Gaining acceptance

The full cooperation of business lines is needed to meet compliance goals. It is an
ongoing struggle to generate assistance and cooperation from the business side since
compliance is viewed as a fixed cost drag on profits. No matter now skilled the
compliance people nor how detailed the reports, there are business subtleties and
nuances that are known best by the business people. In the case of a money manager,
compliance may be focused on satisfying external regulations and overlook ‘fairness
issues’ relating to equal treatment for all investors.
You will obtain more cooperation from business line employees by making it
convenient to comply. Staff the compliance function adequately, give them cellular
phones and beepers. Ensure that you have an early and late shift, if necessary, to
cover the full trading day. Business people are notorious for making one feeble
attempt at compliance and not following up. Help ensure that they connect with
compliance the first time.

The derivatives industry is too dynamic for permanent organizational charts.
Never believe that having formal lines of communication will ever be sufficient by
themselves. Informal contact should supplement control measures and will allow
greater insight into risks being taken. When a potential error is spotted or an error
made repeatedly, it may be time to update the procedures and communicate those
changes. Some errors are correctable with certain efforts and there may not be a
need to elevate an error to a violation level if it is easily corrected or controlled.
You must ask proactive questions. Is the trader using derivatives in an authorized
fashion? Is he or she reducing risk the market has created or creating certain
exposures that force him to use derivatives to bring his exposure back into line? One
should closely monitor credit downgrades and mark-to-market changes. Will the
cheapest to deliver change dramatically for a specific futures contract or when it is
rolled to a new contract month?

Employees should be conditioned to report on possible problems or positions that
are deteriorating. Given some lead time, it may be possible to address pending
compliance issues if actions can be taken in advance of the possible violation. If a
transaction has just occurred, it may be possible to rectify the damage or ask that
deal be booked elsewhere with the consent of the client. To obtain full disclosure,
you need to maintain an open environment. They need to come to you with their
mistakes and problems. Be careful that unclear wording as to trading parameters
may enable traders to take unwanted liberties. One should also monitor the behavior
of traders. Measuring changes are an important control measure and one should
focus on new trends and new counterparties.
Some compliance issues are well known and can be planned for via compliance
calendars, e.g. periodic audits, regulatory reports, etc. There are often prealerted
situations, e.g. we are sending a new term sheet to five clients, and can you review
it first thing tomorrow morning? Others do not present themselves until a transaction
evolves into its final form. You want to prevent short cuts like an informal, unreviewed
term sheet being sent out and then followed by a full, properly completed term sheet.
Odds are that the informal term sheet will be the one retained by the client since the
major analysis may be done on the basis of the preliminary term sheet.
You want the compliance efforts to be systematic and comprehensive. You want it
done right every time. It is paramount to obtain full disclosure the first time.
Compliance often has to ferret out problems since there is an innate tendency by
business people to bend the rules. Business staff have to be encouraged to provide
information. At the same time, the compliance staff should have the expertise to
know what they should be looking for. The business people should not have to
‘spoonfeed’ the compliance staff: it is a recipe for a later, unhappy surprise.
The markets have a propensity to outpace existing regulations and internal guidelines.
Certainly, no one should presume that a control structure designed for plain
vanilla swaps will adequately adjust to leveraged or exotic swaps. Similarly, a credit
monitoring system geared to corporate exposure might not work as well for monitoring
hedge fund exposure since most investment-grade corporations borrow without
posting collateral and are generally not highly leveraged.
It is an innate human tendency to look for short cuts or rules of thumb in order to
simplify things. As elaborate or logical as a compliance system may be, people will
still finds ways to make it perfunctory or use less time, probably at a cost of stripping
away some of the safeguards. Sloppiness and inattention are culprits as well as a
general casual attitude.

The team environment is fostered with clearly written policies, which itemize the
requirements and explain the need for compliance. The compliance staff can alert
business staff to potential problems and steps to be taken to avoid problems. The
compliance staff, by responding quickly, authoritatively, and accurately, can help
foster this cooperation.

The compliance staff can also alert the business side to the costs of non-compliance.
With violations such as lack of supervision or non-disclosure, each occurrence
may be considered a separate violation. If there is a systematic flaw in the operations
process or sales process in an institution, they will be making the same
mistake many times. If each violation is serious enough the individual penalties
could add up.

Proper compliance means digging into the details of each transaction to be reviewed.
If the salesperson represents that a deal is just like a previous transaction, do not
accept that representation at face value. Buying a foreign pay security along with a
cross-currency swap back to US dollars is one thing. Buying all the shares of a
company whose only asset is the foreign pay security is another. Economically the
contractual cash flows are identical and the swap provides a valid hedge. In the
former case it is simply an interest payment, in the latter it may be construed as a
dividend payment and may cause withholding taxes to be paid in the foreign
jurisdiction. 510