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.