New York State Banking Department
|To:||Examiner Nosikovsky FWBD|
|From:||Rosanne Notaro - Legal Division|
|Date:||August 15, 2008|
|Subject:||[---] – Notice of Intention to Commence Property Derivatives Activities|
Is there any legal objection to the proposal by [---] (the "Bank") to commence property derivatives activities, using the Bank's New York branch ("Branch") personnel to market, structure, trade and risk-manage such property derivatives contracts.
We have no objections on legal grounds to the activities being conducted by the Branch under the conditions described in the Bank's submissions. The analysis of the proposed activity is relatively simple from the perspective of whether such activities are legally permitted "powers" of the Branch since the Branch proposes only to act as agent for the Bank's London branch in entering the property derivatives transactions. The fact that the transactions will not be booked in the Branch avoids questions such as whether the Branch will be owning impermissible property-related assets.
Background and Reasoning:
By letter dated April 3, 2008 as supplemented by letter dated June 25, 2008, the Bank advised the Department that it intends to commence certain property derivatives trading activities through the Branch. In accordance with the Department's guidance in AEM 2006-10, the Bank sought the Department's concurrence that the proposed activities are permissible for the Branch from a legal perspective, and if so, that the Department has no objections on safety and soundness grounds to the Branch engaging in the activities. This memo addresses only the legal issues.1
According to the Bank's letters, the Branch would market, structure, trade and risk manage customer driven, non-proprietary cash-settled derivatives transactions based on property indices (the "Transactions"). While the Transactions would be marketed, structured and risk-managed by personnel of the Branch, the Transactions would be entered into (booked) by the Bank's London branch. Accordingly, the present proposal does NOT raise the question whether a NY-licensed foreign branch could engage in the proposed activities as principal, since the Branch only proposes to act as agent.
The proposed Transactions would be customer-driven, non-proprietary, cash-settled swaps, forwards, caps, floors and options referencing property indices. The Bank's letters listed several indices that will serve as reference indices, and indicated that in the future, other indices may also be used as reference indices. The legal analysis does not depend on which property indices are used. The Bank stated that it will offer the Transactions to its institutional customers, including affiliates of the Bank. The customer base will not include retail customers. The Bank explained that the Transactions are attractive to customers as a means of managing financial risks associated with real estate or related payment obligations and meeting other financial needs. By stating that the Bank will enter Transactions only as part of a "customerdriven" business, the Bank is representing that the activity is being performed as a financial intermediation business, and not a proprietary trading business, and that it is driven by customer business purposes. The Bank cites the Department's April 25, 2003 letter (the "Equity Derivatives Letter"), which permitted "customer-driven" equity derivatives activities and defined the phrase "customer-driven" to mean "entered into with independent third-party customers" for legitimate customer business purposes such as reducing the customers’ exposures to various risks." Another requirement in the Equity Derivatives Letter was that the equity derivatives transactions be conducted as a means of financial intermediation. This requirement helps to establish the legal permissibility of the activities, since financial intermediation is a fundamental banking activity, and generally for activities consisting of trading non-financial-based instruments activities to be found to be permissible for banks or foreign bank branches in the U.S., such activities must be found to be part of the business of banking. We note that the Bank represents that the trading of property derivatives will be conducted as a form of financial intermediation.
The Transactions also will be cash-settled, which was also a requirement in the Equity Derivatives Letter. This condition helps to ensure that the Bank will not acquire the underlying reference asset (in this case, real estate indices) and thereby own or be exposed [to the] value of an investment that is impermissible for the Bank. We note that in this case, since the Transactions are not being booked at the Branch, the New York and U.S. law does not come into play regarding what assets can be owned by the Branch. Nevertheless, the cash-settled aspect of the proposed Transactions helps to support the Bank's argument that the Transactions are not being entered as a proprietary investment, as the settlement of the contracts will not lead to the Bank owning positions in the underlying indices.
The Bank will seek to minimize its market risk by hedging the Transactions. The Bank explained, including particularly in its supplemental June 25, 2008 letter, that the Bank will hedge the Transactions either by (i) entering Transactions on a "matched" basis (meaning that each Transaction that the Bank enters into with a customer would be matched by a Transaction between the Bank and a counterparty (which could be another customer or dealer) with terms that are equal to but opposite to those of the first transaction); or (ii) hedging market risk with respect to the Transactions on a portfolio basis, including in cases where (a) it may not be possible to match the terms of a Transaction with a perfectly matched offsetting Transaction or to enter into an appropriate hedge at the same time as the customer-driven transaction. As the Bank's submission points out, hedging on a portfolio basis will imply that, in certain circumstances, the Bank's risk arising from Transactions may not be perfectly matched or hedged, which could mean that the Bank would have some residual risk. The Bank stated that such residual risk will be priced and managed using the Bank's existing risk management framework for market risk and counterparty credit risk, adapted to the specifics of the property derivatives market. The Bank's plans to hedge the Transactions as described further support its position that it is not entering the Transactions as a "positioning" or "proprietary" business. Again, we note that the New York and U.S. law that would disallow the Branch from entering into the Transactions as a "proprietary" business would not necessarily be relevant here, as the principal in the Transactions will be the London Branch.
- We note that the Bank's submission also described how it will submit the new proposed activities to its new product approval process, as well as some description of its risk management process. We understand that FWBD and the Capital Markets Team are reviewing the proposed activities from a risk management/safety and soundness perspective. Before any approval is given to the Branch to commence activities, the supervisory division must find the Bank's proposal unobjectionable from this standpoint.