NEW YORK-Still waters run deep. You could say that the OTC derivatives (OTCD)-laden waters of 2008 ran even deeper.

Had it not been for the quick actions of the Federal Reserve Bank of New York, the Depository Trust and Clearing Corp. and major back-office providers to probe for weaknesses in the backlog of OTC derivatives two years ago-the Lehman Brothers-led credit crisis would have been even more of a capital markets and economic catastrophe.

That was the consensus of speakers at a Capital Markets Consortium presentation last Tuesday on: "New Frontiers of OTC Derivatives Processing and Preparing for What's Coming in the Future."

While Federal Reserve Chairman Ben Bernanke, then-New York Federal Reserve Chief Timothy Geithner and U.S. Treasury Secretary Henry M. Paulson worked assiduously around the clock to save the major investment banking houses from collapsing, DTCC, the New York Federal Reserve, 14 major primary dealers and nine key buy-side firms began their monumental work on the back-office OTC derivatives morass.

Information on trade commitments was non-existent. And, as it has since repeatedly been revealed, in news articles and Congressional testimony, even the derivatives originators, credit rating agencies and credit default swaps insurers themselves didn't really have their arms around the underlying mortgage securities risks.

As one operations executive said, speaking off the record, AIG wasn't the only underwriter that "egregiously [failed to] understand the complexity of the products."

Nonetheless, when Lehman Brothers and Bear Stearns began to cave under the weight of their asset-backed securities, hedge fund and leveraged holdings, the Federal Reserve Bank of New York and its counterparts in the U.S. and around the world realized early on how critical it was to unearth information on counterparty credit risk.

Weakness in firm-level risk management and a tremendous backlog of OTC derivatives deals in July and August of 2008, also gave regulatory officials and operations executives pause.

The solutions, they quickly deduced, would have to center on building a strong data repository and database management system to unearth the holdings, the risks and the counterparty risks of these highly complex instruments.

As Wendy Ng, assistant vice president in the N.Y. Fed's bank supervisory group, explained in her keynote speech at the forum: "Our policy objective is to make sure that there is a central database where regulators can access information about the CDS market so they have the information necessary to do their jobs well."

International cooperation is also a critical part of this, Ng continued. "It's important to work globally because the market is global. You wouldn't want to encourage regulatory arbitrage."

John Avery, partner, SunGard, underscored how significant work on a derivatives data repository is, including the N.Y. Fed's work on an equity derivatives database and DBs for other asset classes.

"In the past 18-24 months, we've seen the economic impact of collateralization-particularly among counterparty clearing partners (CCPs)," Avery said. "OTC and non-OTC derivatives are two very different set of data."

Luckily, firms like Omgeo, a joint venture between Thomson Reuters and DTCC, are successfully working on the related issue of clearing, with 50% of Omgeo's trades completed same day, or T, and 90% in T+1.

Omgeo has achieved this using SwapsWire via its Market Trade Manager (MTM). Still, because data is imperfect-particularly where OTC derivatives are concerned-Omgeo adds another protective layer of due diligence, said John Burchenal, managing director, market growth, Omgeo. "We don't trust SwapsWire, so we validate," he said. Still, Omgeo is sensitive to the source of the data. "We make margin calls to some dealers but not to others," he said.

While transparency in the OTC derivatives market may never realistically be achievable due to the near-frenetic pace at which Wall Street develops these and other products, the past six months have seen "significant partnership" among infrastructure providers to build stronger networks, Avery said.

SunGard, for instance, has rolled out CLIQ to "glue buy-side and sell-side" trades.

Back on the regulatory side of the equation, with respect to work on the many different asset classes derivatives are popping up in, Ng said: "The industry has divided into implemention groups, so the work is not as overwhelming."

Where OTC derivatives are concerned, it's whitewater rapids, indeed.

"It's important to work globally because the market is global," said Wendy Ng, assistant vice president in the Bank Supervision Group at the Federal Reserve Bank of New York. "You wouldn't want to encourage regulatory arbitrage."

Investors Now Jittery Over Global Investments

This year's stock market volatility and the EU debt crisis has caught some investors off guard, causing them to now start pulling money out of international mutual funds.

Todd Rosenbluth of Standard & Poor's Equity Research Services thinks advisors should use this opportunity to talk to investors about risk exposure and several funds that may be appealing to the risk-averse.

U.S. mutual fund investors are questioning whether the falling Euro and sovereign debt crisis in Europe are reason enough to shift their assets away from international investments. While money moved into international mutual funds in each of first four months of 2010 and the first week of May, approximately $3.7 billion flowed out of these funds in the week ended May 12, according to data from the Investment Company Institute.

S&P's Investment Policy Committee recommends that investors with moderate risk tolerance have a 45% exposure to U.S. equities and 15% exposure to foreign stocks; the remaining 40% allocation should be in fixed income and cash.

The problem is that many investors forget that their domestic mutual funds have both direct and indirect exposure to international markets, said Rosenbluth in an S&P research report released Tuesday.

"There are a lot of U.S. based companies-IBM, General Electric, Hewlett Packard and Exxon Mobil-that all have 40% or more of sales coming from outside the U.S.," Rosenbluth said in a interview. "We don't think people should pull out of Europe. Investors should have diversification globally and exposure to Europe and Asia as well as the U.S."

Meanwhile, he says, there are still a number of large-cap U.S. stocks that are currently undervalued based on S&P's methodology, have above-average quality rankings, and generate 40% or more of their revenues from overseas markets. These companies include: ExxonMobil, where 70% of 2009 revenues stemmed from international operations; General Electric, where 54% of 2009 revenues stemmed from international operations; International Business Machines, with 58% international exposure, and Procter & Gamble, with 57% of 2009 revenues from outside of North America.

- Ruthie Ackerman

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