CAPITAL MARKETS A PUBLICATION OF STROOCK & STROOCK & LAVAN LLP VOLUME 1 NUMBER 4 OCTOBER 1999

Transcription

1 CAPITAL MARKETS A PUBLICATION OF STROOCK & STROOCK & LAVAN LLP VOLUME 1 NUMBER 4 OCTOBER 1999 LONG TERM EFFECTS OF LONG TERM CAPITAL MANAGEMENT: RECENT DEVELOPMENTS IN THE REGULATION OF DERIVATIVES Policymakers Weigh Options for Derivatives Regulation The financial markets were in turmoil. Many prominent players had large, highly leveraged portfolios of illiquid investments. Rumors of serious liquidity problems possibly leading to the failure of a high-flying financial institution were all over the Street. There was a real danger panic selling would trigger a landslide of bankruptcies and cross defaults, with grave consequences for the economy. The question was, what could anyone do to put things right? In 1907, when the financial problems of Knickerbocker Trust precipitated a run on the banks, J.P. Morgan s answer was to summon the leading financiers of his day to meet with him in his library, where they hammered out agreements for cash infusions to end the crisis. In September 1998, with neither J.P. Morgan nor his library readily available, and the hedge fund Long Term Capital Management ( LTCM ) facing imminent collapse, the Federal Reserve Bank of New York contacted a consortium of LTCM s counterparties to find an alternative to a fire-sale liquidation of LTCM s portfolio of swaps, options and other derivative instruments. They did, agreeing to provide $3.5 billion in new capital to LTCM, thereby avoiding a crisis. Even before the LTCM bailout, there was pressure for increased regulation of the derivatives market. The derivatives market has sometimes been viewed by the general public, and even by otherwise sophisticated regulators, policymakers and investors, with a mixture of curiosity and alarm. Twenty years ago, when the derivatives market was smaller and the community of end-users relatively limited, this did not present a problem. Since 1990, however, corporations, hedge funds, financial institutions and governmental entities have increasingly relied upon derivatives to help them unbundle risks, increase investment yields by leveraging their capital and hedge against fluctuations in interest and foreign exchange rates. As a result, the notional value of outstanding derivatives contracts reported by United States commercial banks has increased at a compound annual rate of approximately 20% since 1990, to a total of $33 trillion by the end of Of this $33 trillion, only $4 trillion were exchange-traded derivatives subject to regulation by the Commodity Futures Trading Commission ( CFTC ) under the Commodity Exchange Act ( CEA ). The remaining $29 trillion were over-the-counter ( OTC ) derivatives, which generally are exempt from all or almost all of the provisions of the CEA. Not only has the notional value of outstanding derivatives contracts increased, but new end-users such as pension funds, insurance companies, local municipalities and school districts have steadily entered the market, and derivatives have been used to perform an ever-widening variety of risk management functions. Chairman Greenspan has characterized the dramatic growth of the derivatives market as by far the most significant event in finance during the past decade. The LTCM crisis, however, has forced public and private policymakers to seek a better balance between the benefits provided by the derivatives market and the risks associated with derivatives trading lack of transparency, the high degree of leverage of many market participants and the potential for significant future credit exposures in the event of defaults. These efforts are ongoing, with many works in progress, but two things are already clear. First, no sector of the global economy stands in isolation from the derivatives market. Second, changes are occurring rapidly in the regulation of the derivatives market, best practice for disclosure of derivatives trading activities, and in other market practices and conventions. Though the full impact of these changes has not yet emerged, the process warrants close attention. This issue of Stroock Capital Markets focuses on the current status and policy implications of the debate. We examine proposals to close regulatory gaps by groups such -1-

2 as the Basel Committee on Banking Supervision (the Basel Committee ) and the International Organization of Securities Commissions ( IOSCO ). These include proposals to improve regulatory disclosure and reporting and proposals to improve supervisory oversight of highly leveraged institutions active in the derivatives market. We also look at efforts to improve market practices and conventions to develop best practices by groups such as the Counterparty Risk Management Policy Group ( CRMPG ) and the Foreign Exchange Committee of the Federal Reserve Bank of New York. Our next issue of Stroock Capital Markets looks at other developments affecting the derivatives market, including FASB Statement No. 133 (Accounting for Derivatives Instruments and Hedging Activities), developing best practices for credit risk management and disclosure, and the continuing debate on reauthorization of the CFTC. Closing Regulatory Gaps; Developing Best Practices Numerous studies have been commissioned to examine the policy implications of the LTCM crisis for both regulators and market participants. The following is a summary of some of the recommendations in those reports and an overview of recently introduced legislation in the United States. Improving Disclosure and Reporting Financial Statement Disclosure In February 1999, the Basel Committee and IOSCO jointly issued a report entitled Recommendations for Public Disclosure of Trading and Derivatives Activities of Banks and Securities Firms (the Basel/IOSCO Report ). This was followed by the April 1999 Report of the President s Working Group on Financial Markets (the President s Working Group Report ), the June 1999 report of the CRMPG entitled Improving Counterparty Risk Management Practices (the CRMPG Report ) and most recently, on October 5, 1999, the Basel Committee s Recommendations for Public Disclosure of Trading and Derivatives Activities (the Basel Derivatives Disclosure Report ). A common theme of these reports is that timely, forward-looking and reliable public disclosure and reporting by institutions about their derivatives trading activities and exposures will enhance the ability of regulators, counterparties and investors to make informed judgments. For example, the Basel Derivatives Disclosure Report and Basel/IOSCO Report recommend banks and securities firms should: provide financial statement disclosure that gives users a clear picture of the scope and nature of their trading and derivatives activities, how those activities contribute to earnings, the major risks associated with those activities, and their performance in managing those risks; and disclose information generated by their internal risk measurement and management systems concerning their risk exposures and their actual performance in managing those exposures (so that public disclosures are consistent with internal approaches used to measure and manage risk). The difficulty, of course, is determining what information would provide a clear picture of the risks associated with an institution s trading and derivatives activities. Balance sheet leverage alone does not fully reflect the fragility of an institution s portfolio. Off-balance sheet exposure information, such as market, credit and liquidity risks, is also important. The President s Working Group Report suggests using an alternative measurement, such as the ratio of potential gains and losses to net worth. Obviously, an important first step will be settling on a core set of data regarding the risk exposures of institutions, and agreeing on the manner in which off-balance sheet exposure information should be presented and the frequency with which information should be publicly disclosed in financial statements or otherwise. Disclosure to Regulators In addition to financial statement disclosure, several of the reports recommend voluntary disclosure by institutions to their primary regulators. However, the reports emphasize the need to tailor disclosure to the size and nature of the disclosing institution s trading and derivatives activities. As noted in the IOSCO/Basel Report, some institutions are wholesale market makers in a range of cash and derivative instruments, while others primarily use derivatives for their own risk management purposes. The extent of information disclosed about trading and derivatives activities should relate to the importance of these activities in the institution s overall business, earnings and risk profile. With that in mind, the CRMPG Report recommends voluntary disclosure by financial intermediaries to their primary regulators regarding significant counterparty credit and/or market exposure. The report acknowledges the importance of such financial intermediaries and regulators reaching agreement on permissible uses of such information and safeguards against its misuse. The CRMPG Report suggests disclosures be made on a consolidated basis, listing the ten largest exposures of such financial intermediaries in any of four categories: (1) current replacement cost (measured at market), including the benefit of netting agreements (if there is a high degree of confidence such agreements will be legally enforceable), but before consideration of any relevant collateral; -2-

3 (2) current net of collateral exposure, measured as replacement costs minus the market value of collateral, where there is a high degree of confidence about the enforceability of the security interest; (3) current liquidation exposure, measured as net of collateral exposure using estimated liquidation values of contracts and collateral, rather than current market values; and (4) potential exposure of OTC derivatives positions and non-regular way settlement trades (i.e., forward). Disclosure of Market, Credit and Liquidity Risk and Risk Management Controls The reports highlight the need for improved public disclosure by institutions of both qualitative and quantitative information about their trading and derivatives activities, including disclosure regarding market, credit and liquidity risk and risk management controls. Among their recommendations are the following: Risk Management Controls Institutions should provide (to regulators, in financial statements or otherwise) a general overview of their risk management and control structures and processes, including a description of how risks arise and how they are measured and managed. The overview should include, for example, discussion of limit policies for exposures to market and credit risk, and an explanation of how value-at-risk measures are used to manage credit risk. Market and Credit Risk The reports include many recommendations for improving disclosure of market and credit risk. Among other things, institutions are advised to summarize their policies for measuring and managing market and credit risk, and to supplement their quantitative disclosure of market risk with, for example, discussion of the material assumptions and parameters of their internal risk models and their method of aggregating risk, including the extent to which internal models assume less-than-perfect correlation among an institution s various risks. The reports also recommend disclosure of the procedures used for portfolio stress testing and the methodologies used to develop stress testing scenarios. Liquidity Risk - Exposure to Highly Leveraged Institutions Improved disclosure of liquidity risk is viewed as an important mechanism to limit what the President s Working Group Report describes as the potential contagion effect of financial problems originating in one firm and spreading quickly, due to illiquidity problems and the interdependence of highly leveraged financial institutions in the global economy, to infect other firms. As noted in the report, neither SEC rules nor generally accepted accounting principles provide specific guidance for disclosure by companies with material exposures to significantly leveraged financial institutions. The President s Working Group Report proposes closing this regulatory gap by requiring public companies to disclose such exposures in the Management s Discussion and Analysis or Description of Business sections of their periodic disclosure reports on Form 10-K and 10-Q. Proposed Legislation Would Require More Detailed Reporting by Hedge Funds On September 23, 1999 (the first anniversary of the LTCM crisis), Representative Richard Baker (R-LA), chairman of the House Capital Markets Subcommittee, introduced legislation requiring more detailed reporting by hedge funds. The proposed legislation would require hedge funds with capital of more than $3 billion, hedge funds with aggregate assets of $20 billion or more, and certain hedge funds that are leveraged more than 10:1, to file quarterly reports with the Board of Governors of the Federal Reserve System, the Department of the Treasury, the SEC and the CFTC (all of which are members of the President's Working Group on Financial Markets). According to a statement released by Representative Baker, the proposed legislation is intended as a marketoriented approach of enhanced disclosure to enhance market discipline and allow market participants to make better, more informed judgments about the creditworthiness of hedge funds. Critics of the legislation argue it would simply drive hedge funds offshore, and in any event, is not needed. To such critics, investor pressure is the appropriate mechanism for determining the type and frequency of disclosure by hedge funds and other participants in the derivatives market. They point to the growth of Internet websites devoted to hedge fund and derivatives market data including detailed risk analyses as evidence that such legislation is unnecessary. Improving Supervisory Oversight The President s Working Group Report and CRMPG Report include recommendations for improving supervisory oversight of participants in the derivatives market. The President s Working Group Report recommends that banking, securities and futures regulators assume greater responsibility for monitoring and encouraging improvements in the risk management systems of regulated entities. For example, the report recommends that the SEC encourage securities firms to implement and follow prudential practices in their counterparty and credit relationships. Such practices should take into account the scale and complexity of such -3-

4 relationships, the investments they make and meaningful measures of future credit exposure. Both the CRMPG Report and the President s Working Group Report emphasize the responsibility of senior management and boards of directors for monitoring an institution s trading and derivatives activities. This responsibility includes: understanding the strengths and weaknesses of the institution s risk measurement systems, including model risk, liquidity risk, and risk of breakdown of historical correlations among different instruments and markets; and having a realistic assessment of the institution s tolerance for risk, including potential losses in adverse markets. The President s Working Group Report also notes the importance of senior management and boards of directors developing a clear understanding of legal risks, including contract enforceability and uncertainties concerning different legal regimes in different countries, and implementing procedures to ensure that such risks are controlled. Improving Market Practices and Conventions for Management of Counterparty Risk Considerable attention also has been devoted to developing best practices for counterparty risk management. Studies include the President s Working Group Report, the CRMPG Report, the March 1999 review of collateral management practices (the ISDA Collateral Management Report ) issued by the International Swaps and Derivatives Association ( ISDA ) and the March 1999 report issued by the Institute of International Finance, Inc. entitled Report of the Task Force on Risk Assessment. The President s Working Group Report recommends the development and publication, by financial institutions as a group, of improved risk management standards. The report lists a number of areas to be addressed, including: (c) appropriate measurement of leverage and risk; (d) approaches to limit concentration of credit exposures; (e) approaches to limit concentration of exposures to particular markets; (f) fuller integration in risk management practices of the connections between credit and market risks; (g) valuation practices for derivatives and collateral; and (h) procedures for close-out and liquidation of contracts and collateral. The CRMPG Report reviews risk management market practices and conventions in a number of these areas, and sets forth the CRMPG s recommendations for improving them. Among these are recommendations to improve the quality of internal risk management tools for estimating counterparty exposure and risk, and for managing that exposure and risk. The intent is that these improvements lead to improved credit practices, risk analysis and senior management reporting. Among the specific recommendations in the CRMPG Report are the following: Counterparty Exposure and Risk Estimation Prevailing market practice has been to measure credit exposure related to derivatives contracts in terms of current exposure (the current replacement cost of the derivative payable or receivable) and potential exposure (an estimate of the future replacement cost). At present, two measures of potential exposure are used expected exposure and peak exposure (an estimate of the maximum future exposure under stress market conditions). The 1998 market crisis highlighted a number of problems with these traditional exposure measurement techniques. For example, current exposure (net of collateral) estimates of replacement value of contracts or liquidation value of collateral too often did not reflect the impact that the size and illiquidity of the contract (and collateral) would have on market prices if immediate replacement (liquidation) had to occur. Similarly, peak exposure measures generally underestimated the extreme size of stress market moves and the difficulty of receiving collateral in stress market situations. Based on these and other identified weaknesses in current market practice, the CRMPG Report recommended the following improvements: If exposures to a counterparty are large or illiquid, estimates of credit exposure should take into account both current mark-to-market replacement value and estimated liquidation-based replacement value. Such estimates should reflect both the possibility of adverse price movement before the liquidation value of contracts with the counterparty is determined and collateral can be liquidated, and the effect of stressed market conditions on the liquidity characteristics of such contracts and collateral. Institutions should improve their ability to monitor and set limits for various measures of credit exposure, including current replacement cost, current net of collateral exposure, current liquidation exposure and potential exposure. (a) the credit approval process and ongoing monitoring of credit quality, including the availability of information on counterparties and its use in making credit decisions; (b) procedures for estimating potential future credit exposures, including stress testing to gauge exposures in volatile and illiquid markets, and model validation procedures, including backtesting; -4-

5 Market and Credit Risk Stress Testing The CRMPG Report acknowledges there are obstacles to developing and conducting meaningful portfolio stress testing. Not only does stress testing require financial and management resources, but stress testing is unlikely to be successful if the test scenarios are perceived as far-fetched or unrealistic. The CRMPG Report indicates these and other problems associated with stress testing are causing risk managers to seek various improvements in the stress testing process. Risk managers are increasingly relying on customized stress scenarios developed to answer both how much could I lose if and how could I lose more than X questions. In addition, more firms now attempt to develop stress tests that will determine the economic effects of market stress not only on trading portfolios, but also on credit and investment portfolios. Finally, stress tests are being developed to measure counterparty credit exposure under stress conditions because of possible correlations (a) between market and credit risk factors and (b) between a firm s own positions and market factors which would affect the quality of its counterparty exposures. The CRMPG Report recommends stress tests should assess: concentration risk with respect to both a single counterparty and to groups of counterparties; correlation among market risk and credit risk factors; and risk that liquidation of positions may move markets. Valuation and Exposure Management Prevailing market practice for managing counterparty credit risks has not provided incentive for proactive management of such risks. The CRMPG Report notes the need for firms to provide incentives for business managers to enter into profitable transactions by assuming counterparty credit risk, as well as the need to have in place incentives to keep such risks within predetermined limits. To accomplish this, many firms make a credit valuation adjustment to the fair value of their receivables to reflect the credit cost associated with those receivables. The credit valuation adjustment is charged back to the relevant businesses, providing an incentive to choose carefully and price appropriately the risks they assume. Another developing practice noted in the report is the allocation by firms of their economic capital and costs among their respective businesses according to the perceived risk posed by those businesses. Acknowledging the need for firm specific approaches in this area, the CRMPG Report recommended the following to improve valuation and exposure management: development by firms of internal tools and procedures to provide trading business and credit risk managers with incentives to proactively manage counterparty credit risks, including procedures to reflect the cost of credit risks in internal risk or capital charges, procedures for proactive adjustment of counterparty credit limits, and tools for periodic evaluation of the adequacy of credit valuation adjustments to asset carrying values; and development and use by financial intermediaries and large trading counterparties of independent price verification procedures that include fair value adjustments to mid-market values which are assessed dynamically and consistently to account for, among other things, illiquidity characteristics of complex instruments or positions, any substantial specific repayment concerns, and operational and model risks associated with complex or large positions. Improving Documentation Policies and Practices The growth of the Internet and near-instantaneous communications notwithstanding, written documentation remains the most important means to ensure parties to derivatives transactions agree on the terms and conditions of those transactions. Consequently, failure to document a transaction accurately, completely and expeditiously creates risk that a party will attempt to disavow the transaction or dispute the nature of its rights and obligations. In times of market stress and disruption, this documentation risk becomes even more problematic. The CRMPG Report recommends adoption by senior management of written policies to manage documentation risk. The report notes each institution must adopt policies based on its own business and risk profile, and recommends such policies address the following: documentation of privately negotiated OTC transactions, including master agreements and confirmations; documentation risk factors such as counterparty credit quality, jurisdiction and transaction complexity; procedures to identify principals acting through agents; procedures to ensure timely completion of master agreements and confirmations; exception and exemption procedures and reporting; and procedures for tracking violations and backlogs. The report suggests firms adopt a goal to execute new master agreements within 90 days of a transaction, and that pending such execution, firms utilize a long form confirmation that incorporates the industry standard form of master agreement. Parties to privately negotiated OTC transactions should agree in advance as to which party will initiate the confirmation. Confirmations should be sent by the next business day following the trade date. The report recommends a party should, within five business days after the trade date, obtain assurances of agreement with their -5-

6 counterparty on all material terms to the trade and written evidence of their binding agreement. In addition, procedures should be in place to track unexecuted masters, unsent confirmations and unaffirmed trades. Finally, controls should be developed to ensure that senior management receives reports regarding material deviations from documentation policies. Developing Best Practices for Documentation Content Standard forms of documentation for particular segments of the derivatives market have been developed over time by various trade associations. These include the 1996 TBMA Master Repurchase Agreement, PSA/ISMA Global Master Repurchase Agreement, 1992 ISDA Master Agreement, and the 1997 FEOMA Agreement. Following the market disruptions of 1998, these documents were closely scrutinized by the CRMPG and others to identify instances in which: (i) provisions did not function as anticipated; (ii) inconsistent product documentation led to incongruous results ; (iii) provisions generally not included in such documentation proved to be necessary; or (iv) documentation provisions resulted in greater credit or market exposure than intended or anticipated. Based on these reviews, a number of recommendations for improving documentation content emerged, which can be divided into the following three categories: Close-Out and Valuation The CRMPG concluded that close-out and valuation procedures often did not operate as anticipated during the 1998 market crisis. For example, under the ISDA s Market Quotation method (prevalent in the swaps market), parties generally are required to obtain price quotes from five dealers for closed-out transactions. This often proved to be difficult or impossible under the stressed market conditions of the summer and fall of However, market participants were concerned about legal risk involved in reverting to the Loss method (a commercially reasonable and good faith standard) provided for in ISDA documentation as an automatic fallback. In addition, inconsistencies among standard agreements used to document functionally equivalent transactions resulted in different valuations for those transactions, creating documentation basis risk. As an example, the CRMPG Report cited close-outs of ISDA-documented swap transactions based on an asset using the ISDA s Market Quotation method, hedged by TBMA-documented repos on that same asset. Firms were able to value the close-outs of repos quickly and efficiently applying the commercially reasonable, good faith standard of the applicable TBMA form, whereas the swap valuations were sometimes delayed as firms attempted to comply with the Market Quotation method, and in some instances produced an implied value of the underlying asset that was different from that produced in the repo hedge valuation. To address these problems, the CRMPG Report recommends revising documentation to ensure a non-defaulting party has the flexibility to value transactions in a good faith and commercially reasonable manner as is already the case with the TBMA/GMRA and FEOMA standard form agreements and ISDA s Loss methodology. Because a commercially reasonable valuation contemplated by the Loss methodology will often involve use of market quotations, the report also recommends enhancing the effectiveness of a market quotation technique. Among other things, it recommends modifying the Standard ISDA Master Agreement and Schedule to provide that: Potential quotes provided by third parties may include not only price, but also yields, yield curves, volatilities, spreads or other relevant inputs. These inputs should be based on the size of the transaction, the liquidity of the market and other relevant factors. The number of third parties from whom inputs are sought may be reduced. Third parties from whom inputs may be sought may include not only dealers, but also major end-users, third party pricing sources or other relevant sources. Market quotations are but one means to achieve good faith valuations and may be by-passed when, in the judgment of the non-defaulting party, they are unlikely to produce a timely and commercially reasonable result. Proposals to Reduce Credit-Related Legal and Operational Risk Several recommendations for revising standard industry documentation are intended to reduce credit related legal and operational risk. Some of these are relatively straightforward, such as the CRMPG Report recommendation to permit delivery of notice by any commercially reasonable method that is legally sound in the relevant jurisdictions, with the sender having the burden of proof of delivery, and telephone confirmation constituting acceptable proof of delivery. Others, like those relating to payment netting, cross-product obligation and collateral netting and set-off, involve more complex legal and operational issues. Recommendations to facilitate payment and collateral netting and set-off are consistent with what the ISDA s 1999 Collateral Review describes as a desire in the financial services industry to progress towards collateralizing entire counterparty relationships. Payment and collateral netting and set-off are viewed as important mechanisms to reduce risk and to enhance operational efficiency. However, although many standard agreements already permit netting of same day payments, and some firms have modified the TBMA/GMRA annexes to reinforce and implement payment date netting, the widespread use of many productspecific, standard form agreements inhibits cross-product obligation and collateral netting and set-off. Legal and -6-

7 regulatory requirements in a number of jurisdictions including the United States also interfere with the implementation of such mechanisms. The following is a summary of some current proposals to enhance payment netting, cross-product obligation and collateral netting and set-off: Payment Netting The CRMPG Report recommends revising documentation to provide for netting of all amounts (in a single currency) that are payable on the same day. At a minimum, the report notes, documentation should provide for payment netting across like kind transactions. A more effective approach, the report concludes, is to permit payment netting across multiple products using the mechanism of a master agreement or a master-master. Cross-Product Obligation and Collateral Netting Both the CRMPG Report and the ISDA 1999 Collateral Review recommend development of documentation permitting cross-product netting and cross-product collateralization of a wide range of products. The CRMPG Report recommends parties facilitate obligation netting and collateral netting across product lines by using, when possible, multiproduct master agreements, and master-masters. If the parties do not have the ability to net collateral, the report recommends modifying documentation (subject, of course, to applicable law) to permit the secured party to retain excess collateral to secure the pledgor s other obligations to the secured party. Set-off The CRMPG Report recommends several modifications to standard documentation to permit non-defaulting parties to exercise broad rights of set-off. In addition to the right of the non-defaulting party to set off against obligations of the defaulting party, and the right of the non-defaulting secured party to transfer excess collateral to an affiliate to secure obligations of the pledgor to the affiliate, these include set-off rights with respect to the following: obligations of the non-defaulting party (or affiliates of the non-defaulting party) to the defaulting party under other transactions or documentation; collateral or property of the defaulting party held by the non-defaulting party (or affiliates of the nondefaulting party) under other transactions or documentation; obligations of the non-defaulting party to affiliates of the defaulting party under other transactions or documentation; collateral or property of affiliates of the defaulting party held by the non-defaulting party under other transactions or documentation. Contract Termination Provisions The CRMPG Report includes several recommendations aimed at clarifying the ability of parties to terminate agreements in specific circumstances, as follows: Events of Default The report notes that cross-default provisions exist in some, but not all, agreements, giving rise in some circumstances to uncertainty among non-defaulting parties as to their rights against defaulting counterparties. Further complicating matters, some cross-default provisions are limited to counterparty defaults, whereas others also are triggered by defaults of a counterparty s affiliates. The CRMPG Report recommends that cross-default provisions should, at a minimum, include as an event of default any default by the counterparty under any other transaction or agreement with the non-defaulting party or its affiliates. No-Fault Termination Events such as changes in law or regulation, or certain governmental actions, can substantially impair the ability of a party to perform its obligations, or increase the cost of rendering that performance. Some standard agreements (such as the ISDA s standard documentation) include the concept of no-fault termination events. The CRMPG Report recommends including this concept in all standard documentation, and recommends consideration of its corollary of midmarket termination pricing of transactions. Coming Soon Stroock Online, a monthly newsletter about legal issues affecting business on the Internet. Whether your focus is online securities trading, or advertising and promotion on the Internet, or E-commerce generally, we think Stroock Online will be of interest to you. -7-

8 Y2K: Best Practice in the Foreign Exchange Market In October 1999, the Y2K Working Group of the Foreign Exchange Committee of the Federal Reserve Bank of New York issued guidelines reflecting its view of Best Practice to be followed in the foreign exchange market concerning the effect of certain Y2K Events on foreign exchange contracts, options and swaps ( Transactions ). Stroock & Stroock & Lavan LLP served as outside counsel to the Y2K Working Group. The Best Practice reflects commercially reasonable standards for market participants that will provide guidance to regulators and courts considering the actions of participants in the foreign exchange markets. The Release describes the process by which the Y2K Working Group arrived at the Y2K Best Practice, including its review of various scenarios which could arise as a result of the transition into the year The Working Group concluded two scenarios were appropriately the subject of a Best Practice, because they are events generally outside the control of individual market participants, yet ones which will impact many (if not all) participants involved in the settlement of a particular currency. These are: (1) the failure, due to a Y2K Event, of a clearing bank to clear a transaction, and (2) the failure, due to a Y2K Event, of a central bank to transfer its local currency. In general, the Best Practice recommends a short waiting period after a Y2K event occurs that affects a clearing bank or a central bank. If the Y2K event is not remedied within the specified waiting period, the Best Practice states that some or all affected transactions may be liquidated at then current market prices. Parties are, of course, free to mutually agree to take actions other than as specified in the Best Practice. The Best Practice does not apply to a failure to settle as a result of a Y2K problem within the systems of a party to a contract, which would be covered by the non-payment provision of the applicable contract. Parties to transactions will retain the rights and remedies provided in their contractual arrangements. In particular, the Best Practice would not change credit provisions and defaults unrelated to Y2K events. It is anticipated that foreign exchange market participants both inside and outside of the U.S. will use the guidelines. The Best Practice is available at the Foreign Exchange Committee s web site: Maiden Lane New York, NY Tel: (212) Fax: (212) Stroock Capital Markets is a publication of Stroock & Stroock & Lavan LLP Stroock & Stroock & Lavan LLP. All Rights Reserved. Quotation with attribution is permitted. This newsletter offers general information and should not be taken or used as legal advice for specific situations which depend on the evaluation of precise factual circumstances. For further information on the material contained in Stroock Capital Markets or other matters related to Stroock s practice, please contact Richard Fortmann (Editor) (212)