High Tech OTC-Trading, in Chicago’s Annual Capital Markets Conference, Dec1999

1. FEDERAL RESERVE BANK
OF CHICAGO
CAPITAL MARKETS NEWS
December 1999
Chicago's Annual Capital Markets Conference
T
he calendar rolled over on
another annual Capital Markets
Conference' sponsored by the
Capital Markets Group at the
Federal Reserve Bank of Chicago.
Representatives from a variety of global
supervisory and regulatory agencies as
well as banking and financial industry
participants explored old and new topics
in capital and financial markets supervi-
sion. In addition to the now regular
agenda item of "the year in review", the
conference featured discussions on credit
risk models and their utility within Basel's
new Capital Adequacy Framework2
, ses-
sions related to operational risk, a look at
the newest developments in energy
derivatives, and new electronic trading
systems for "over-the-counter" (OTC)
derivative products.
Global Supervision
U.S. supervisors began "the year in
review" by citing some ofthe supervisory
and regulatory hurdles they face in the
United States' . The financial sector con-
tinues to present new challenges, most
notably merger and acquisition assimila-
tion and integration of cultures. E-com-
merce, once thought to be only on the
horizon, is speeding forward .
Concentration and systemic risk issues
continue to crop up, keeping supervisors
on edge trying to anticipate the next
occurrence. Debt and equity markets,
pausing after 1997 and 1998', continue
"exuberantly" expanding into products
in the high yield, equity, and credit deriv-
ative arenas. The Gramm-Leach-Bliley
Act of 1999 5
is expected to have a major
impact on cross-industry mergers a~d
could potentially reconfigure financial
supervision and regulation in the U.S.,
requiring all regulators to adapt to the
changing financial sector landscape.
In exploring the risk profile of the
banking industry, the OCC's• review of
the U.S. banking picture pondered the
ever-present question; "Can ROE above
15% be sustained?" Recent financial data
analysis indicates that credit risk is on the
rise; additionally, default risk is rising sig-
nificantly although from a low base.
Asset/liability management is strained as
bank deposits continue to decline and
incremental funding is obtained via pro-
fessional markets. On-hand liquidity is
minimized, asset maturities are lengthen-
ing, and price sensitivity ofassets is rising,
making asset/liability management
increasingly important in the current rate
environment. Unused loan commitments
continue to balloon off balance sheet
ratios as banks reach for non-interest
income. Finally; structured finance, for all
its benefits, will require its own valuation
and risk mitigation techniques, and is sure
to provide new challenges for supervisors
and regulators.
The global financial sector faces simi-
lar challenges. International regulators
and supervisors' landscapes are driven by
technological innovation, financial sector
consolidation, and deregulation. The
changing financial sector has spawned
new supervisory and regulatory struc-
tures. The U.K. consolidated nine of its
regulators into a single financial regulator,
the Financial Services Authority (FSN,
in June of 1998. Singapore has taken a
new approach toward financial sector
reforms driven by the above themes.
Their initiative will encompass liberaliza-
tion of commercial banking along with
enhanced bank supervision, strengthen-
ing the competitiveness of the securities
industry and the futures industry as well
as the fund management industry and the
insurance industry. The Monetary
Authority of Singapore (MAS) meets its
supervisory challenges through a contin-
ued risk-focused approach with emphasis
on management quality, knowledge
expertise, and risk infrastructure.
Credit, Credit, and More Credit
Credit, the biggest component of risk
in most banking enterprises, continues to
be a source ofmuch discussion and quan-
titative investigation. Work has pro-
gressed from developing credit risk mod-
els to a dialogue on using internal credit
risk models for capital allocation to the
development of a broad credit derivatives
market. Making capital more credit risk
sensitive has advanced a review of the
1988 Basel Accord'. Capital allocation for
market risk and interest rate risk in the
banking book has made enormous strides
Capital Markets News is published quarterly by the Capital Markets Group of the
Supervision and Regulation Department. Its primary intention is to further
examiners' understanding of topical issues pertaining to derivatives and other
capital markets subjects. Articles are not intended as exhaustive commentaries of
the subject matter; rather, they are summaries meant to convey a basic under-
standing of the issue and to serve as a foundation for further analysis. Readers
who would like further information on any ofthe articles may contact the author
directly. For additional copies of back issues of the newsletter, please contact Joe
Cilia at (312) 322-2368.
Any opinions expressed are the authors' alone and do not necessarily reflect
the views of the Federal Reserve Bank ofChicago or the Federal Reserve System.

2. CAPITAL MARKETS NEWS
Chicago's Annual Capital Markets Conference continued
since the issuance of the 1998 Accord; it
follows that the next task would be to
take another piece offinancial sector risk,
credit risk, and strengthen its link to cap-
ital allocation. The heightened awareness
of the inadequacy of current regulatory
capital regimes and the recent trends
toward a more quantitative assessment of
risk through integrated portfolio mea-
surement has launched a focus on internal
credit risk models and capital allocation.
Basel realizes the need to reform its
1998 Accord because of the distorted
risk management incentive in the
current regulatory capital allocation.
Recognizing that regulatory capital
imposes financial costs and influences
behavior, and recognizing that capital
arbitrage exists due to gaps between eco-
nomic and regulatory measures ofcapital,
the Committee" felt that the current situ-
ation risks the credibility of the Accord.
The reform effort rest on three pillars; an
overriding goal to make regulatory capi-
tal requirements more risk sensitive,
supervision toward risk-focused assess-
ments of capital adequacy, and market
discipline toward better risk disclosures.
David Jones from the Board of
Governors' staff introduced the concept
of an internal ratings-based bucketing
(IRB) approach toward capital allocation
for credit risk. This is essentially a scheme
to link an economically meaningful con-
cept of credit risk to the bank's internal
risk assessments, and then to link this
measure to capital allocation.
As bank regulators consider develop-
ing a new capital accord based on bank
internal risk ratings, they face a tradeoff
between simplicity and accuracy. Jon
Frye, from the Chicago Reserve Bank's
Capital Markets Group, offered a para-
digm that began with the simplest
approach based on expected loss, and
compared it to more complicated alter-
natives that take into account various
forms of diversity within an internal risk
rating. These include expected loss given
default, the volatility ofloss given default,
and correlation. His model (see sidebar)
highlights a particular correlation that is
often overlooked: the correlation
between a firm's default and the collateral
that it posts. Surprisingly, when this cor-
relation takes on a reasonable value, the
importance ofexpected loss given default
becomes minimal. This strengthens the
case for regulatory adoption of a capital
standard based on expected loss.
Michael Ong of ABN AMRO
9
con-
Alternative Capital Measuresfor Credit
tinued the discussion of linking capital
allocation to credit model risk measure-
ment. Mr. Ong took the audience
through the components of a sound
credit risk model including default and
Regulators obligate banks to hold costly capital to protect against large losses. The current
bank capital accord requires that 8% of capital be set aside irrespective of the credit quality
underlying a bank exposure, thus making it expensivefor banks to maintain good quality cred-
its and inexpensivefor banks to maintain poor quality credits. The current rule contains a per-
verse incentive: it encourages banks to degrade their own soundness. A more risk-sensitive alter-
.native, favored by the Chicago Federal Reserve Bank, allocates capital according to the expected
loss (EL) of bank exposures; exposure to lower-rated credits would require greater capital than
exposure to higher-rated credits. Making the capital requirement more risk-sensitive would
reduce, and ideally remove, the perverse incentive provided by the current rule. In addition to
EL, several other characteristics might also have an effect on desired capital, such as expected
loss given default (ELGD), the volatility of loss given default, the correlation between a given
obligor and other obligors in the portfolio, maturity, the nature and amount ofcollateral, as well
as otherfeatures ofthe exposure facility. Any subset ofthese characteristics might be employed
within a model, more complicated than one based only on EL, to derive a capital requirement.
A Monte Carlo simulation can provide insight into which characteristics matter the mostfor
calculating capital. First, the model uses only EL information to imply capital factors for seven
EL classes. Next it adds a characteristic, assuming that the characteristic takes on a range of
values within the EL class. It then becomes a simple matter to observe the degree ofdiversity in·
the resulting capital factors: if a rule that employs a given characteristic produces results similar
to a simpler rule that ignores that characteristic, there would be little reason to adopt the more
complicated alternative. The model also highlights the correlation between the default of afirm
and the value of the collateral that it posts. Bankers observe this correlation most often when
lending to real estate developers. In other words, developers are more likely to default when the
collateral they post suffers depreciation. Bankers with longer memories see this as ageneral phe-
nomenon: the years with the highest defaults tend to be years oflow recovery, and the years with
the lowest recovery tend to be years of high default. This correlation can cause computational
difficulties for a credit model; models such as CreditMetrics and CreditRisk+ assume the cor-
relation is zero, a convenient assumption whic/, comes at the expense of distorting some impor-
tant conclusions.
Tlie results of tlie Monte Carlo model show that, in addition to knowing EL, the most
important information obtained is the degree ofcorrelation between obligors. Unfortunately, cor-
relation estimates have the greatest error bars around them and are the most d!fficult for exam-
iners to validate. Also, the pair-wise nature ofcorrelation does not lend itself to a rule tliat ca11
be summarized in a set oftables. Correlation effects are best captured within afull credit model
run by an individual bank. The primary importance ofcorrelation guarantees tliat the greatest
single improvement to an EL based rule would come only when each bank can fully model the
correlation effects within its own porifolio. Of less importance than correlation is the volatility
of collateral value. This is basically a measure of collateral quality rather than quantity; cash
collateral has the lowest volatility. As a characteristic of the individual facility rather than ofa
pair offacilities, volatility would be much easier than correlation to include in a capital rule. Of
almost no significance is the quantity ofcollateral. While this result may seem counterintuitive
atfirst, within an EL class one would find both uncollateralized loans to better credits and well
collateralized loans to poorer credits. The former loans have only one risk, that ofagreater titan
average number of defaults; the latter loans have two types of risk, default risk and recovery
risk. Ifthese two risks were uncorrelated, the latter loans would be less risky than the former.
2

3. Chicago's Annual Capital Markets Conference continued
However, the existence ofco"elation between default and recovery means that both risks will
tend to be experienced in the same circumstances. With co"elation set to reasonable levels, the
combination ofthe two risks amounts to about the same overall risk as the uncollateralized loans
to better credits. Models that assume zero correlation make the opposite conclusion and point to
the needfor expected loss given default information. Under a more realistic assumption for cor-
relation, the importance ofELGD becomes minimal.
These results, reflecting only a single model specification and a single set ofparameter val-
ues against which the alternatives are judged, are preliminary and need to be confirmed through
more analysis. However, ifconfirmed, the results have important implications for the near-term
evolution ofpolicy towards bank capital requirements. First, a capital rule based on expected
loss appears to go a long way toward reversing the current incentivefor banks to reduce sound-
ness through regulatory arbitrage or other means. Second, the most important improvement to
an EL based rule relies on co"elation; this improvement must waitfor the eventual adoption of
bank internal capital models. Third, very little would be gained by requiring banks to revamp
their internal risk rating systems to account for ELGD, especially if that requirement were to
delay the long-overdue reform ofthe 1988 capital accord.
- Jon Frye, Ph.D.
credit quality correlation, risk contribu-
tion, and credit concentration. After a
briefsynopsis ofthe modeling process, he
discussed the current analyses and short-
falls of the various approaches in use.
Some final thoughts emerged from his
presentation: Modeling efforts create the
discipline of looking at credit risk from
different perspectives and force the inte-
gration of credit risk and market risk.
Further, the credit risk modeling process
encourages the marking to market of the
loan portfolio and the use of multi-year
analysis horizons. In addition, Mr. Ong
posed some questions to ponder:
• Why is there not more focus on issues
of concentration and diversification? and
• Who is looking at consumer loans and
commercial real estate?"
Someone, in fact, was looking at con-
centration risk in bank loan portfolios, as
demonstrated by Banco de Mexico's
Javier Marquez Diez-Canedo'0
• While
formal work on credit concentration risk
has focused mainly on applying modern
portfolio theory to portfolios of traded
fixed income assets, no comparable coun-
terpart has emerged in dealing with
everyday bank loans, for which informa-
tion compatible with portfolio theory is
difficult to obtain. Mr. Marquez proposes
that the "Herfindahl-Hirshman" index
emerge as a measure of concentration,
and explores a direct relation between
this index and the "single obligor limit".
His presentation walked the audience
through the details ofan elegant, mathe-
matically driven process for modeling
concentration risk, establishing a rela-
tionship between a concentration index
based on the "Herfindahl-Hirshman"
index and applying this tool to ensure
capital adequacy for the risk structure of
the portfolio.
Rounding out the credit risk picture,
Rick Nason of the Bank of Montreal
provided a succinct presentation on credit
derivatives. The market for credit deriva-
tives, which began in 1992, has exploded
to approximately $199 billion." today;
users include institutional investors, asset
managers, bank and financial institutions,
and corporations. The strategic objective
of firms using credit derivatives revolves
around a new sensitively to optimize the
loan portfolio within the constraints of
the firm's origination strategy and regula-
tory capital. Mr. Nason provided a
detailed explanation of both swap and
securitization structures. The advantages
of credit derivatives are, of course,
quickly lauded by the industry; they
extend the benefits of derivatives to a
new asset class and create a new market
class - pure credit. It will be the ongoing
job of financial sector supervisors to
unearth the attendant risks.
3
Operational Risk --"The New Frontier"
Changes in new business environment
complexities, technology product com-
plexity, and the propensity towards litiga-
tion have sensitized the financial industry
to operational losses. Organizations are
now experiencing the key phases that
have accompanied other risk modeling
issues: recognition, self-assessment, sys-
tems development and, finally, some type
of insurance. Michael Haubenstock of
PriceWaterhouseCoopers (PWC) pro-
vided a perspective on "Measuring and
Managing Operational Risk" through the
concept ofOpVar, their model for opera-
tional risk. PWC defines operational risk
as "the risk of direct or indirect loss
resulting from inadequate or failed inter-
nal processes, people and systems, or from
external events. Measurement can
include direct losses and forgone income.
Development of an operational risk
framework stemmed from a desire to cre-
ate management awareness, to forge a
link from business controls to perfor-
mance, and to rationalize insurance pro-
grams. The discussion introduced several
approaches to operational risk measure-
ment including peer comparison, sce-
nario analysis, total capital and capital
allocation, earnings volatility (EaR), and
a statistical/actuarial (VaR) approach.
OpVaR models use hard data on actual
losses experience by similar institutions
and apply a "bottom-up" approach for
quantifying risk at the business unit and
firm level. Results are based on industry-
specific data by business line, and the
model is flexible and can be customized
to any institution.
Energy Risk
Jeffrey Roark ofSouthern Energy pre-
sented an overview of the characteristics
of the electric utility industry.
Historically, utilities in the U. S. operated
under the regulatory compact which
maintained exclusive territory, allowed
for central planning with appropriate reli-
ability, and regulated return on and of
invested capital. Rapid growth in the
1950s and 1960's produced overcapacity.
Quixotically, due to the regulatory influ-
ence, retail prices rose with the surplus
instead offalling. The business climate in
the U.S. and globally made industries

4. -----·CA p ITAL MARKETS N E W S - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Chicago's Annual Capital Markets Conference continued
acutely aware ofthe geographic price dif-
ferences within the U.S. Competitive
market creation, vertical disintegration,
horizontal reintegration, convergence,
wholesale liquidity and volatility created
competitive electricity markets world-
wide in the 1990s.
Understanding the changes in the
energy industry early in the 1990s,
Dragana Pilipovic of SAVA Risk
Management Corporation began explor-
ing the creation ofa model to capture the
complex reality of deregulated price
behavior present in today's electricity and
energy markets. SAVA's approach looked
at how energy prices behave and how
they differ from money markets. SAVA's
tools represent a fresh departure from the
traditional "structure" models ofthe reg-
ulated electricity world, and offer a mark-
to market framework for valuing price
and risk according to market prices.
Their "Price-Risk" pyramid represents
the proper process ofvaluing and manag-
ing energy derivatives; forward price and
volatility analyses form the keystones of
this pyramid. Ms. Pilipovic took the par-
ticipants through her methodologies of
building a forward price curve and a vari-
ety of volatility methodologies. Option
valuation forms the middle layer of the
SAVA "Price-Risk" pyramid; options
and optionally are the linchpin of the
pyramid. Risk management can only be
meaningful once all of these layers are in
place Ms. Pilipovic discussed the standard
options within the energy markets and
her firm's approach to their valuation. In
so doing, she demonstrated the pricing of
a variety of energy related options prod-
ucts and left the participants with an in-
depth introduction to the complexities of
a new discipline.
High Tech OTC Trading
Two web-based trading systems are
being developed in response to market
demand for a centralized marketplace in
OTC derivative instruments.
Blackbird™ , developed by Derivatives
Net, Inc. which was founded in 1996, has
just gone live this year. Creditex, for
credit derivatives, is a new effort and the
trading system is still under construction.
Creditex' anticipated launch date is the
first quarter 2000. Both systems offer an
alternative to a broker-based environ-
ment where transactions are done over
the phone, and promise more trans-
parency and liquidity. Blackbird™, is the
world's first intranet-based electronic
negotiation system for inter-dealer trans-
actions in swaps and other OTC deriva-
tives. The system has been developed as a
negotiation platform for a wide range of
instruments. The initial release of
Blackbird™ includes interest rate swaps,
FRAs, and switches in most major cur-
rencies. Blackbird™ believes that the
benefits of electronic execution are over-
whelming, citing such advantages as
greater transparency, better anonymity,
reduced operational risk, lower process-
ing costs, access to historical transaction
data, and better control of credit lines.
The founders are careful to point out that
what the system does not attempt to do is
change the way dealers transact or oper-
ate in the OTC derivative markets, nor
does Blackbird™ clear transactions, pro-
vide credit support or change the way
settlement occurs. Blackbird™ is also
careful not to represent itselfas a replace-
ment to exchange traded derivatives.
What Blackbird™ is doing for its prod-
ucts, Creditex is attempting to do for
credit derivatives. Believing that market
4
growth and maturity in credit deri· .
. . . vanves
1s constrained by limited outlets for risk
transfer, lack ofliquidity, lack ofstandard-
ization, and data transparency, Creditex
intends to create a web-based electronic
platform for the purpose of transacting
trades in credit derivatives.
- Donna Zagorski and Gloria Ikosi
I
The annual Capital Markets Group Conference
was held November 1-5, 1999, at the Federal Reserve
Bank ofChicago
2
A New Capital Adequacy Framework is a consul-
tative paper by the Basel Committee on Banking
Supervision that was issued inJune 1999. The paper is
out for comment until March 31, 2000.
3
James Embersit, Manager Capital Markets,
Division of Banking Supervision & Regulation,
Board of Governors of the Federal Reserve System.
4
The Asian crisis in 1997 and the Russian debt
default crisis in 1998.
s
The bill, which passed both houses ofthe U. S.
Congress on November 4, 1999, repeals the Glass-
Stegall Act of 1933 that separated commercial and
investment banking and eliminates the Bank Holding
Company Act of 1956's prohibition on insurance
underwriting activities. For an in-depth cliscussion,
see Dale Klein's article in this edition of Capital
Markets News.
6
Michael Bronson, Office of the Controller of
the furrency.
International Convergence ofCapital Measurement
and Capital Standards, Basel Committee on Banking
Sup~rvision (July 1988).
9
The Basel Committee on Banking Supervision. .
Michael Ong, Senior Vice President and Head,
Ent~~prise Risk Management, ABN AMRO Bank.
Concentration Risk in Bank Loan Portfolio's:
Measurement, Single Obligor Limits, and Capital
Adequacy, Javier Marquez Diez-Canedo, Calixto
Lop~
1
z Castanon, Banco de Mexico, November 1999.
As reported in the 1999 OCC call reports.

5. Financial Modernization -A Summary of the Gramm-Leach-Bliley Act of 19991
O
n Friday, November 12, 1999,
President Clinton signed into
law the Gramm-Leach-Bliley
Act of 1999 that repeals the Depression-
era laws governing the U.S. financial sys-
tem. Prior to the President's action, the
bill cleared the Senate and House by sub-
stantial margins, 90-8 and 362-57 respec-
tively, on November 4, 1999. In brief,
Gramm-Leach-Billey is organized as fol-
lows: Titles I, II & III apply to organiza-
tional and regulatory structure issues,
Title IV limits unitary thr_ift holding
companies, Title V creates privacy pro-
tections, Title VI modernizes the Federal
Home Loan Bank System, and Title VII
address other issues. This article discusses
the bill, its components, and its implica-
tions on the financial industry landscape.
Title I - Facilitating Ajftliation Among
Banks, Securities Firms, And Insurance
Companies
The main purpose of this initiative
was to repeal the provisions of the 1933
Glass-Steagall Act and the 1956 Bank
Holding Company Act that prohibit the
affiliation of banking, securities and
insurance firms. The Gramm-Leach-
Bliley Act of 1999 removes these barriers
in various ways.
Bank holding companies will be
allowed to enter the previously prohib-
ited lines of business after qualifying as a
financial holding company (FHC). FHCs
will be allowed to engage in approved
financial activities including insurance
and securities underwriting and agency
activities, merchant banking', and insur-
ance company portfolio investment
activities. To qualify as a financial holding
company all insured depository sub-
sidiaries must have attained at least a "sat-
isfactory" CRA rating at the time of
application. The holding company will
not be allowed to make new non-bank-
ing acquisitions or engage in new finan-
cial activities if even one insured sub-
sidiary falls below a CRA rating of
"satisfactory."
Gramm-Leach-Bliley also establishes
guidelines under which national banks
may enter new financial activities, includ-
ing securities underwriting, through a
financial subsidiary.' {National bank sub-
sidiaries will not be permitted to engage
in insurance underwriting, real estate
investment and development or merchant
banking.') The legislation also allows
banks to directly deal in, underwrite, and
purchase municipal bonds (including rev-
enue bonds) for their own accounts.
National banks must meet the following
requirements in order to engage in these
new activities:
• The bank and all of its insured depos-
itory institution affiliates must be well
capitalized and well managed after the
bank's investment in its financial sub-
sidiaries is deducted from the bank's cap-
ital. A bank may not invest more than
45% of its assets, or $50 billion,
whichever is less, in financial subsidiaries.
• Banks' loans to and investments in its
subsidiaries would be limited to no more
than 20% ofthe bank's capital.
• The bank and all depository affiliates
must have at least a "satisfactory" CRA
rating.
• The following ratings-based criteria
must be met:
• Ifthe bank is among the 50 largest
insured U.S. banks (in terms of assets), it
must have at least one issue oflong-term,
unsecured debt outstanding that is rated
within the top three rating categories of
an independent rating agency.
• Ifthe bank is among the 100 largest
insured U.S. banks (but not the 50 largest)
the bank must meet either the rating
requirement noted above or a comparable
test jointly agreed upon by the Federal
Reserve and the Treasury.
• The above does not apply to
national banks that are not among the
100 largest insured U.S. banks; that is,
these institutions will not be able to
engage in new financial activities.
Gramm-Leach-Bliley preempts State
law, with certain exceptions, and puts
national and State chartered banks on a
more equal footing in exercising
expanded powers. State banks will have
to meet criteria similar to a national bank
before they would be able to establish
new financial subsidiaries. The bill also
mandates that all individuals engaged in
insurance activities be appropriately
licensed as required by State law.
The legislation provides for the
streamlining of bank holding company
supervision. The responsibility of the
5
Federal Reserve {Board) will be extended
to the regulation of FHC organizations.
In the Board's execution of its
supervisory activities, it will accept
reports from other regulatory agencies to
the fullest extent possible. The Board
may examine functionally regulated sub-
sidiaries when they pose significant risk
to affiliated banks and thrifts, when exist-
ing reports do not adequately depict risk
monitoring systems, or where there is
sufficient reason to believe that the sub-
sidiary is not in compliance with Federal
law. Gramm-Leach-Bliley also contains
provisions under which FHCs and banks
may enter additional activities, and the
Federal Reserve and Treasury must
jointly approve these new activities.
Title II - Functional Regulation
Gramm-Leach-Bliley eliminates the
broad broker-dealer exemption currently
given to banks, with a few exemptions.
This generally means that banks provid-
ing securities related products would be
subject to the same regulation as other
providers. The Securities and Exchange
Commission has primary regulatory
authority over these activities, however,
banks may continue to be participants in
derivative activities involving credit and
equity swaps. The SEC and Board share
"rulemaking and resolution" powers
regarding the treatment of new products
that contain both banking and securities
elements. The SEC is tasked with deter-
mining the treatment of any new hybrid
product created by the industry. Prior to
commencing the rulemaking process for
any product, the SEC is required to seek
agreement with the Federal Reserve
regarding broker-dealer registration
requirements.
In drafting the bill's language and
Conference Report, lawmakers were
careful to ensure that the SEC's oversight
will not disturb traditional bank trust
activities. To that end, the bill exempts
banks that execute transactions in a
trustee or fiduciary capacity from regis-
tration under Federal security laws. Two
criteria that must be met to qualify for
this exemption: The bank must be chiefly
compensated for these services by means
of administration or annual fees', a per-
centage of assets under management per

6. CAPITAL MARKETS N E W S - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Financial Modernization continued
order processing fees', or any combination
thereof. Additionally, the institution may
not publicly solicit brokerage business.
Title III - Insurance
The legislation preserves and expands
the primary jurisdiction of State insur-
ance regulators over insurance activities,
including serving as the functional regu-
lator of insurance activities at national
banks. Federal regulators are tasked with
establishing consumer protection rules
for the sale of insurance by national
banks. They are to ensure, for instance,
that customers are not mislead into
believing such insurance products are
federally insured, and are not coerced
into buying other bank products.
Title IV- Unitary Savings And Loan
Holding Companies
Lawmakers effectively closed the
banking-commerce loophole created by
the Unitary Thrift Charter. Existing uni-
tary holding companies may only be sold
to financial companies and de novo thrifts
are prohibited from engaging in or affili-
ating with non-financial companies.
Title V - Privacy
Gramm-Leach-Bliley contains many
provisions regarding the privacy of con-
sumer financial information. Federal and
state regulators are directed to establish
standards for ensuring security and confi-
dentiality of consumers' personal infor-
mation. State laws may provide greater
privacy protection above and beyond fed-
eral laws. The bill places several require-
ments on financial institutions: All finan-
cial firms are barred from disclosing
account numbers or access codes to unaf-
filiated third parties for direct marketing
purposes, and credit card and transaction
account numbers are also not to be dis-
closed to unaffiliated third parties.
Additionally, financial institutions are
required to make their policies on privacy
and disclosure of personal financial infor-
mation known to all customers on an
annual basis. Customers are given the
right to "opt-out" ofinformation sharing
arrangements with unaffiliated third par-
ties, except when the arrangement is
related to the processing of customer
transactions.
Title VI - Federal Home Loan Bank
System Modernization
Banks with assets below $500 million
may use long-term advances from the
FHLB for funding loans to small busi-
nesses, small farms and small agri-busi-
nesses. Eligible collateral for these
advances includes loans secured for such
advances and securities representing a
whole interest in these loans. The bill also
sets terms and compensation policies for
Federal Home Loan Bank directors and
establishes a new capital structure for the
Home Loan System Banks.
Title VII - Other Provisions
The Other Provisions section of
Gramm-Leach-Bliley contains several
modifications to community reinvest-
ment. Lawmakers were very clear in their
language to stipulate that nothing in the
bill would repeal any part of the
Community Reinvestment Act. The
bill's provisions require community
groups to disclose certain agreements
with banks and how the agreements are
implemented. Additionally, small banks
($250 million or less in assets) will be sub-
ject to CRA reviews every five years
rather than 18 months if they have an
"outstanding" rating. The section also
addresses other issues including ATM fee
disclosure requirements, studies to deter-
mine the impact of many modernization
provisions, and independent audits of
Federal Reserve Banks and the Board of
Governors
-Dale Klein
6
I
This article contains information from legisla-
tion and press releases.
2
Merchant banking is defined as the privately
negotiated purchase ofequity instruments by a finan-
cial institution with the objective ofselling the instru-
ments at the end of an investment horizon, typically
measured in years.
' Financial subsidiaries are defined as any sub-
sidiary other than those solely engaged in previously
approved activities.
' In five years national bank subsidiaries may be
able to engage in merchant banking activities if both
the Fed and the Treasury agree to allow it.
' Administration or annual fees may be payable on
a periodic basis (i.e. monthly or quarterly).
' Processing fees may either be flat or capped and
may not exceed the cost ofexecuting transactions on
behalfofcustomers.

7. I
J
I
The Importance of Capturing Volatility Skew...
and the methods by which it is estimatea
W
hen a financial institution
revalues its options trading
books each day the middle
office obtains, from brokers, quotes for
implied volatility which are input into a
pricing model to generate current market
values for each option. Usually the quotes
are for at-the-money (ATM) option for
each expiry. Banks do not routinely
obtain the implied volatilities for in-the-
mo ney (ITM) or out-of-the-money
(OTM) options, as the prices of these
less-liquid securities may vary from one
broker to another or are not quoted.
Consequently, the ATM volatility is often
used to revalue all options (of the same
expiry), regardless of whether the option
is ATM, ITM, or OTM. Under Black-
Scholes option pricing theory, options of
all strikes should trade at the same volatil-
ity since they are all based on the same
underlying instrument. In reality, how-
ever, when implied volatilities for OTM
and ITM options are available, they are
often quite different than those for ATM
options. As a result, using ATM volatili-
ties to revalue options across all strikes is
likely to rnisprice the options book.
Volatility Skew
Implied volatilities for OTM and ITM
strikes tend to be different than that for
the ATM strike. This phenomenon is
known as the volatility skew, and has been
observed across the equity, interest rate,
foreign exchange, and commodity deriv-
atives markets. The following graphs'
depict this phenomenon for exchange
traded three-month December 1999
option contracts as of October 19, 1999,
on Eurodollar (ED) and Japanese Yen
OPY) futures, respectively. The dotted
line reflects the ATM volatility applied
across all strikes. Notice the pronounced
implied volatility skews for these markets.
A common theory as to why skews
occur relates to the imbalances in supply
ofand demand for options having differ-
ent strikes. Strikes that are in higher
demand will likely trade at a higher
volatility (price).
JPY Dec 99 Volatility Skew
22 - - - - - - - - - - -n
21
20 ·
j 19
i, 18
j ::a.
.§ 15 .
14
13 +.--,-~~~~~~~~~-rrr1
"' ,;, ,l .,, ~., -~ -~
17 -
16
15
j 14
1l
Jl 13
J 12
11
Strike
ED Dec 99 Volatility Skew
10-1---~- ~~-~--------<
<G:fr ... i" "' .,.~~ "',fJ
Strike
_;::,
• • • ATM~
"'
_;::,
•••ATMlmpled
"'
As the graphs above depict, in some mar-
kets, such as interest rate options, there
are a preponderance of hedgers who buy
downside puts and sell upside calls, result-
ing in a downward sloping skew. In other
markets, many of them currencies, there
is no directional bias. There is both a pos-
itive upside call skew and a positive
downside put_skew, resulting in an
implied volatility curve shaped like a
"smile".2
Other shapes such as frowns can
also occur. Implied volatility is not static;
the overall shape, slope, and curvature of
the skew (as well as term structure)
change over time in response to fluctua-
tions in demand, seasonality', or other
market forces.
Impact ofNot Incorporating Skew
When a financial institution uses an
ATM volatility to revalue options that are
OTM or ITM, the resultant market value
ofthat option may not be correct. To the
extent that the majority ofoptions within
the trading book were OTM, this book
would be materially mispriced. The daily
mispricing ofan options book has poten-
tial risk management and regulatory cap-
ital implications. The market values of
options are used to calculate daily market
risk statistics such as Value at Risk (VaR),
which, for some institutions, are used to
7
determine the supervisory capital
charge for market risk.• The undervalua-
tion of an options book could understate
the VaR metric for this book. To the
extent that option-based books predomi-
nate the trading activities of a bank, an
understated global VaR statistic could
result in an underallocation of capital for
market risk. Therefore, examiners should
ensure that options books are being reval-
ued accurately.'
Methods Used to Capture Skew
There are many different ways to cap-
ture implied volatility skew during the
revaluation process, and the method
implemented typically depends on the
type and complexity ofthe option and the
ease with which the methodology may be
implemented. The following is an
overview of some of the more common
skew methodologies, and the benefits and
disadvantages of each. The first three are
"mark-to-market" methodologies, while
the last two represent "mark-to-model"
approaches. It should be noted that it is not
the purpose ofthis article to advocate any
one particular method, as no method is
perfect. The method implemented should
be well understood by bank management,
be appropriate for the product traded, and
not introduce new sources ofrisk.
Formulaic Adjustment
This method encompasses a separate cal-
culation within the revaluation process.
The ATM implied volatilities are
obtained from brokers as usual, but these
volatilities are manually adjusted accord-
ing to a predetermined formula to repli-
cate the market skew. For example, for
those strikes that are greater than the
ATM strike, a downward adjustment of
50 basis points in volatility is made for
every 50 basis point increase in the
strike. For those strikes less than the
ATM strikes, an upward adjustment of
75 basis points in volatility is made for
every 50 basis point decrease in strike.
There is a' great deal offlexibility in this
method as the adjustment can vary by
any amount. Moreover, this method can
be used for options in any market (inter-
est rates, equities, etc).

8. CAPITAL MARKETS N E W S - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
The Importance of Capturing Volatility Skew... continued
Interpolation and Extrapolation of
Implied Volatility
This method involves obtaining from
brokers several implied volatilities for
strikes that are ITM and OTM, in addi-
tion to the ATM volatilities, and then
using linear interpolation and extrapola-
tion to identify the curve of remaining
implied volatility points.6
This commonly
used method can be used for options in
any market. However, the effectiveness of
this method depends on how deep the
ITM and OTM volatilities are, how many
points are obtained, and how accurate the
broker quotes are. Obviously, the greater
the number ofpoints used in the interpo-
lation process, as well as how well spaced
and deep away from the money the actual
volatility points are, the better the
approximation of the skew will be.
Obtaining reliable points from brokers for
away-from-the-money strikes is no easy
task due to the liquidity issues noted ear-
lier. However, a0
reasonable approach is to
take an average ofbroker quotes for a par-
ticular strike to derive a market consensus
of the implied volatility for those strikes
ITMandOTM.
Implied Volatility Trees 7
This numerical approach, developed by
E. Derman and I. Kani in 1994 8, involves
building a recombining tree using, as
inputs, the actual implied volatilities ofall
the traded options across strike and
expiry of a particular underlying. Since
this method incorporates the actual skew
and term structure of volatility directly
into the tree, it should be able to price any
option on the underlying. However, the
disadvantages of this method are not
insignificant. Implied volatility tree con-
struction is a very difficult, labor intensive
process, requiring a significant number of
implied volatility quotes across strike and
tenor to be effective. This is why this
method is best used for equity options,
which are generally more often quoted
than the options in other markets. Since
there typically are more nodes on a tree
than there are market quotes for any
given underlying (including equities), the
tree will likely have empty nodes that
need market prices. To deal with this, the
implied volatilities of neighboring nodes
are interpolated to populate the empty
nodes of the tree. By doing so, however,
the interpolated value for a node may not
satisfy the no-arbitrage requirement,
which necessitates that the resultant tran-
sitional probability attributable to an
interpolated node range between O and
1.0. To correct these "bad probabilities",
a new option value that satisfies this
requirement is found to replace the bad
node within the tree.9
This tweaking is
performed node after node until the tree
is complete. One should remember that
these "plugged" values do not reflect the
best possible market prices; consequently,
trees having a high concentration of
plugged nodes may not accurately revalue
options. Also, the implied volatility tree
may not price instruments dependent on
volatility as observed at a future time such
as forward start options and compound
options.10
GARCH Models
One of the assumptions of the Black-
Scholes model is that volatility of the
underlying asset is constant. In realty,
volatility is not constant and fluctuates
randomly through time. Many practi-
tioners use a quantitative technique called
GARCH (generalized auto-regressive
conditional heteroscedasticity) to model
this random (stochastic) behavior of
volatility over time. One characteristic of
a GARCH process is "volatility cluster-
ing" (i.e. the tendency for days of high
volatility to be followed by more days of
high volatility, and vice versa). GARCH
models this phenomenon by letting cur-
rent volatility be a function of both the
prior period's volatility and the change in
the asset price. 11
The constant volatility
assumption of an option pricing m~del
can be replaced with the stochastic
GARCH volatility.
Pricing models that contain stochastic
volatility parameters are able to generate
some degree of skewness. This makes
GARCH a very popular methodology,
particularly for equity options. However,
because GARCH is a two-factor model
(with stochastic volatility being the sec-
ond factor), it does have several draw-
backs. First, GARCH fails to capture the
complete skew. This is because there are
more factors required to model the skew
and term structure than are present in the
8
model. Depending on the prodUct,
G~RCH models may capture as little as
S?¼ of _the actual skew. To mitigate the
nsk of maccurate pricing, reserves are
often used in conjunction with
GARCH-based models. Second, while
GARCH models appear to be an effec-
tive predictor of volatility over the short
term, they are not over the long term_1,
Third, it is difficult to achieve computa-
tional efficiency with GARCH-based
models, making calibration and imple-
mentation problematic.13
Constant Elasticity of Variance
(CEV) family of models
CEV, as an alternative stochastic process,
was discussed by Cox and Ross in 197614,
and was later applied to option pricing by
Schrodei- in 198615
, Blyth and Uglum in
199916
, and Khuoung-Huu in 199917
• The
CEV family of option pricing models
attempts to strike a balance between mod-
els having lognormal asset distributions
(i.e. Black) which do not generate any
skew, with models having normal distrib-
utions (i.e. Hull-White) which generate
too much skew and permit negative
underlying asset prices. The motivation
for this stems from the observation that
the skew for interest rates products has
tended to lie somewhere between the log-
normal and normal models.18
CEV-based
models interpolate the two distributions1
•,
and provide a flexible weighting scheme
that allows one to choose how much
weight to place on a distribution. This is
effected through the models' "p" parame-
ter where "p" ranges between O and 1.
For example, if 1 is chosen, then the dis-
tribution is lognormal, and no skew is
generated; that is, the volatility-strike
relationship is flat. If Ois chosen, the dis-
tribution is normal, and a steep downward
sloping skew relationship is captured but
the probability of negative underlying
asset prices exists. By choosing any "p"
value between O and 1, one is able to
select the desired degree of skew while
controlling the probability of generating
negative undeilying asset values. Since the
skew generated by this model is down-
ward sloping and generally linear, it is
more applicable to interest rate options,
whose skew tends to take on a similar
shape. However, the method is impracti-

9. -
The Importance of Capturing Volatility Skew... continued
cal for pricing options in other markets
(i.e. foreign exchange), as it is unable to
generate smiles, frowns, or any other
shapes. As with GARCH, this mark-to-
model approach may expose the financial
institution to model risk to the extent that
the skew generated by the model does not
accurately reflect the market skew.
Calibrating the Model
In the previous section, we discussed
various methodologies that can be used
to capture skew. However, no matter how
sophisticated the model is, it will not
accurately revalue options ifit hasn't been
calibrated to reflect the actual market
skew. The bank must be familiar with the
general shape and magnitude ofthe actual
skew observed in the market for the
traded options, and then set the model
parameters accordingly. But how can one
determine what the market skew actually
looks like? Exchange traded options on
futures are not necessarily a good choice
due to the lack ofliquidity in long-dated
options (short-dated contracts tend to be
traded). Using broker quotes of implied
volatility is a common way to ascertain
the general shape and magnitude of the
market skew. But as noted earlier, implied
volatilities for deeply away from the
money options are difficult to obtain, or
may vary from broker to broker. Using an
average of broker quotes for a particular
strike and expiry is a reasonable approach
for obtaining a market consensus for that
implied volatility. Knowing the dynamic
nature of the skew; that is, how the skew
changes size and shape over time, is
equally important. Skews can flatten,
steepen, or invert in response to hedger
and speculator demand for certain strikes.
The examiner should ensure that the
bank periodically monitors the general
shape of the market skew over time and
adjusts the skew (or the parameters ofthe
model that generate the skew) as market
conditions warrant.
When Capturing Implied Volatility
Skew May Not Be Needed
There may be occasions when captur-
ing the implied volatility skew may not be
needed. A trading book containing
options that are clustered around the
ATM strike is one example. Those
options that are only slightly away from
the ATM strike would not likely have
that significant of a skew. The financial
institution should regularly monitor the
composition of its option trading books
in terms of the distribution across strikes
to determine whether capturing the skew
1s necessary.
A second example of when this
process may not be needed is when the
particular market itself is not experienc-
ing much of a skew. This can be deter-
mined by reviewing the strike-implied
volatility graphs of options for specific
markets. If the market does not have a
well-defined skew, that is, if the graph is
relatively flat across all strikes, then it
would be reasonable to not make a skew
adjustment. The bank would need to
periodically monitor this situation to
watch for development ofa skew.
Summary
This article discusses the importance
ofcapturing implied volatility skew when
revaluing options, and summarizes several
methodologies for estimating it. The
middle office revaluation process should
include a methodology for capturing
skew, otherwise the options book may be
mispriced.
- Cheryl L. Sulima, CPA
' Underlying data as ofOctober 19, 1999
was obtained from http://www.pmpub-
lishing.com. The implied volatility skew
curve represents an amalgamation of the
put and call skews for illustrative pur-
poses. Generally, the respective put and
call skews are not always identical.
'http://www.futurewis~trading.com/
newpage2.htm
' "Application ofDerivative Strategies
in Managing Global Portfolios", Roger
G. Clarke, Derivative Strategies for
Managing Portfolio Risk, ICFA
Continuing Education, 1993.
' Applies to those financial institutions
subject to the Market Risk Amendment
ofthe Risk Based Capital Standards.
'"Pricing Model Inputs", Trading and
Capital Markets Activities Manual,
Section 2100.1, page 5.
9
'· For additional detail on interpolation
and extrapolation, see Black Scholes and
Beyond - Option Pricing Models, by Neil
A. Chriss, pages 364-366.
' It is helpful to have a solid under-
standing of the construction of standard
binomial trees. A good reference is Neil
A. Chris's Black Scholes and Beyond -
Option Pricing Models, 1997.
""The Volatility Smile and Its Implied
Tree", Emanuel Derman and Iraj Kani,
Goldman Sachs Quantitative Strategies
Research Notes, January 1994.
' Black Scholes and Beyond- Option
Pricing Models, by Neil A. Chriss, 1997.
'" John C. Hull, Options, Futures, and
other Derivative Securities, Fourth
Edition, 1999, page 486.
" Alejandro A. Latorre, Risk
Management Specialist, Risk Assessment
Unit, Federal Reserve Bank of New
York.
"Ibid.
" "A One-Factor Volatility Smile
Model with Closed-form Solutions for
European Options", Anlong Li, The
Journal ofEuropean Financial Management,
Vol. 5,July 1999, pp. 203-222.
" "The Valuation of Options for
Alternative Stochastic Processes" J. Cox,
S. Ross, Journal of.Financial Economics,
Volume 3, 1976, pp. 143-159.
" "Computing the Constant Elasticity
of Variance Option Pricing Formula",
Mark Schroder, Journal of Finance, 44,
March 1989.
"' "Rates ofSkew", Stephen Blyth and
John Uglum, Risk,July 1999, pp. 61-63.
" "Swaptions with a Smile" by
Philippe Khuoung-Huu, Risk, August
1999,pp. 107-111.
""Rates ofSkew", Stephen Blyth and
John Uglum, Risk,July 1999, pp. 63.
" "Swaptions with a Smile" by
Philippe Khuoung-Huu, Risk, August
1999,pp. 108
* Many thanks to Alejandro A.
Latorre for so generously sharing his
experience and knowledge on this topic.

10. CAPITAL MARKETS
NEWS _ _ _ _ _ _ _ _ _ _ _ _ __ _ _ _ _ _ _ __ _ __
The Strategic Plan of the Chicago Mercantile Exchange
introduced weather derivatives, an inno-
vative contract in a new product area.
3
T
he Strategic Planning Ste_ering
Committee of the Chicago
Mercantile Exchange (CME)
issued a progress report in September
1999 which was made available to its
membership and the general public
through the exchange's website at
http://www.cme.com. The release of
the report coincides with increasing
efforts by US exchanges to compete
effectively with overseas exchanges' now
that the CFTC has opened the US mar-
kets to overseas exchanges.2
This article
will articulate these and other major
points relative to the report, including
the introduction ofnew trading products
and the bevy and myriad of strategic
global alliances being formed by the
exchanges.
The Committee was formed in May
1998 to strategically position the CME
given new trends and alliances in the
marketplace. The report presents, in
detail, a five-point strategic plan, which
seeks to:
• strengthen and defend the exchange's
existing product base;
• develop alliances to expand the
exchange's product base, distribution
and technological capabilities;
• treat clearing as a strategic asset;
• use technology to improve trading on
the floor and prepare its members for
electronic trading; and
• change its governance structure to a
more commercial-type model
Central to the effort to strengthen the
existing product base was the implemen-
tation of side-by-side trading in
Eurodollars on the floor and GLOBEX2,
the electronic trading system of CME, as
well as the introduction of a series of
e-mini products more suitable to the
retail investor. In June 1999 the CME
introduced the e-mini NASDAQ 100
contract which, like the e-mini S&P
500, is one-fifth of the larger index
futures contract and trades almost con-
tinuously on GLOBEX2. In October
1999 the CME began trading two scaled-
down versions of its most successful for-
eign exchange futures contracts the
e-miniJapanese yen and thee-mini Euro
fx. At one-half the size of the regular
contracts, they inaugurate the exchange's
e-fx program. In addition, the CME
The CME expanded on the Globex
Alliance and entered into three new
strategic partnerships. In September
1999, the Montreal Exchange and
Brazilian BM&F (Bolsa de Mercadorias
& Futuros) joined the Globex Alliance,
adding to the original partners of
SIMEX, CME and ParisBourse SBF.
The Globex Alliance will offer cross-
trading of all products on the exchanges'
electronic venues as well as cross-mar-
gining benefits across exchanges. The
participating exchanges are now in the
process of harmonizing trading rules and
preparing the technological infrastruc-
ture that will enable the exchange sys-
tems to interface; trading is scheduled to
begin in the first quarter 2000. In August
1999, the CME entered into a strategic
partnership with LIFFE, an initiative that
is expected to strengthen the short-term
interest rate franchise of the exchange.
LIFFE still dominates the market for
short-term interest rate products in
Europe - with the introduction of the
Euro, LIFFE's Euribor contract has
emerged as the European benchmark.
The partnership entails cross-exchange
access, interconnection of the two
exchanges' trading platforms, and the
implementation of a cross-margining
program. Through the CME-LIFFE
partnership and the CBOT-Eurex
alliance, the Chicago exchanges reassert
their dominance in different areas of the
yield curve.
Equally as interesting is the creation of
a new for-profit venture "designed to
capitalize on new markets and products."
Earlier in the year, LIFFE entered into a
partnership with the London Clearing
House (LCH) to work together on inno-
vative new products, a partnership
viewed with considerable interest in light
ofthe LCH's expansion ofclearing to the
OTC markets with the SwapClear and
RepoClear facilities.4
In July 1999, the
CME entered into a new alliance with
MEFF, the Spanish derivatives exchange
and member of EuroGlobex, a Europe-
based alliance initiated by the French
ParisBourse SBF, to trade the new S&P
Euro and Euro Plus Index futures and
options contracts,5 as the battle for the
10
prevailing index futures contr ( ) .
b
. r . act s is still
emg 1ought m Europe Th
·11 b 1· . . . e contracts
wi e isted Jomtly will t d
GLO
' ra eon
BEX2 and on MEFF's I
d
. e ectronic
tra mg platform, and are exp d
1
. . . ecte to
attract iqmdity from the partners of
EuroGlobex (technically CME .' is not
part of EuroGlobex). As part f h
I
. o t e
c earing arrangement MEFF .. • will
become a clearmg member of the CME
through which MEFF members will
clear.
On the technology side, the CME
introduced hand-held devices for locals
in the currency and Eurodollar pits. In
addition the new FIX API, a second gen-
erati on Application Programming
Interface which features open architec-
ture, will permit the routing of orders
both to GLOBEX2 and the floor and,
over time, will come to replace the
CME's Order Routing API to which
some 10,000 terminals are linked.
Currently, nine of the top ten retail-ori-
ented FCMs have Internet order routing
through their facilities and into
GLOBEX2. The CME has sponsored a
successful program to train members to
use GLOBEX2, and has used the
Internet as a venue to educate and
inform its members and customers. A
wealth of information can be found on
the CME's website, ranging from an
electronic version of the rulebook with
search capabilities, to letters to the
exchange's membership, contract specifi-
cations, trading kits for different prod-
ucts, and news.
The Strategic Planning and Steering
Committee of the CME worked closely
with the investment banking firm of
Salomon Smith Barney on a demutual:
ization plan to change the exchange
5
. f m member-
ownership structure ro . .
owned to for-profit. Demutualization is
b·1· to
crucial to the exchange's a i it'!.
•fi I ompet1t1Ve
respond more swi t Y to c
ffi
· t capital to
threats and raise su iCien
retain a reliable electronic trading venhue
· 1 isks T e
and mitigate operationa r · htedtote
details of the plan were presen .
CME membership at its Annual Meeu;g
6 h 1 n allows ior
in November 1999. T e Pa . hts
• · h trading ng
ownership wit out ff classes o
through the issuance O
two h rep-
. h ands ares
shares - pure equity s ares

11. s
The Strategic Plan of the Chicago Mercantile Exchange continued
resenting both equity and trading rights.
The Board is reduced to 19 members
instead of the current 39; a 2/3 member
vote is required for approval of the plan.
- Gloria Ikosi
1
CX, the Cantor exchange, has submitted a
proposal for block trading. Block trading allows
large orders to be executed at a single price and in
a single lot off the exchange floor or the exchange's
electronic system. Block trades are to be reported
by the exchange and cleared as regular trades.
LIFFE and SIMEX introduced block trading this
year. The CBOT, NYMEX and the CME submit-
ted a petition requesting that exchanges be permit-
ted to adopt trading rules and procedures compara-
hie to those ofa foreign exchange with terminals in
the U.S. without submitting them to the CFTC.
The US exchanges also requested more prompt
approval of contracts.
2
In the summer, the CFTC issued no-action
letters to four international exchanges - LIFFE of
the UK, Eurex of Germany-Switzerland,
SFE/NZFOE, and ParisBourse SBF (parent of
MATIF and MONEP) of France - granting per-
mission to place their trading workstations in the
US and trade their products electronically without
seeking designation as a contract market.
3
See the article on weather derivatives in June
1998 issue of Capital Markets News.
4
ln November 1999, the LCH launched ajoint
venture with Euroclear and NSCC to provide net-
ting services for repo and cash trading ofEuropean
11
government bonds. The new venture will go live in •
early 2000.
5
The S&P Euro Index is a capitalization-
weighted index of 160 stocks from 10 EMU coun-
tries -Austria, Belgium, Finland, France, Germany,
Ireland, Italy, Netherlands, Portugal and Spain -
and had a capital pool of 1.76 trillion euros as of
12/31/99. The S&P Euro Plus Index includes 200
securities from these countries, as well as
Switzerland, Sweden, Denmark and Norway; it
represents a capital pool of 2.26 trillion euros as of
the same date.
6
The CME is the first among exchanges in the
US to present a demutualization plan. LIFFE,
CME's partner in the UK, demutualized this year.

12. FEDERAL RESERVE BANK
OF CHICAGO
P.O. BOX 834
CHICAGO, ILLINOIS 60690-0834
Return Service Requested
Publisher
Adrian D'Silva (312) 322-5904
Director, Capital Markets
Editors
Joe Cilia (312) 322-2368
Senior Capital Markets Analyst
Craig West (312) 322-2312
Senior Capital Markets Analyst
Capital Markets Group of
Supervision and Regulation
14th Floor
Federal Reserve Bank of Chicago
P.O. Box 834
Chicago, IL 60690-0834
PRESORTED
FIRST-CLASS MAIL
ZIP + 4 BARCODED
U.S. POSTAGE PAID
CHICAGO, IL
PERMIT NO. 1942