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