The Ldc Debt Market: It's A Jungle Out ThereKelley Holland
Time was when trading debt from less-developed countries was a real adventure. The market for the debt, chiefly nonperforming or troubled loans made by big banks to developing countries, was so illiquid that millions could be made and lost in a matter of days. Offers to sell could be several percentage points higher than offers to buy--and vice versa--assuming a trade could get done at all. Rumors flew through the market and sent prices up and down willy-nilly. LDC debt traders needed nerves of steel.
Today, much of the Wild West atmosphere in the market has evaporated. Lists of bid-offer prices on many LDC-debt instruments can be punched up on any Reuters terminal. Country loans have been converted into bonds backed by U.S. Treasuries, and a flood of banks, broker-dealers, and trading boutiques into the market has made buying and selling much easier. Even mutual funds of LDC debt are being marketed to individual investors.
The market, though, is a lot less sedate than it may seem. The Federal Reserve and the Manhattan district attorney are investigating the market. There is speculation that the probes will focus on potentially illegal trading practices, including misuse of inside information and trading ahead of customers. Rumors of price manipulation and similar practices are commonplace. The market still has pockets of illiquidity, which inevitably invite abuse.
CODE OF CONDUCT. Abuse is also invited by the limited oversight by regulatory agencies. That could change, however, if evidence of substantial wrongdoing is uncovered. The market for LDC debt, says Harvey L. Pitt, former general counsel of the Securities & Exchange Commission and a partner at Fried, Frank, Harris, Shriver & Jacobson, "is a marketplace that is going to come under more intense scrutiny because there are less well-defined rules" than there are for other markets.
Big players in the market are taking steps to monitor trading themselves. The major LDC-debt trading institutions have organized the Emerging Markets Traders Assn., which sets guidelines for trading, settlement, and more. Thomas E. Winslade, executive director, says the group has sent its members a draft code of conduct for traders, and he hopes to have the final code in place by midyear. Although the association lacks enforcement powers, Winslade says, "I think the [guidelines] are by and large being followed."
"My general impression is that emerging markets and developing-country debt markets have become much more sophisticated in the last year or so," adds Antoine van Agtmael, president of Emerging Markets Management. "But like any relatively young market and one without an exchange, there's always the risk of manipulation of prices."
VOLATILE. Trading in LDC debt has exploded in recent years. There are more than 100 firms in the traders' association, including banks, broker-dealers, and trading boutiques. Virtually all the major banks and investment banking houses are active traders of LDC debt. Trading volume in the market approached $500 billion in 1992--small compared with the $1.7 trillion or so that traded on the New York Stock Exchange but up sharply from prior years. There are also many different trading instruments, from loans to Eurobonds and so-called Brady bonds--issued when a country has renegotiated the terms of its debt.
The market is not for the unwary. Losses or gains can be sudden and swift. The restructured debt of Peru, for example, was trading at less than 13 on the dollar at the end of 1991. During 1992, the price rose to 18 , dropped to 13.5 , and rose again to finish the year at nearly 20 on the dollar.
No government agency keeps tabs on the whole market (table). The SEC has jurisdiction over some of the bonds traded in the market, but under current law it can't oversee the trading of most loans. The Federal Reserve regulates the holding companies that own the banks that made the original loans, but its main focus is on the banks' safety and soundness, not their trading per se.
Because loan trading seems to fall between the regulatory cracks, questions crop up about what constitutes legitimate trading. It's not clear whether rules barring misuse of inside information in trading securities also apply to trading loans. "To the extent that securities are involved, [SEC Rule] 10b-5 applies," says Robert Tortoriello, a partner at Cleary, Gottlieb, Steen & Hamilton. "But if securities are not involved, there's nothing. To date, caveat emptor has been the standard." While Rule 10b-5 bars trading securities on the basis of material nonpublic information, it hasn't yet been used to test the propriety of a bank trading country loans, for example, using knowledge obtained as part of a creditor committee involved in debt restructuring talks.
Trading on the basis of information from a creditor committee is less of a front-burner issue today, chiefly because most of the debt restructuring talks have been completed. But it hasn't gone away, and there are still rumors of price manipulation in the market for LDC debt. One story making the rounds last fall had bankers trying to drive down the price of Argentine bonds in order to complete a debt-equity conversion onthe cheap. Earlier, there was talk that some traders depressed the price of Ecuadoran debt by selling their holdings, apparently anticipating a large saleof the debt by a Japanese bank. Later, they bought the debt at a bargain price.It's not clear that firms have handled ambiguities in the rules very well. Last March, Chester B. Feldberg, executive vice-president of the Federal Reserve Bank of New York, sent a letter to chief executive officers of the banks in his Fed's district. "We have become aware in recent months of several instances of basic internal-control weaknesses in the trading operations of both domestic and foreign banks," he told them.
SCRUTINY. To be sure, most of the big players in the market have rigorous rules for their traders. At Citicorp, close interaction is forbidden between traders and the bankers involved in restructuring Citi's loans to less-developed countries. And there are clear restrictions on how traders can trade for their own accounts. "We apply the same rules to emerging-markets [trading] as we do to any other kind of trading," says a compliance officer at an investment bank. But the banks must monitor procedures constantly. "If debt negotiations are going on and you're trading the loans, these are evolving situations," says Kathylynn Galbraith, head of the emerging markets group at Chase Manhattan Corp. "One minute, things are nonpublic, and the next minute, they're the reverse."
Many big users of the market, indeed, insist that it is actually pretty safe. "There is no question in my mind about the integrity of this market," says Simon E. Nocera, head of research and a portfolio manager at GT Capital Management Inc. "There are a lot of insider rumors, but that's exactly like any other market."
Nocera had better be right. He is among those who are managing retail mutual funds that invest in LDC loans and bonds. By buying shares in a mutual fund, individual investors will have the buffer of a professional fund manager and a chance at the stellar returns available in the LDC debt market. But for now, it looks like they had better have a taste for adventure as well.
WHO'S MINDING THE STORE? "BRADY BONDS" Issued by countries that have renegotiated their bank debt; backed by U.S. Treasury securities and regulated by the Securities and Exchange Commission if sold in the U.S. COUNTRY LOANS Made by banks and traded actively by banks and other investors; Federal Reserve regulates banks, but its principal involvement with country-loan trading is determining whether these loans affect a bank's safety and soundness EUROBONDS Issued overseas and usually traded outside the jurisdiction of U.S. regulators; often sold to U.S. investors abroad YANKEE BONDS Marketed in the U.S. by foreign entities and regulated by the Securities & Exchange Commission DATA: BUSINESS WEEK