Outside money managers

An outside money manager can do an excellent investment job. The problems are
that they are typically off-site, have a different investment strategy, are not your
company employees, and their credit analysis and standards may be different from
those of your company.
The investment agreement and policies and procedures for the use of derivatives
must be carefully crafted. The policies must be comprehensible, focused, comprehensive
and enforceable. We are a contract-based society. It must be clear about what
has been delegated to other institutions and what fiduciary responsibilities we have
assumed (Erikson, 1996).
As we have reviewed, compliance policies developed and implemented within an
organization should be internally consistent and provide sufficient controls. When
funds are transferred for management to a partnership, affiliate, or outside money
manager, control becomes significantly more difficult. These legal divisions must be
respected and limited partners should be cautious not to direct the business and
infringe upon the rights of the general partner and so jeopardize tax and legal benefits
of the structure.
With any investment approach, there are typically multiple objectives and these
should be ranked by priority to ensure that the manager will follow guidelines. It is
prudent to evaluate how a hedging strategy will be viewed under various market
scenarios and whether end of year results or interim mark to market pricing has
priority. An equity collar to protect a stock position, will look poorly if the equity
market rises sharply. Although collars may be a prudent strategy, performance could
be several percentage points behind an unhedged equity position on an interim markto-
market basis.
To maintain independence, an investor cannot control a manager’s credit selections
as they are made. Rather one must set up a process that reflects desired parameters.
A common predicament is when an asset is sold by the investor and yet the outside
manager may buy it as attractive. How do you reconcile that to your board? If you
sell assets and incur a tax loss, one must wait the requisite period of time before
repurchasing them or else ‘wash sale’ rules may be invoked. What happens if an
outside manager buys those same assets in the market prior to the time limit? It
may jeopardize your tax strategy.
In order to avoid ‘delegating in the dark’, the proper controls must be communicated.
After all, your controls’ effectiveness will always be reviewed post facto. Reports
may not be available until days or weeks after the end of the reporting time period.
If reports arrive by fax and have to be reentered into your systems, it’s a process rife
with error.
With money managers, the following topics are especially important to focus upon:
Ω Clearly document fiduciary relationship
Ω Explicitly outline investment policy
Ω Summarize derivatives policy
Ω Agree on methodology for tracking performance
Ω Specify credit standards
Ω Select permitted counterparties
Ω Collateral usage
Ω Repo activity/leverage
Ω Types of reports and frequency
The investment manager contract should be clear and crisply written. The fee
schedule should be clearly agreed upon. Any ‘buzzwords’ should be defined. Proxy
hedges should be limited to specific circumstances. Leveraging should be prohibited
or controlled as deemed appropriate. If the outside manager uses futures contracts,
the activity may impact the treatment/status of the investor. The futures position
may need to be aggregated for reporting purposes.
The derivatives policy should be clearly summarized. Note that separate investment
guidelines and derivatives guidelines are commonly prepared for external managers.
Also the external manger should provide the client with a derivatives strategy statement
citing types of derivative to be used and for what purpose(s). The strategy statement
should be signed by the board of directors or its designate. The derivatives
products allowed should be clearly stated. Some firms categorize derivatives by level
of risk and depth of market. These categories are not permanent classification since
markets may become more developed over time, e.g. credit derivatives. In one classification
schema, ‘A’ derivatives are liquid and standardized products, ‘B’ are semi-liquid
and customized, and ‘C’ are leveraged or exotic products and so off limits. There is
room for the ‘B’ and ‘C’ products to migrate over time to a higher status. Limitations of
hedging to transaction specific as opposed to macro hedges should also be enumerated.
The methodology for tracking performance should be explicit. What is the benchmark/performance objective and how frequently can the portfolio rebalance?
What are investment guidelines, asset selection methodology, and portfolio composition/
allocation ranges? Define duration and spread parameters. What are the gain/
loss constraints? Tax guidelines? How will income be reinvested? It takes time to
invest sufficient amounts of money to achieve diversification. When do the standards
as to diversification kick in? Are you monitoring all purchases or the aggregate
impact on the portfolio?
Credit parameters are a common area of dispute. Is subordinated or junior paper
permitted? Is the credit test simply at inception or is it a maintenance test? Quality
ratings for individual securities and total portfolio? How are split ratings handled? If
a downgrade occurs, is there an automatic sale provision or is each investment
considered separately? Permitted counterparties are a companion issue. Must they
be from the same approved list of the investor or can the investment manager make
his or her own determination?
Collateral usage brings with it all the issues of monitoring, valuation, custody, and
rehypothecation. As the investor, you are one step removed from the investment process
already and this adds another layer of complexity to the outside manager. Repo
activity, leverage, and the writing of covered calls are all methods of enhancing income.
Depending on the risk tolerance of the investor and how restrictive the fiduciary guidelines
that the investor must follow, these may be avenues open for pursuit. 508

Business conduct policy

Employees need a roadmap to guide them and a typical conduct policy would address
the following issues:
Ω No insider trading
Ω No acceptance of gifts over a certain value
Ω No interested transactions with the company
Ω Whistleblower protection
Ω Salespersons shall not own stock of companies covered
Ω Traders shall not trade the same instrument for personal accounts that they trade
on the job
Ω Competitor contact parameters
Ω Comments to media
Ω Software development
Ω Client entertainment
Ω Confidential information
Policies are often too broad or simply written poorly. It is typically helpful to
provide examples when there is any likelihood of any misunderstanding or confusion.
pwdAlternatively, one may want to use an example to emphasize the significance of
a particular rule.
No employee should trade based on non-public information of information obtained
due to his or her unique relationship with a company. Even the appearance of
impropriety should be avoided. Salespersons cannot own customer stock simply to
ensure that there are no trades that can ‘tainted’ by possible access to confidential
information. In the same spirit, a trader cannot trade the same product for the
company that he or she trades for their own personal account. This discourages
moral hazard and the temptation to focus on personal positions to the detriment of
the company’s position. Competitors can be contacted as long as it is on a professional
basis and no laws are violated such as price fixing, collusion, etc. or the meetings
can be construed as creating a buying cartel.
Media comments and training tapes are two areas of special caution. Publicity is
generally good but you want to ensure that it is controlled and that there is no
inadvertent release of information. Moreover, there may be strategic initiatives that
are occurring unknown to the person providing media comments and those comments
may be misconstrued in retrospect. Training tapes are often given to hyperbole
and when taken out of context, may present a distorted view of company policies.
Client entertainment should be appropriate to the overall client–dealer relationship.
For clients similarly situated, the frequency and expense should be in a comparable
range. It is a preferred practice to accompany a client rather than send a client to an
event.
Salespersons may become privy to confidential information about a client. They
should be especially careful not to divulge the information especially if it is material,
non-public information. Conversely, compliance should ensure that spreadsheets
and dealers’ proprietary information are not being sent out to a customer via
facsimile, e-mail or other means without proper authorization. Any non-standard
information that does not fit into a prespecified template should be approved by
divisional compliance. There are two main cautions. The customer might rely on a
spreadsheet or adjust it for purposes/transactions for which it was not intended. In
addition, if there are any dealer trade secrets or protected information, it may lose
its protected status if it is widely or indiscriminately disseminated.
In the documentation of a transaction, a dealer should establish non-reliance on
the part of the end-user. Moreover, the dealer is not a financial advisor and each
party to the trade is acting independently and the end-user should determine that
transaction is an appropriate one. No guarantees or assurances as to the results of
the transaction should be made. Each party should have the authority to enter into
the transaction and take on the risks entailed in the specific transaction.

Sales function checklist

Looking specifically at a dealer’s sales force, the following is a generalized checklist
of problem areas encountered:
Ω Market information
Ω Sales materials
Ω Term sheets
Ω Transactions
Ω Confirmations
Ω Valuations
Ω Warranties and representations
Ω Business conduct
Dealer salespeople should endeavor to ensure market information disseminated to
clients is obtained from sources believed reliable. Appropriate written disclaimers
should be employed. Salespeople should refrain from casting competitors in an
unfavorable light. Competitor comments should be limited to our credit department
has/has not changed its credit outlook on that name. As to derivatives transactions
activity, other customers’ names and activities should not be directly revealed
and any trade information should be shrouded sufficiently so that other clients’
confidentiality is preserved.
Derivatives sales materials should provide reasonable illustrations of the product.
The pricing over various scenarios should represent a valid range of scenarios and
assumptions should be clearly stated. Disclosure should provide all the relevant
information that is needed to enable a comprehensive analysis. The more standardized
the product, the more likely that standardized disclosure language may be
sufficient.
Term sheets should be accurate and disclose appropriate risks to consider. Pricing
and liquidity issues are especially important to mention. If the term sheet is being
sent out to multiple clients, it should be proofed carefully to remove any mention of
a specific company. The law department should approve standardized disclosures
and should be consulted for the one-off situations where a customized product is
involved. A legal department approval number with expiry date should be included.
For non-standard trades, it is often wise to do a ‘dry run’ if feasible and involve the
operations unit. Frequently there is a clearing issue or documentation issue or
details of the trade that turn out not to have been considered/finalized in advance.
It’s a preferred time to resolve these omissions before trade time. The completed
transaction should reflect the term sheet. ‘Bidding to miss’ (where a dealer makes
only a semi-interested bid for business) should be avoided since it hurts all parties
involved. The customer does not receive a true market price comparison, the bidder
may develop a bad reputation, and the winner does not get an accurate ‘cover’.
The following are items that should be clarified prior to time of trade:
Ω Exact legal name of the counterparty
Ω Verify credit availability
Ω End-user company has power to transact
Ω End-user employee has specific authority to transact
Ω Derivative is suitable given client’s size, sophistication, and risk profile
Ω End-user has analyzed or has the capacity to analyze the deal(s)
Ω Dealer is not acting as a fiduciary
Most large corporations have a large number of affiliates, partnerships, or joint
ventures. It is imperative that the dealer establishes who is the exact, legal counterparty
on a transaction. It will help determine the dealer’s legal rights in the event of
breach/non-performance. It is critically important to determine whether the enduser
is dealing in the name of its holding company, operating company, or other
corporate affiliate.
Credit availability should be obtained from a listing that is current. Some firms
rely on a printout from the previous day and do not have on-line capabilities to know
the full, current exposure. If credit approval is not preset, then salespeople need to
obtain current financials from client for the credit approval department. Even when
a dealer sells an option to an end-user, due diligence dictates that the dealer obtain
end-user financials as part of the ‘know your customer’ requirements.
Most corporate end-users are empowered by their charter to do almost anything.
Highly regulated industries like insurance companies and municipalities have significant
restrictions. The law department of the dealer should be comfortable with the
end-user’s power to contract or alternatively the dealer must ask for an amendment
to the charter or board approval or alternatively for a legal opinion from the enduser’s
counsel indicating that the contemplated transaction is permitted.
An end-user may have actual or apparent authority. The dealer should rely on
actual authority and the dealer should ask for a listing of approved traders. After the
trade, it may be prudent to ask for a certificate of incumbency of the end-user
employee/officer who signs the derivative confirmation.
Suitability does not simply mean that the end-user can use derivatives. Rather it
is a higher standard. Given the size, skill, and sophistication of the end-user (coupled
with its outside advisers if any) and in view of its risk appetite, past activity, etc. is
the deal appropriate? It is advisable to look inside the customer and establish that
the customer meets this suitability threshold.
One needs to ‘know the customer’. One should examine closely the economic
purposes for using derivatives. Some end-users in the past have used the swap
market to mask loans. A bank would make an upfront payment (or during the first
year) and the recipient would then repay the loan amount as part of the coupon
payments scheduled over the remaining life of the swap. In a similar vein, Merrill
Lynch currently is engaged in a lawsuit filed by the CFTC. Merrill is charged with
‘aiding and abetting’ Sumitomo to corner the copper market by providing a trading
account and more than a half billion dollars’ worth of financing and letters of credit.
The regulator charges that Merrill employees knew of the illegal conspiracy to corner
the copper market (Peteren, 1999).
The salesperson must be properly licensed and communication with the client
should be monitored periodically. Term sheets must be vetted to ensure sufficient
disclosures and disclaimer. It is important to note that adequacy of disclosure may
well vary with the complexity and risk of the product being sold. Although futures
contracts lend themselves to standardized disclosure, the OTC derivatives market
does not. Proper safeguards should be in place so that no side guarantees are being
made to the customer. Beware salespeople who are CPAs or JDs, since they may
cross the line and provide professional advice. One of the biggest sources of litigation
in the past has been the failure to adequately supervise the sales staff.
Confirmations should be timely and accurate. Typically in a large dealer, the
salesman, trader, and compliance/legal will review a confirmation before it is sent
out to the client. If a dealer is not able to send out a confirmation on a timely basis,
it should send out a preliminary confirmation. This would contain the name of the
product and a description of the transaction included essential information such as
notional amount, index, start and end date, and with the disclaimer that it is a
preliminary confirmation to be superseded by a formal confirmation. In times of
market turmoil, it sometimes occurs that confirmations are delayed. Given the lack
of written confirmation and fast moving markets, there exists the moral hazard where
a losing party denies the existence or terms of a deal. This can be combated most
effectively by securing a written confirmation.
Valuations sent to customers should always be written and qualified as whether it
is a firm price or an estimate. Whenever possible, it should also contain a reference
interest rate and/or volatility level along with date and time so that customer can
place the pricing in context.

Sell side versus buy side

The compliance structure tends to be highly formalized on the sell side but less so
on the buy side. Generally, the buy side has a single location and may not support
a full-time derivatives team. Indeed the derivatives person might be charged with
other duties as well. Control is more informal and subject to periodic oversight and
periodic audit inquiries.
The buy side should generally have an easier time in ensuring compliance. Often
they are not as heavily regulated an entity as a broker dealer. The number of
individuals involved is typically small. Since derivative products are often used solely
for risk-reducing purposes there is significantly less latitude for engaging in derivative
activities. The debate continues as to whether highly formalized controls are needed
by end-users. One industry study advises that ‘it is crucial to rely on established
reports and procedures, rather than culture or single individuals to sound the alarm’
(Risk Standards Working Group, 1996).
The danger is that the people on staff understand the product but the audit
function does not. Volumes are low and so the derivatives profile may be relatively
low. The cost–benefit of doing a compliance audit is not deemed worth while. The
obvious danger of this is shown by the off-site foreign affiliates of major banks that
have lost great sums using derivatives or securities. The speculation using Treasury
securities and forwards by Daiwa’s New York office is a classic example of the
difficulties faced in policing a remote office. Here a trader hid losses on US government
bond trades over a 10-year period which totaled over several billion dollars.
The sell side given its enormous size and multi-site locations tends to have
extensive formalized controls. Given that some of the trading sites are located in
foreign money centers, it frequently occurs that compliance is controlled initially by
on-site staff in each geographical location. Appropriate regional safeguards should
be in place and enforced and head office should be kept informed. Head office should
make periodic, comprehensive compliance reviews. The failure is often twofold–
regional oversight fails and head office fails to follow up. The classic case was Nick
Leeson who single-handedly bankrupted Barings plc. There the trader controlled
trading as well as funds disbursement for the Singapore office of a UK merchant bank.
Moreover, audit recommendations pointed out control lapses and recommended
corrective measures. These audit recommendations were never enacted and within
year, the firm was sold for a $1 to ING. A similar example with far fewer losses is
now unfolding for Merrill Lynch in 1999. Its Singapore office finds itself embroiled in
a scandal where a single private banker circumvented ‘Merrill’s accounting, compliance,
and auditing operations’ to engage in unauthorized trading using client funds
(McDermott and Webb, 1999). The regional director knew that something was amiss
but apparently did not pursue the issue.

Format of policies

The typical content of derivatives policies can be organized in the following way:
Ω Introduction
Ω Objectives
Ω Organization and responsibilities
Ω Permitted instruments/strategies
Ω Pre-transaction approval
Ω Post-transaction reporting
Ω Program approvals
Ω Counterparty guidelines
Ω Discipline/sanctions
Ω Policy review and modification
The introduction should outline the source of authorization and invoke underlying
law and/or regulations and corporate authorization. The reader of the policies
should be able to understand the reasoning and importance of fulfilling regulatory
requirements and of conforming to internal control measures. There can be minimum
standards but there should also be preferred standards that may provide the firm
with an additional layer of protection. The information should be distilled down to
the essentials. The business staff rarely embraces compliance requirements willingly
but if they follow compliance rules then the intended goals are achieved.
The objectives section should delineate what are the appropriate uses for derivatives.
They should be specific as to what type of risk-reduction is permitted and
whether trading is contemplated or permitted. Issues such as leverage, holding
period, and return measures should be specified.

The organization section should trace the delgation of authority from the board to
senior managers. It should alert the reader to the chain of responsibility within the
company. In addition, the escalation triggers and procedures should be outlined.
Permitted instruments should address which items are approved and for what
customer/which purposes. It should indicate what is excluded as well. It might be
prudent to mention the specific types of risk being hedged in addition to simply
naming the instruments. There appears to be a whole cottage industry devoted to
‘regulatory arbitrage’ where instrument name does not always provide a true description
of the instrument. The name serves mainly to fit it within regulatory reporting
requirements or authorizations. This section should also address limits as to positions
and credit exposure in notional terms (if applicable) but more likely in terms of
actual and potential market and credit exposure terms. Duration measures and
replacements costs are likely needed as additional measures of reference. This section
would likely also address issues such as use of collateral, margin, and limits.
Pre-transaction approval should delineate the process of approval to be followed.
It should specify with particulars, who is permitted to approve a transaction. An
appendix, listing authorized employees, is appropriate and should be updated as
needed. One could also provide a copy of a sample trade authorization form, numbering
system methodology, and which departments are notified electronically of
transactions.
Post-transaction reporting is especially important since this is often where problems
are first detected. The more intractable problems with derivatives tend to be
with non-standardized products. Initial cash flows often occur 3 or 6 months into
the future so problems can remain hidden or undiscovered for some time and the
market can move significantly in that time period.
Program approvals are especially important in order to expedite business. It makes
no sense to revisit a specific type of transaction if each deal is a carbon copy of a
previous one. One must ensure that the transactions are indeed standardized and
not just similar. It would be prudent to spot test these types of transactions in order
to verify/ensure that they are being recorded accurately.
Counterparty approval is especially important since credit risk typically represents
one of the biggest risks taken by most institutions. The approval process should be
specified and what resources need to be checked, e.g. the specific credit monitoring
system. The counterparty section should also address the use of affiliates or related
entities of approved counterparties. There should be a strong focus on the appropriateness
of intercompany, arm’s-length transactions and ensure safeguards that
normal industry practices are adhered to. It is important to be alert for trades done
at off-market prices or ‘rolled into’ a new reporting period.
Discipline and treatment of violations should be consistent, clear, and timely.
Enforcing discipline will give ‘teeth’ to the guidelines and encourage active efforts at
compliance. Problems corrected early are generally less costly and regulators tend to
react less aggressively if a company can mend itself.
Providing an established routine for policy modification is paramount. You can
rarely anticipate every situation and markets are dynamic enough that an annual
review to policies and procedures, while a prudent choice, may not always be
sufficient. With an escalation process in place, you will not find yourself locked into
having to go to the board for marginal changes. Within certain constraints board
ratification, as opposed to preapproval, may be a process that provides sufficient
flexibility.

The ideal situation is to have compliance requirements that dovetail with sales,
business, and investment practices. It eases the compliance process and enables
employees to fold compliance into the normal business activity routine. You want to
avoid too high hurdles, overly conservative compliance, and, even worse, redundant
controls and reporting. If the reports ever become perfunctory, it may lead to problems
that will remain under the radar. You will then have the most insidious of all
situations, where there is an appearance of control where none in fact exists.
Compliance should be done on a formalized basis not ad hoc. The purpose,
procedures, and protocol should be set out clearly so that employees know what is
required. If everyone is responsible then no one is likely performing the necessary
function. When specific individuals are not charged with oversight, gaps often occur.
An analogy from the credit world is when a security is fully collateralized no one is
responsible for monitoring the credit risk of the bond.

Purpose of policies

To be usable, Polices and Procedures (P&Ps) must stand in the context of a complete
control environment. As a stand-alone document, they have limited usefulness
unless they shape and reinforce corporate policies. P&Ps should provide a context
for determining what rules apply, who has oversight, and what compliance documentation
is appropriate. In order to be effective, the compliance manuals should be
explanatory documents and not simply a listing of requirements. The front office
must adhere closely to these permitted activities. Moreover, the back office must
understand the business strategy so they can help identify bottlenecks and danger
areas. An action may appear valid on the surface but has an unintended consequence
which may breach a limit or cause a change in status. Dangers are often hidden
from plain view and the players are simply caught looking the other way.
P&P exposure limits should reflect true exposure such as leverage or market
replacement cost. Notional limits invite violations since they are a crude measure of
risk. Escalation procedures should be in the document itself and having a bubbleup
process is likely to be more reliable than a static ‘break glass in case of emergency’.
One should specifically designate that if the P&Ps are silent then they do not enable.
Policies should also not be engulfed in such minute detail that they are applicable to
a few desks or for a limited time only.
As one writes derivatives compliance policies, one should build on existing best
practices as exemplified in industry and regulatory guidance.7 Today, there are good
resources and materials available on the Internet so that keeping pace with the
changes and communicating them can be more easily effected. Industry groups,
lobbyists and outside counsel are also good resources.
Desk procedure manuals and guides are required for the micro level of activity.
They should describe the interfaces and responsibilities between and within departments.
A typical compliance manual is often a stand-alone document, a chapter
within an operations manual or woven into an omnibus document. It is often
structured as follows. It commences with a description of the overall compliance
goals and importance of the those goals. It then moves to a classification of derivatives
by category: fixed income, equity, commodity, or credit and describes which products
belong in the appropriate categories. Then a hierarchy of compliance requirements
is laid out. Often there is an accompanying workflow chart that indicates which
department or unit handles each specific step and it outlines the proper sequence of
events. It will provide key questions to ask and answer as well as identify specific
pitfalls to avoid.
The compliance manual will also direct the reader where to seek additional direction
and how to determine whether any of the procedures have been updated or changed.
A typical compliance manual may also become outdated rather quickly. Frequently,
regulations change or the business mix changes and a business outgrows its controls.
Updates must be sent as needed and on a timely basis. Some banks even distribute
single-sheet risk placemats that can be kept at each trading or sales station so that
compliance essentials are available for immediate reference.
A planning and coordination process should occur, so that you have a comprehensive
and logical approach to compliance control that mimics your business processes.
The problem often exists that the compliance process at many large institutions is
the result of ad-hoc, incremental changes and not part of a coherent strategy. This
almost ensures that gaps occur in the oversight process.
A prudent compliance and business strategy is to maintain the same level of
control for unregulated OTC derivative sales as would be sufficient to meet the quality
of SEC/CFTC oversight for exchange traded derivatives. There is always a danger
that at a later date or during the course of litigation a transaction or relationship
may be reclassified and a post-facto application of a different (higher) standard will
be invoked. An aggrieved party might also attempt to invoke the fraud or disclosure
provisions of securities law or commodities law in hopes of bolstering a cause of
action.

Creating enforceable policies

This section details the purpose and content of compliance policies. It examines in
detail a suggested policies format and focuses on the challenges of overseeing a
dealer’s sales staff. This section ends with a review of compliance controls suited for
money managers.

Typical compliance issues

The following are examples of compliance issues that can often lead to significant
problems (ignoring the obvious example of insider trading):
Ω Lack of notification
Ω Focusing exclusively on a transaction and not the aggregate effects
Ω Miscommunication internally
Ω Unwillingness to admit error
Ω Lack of planning
Ω Fragmented internal oversight
Ω Failure to segregate customer and proprietary trading
Ω Failure to enforce basic rules
Ω Failure to follow market changes
Ω Failure to link system reports
Ω Multi-tasking of compliance
Ω Failure to track competitor activities
Lack of notification may lead a firm to be unaware that a compliance event has
occurred. Businesses typically focus on sales volumes or profits. What many in a
large corporate family overlook is that positions and actions are often aggregated
across related companies for regulatory purposes. A related affiliate may be active
with the same customer or use the same futures contract. These positions might
need to be aggregated for purposes of complying with contract reporting or contract
position limits. Alternatively, special regulatory filings may be triggered unless
regulatory exemptions can be obtained.
Business people often focus on transaction specifics and may overlook the marginal
impact on existing portfolio(s). The purchase of a specific bond may be entirely
prudent. However, the regulations or internal policies and procedures might have
credit concentration limits or country basket limits. There might well be enough
room under the credit line for the particular obligor but the transaction runs foul of
various macro limits. If the deals are not properly coded in inventory systems then
country limits or currency limits may be unknowingly breached.
Miscommunication often occurs when people lapse into jargon. In one company,
managers using futures have confused reporting limits with position limits. As a
result, they used a less appropriate futures contract to hedge an exposure since they
mistakenly thought they were nearing a position limit for a specific futures contract.
This can result in an economic cost of executing a suboptimal hedging strategy. In a
related occurrence, an external auditor disallowed favorable accounting treatment
for short positions in futures. Short hedges were not utilized by the company until
the external auditor later corrected the restriction so it would be applied properly
only to naked ‘short sales’.
Business people are often unwilling to say ‘I don’t know’ or ‘I made a mistake’. A
trader might err when trading a position with a broker. In order to hide the error, he
arranges with the broker to ‘correct’ the price. In turn, the trader directs new business
to the broker to pay for the favor. Several large derivatives losses have occurred as a
result of a trader speculating in the market to hide a previous error. In the late
1980s, ABN’s New York branch had a FX options trader that executed sales instead
of buying FX call options. The trader attempted to ‘trade out’ of the mistake and
eventually lost more than $50 million.

Simply not planning ahead with compliance can trigger problems. Traders often
focus strictly on the economics of a transaction to the exclusion of regulatory
requirements. They may wait until the last minute to consult with compliance. In
the heat of battle during a trading day, traders may not inquire about the rules since
there is time only for reflex action and not for reflection. A preventable violation may
ensue and corrective action must then be undertaken.
Compliance areas sometimes exercise fragmented oversight and there is a danger
that compliance staff becomes too specialized. They may be focused strictly on the
requirements of securities law or commodities law and fail to see the full range
of other regulations that may apply (e.g. pension money typically invokes ERISA
regulations). There may be filing or disclosure documents that are triggered. Simply
focusing on product-related compliance does not ensure success in satisfying complex
entitywide regulatory requirements or customer disclosure requirements.
Failure to segregate customer and proprietary trading leads to the abusive practice
of front running, i.e. knowing a customer’s order and trading in the market ahead of
the customer’s trade. It is an ethical violation as well as violation of the fiduciary
relationship that is created when a firm acts on behalf of its customer. An equally
insidious practice is when a trader can execute for both a firm’s account and
customer accounts. Unless there is strict compliance control, losing trades have a
tendency to wind up in the account that best suits the trader’s compensation scheme.
A trader of Canadian Governments at a New York money center bank had trading
authority on a proprietary book as well as on clients’ behalf. The bond clearing was
done in Canada, the accounting in the UK, and trading in New York. The trader hid
losses in customer accounts and eventually cost the bank more than $50 million in
unauthorized trading losses. The division of controls in three geographic locations
certainly played a role as well.
Failure to enforce simple rules and deadlines tends to lead to larger violations.
Non-cooperation on the part of the business people with compliance is a frequent
experience. If the business people are not required to abide by filing or reporting
requirements, they may be enticed by gaps in oversight to violate more significant
compliance guidelines.
As products and markets change, the type and range of compliance requirements
will change as well. Frequently, business people will rely on documents that were
negotiated and signed years before. Market practices could well have changed and
the document no longer reflects best practices or current market conventions.
Failure to link systems reporting to all functional areas leads to gaps in oversight.
Incompatible systems where manual reentry of data occurs is a companion issue.
One large derivative dealer started to trade credit derivatives and the transactions
were reported to all departments except the risk department. The risk unit was
caught by surprise since the risk module report had not been linked-in. The risk
unit knew that the product had been approved but were never notified that trading
had actually started until a small portfolio had already been created.
When compliance units are charged with other duties, compliance may lose its
focus. Production duties tend to get priority since they typically have pressing closing
schedules. Frequently a compliance area may be doing a review just prior to the
deadline. This tends to result either in an incomplete or hurried review which creates
the opportunity for more errors to occur.
When a competitor makes a high-profile error, the regulators will often focus on
the same issues in their next review Given the public awareness of the type of error
made, regulators will often apply a higher standard of evaluation if they encounter a
similar problem in the organization. This may occur even if no updated legislation or
regulations have been enacted. Regulators typically can discover large compliance
problems in a variety of ways: newspaper story, trade journal comments, competitor,
disgruntled employee, aggrieved customer, private litigant, or auditor contact. 499

Staffing the compliance unit

Compliance officers typically have experience in operations, audit, legal, or trading.
Within a divisional staff, one needs compliance specialists especially for exchange
traded contracts or equity derivatives. The expertise need will vary by the complexity
of the product and of the regulatory scheme. It may be helpful if the compliance staff
is licensed to the same degree as the sales staff since compliance personnel may in
some circumstances need to talk to a client directly.
The compliance staff should also be cross-trained in a different discipline so that
the firm has a ‘deeper bench’ and so the compliance staff has a better understanding
of activities across the firm. This keeps the staff fresh and rotation allows a new set
of eyes to review the processes. This cross-pollination may also expose areas where
the compliance guidelines have not kept pace with market activities. To increase
their usefulness, a compliance officer should develop a solid knowledge of the
economics of the products being sold as well as an intimate understanding of the
applicable regulations.
Some turnover is not necessarily bad within the compliance function. A new
employee may well discover items that have been overlooked. Alternatively, the new
employee may help identify short-cuts or bad habits that have been allowed to creep
into the compliance process.

Division of labor

The term ‘derivative’ covers a wide range of instruments that could be construed
alternatively as a security, a futures contract, a hybrid, or have an uncertain status.
For the purposes of this chapter, we eliminate all discussion of derivative securities
such as Mortgage Backed Securities (MBS). Instead the focus is primarily on overthe
counter (OTC) derivative contracts: swaps, caps, floors, etc. with some discussion
of exchange traded instruments.
There is no single, proper compliance structure given the wide range of business
structures using derivatives. Instead, a proper infrastructure reflecting the specific
needs of each organization is the goal. Ideally, the compliance framework should be
structured along business and functional lines. The key departments are likely to be
divisional compliance units, possibly a central compliance department (for a large
firm) and the law department.
Divisional compliance units should be independent of the business stream but
would likely report to a business head as well as to central compliance. Divisional
compliance personnel should be on-site providing immediate access to the business
people. This facilitates daily interaction and allows compliance to be familiar with
customer flows, market changes, and problems as they occur. In addition, they can
provide an immediate response to business people. This encourages an informal
exchange of information as well as facilitating business processes. This informality
allows information to be placed in context and enables compliance to observe the
behavior and attitude of the business people. This proximity should function as a
‘safety net’ or early-warning system. Relying exclusively on formalized reports and
scripted encounters ensures that compliance can only detect, they cannot prevent.
Whistleblowers are also more likely to alert compliance to activities which merit
further review in an informal environment.
A central compliance unit can focus on regulations applying across an entire legal
entity. These macro concerns would include regulatory inquiries, Chinese wall issues,
employee licensing, compliance training, business conduct issues, and employees’
personal trading accounts and the coordinating of regulatory reporting (with controllers
being primarily responsible).
The law department properly focuses on approving the ISDA, IFEMA5 templates,
regulatory disclosures and filings, and certifying reports to the board of directors.
The law department also confirms the range of activities permitted by each legal
entity, approves press releases, and oversees contacts with the media. The department
would also work with a company’s governmental affairs unit as relevant
legislation is proposed.
Many large institutions tend to have several attorneys involved in the compliance
area and given the typical complexity of derivatives oversight, this is often a preferred
approach. In a large institution, there is frequently an imprecise allocation of compliance
responsibilities that sometimes results in an overlap or gap of responsibilities.
Depending on the corporate structure, if the compliance attorneys are placed in
competition with attorneys from the law department there may be an effectiveness
concern. Compliance personnel will be closer to the market but the law department
may have more time for additional analysis. Without a clear hierarchy, one may have
a situation where compliance could handle matters in a manner independent from
and without the knowledge of the law department. As a result, the business people
may simply choose the lowest compliance hurdle. In a similar vein, if the head of a
compliance unit does not strictly enforce requirements, then it will difficult for the
subordinates to get full cooperation from the business people.
It is difficult to determine how many compliance people are required for an
institution since it depends heavily on the nature of the products sold, the complexity
of line of business or products, type of legal entity, and the nature of the customer
base. A simple adequacy test is whether or not delays occur in sending out marketing
materials because compliance is not able to review the disclosure language. Serious
mistakes can occur equally from insufficient staffing or from an overworked staff. If
expansion of the compliance staff is needed, it should not be allowed to lead to a
diminution of quality. At a minimum, it is recommended that management review
the adequacy of training and knowledge base of the compliance officers on an annual
basis. 496

Delegation by board of directors

Compliance controls, like any core business strategy, emanate from the top. The
board of directors oversees the control culture and corporate personality of a firm.
The board should promulgate a mission statement that highlights the importance of
compliance and evidences the board’s full support for compliance efforts. The head
of compliance should likely report to the head of the law department or the CFO. As
regards derivatives, the board has several key responsibilities including:
Ω Understanding the broad risks of derivatives
Ω Setting clear objectives
Ω Making informed decisions
Ω Identifying specifically who can authorize risk taking
Ω Ensuring adequate controls are in place
Ω Ensuring that senior management hires qualified personnel
Ω Complying with external regulations and with company’s stated compliance and
investment policies
Ω Overseeing public disclosures
The board must understand the fundamental risks of derivatives. They must be
conversant with concepts ranging from liquidity, volatility and market share to option
fundamentals. Risk measurements such as the broad outlines of Value-at-Risk must
be a familiar subject.
The board must set clear objectives as to risk appetite, permitted instruments, and
maturity limits that are measurable and enforceable. Notional amounts often are too
crude a measure since they do not adequately account for leverage and imbedded
options. A credit equivalent exposure may be more appropriate.
The board must review proposed transactions/programs and ratify completed
transactions, ensuring full disclosure of risks and volatility of returns. Where
information is inadequate, the board must be sufficiently knowledgeable to know the
proper questions to ask.
The control of which individuals can take risk is perhaps the most significant
preventative measure that a board retains and should ensure this oversight is strictly
enforced. The board should be especially alert to those who have actual authority as
well as those with apparent authority. A periodic update sent to counterparty dealers
indicating changes in authorized employees is a useful control.
The board must put in place a structure that will ensure controls adequate to the
proposed uses of derivatives. Compliance risk is a key consideration in managing
the business risks of a firm. A compliance officer should be linked to each major
business stream. Many compliance losses result generally from a pattern of conduct
as opposed to a single event. Having compliance personnel ‘rubbing elbows’ with the
business side is an essential safeguard.
Compliance officers should exercise independence of the line of business, otherwise
there is a fundamental flaw in the compliance structure itself. A common mistake is
that the compliance process is designed around employees rather than job functions.
Another potential flaw is when turnover of staff allows business employees to ‘drift
into’ compliance-related functions. This frequently happens when the compliance
staff lacks a thorough understanding of the business processes.
Senior management must ensure that qualified personnel staff the critical compliance
functions. The staff should be experienced, sufficiently trained, and provided
with sufficient resources and tools to remain current. This means adequate technology
support, seminars, publications and access to internal/external counsel. There
is no implication that the board of directors follow every nuance in derivatives
activity. Rather they can and do rely on the representations of senior managers and
audit professionals. They must review derivatives reports and information and activity
for consistency, accuracy, and conformity to company goals and delegated authority.
Not only must there be a sufficient control environment, the Board must actively
verify the effectiveness of these controls.
Senior managers often view exposures in economic terms and do not focus on legal
or disclosure requirements. Management may lose sight of the fact that legal liabilities
related to compliance errors often dwarf business risks. Products need to be sold,
customers need to be served, and profits need to be made. The full impact of which
legal entity is used for booking a non-standard deal is often an afterthought. The
deal may run foul of compliance and legal requirements despite the best of intentions.
The demands of immediate economic performance should not be a rationalization
for sloppy controls.
A companion concern is when a company has so many large businesses that the
ramifications of a smaller segment of a business seems unimportant. Management
focus is often on dollar volume or profit margins and less focus is given to products
having lower profiles. Another issue is that given the increased complexity of the
business, compliance and audit staffs may be understaffed or insufficiently trained.
Control activities are most effective when they are viewed by management and other
personnel as integral part of, rather than an addition to, the daily operations of the
company [bank] (Basel Committee on Banking Supervision, 1998).
Public disclosures are generally the responsibility of the controller’s unit and it is
often the audit committee of the board, with some help from the law department,
that oversees these activities. Problems in this area tend to occur infrequently but
often have major impact. There has been increasing SEC focus on this area and
inadequate or inaccurate disclosure has enabled the SEC to pursue an enforcement
action that might otherwise have been doubtful. In the Gibson Greeting case, the
deliberate misvaluations of derivatives provided by the counterparty bank led to
Gibson releasing inaccurate financial statements. This led to SEC charges against
the bank as well as against officers of Gibson Greetings itself.

Structuring a compliance unit

This section focuses on properly structuring a compliance unit. It details the duties
of senior management, describes how to align compliance with business lines, and
describes a range of compliance activities. The section ends with a review of common
compliance errors.

Defining compliance risk

Compliance risk can be defined as ‘the risk to earnings or capital from violations, or
nonconformance with laws, rules, regulations, prescribed practices, or ethical standards’
(OCC Comptroller’s Handbook, 1997). Compliance programs typically originate
to satisfy external laws and regulations. As programs become more developed, they
start to include monitoring of adherence to internal guidelines and management
directives. One stumbling block is that compliance risk is often not subject to
sufficient scrutiny. Instead, ‘compliance risk is often overlooked as it blends into
operational risk and transaction processing.’1
Focusing exclusively on satisfying external compliance is a necessary but perhaps
not a sufficient standard. The derivatives markets continue to outpace the regulators
and oversight often lags behind the creation of new products and markets. The ‘crazy
quilt’ structure of derivatives’ regulations tends to compound these compliance
risks since oversight gaps occur. Given the overlapping and sometime conflicting
framework of oversight, this can be a real challenge. (See the Appendix for an outline
of US and UK regulatory schemes.) Compliance controls remain a front-line defense
and the proper goals should be to help insure against large losses as well as prevent
regulatory violations.
The typical reaction to compliance standards is that one needs only to maintain
minimal standards. Cooperation from the business staff is often limited. Compliance
is not a particularly popular topic among traders and salespeople since they focus
on business targets leading directly to higher compensation. Only grudgingly will
employees focus on this type of risk and often, the focus is on the negative duties of
compliance. The reality is that compliance can ‘empower people’. These controls
enable people to accomplish goals and ensure closure. ‘It is only when procedures
are neglected or abused that they become an impediment.’2
The other extreme may occur where compliance controls represent a virtual
straitjacket. In some organizations, compliance standards to satisfy regulatory
requirements are set so high that they become obstacles to daily business. Typically
this occurs when a company has suffered a major loss and attempts to ‘overcompensate’
for past errors.3 A companion danger is when internal controls are so rigid, an
exception must be made for normal, large-sized transactions. The automatic granting
of exceptions can easily undermine controls or foster an attitude that all standards
can be negotiated.
The dramatic growth and widespread usage of derivative instruments as well as
the diversity of market participants have provided fertile ground for disputes. Given
the large sums of money involved and the relatively small amount of initial cash
outlays (i.e. leverage), compliance failures have been costly. This has been a major
risk in the derivatives world since the Hammersmith and Fulham case in the 1980s,
through the Procter & Gamble fiasco of 1994–5, to today where companies in Asia
are attempting to renege on losing derivatives contracts.
Hammersmith and Fulham was a municipal UK entity that engaged in swap
transactions. The English courts determined that the transactions were outside the
scope of the municipality’s charter (i.e. ultra vires) and the municipality was not
required to pay accumulated losses of several hundred million pounds. A more
thorough legal review of the counterparty’s ‘capacity to contract’ would likely have
limited the losses suffered by the counterparty banks.
Procter & Gamble was able to avoiding paying much of its swap losses due to the
failure of the counterparty bank to provide accurate valuations and full disclosure
as to transaction risks. A stricter control oversight of client communications and of
periodic valuations sent to the client would likely have limited these losses by the
counterparty bank. The current litigation involving Asian companies centers again
around similar issues of disclosure and fiduciary duties, if any, that exist between
the swap counterparties. In today’s litigious environment, compliance errors often
have expensive consequences. 493

External reporting: compliance and documentation risk

Billions of dollars have been lost in the financial services industry due to compliance
violations and documentation errors. The misuse or misapplication of derivative
instruments has been a major factor in many of these losses. The actual violations
have ranged from inadequate disclosure to clients, unlicensed sales personnel,
improper corporate governance, ultra vires transactions, and inadequate or errorprone
documentation. The root causes have been primarily insufficient or outdated
controls or failure to enforce controls. The media focus on these major losses due to
lax internal controls or violations of external regulatory requirements has become a
permanent blotch on the reputation of the industry.
While Value-at-Risk and stress scenarios can help optimize the use of risk capital
and improve returns, large equity losses are often the result not of market risk but
rather of compliance failures. Often it is a trusted or highly regarded employee (often
long standing) who causes the damage. Typically, the loss is not triggered by a single
event but occurs over time. A recent example occurred in Chicago in late 1998, where
a futures brokerage was being sold. Just prior to the scheduled closing, the CFO of
Griffin Trading Co. revealed that he had lost millions by trading stock options with
the firm’s money. The unauthorized trading went undetected for more than a year
and the company became another compliance casualty (see Ewing and Bailey, 1999).
While compliance and documentation risks can never be eliminated, they can be
contained. This chapter is intended as a broad overview of compliance risk and
highlights the major issues confronting manager of derivatives sales staffs. It focuses
on practical methods to ensure compliance that will survive the continuing consolidation
of financial service companies and changes in regulatory oversight. This chapter
is divided into four main parts:
Ω Structuring a compliance unit
Ω Creating enforceable policies
Ω Implementing compliance policies
Ω Reporting and documentation controls.

There will be reference throughout the chapter to actual losses that have occurred
to emphasize the critical importance of appropriate controls. The goal is not to detect
actual problems. Rather it is to discover ineffective, omitted, or outdated controls
that could lead to actual losses. The reader should have an overview of why compliance
controls are critical and how they can be used to limit business risk.
A compliance unit should play an active role in a firm’s business strategy. It
enables business lines to optimize revenues by limiting non-market risks such as
credit, operations, and reputational risk. In many firms, however, compliance is
viewed as an add-on expense and an impediment to performance. It is perceived to
drain valuable resources and time and to serve as an adversary to achieving business
goals. This chapter reflects the view that compliance is necessary and beneficial.
Complying with external regulations and internal policies will insure greater consistency
of performance and will in the long run, reduce capital needed to fund incidences
of operational failure and fraud.

External reporting

The external reporting of the effect of financial instruments by end-users is the area
which attracts most of the commentary in the press on accounting for derivatives,
but as discussed in the previous section, neat answers will never be obtainable while
historical cost accounting is standard for these entities. The impossibility of coming
up with a neat answer is probably the explanation for the great amount of discussion,
although considerable effort has gone into trying to define tightly the scope of hedge
accounting. As discussed above, that is almost by definition a very subjective area.
Given that the primary financial statements (balance sheet and profit and loss
account) cannot currently be changed from historical cost, the various accounting
standards promulgated by various standard-setters concentrate on requiring extra
disclosures in the annual accounts. The usefulness of these is debatable, and as
accounts are hardly ever published until at least 60 days after the end of the year,

when positions can be changed with a five-minute phone call they cannot be any
more than an indication to investors of possible questions for management.
The most obvious sticking point is any fixed rate debt used for funding the
company. Unless this is revalued using the market yield curve, does it really make
sense to revalue the interest rate swap that converts some floating rate debt to fixed?
If the company is considered a poor credit risk and so its debt is trading at a
significant discount, should the accounts value it at the amount that it would
actually cost to buy it back? It seems intuitively wrong to record a gain just because
the company is considered more likely to go bankrupt! There are no easy answers to
such questions, and so the risk of accounting treatments leading to inappropriate
decisions is higher when dealing with investment decisions based on published
accounts than with management accounts.
As the published accounts may not reflect the full economic mark to market
position, there may be situations where management has to choose between hedging
the economic position and hedging the published numbers. Such a conflict of
objectives can be reduced by providing extra information in the accounts, and
educating the analysts who use it.

Conclusion
While the accounting function may seem simple until accountants start talking, we
have shown in this chapter some examples of how a clear and coherent policy is
essential to avoid the various traps which can cause accounting data to encourage
suboptimal decisions. It is important that policy on all such issues is clearly set out
at a senior and knowledgeable level on such matters as profit remittance which has
implications for both FX and interest allocation. Such policy needs to be implemented
in the systems and procedures throughout the organization, and monitored by
Control departments or Internal Audit. Inaccuracies are less likely to arise if senior
management does not fret at some ‘noise’ in the reported profits.

Discount rate

Non-banks need to consider the discount rate they use, but there is no simple
answer. Banks blithely reach for LIBOR in nearly any situation because that is the
rate at which they can lend and borrow in the market (unless they are beset by
rumours of impending bankruptcy). A non-bank may well face a rather higher rate
for loans, although it should be able to obtain a rate very similar to the banks for
deposits. Thus if an industrial organization is short of cash it might consider valuing
future predicted cashflow streams at its cost of borrowing.
Otherwise if LIBOR is used, a trader would appear to make profits on inception for
loans to counterparties at rates above LIBOR but below the organization’s cost of
borrowing, although this profit would leak away as the real cost of funding was
recognized over time. However, it does not seem sensible for such an organization
valuing options using the Black–Scholes model to use anything other than LIBOR as
the input parameter. This is an area where consensus has not yet been reached.

Hedge accounting

For management decision-making all relevant instruments should be marked to
market. For the financial instruments this is conceptually straightforward, although
all but the largest end-users lack the critical mass of banks in terms of modelling
expertise and market price knowledge so for OTC instruments may rely on the
provider of the instrument. OTC instruments also suffer from a lack of liquidity, but
per se this should not affect their value, since most end-users intend to hold their
instrument until maturity.
The more difficult aspect can be in identifying the movements in value of the assets
or liabilities against which the financial transactions were entered into as hedges. If
an interest-rate swap is entered into as a hedge to fix the rate of a floating rate
debenture then it is easy to value the debenture using a market yield curve and show
how effective the hedge is. Such matching is similarly easy if a specific oil cargo in
transit is sold forward, or put options representing the same volume of oil as in the
cargo are purchased, since the physical commodity can be separately identified and
valued at the spot price.
Things become less clear-cut when considering the situation faced by an oil refinery
which has sold a three-month crack spread future. The volume sold may be chosen to
approximate the physical capacity of the refinery for the third month, but operational
realities may result in a slightly different actual throughput. The mix of refined
products that will be produced is not known exactly in advance, and hopefully will
depend on which provide the greatest profit at the time of sale. Should all the firm
purchases and sales for the third month, for the next three months, or for all time,
also be marked to market?
One way to make the decisions easier as to what to include in the mark-to-market
model is to transact trades in the underlying commodities between the operational
department and the treasury department. With this approach the operational department
treats treasury like any other customer, and mark-to-market accounting is
restricted to the treasury department. This certainly places a clear understandable
boundary around market operations. It has the disadvantage that the same position
may be valued differently in two departments within the one entity, but such a
mismatch has to happen somewhere in an entity using two methods of accounting.
In the case of a flexible refinery there is also the mismatch between the product mix
sold to treasury and that produced in fact.
Treating treasury as an external customer has implications for culture, and
possible choice of personnel, which need to be addressed. There is a danger that
operational department will feel exposed to treasury, and therefore recruit what is
effectively a subsidiary treasury function themselves, thus duplicating effort and
increasing costs unnecessarily. To prevent this it is necessary to have an overall firm
culture (with matching appraisal and bonus policies) which stresses cooperation.
We can also consider the case of the ice-cream manufacturer which has sold
heating degree days in a weather swap on the basis that the hotter the weather, the
more ice cream it will sell and thus the higher will be the gross margin. The swap
could be valued based only on actuals with historic averages for the future, or
including latest forecast. Which is considered most appropriate would depend on
whether the manufacturer sold direct to the public, in which case sales would only
be recognized on the day of consumption, or to wholesalers who might buy greater
quantities as soon as they saw more warm weather coming.

The fact that the profit or loss on the derivative transaction can be accurately and
precisely defined, while the hopefully opposite result which it is hedging is often
more difficult to measure, may result in treasury being unfairly criticized for losses
on hedges. One would expect hedges to lose money half the time – the benefit is that
the volatility of overall earnings should be lower and the risk of bankruptcy lower.
A particular situation which occurs frequently is FX transactions entered into to
hedge the results of the operations of foreign-currency subsidiaries. For end-users
the average-rate translation of profits is standard, and management may well have
entered into the hedge with the first priority being to protect the operating profits
line appearing in the published accounts rather than net assets. This is a clear case
of an inappropriate policy, in this case an accounting standard, leading to suboptimal
economic decisions. In such a situation it makes sense for management reports to
show the hedge marked to market, together with the effect of rate movements on the
projected profit of the foreign subsidiary.
It is clear that this is a field where there are few definitive answers, and judgement
is required by management to define what they want to gain from the information
they receive. Unless there is a move to full current cost accounting, any mark
to market information in an end-user environment will only ever be indicative
information. 489

Accounting for end-users

End-users are different because financial instruments are only part of the business.
While financial instruments can easily be marked to market since the assets are
fungible and there are more or less liquid two-way markets, this does not apply to
assets such as factories or work in progress. Thus such entities use historical cost
accounting as a default. However, they may use accrual accounting or mark to
market for their trading assets.

The pure historical cost method does not recognize the cost of borrowing in the
trading accounts because that is included with all the other borrowing costs for the
organization, and delays recognizing the profit until the sales invoice is due. The
accrual method includes all the costs, but at their final cash value, and spreads the
profit over the period of the deal. The mark to market method calculates the net
present value of all income and costs, but recognizes the gain immediately. As the
spot and forward prices of oil move over the following six months, the mark to market
method would recognize any net differences each day, but with such a cleanly hedged
position the effect would be unlikely to be much different from the smooth drip
shown which represents the interest on the net profit (592*6%/2ó18).
Profit is recognized earlier in the mark to market method. Losses are recognized at
the same time under all methods, since the historical cost and accrual methods are
not symmetrical, because they embrace the concept of prudency. Applying such lack
of uniformity requires more human judgement. This illustrates the higher risk
associated with longer-term trades, where the acceleration in the recognition of profit
is most marked.