bank facilities are not as generous as they were in the past, while corporate credit ratings are declining in Australia, which boosts the cost of debt funding. As a result, many corporates have looked towards securitisation of trade finance receivables as a way of raising capital. Says Cheval: “The securitisation of assets on their balance sheets is starting to become more cost effective for them.” He says that typical deals are relatively small – A$200 million to A$500 million in size – and the deals tend to be complex to put together, but that “the economics from the issuers’ and arrangers’ perspective stacks up.” Bankers point out that trade receivables can either be securitised as term transactions, or through the growing commercial paper securitisation market in Australia. Markets such as the US and Europe have seen a great deal of success from securitising auto loans and credit card receivables, but these types of transactions will probably take a great deal more time to develop in Australia, according to bankers. Investors are interested in these kinds of deals, says Macquarie’s Lee. “There is plenty of demand for diversification from investors, especially those who are seeking shorter maturities.” The problem is on the supply side – banks have little interest in securitising these types of receivables at the moment, because their focus is on securitising larger portfolios, such as mortgages. As well, many banks “do not have information and systems in place to make it efficient to securitise these receivables”, says Fitch’s McCarthy. “The data that they have on their customers is not that great.” In addition, Australia’s relatively small population of 19.5 million people limits the overall total of assets that are potentially available for securitisation, for both credit cards and auto loans. Indeed, according to Deutsche’s McDowell, there is only about A$16 billion in outstandings among the nation’s 12 credit card providers. Still, the creative securitisation juices are flowing in Australia. In the first quarter, a company called APRC securitised A$33 million in tax-effective agricultural investment loans on tree plantations. The rating was the first of its kind globally for Standard & Poor’s. And talk about collateralised debt obligations and collateralised loan obligations – the so-called synthetic securitisations that utilise credit derivatives in their structures – has picked up again according to ANZ’s Addis: “I would expect some sort of transaction to appear in the market-place relatively soon.”
End.
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