Price discovery in gas is not as transparent as in the oil market. The transport and
storage capabilities of the gas market is relatively inflexible compared to the oil
market. The market is also more regional7 than the oil market, with international
trade being restricted by pipeline costs and LNG (liquefied natural gas) processing
and transport costs.
The US gas trading market (although probably the most developed in the world) is
much more fragmented than in the oil market with a large number of small producers,
particularly at the production end. Given the inability to hedge through vertical
integration or diversity this has resulted in a significant demand for risk management
products. The market after the deregulation in the 1980s and early 1990s has been
characterized by the development of a very significant short-term market. This sets
prices for a thirty-day period during what is known as ‘bid week’.8 The prices
generated during this ‘bid week’ create an important benchmark9 against which
much of the trading market is based.
The futures contracts in gas have been designed to correspond with the timing of
bid week, the largest and most developed contract being known as Henry Hub. This
has been quoted on NYMEX since 1990, supports a strong options market and
extends out three years on a relatively liquid basis. Basis relationships between
Henry Hub and the major gas-consuming regions within the USA are well established
and, in the short term, fairly stable. The OTC market supports most basis locations
and a reasonable option market can be found for standard products. It is worth
noting that, credit aside, in energy the value of the futures market and the OTC
forward market is the same, albeit the delivery mechanisms are different. This is
true because there is no direct correlation to interest rates and the EFP (Exchange
for Physical) option imbedded in the futures contract.
In gas, storage costs play a critical role in determining the shape of the forward
curve. A variety of storage is employed from line pack (literally packing more gas
molecules into the pipe) to salt caverns and reservoirs (gas can be injected and
extracted with limited losses) and the pricing and flexibility of the different storage
options varies significantly.
As a general rule, the gas market stores (injects) during seven or eight ‘summer’
months and extracts during the winter months. Significant short-run price movements
occur when this swing usage is out of balance. In these circumstances gas
traders will spend much of the time trying to predict storage usage against their
demand estimations it order to determine what type of storage will be used during
the peak season and thus help set the future marginal price.
Like the oil market, the gas markets exhibit mean reversion, and are subject to
occasional jumps due to particular ‘events’ such as hurricanes shutting down
supplies. But most importantly, despite this storage, gas remains significantly more
seasonal in nature than most of the oil market.
Basis trading from Henry Hub plays a vital part in the market with differentials to
the major consumption zones being actively traded in the OTC market. These basis
prices are less stable than those seen in the oil market given the more constrained
transport infrastructure and volatility in demand. As a result, the monitoring of these
basis relationships under normal and extreme conditions becomes critical.
Risk managers should be very wary of basis traders or regional traders marking
their books against a contract in a different region such as Henry Hub who are
seen to have large ‘book’ profits based on future positions. There have been a
number of instances where such regional traders have had their positions wiped
out overnight when the correlations have broken down under extreme market conditions.
In other words, you need to ensure that the higher volatility or ‘spike potential’
in less liquid regional markets compared to a large liquid hub has been reflected
in the pricing.
Historical ‘basis’ positions may also fundamentally change as the pipeline positions
change. For instance, the increasing infrastructure to bring Canadian gas to the
Chicago and North US markets could significantly change the traditional basis
‘premium’ seen in these markets compared to Henry Hub.
While most trades up to three years are transacted as forward or future positions
an active swap market also exists, particularly for longer-term deals where the
counter-parties do not want to take on the potential risks associated with physical
delivery. These index trades are generally against the published Inside FERC Gas
Market Report Indices although Gas Daily and other publications are also used
regularly. It is necessary to be aware that indices at less liquid points may not be
based on actual transaction prices at all times, but may be based on a more
informal survey of where players think the market is. This may lead to indices being
unrepresentative of the true market. 531
29 Haziran 2011 Çarşamba
24 Haziran 2011 Cuma
The oil market
Crude oil can come from almost any part of the world and the oil market, unlike gas
and power, can be described as a truly global market. The principal production
regions can be generally grouped into the following: North Sea (the most notable
grade being Brent), West Africa, Mediterranean, Persian Gulf (notably Dubai), Asia,
USA (notably WTI), Canada and Latin America. Each region will have a number of
quality grades and specifications within it, in particular, depending on their API
gravity2 and sulfur content.
In Europe the benchmark crude product is North Sea Brent while in the USA it is
often quoted as WTI. WTI is the principal product meeting the NYMEX sweet crude
specifications for delivery at Cushing (a number of other qualities can also be
deliverable, although many non-US crudes receive a discount to the quoted settlement
price). The other major crude product is Dubai, representing the product
shipped from the Persian Gulf.
Each of these three products will trade in close relation to each other, generally
reflecting their slightly different qualities and the transport cost from end-user
markets, all three markets reflecting the overall real or perceived supply/demand
balance in the world market. Other crude specifications and delivery points will then
trade some ‘basis’ from these benchmark prices.
As well as the three crude products noted above, the oil market encompasses the
refined products from crude oil. While thousands of different qualities and delivery
points world-wide will ultimately result in hundreds of thousands of different prices,
in Europe and North America these can generally be linked back to a number of
relatively strong trading hubs that exist, notably:
Product type Principal hubs
Crude Brent/Cushing/Dubai
Unleaded NWE3/New York/Gulf Coast
Gas Oil/No. 2 Oil NWE/New York Harbor
Heavy Fuel Oil/No. 6 Oil NWE/New York Harbor/Far East
In addition, the rest of the barrel, propane, butane, naphtha and kerosene trade
actively, but are more limited in terms of their relevance to the energy complex.
Within the various product ranges prices are quoted for particular standard grades.
For instance, No. 6 oil (also known as HFO or residual oil) can be segmented to 1%,
2.2%, 3% and 3.5% sulfur specifications. Each have their own forward curves and
active trading occurs both on the individual product and between the products. The
market has developed to the point where NYMEX lists not only option prices but also
Crack Spread Options (the option on the spread between the products).4
Like its other energy counterparts most of the trading is done in the OTC ‘brokered’
market that supports most of the commonly traded options, swaps and other
derivative structures seen in the financial markets. Derivatives are particularly useful
in oil compared to other energy products given the international nature of the product
and the relationship between the overall oil complex. For instance, if we take an
airline company, this needs a jet fuel hedge that reflects the weighted average cost
of its physical spot fuel price purchases in different parts of the world. At the same
time it would like to avoid any competitive loss it might experience from hedging out
at high prices. This would be complex (and unnecessary) to achieve physically, but
relatively straightforward to hedge using a combination of different swaps and
average price options, which can be easily linked to currency hedges.
Another common swap is the front-to-back spread, or synthetic storage. This
allows the current spot price to be swapped for a specified forward month. It should
be noted that this relationship may be positive or negative, depending on market
expectations. Locational swaps are also very common, providing a synthetic transport
cost. Such swap providers in this market (and all energy markets), however, need to
be very aware of both the physical logistics and the spot market volatility.
Crack spreads and Crack spread options are used to create synthetic refineries.
The 3:2:1 crack spread that is traded in NYMEX is a standard example of this linking
the prices of crude, heating oil and gasoline.
In oil, the majority of swap transactions are carried out against Platt’s indices that
cover most products and locations, although a number of other credible indices exist
in different locations. For instance, CFD’s (Contracts for Differences) are commonly
traded against ‘dated’ Brent, the price for physical cargoes loading shortly and a
forward Brent price approximately three months away.
While such derivatives are easy to construct and transact against the liquid hubs
they have their dangers when using them to hedge physical product at a specific
delivery point. Specific supply/demand factors can cause spreads between locations
and the hubs to change dramatically for short periods of time before they move back
into equilibrium. For example, extreme weather conditions can lead to significant
shortages in specific locations where imports are not possible leading to a complete
breakdown of the correlation between the physical product and the index being used
to hedge. In other words you lose your hedge exactly when you need it. A risk
manager must look carefully at the spreads during such events and the impact on
the correlations used in VaR and Stress tests. They should also understand the
underlying supply/demand conditions and how they could react during such extreme
events.
It should also be noted that oil products are often heavily taxed and regulated on
a state and national basis which can lead to a number of legal, settlement and
logistical complexities. Going hand in hand with this is the environmental risks
associated with storage and delivery, where insurance costs can be very substantial.
Ever-changing refinery economics, storage and transportation costs associated
with the physical delivery of oil are thus a significant factor in pricing which results
in the forward curve dynamics being more complex than those seen in the financial
markets. As a result the term structure is unpredictable in nature and can vary
significantly over time. Both backwardation5 and contago6 structures are seen within
the curve, as is a mean reversion component. Two components are commonly used
to describe the term structure of the oil forward curve: the price term structure,
notably the cost of financing and carry until the maturity date, and the convenience
yield. The convenience yield can be described as the ‘fudge factor’ capturing the
market expectations of future prices that are not captured in the arbitrage models.
This would include seasonal and trend factors.
Given the convenience yield captures the ‘unpredictable’ component of the curve,
much of the modeling of oil prices has focused on describing this convenience yield
which is significantly more complex than those seen in the financial markets. For
instance, under normal conditions (if there is such a thing), given the benefit of
having the physical commodity rather than a paper hedge, the convenience yield is
often higher than the cost of carry driving the market towards backwardation.
Fitting a complex array of price data to a consistent forward curve is a major
challenge and most energy companies have developed proprietary models based on
approaches such as HJM to solve this problem. Such models require underlying
assumptions on the shape of the curve fitting discrete data points and rigorous
testing of these assumptions is required on an ongoing basis.
Assumptions about the shape of the forward market can be very dangerous as MG
discovered. In their case they provided long-term hedges to customers and hedged
them using a rolling program of short-term future positions. As such they were
exposed to the spread or basis risk of the differential between the front end of the
market (approximately three-month hedges) and the long-term sales (up to ten years).
When oil prices in 1993 fell dramatically they had to pay out almost a billion dollars
or margin calls in their short-term positions but saw no offsetting benefit from their
long-term sales. In total they were reported to have lost a total of $1.3 billion by
misunderstanding the volatility of this spread.
Particularly in the case of heating oil, significant seasonality can exists. Given the
variation in demand throughout the year and storage economics, the convenience
yield will vary with these future demand expectations. This has the characteristic of
pronounced trends, high in winter when heating oil is used, low in summer and a
large random element given the underlying randomness of weather conditions.
The oil market also exhibits mean reversion characteristics. This makes sense,
since production economics show a relatively flat cost curve (on a worldwide basis
the market can respond to over- and under-supply and that weather conditions (and
thus the demand parameters) will return to normal after some period.
In addition, expected supply conditions will vary unpredictably from time to time.
Examples of this include the OPEC and Gulf War impacts on perceived supply risks.
Such events severely disrupt the pricing at any point leading to a ‘jump’ among the
random elements and disrupting both the spot prices and the entire dynamics of the
convenience yield. I will return to the problem of ‘jumps’ and ‘spikes’ later in this
chapter. 529
and power, can be described as a truly global market. The principal production
regions can be generally grouped into the following: North Sea (the most notable
grade being Brent), West Africa, Mediterranean, Persian Gulf (notably Dubai), Asia,
USA (notably WTI), Canada and Latin America. Each region will have a number of
quality grades and specifications within it, in particular, depending on their API
gravity2 and sulfur content.
In Europe the benchmark crude product is North Sea Brent while in the USA it is
often quoted as WTI. WTI is the principal product meeting the NYMEX sweet crude
specifications for delivery at Cushing (a number of other qualities can also be
deliverable, although many non-US crudes receive a discount to the quoted settlement
price). The other major crude product is Dubai, representing the product
shipped from the Persian Gulf.
Each of these three products will trade in close relation to each other, generally
reflecting their slightly different qualities and the transport cost from end-user
markets, all three markets reflecting the overall real or perceived supply/demand
balance in the world market. Other crude specifications and delivery points will then
trade some ‘basis’ from these benchmark prices.
As well as the three crude products noted above, the oil market encompasses the
refined products from crude oil. While thousands of different qualities and delivery
points world-wide will ultimately result in hundreds of thousands of different prices,
in Europe and North America these can generally be linked back to a number of
relatively strong trading hubs that exist, notably:
Product type Principal hubs
Crude Brent/Cushing/Dubai
Unleaded NWE3/New York/Gulf Coast
Gas Oil/No. 2 Oil NWE/New York Harbor
Heavy Fuel Oil/No. 6 Oil NWE/New York Harbor/Far East
In addition, the rest of the barrel, propane, butane, naphtha and kerosene trade
actively, but are more limited in terms of their relevance to the energy complex.
Within the various product ranges prices are quoted for particular standard grades.
For instance, No. 6 oil (also known as HFO or residual oil) can be segmented to 1%,
2.2%, 3% and 3.5% sulfur specifications. Each have their own forward curves and
active trading occurs both on the individual product and between the products. The
market has developed to the point where NYMEX lists not only option prices but also
Crack Spread Options (the option on the spread between the products).4
Like its other energy counterparts most of the trading is done in the OTC ‘brokered’
market that supports most of the commonly traded options, swaps and other
derivative structures seen in the financial markets. Derivatives are particularly useful
in oil compared to other energy products given the international nature of the product
and the relationship between the overall oil complex. For instance, if we take an
airline company, this needs a jet fuel hedge that reflects the weighted average cost
of its physical spot fuel price purchases in different parts of the world. At the same
time it would like to avoid any competitive loss it might experience from hedging out
at high prices. This would be complex (and unnecessary) to achieve physically, but
relatively straightforward to hedge using a combination of different swaps and
average price options, which can be easily linked to currency hedges.
Another common swap is the front-to-back spread, or synthetic storage. This
allows the current spot price to be swapped for a specified forward month. It should
be noted that this relationship may be positive or negative, depending on market
expectations. Locational swaps are also very common, providing a synthetic transport
cost. Such swap providers in this market (and all energy markets), however, need to
be very aware of both the physical logistics and the spot market volatility.
Crack spreads and Crack spread options are used to create synthetic refineries.
The 3:2:1 crack spread that is traded in NYMEX is a standard example of this linking
the prices of crude, heating oil and gasoline.
In oil, the majority of swap transactions are carried out against Platt’s indices that
cover most products and locations, although a number of other credible indices exist
in different locations. For instance, CFD’s (Contracts for Differences) are commonly
traded against ‘dated’ Brent, the price for physical cargoes loading shortly and a
forward Brent price approximately three months away.
While such derivatives are easy to construct and transact against the liquid hubs
they have their dangers when using them to hedge physical product at a specific
delivery point. Specific supply/demand factors can cause spreads between locations
and the hubs to change dramatically for short periods of time before they move back
into equilibrium. For example, extreme weather conditions can lead to significant
shortages in specific locations where imports are not possible leading to a complete
breakdown of the correlation between the physical product and the index being used
to hedge. In other words you lose your hedge exactly when you need it. A risk
manager must look carefully at the spreads during such events and the impact on
the correlations used in VaR and Stress tests. They should also understand the
underlying supply/demand conditions and how they could react during such extreme
events.
It should also be noted that oil products are often heavily taxed and regulated on
a state and national basis which can lead to a number of legal, settlement and
logistical complexities. Going hand in hand with this is the environmental risks
associated with storage and delivery, where insurance costs can be very substantial.
Ever-changing refinery economics, storage and transportation costs associated
with the physical delivery of oil are thus a significant factor in pricing which results
in the forward curve dynamics being more complex than those seen in the financial
markets. As a result the term structure is unpredictable in nature and can vary
significantly over time. Both backwardation5 and contago6 structures are seen within
the curve, as is a mean reversion component. Two components are commonly used
to describe the term structure of the oil forward curve: the price term structure,
notably the cost of financing and carry until the maturity date, and the convenience
yield. The convenience yield can be described as the ‘fudge factor’ capturing the
market expectations of future prices that are not captured in the arbitrage models.
This would include seasonal and trend factors.
Given the convenience yield captures the ‘unpredictable’ component of the curve,
much of the modeling of oil prices has focused on describing this convenience yield
which is significantly more complex than those seen in the financial markets. For
instance, under normal conditions (if there is such a thing), given the benefit of
having the physical commodity rather than a paper hedge, the convenience yield is
often higher than the cost of carry driving the market towards backwardation.
Fitting a complex array of price data to a consistent forward curve is a major
challenge and most energy companies have developed proprietary models based on
approaches such as HJM to solve this problem. Such models require underlying
assumptions on the shape of the curve fitting discrete data points and rigorous
testing of these assumptions is required on an ongoing basis.
Assumptions about the shape of the forward market can be very dangerous as MG
discovered. In their case they provided long-term hedges to customers and hedged
them using a rolling program of short-term future positions. As such they were
exposed to the spread or basis risk of the differential between the front end of the
market (approximately three-month hedges) and the long-term sales (up to ten years).
When oil prices in 1993 fell dramatically they had to pay out almost a billion dollars
or margin calls in their short-term positions but saw no offsetting benefit from their
long-term sales. In total they were reported to have lost a total of $1.3 billion by
misunderstanding the volatility of this spread.
Particularly in the case of heating oil, significant seasonality can exists. Given the
variation in demand throughout the year and storage economics, the convenience
yield will vary with these future demand expectations. This has the characteristic of
pronounced trends, high in winter when heating oil is used, low in summer and a
large random element given the underlying randomness of weather conditions.
The oil market also exhibits mean reversion characteristics. This makes sense,
since production economics show a relatively flat cost curve (on a worldwide basis
the market can respond to over- and under-supply and that weather conditions (and
thus the demand parameters) will return to normal after some period.
In addition, expected supply conditions will vary unpredictably from time to time.
Examples of this include the OPEC and Gulf War impacts on perceived supply risks.
Such events severely disrupt the pricing at any point leading to a ‘jump’ among the
random elements and disrupting both the spot prices and the entire dynamics of the
convenience yield. I will return to the problem of ‘jumps’ and ‘spikes’ later in this
chapter. 529
The energy forward curve
Energy forward curves generally exhibit certain common characteristics; notably,
forward curves in the USA are based upon a wheel and spoke design. A small number
of strong trading hubs exist that, relative to the remaining parts of the market, are
very liquid. In addition, liquidity has been enhanced by the formation of exchangebased
contracts (in particular NYMEX and the IPE) as well as OTC (over-the-counter)
trading.
The currently developed trading hubs do not represent a product that all the
buyers and sellers want, but a particular quality and delivery point that can set a
transparent and ‘unbiased’ benchmark that the industry can price around. Trading
away from these hubs are normally done on ‘basis’. In other words, premiums or
discounts are paid depending on the differential value of the product compared to
the hub product. This differential may reflect a higher or lower transport cost, quality
or locational supply/demand conditions.
forward curves in the USA are based upon a wheel and spoke design. A small number
of strong trading hubs exist that, relative to the remaining parts of the market, are
very liquid. In addition, liquidity has been enhanced by the formation of exchangebased
contracts (in particular NYMEX and the IPE) as well as OTC (over-the-counter)
trading.
The currently developed trading hubs do not represent a product that all the
buyers and sellers want, but a particular quality and delivery point that can set a
transparent and ‘unbiased’ benchmark that the industry can price around. Trading
away from these hubs are normally done on ‘basis’. In other words, premiums or
discounts are paid depending on the differential value of the product compared to
the hub product. This differential may reflect a higher or lower transport cost, quality
or locational supply/demand conditions.
Development of alternative approaches to risk in the energy markets
In response to this market price uncertainty, many oil companies modified traditional
investment analysis approaches to include scenario analysis rather than forecasting
analysis as well as starting to lever off their hedging and trading operations. The use
of a scenario approach in investment decisions was an early indication that even oil
majors accepted that they could not predict future price movements with any
certainty.
Meanwhile the financial engineers on Wall Street were solving the same issue from
another direction, notably the development and refinement of the derivative pricing
models using quantitative approaches. Option pricing models through the 1980s
began by stripping out the observable forward markets from market uncertainty.
Although relatively straightforward in nature, these models facilitated a key move
away from a fundamental analysis approach and allowed the application of some
proven statistical concepts to the markets, most notably the measure of market
uncertainty through the use of volatility estimators.
With the exception of a small group of specialized oil traders, the energy markets
were much slower than the financial markets in embracing these quantitative
approaches. The reasons for this are many and begin to signal many of the risk
management issues associated with energy, notably: . . . energy markets are immature
and often still partly regulated, complex in their interrelationships (both between
products and regional delivery points), constrained by lack of storage, subject to
large seasonal swings, mean reversion, subject to large investment cycle issues,
delivered products tend to be very complex in nature . . . and the list goes on. On a
continuum the complexity increases exponentially as we move from the money
markets to the oil market to the gas market to the electricity markets.
In the last few years an increasing number of practitioners and academics have
began to take on the challenge of developing and modifying quantitative approaches
for the energy markets. The reason for this is simple: while the complexity is much
higher in these markets, the underlying assumption in the quantitative models that
the future is essentially random rather than predictable in nature is particularly
relevant to an increasingly commoditized energy sector. The quantitative approach
is also particularly useful when aggregating a diverse book like an energy portfolio.
For instance, Value-at-Risk (VaR) allows us to aggregate separate oil, gas and power
books daily on a consistent basis. It is difficult to do this without applying a statistical
approach.
The development of risk management professionals within the energy sector has
also accelerated as energy companies have developed their commodity trading experience
and embraced the middle-office concept. An independent middle office is
particularly important in the energy sector given the complexity of the markets. A
combination of market knowledge, a healthy dose of skepticism and a control culture
focused on quantifying the risks provides an essential balance in developing markets
with little historical information and extreme volatility.
Each of the three principal risk management areas – market risk, counterparty
credit risk and operational risk – are relevant to an energy business. There is not
enough space in one chapter to describe the markets themselves in any detail so I
shall focus primarily on those parts of the markets that impinge on the role of the
risk manager. In addition, the examples used will relate primarily to the power
markets, in particular in the USA. This is not to imply that this is the most important
market or the most developed, but quite simply because it provides useful examples
of most of the quantitative problems that need to be addressed by risk management
professionals within energy companies, whether based in Houston, London or
Sydney.
investment analysis approaches to include scenario analysis rather than forecasting
analysis as well as starting to lever off their hedging and trading operations. The use
of a scenario approach in investment decisions was an early indication that even oil
majors accepted that they could not predict future price movements with any
certainty.
Meanwhile the financial engineers on Wall Street were solving the same issue from
another direction, notably the development and refinement of the derivative pricing
models using quantitative approaches. Option pricing models through the 1980s
began by stripping out the observable forward markets from market uncertainty.
Although relatively straightforward in nature, these models facilitated a key move
away from a fundamental analysis approach and allowed the application of some
proven statistical concepts to the markets, most notably the measure of market
uncertainty through the use of volatility estimators.
With the exception of a small group of specialized oil traders, the energy markets
were much slower than the financial markets in embracing these quantitative
approaches. The reasons for this are many and begin to signal many of the risk
management issues associated with energy, notably: . . . energy markets are immature
and often still partly regulated, complex in their interrelationships (both between
products and regional delivery points), constrained by lack of storage, subject to
large seasonal swings, mean reversion, subject to large investment cycle issues,
delivered products tend to be very complex in nature . . . and the list goes on. On a
continuum the complexity increases exponentially as we move from the money
markets to the oil market to the gas market to the electricity markets.
In the last few years an increasing number of practitioners and academics have
began to take on the challenge of developing and modifying quantitative approaches
for the energy markets. The reason for this is simple: while the complexity is much
higher in these markets, the underlying assumption in the quantitative models that
the future is essentially random rather than predictable in nature is particularly
relevant to an increasingly commoditized energy sector. The quantitative approach
is also particularly useful when aggregating a diverse book like an energy portfolio.
For instance, Value-at-Risk (VaR) allows us to aggregate separate oil, gas and power
books daily on a consistent basis. It is difficult to do this without applying a statistical
approach.
The development of risk management professionals within the energy sector has
also accelerated as energy companies have developed their commodity trading experience
and embraced the middle-office concept. An independent middle office is
particularly important in the energy sector given the complexity of the markets. A
combination of market knowledge, a healthy dose of skepticism and a control culture
focused on quantifying the risks provides an essential balance in developing markets
with little historical information and extreme volatility.
Each of the three principal risk management areas – market risk, counterparty
credit risk and operational risk – are relevant to an energy business. There is not
enough space in one chapter to describe the markets themselves in any detail so I
shall focus primarily on those parts of the markets that impinge on the role of the
risk manager. In addition, the examples used will relate primarily to the power
markets, in particular in the USA. This is not to imply that this is the most important
market or the most developed, but quite simply because it provides useful examples
of most of the quantitative problems that need to be addressed by risk management
professionals within energy companies, whether based in Houston, London or
Sydney.
Background
Risk management has always been at the forefront of those within the energy industry
and indeed those within government and other regulatory bodies setting energy
policy. From OPEC to nationalized generation and distribution companies, the risks
associated with movements in energy prices have been keenly debated by both
politicians and industry observers. As such, assessing the risks associated with the
energy markets is not a new phenomenon. However, the recent global trend to shift
the risk management of the gas and power markets from regulated to open markets
is radically changing the approach and tools necessary to operate in these markets.
Energy price hedging in oil can be traced back to the introduction of the first
heating oil contracts on NYMEX in 1978 and the development of oil derivative
products in the mid-1980s, in particular with the introduction of the ‘Wall Street
Refiners’ including the likes of J. Aron and Morgan Stanley who developed derivative
products such as ‘crack’ spreads which reflected the underlying economics of refineries.
While the traditional risk management techniques of oil companies changed
radically in the 1970s and 1980s the traditional model for managing gas and power
risk remained one of pass through to a captive customer group well into the 1990s.
In gas and electricity, regionalized regulated utility monopolies have traditionally
bought long-term contracts from producers and passed the costs onto their retail
base. The focus was on what the correct costs to pass through were and what
‘regulatory pact’ should be struck between regulators and the utilities. Starting with
a politically driven trend away from government ownership in the 1980s and early
1990s, this traditional model is now changing rapidly in the USA, Europe, Australia,
Japan and many other parts of the world.
Apart from the underlying shift in economic philosophy, the primary driver behind
the change in approach has been the dramatic price uncertainty in the energy
markets. Large price movements in the only unregulated major energy market, oil,
left utilities with increasing uncertainty in their planning and thus an increasing
financial cost of making incorrect decisions. For instance, the worldwide move by
utilities towards nuclear power investments as a means to diversify away from the
high oil prices in the 1970s led to significant ‘above market’ or stranded costs for
many utilities.
and indeed those within government and other regulatory bodies setting energy
policy. From OPEC to nationalized generation and distribution companies, the risks
associated with movements in energy prices have been keenly debated by both
politicians and industry observers. As such, assessing the risks associated with the
energy markets is not a new phenomenon. However, the recent global trend to shift
the risk management of the gas and power markets from regulated to open markets
is radically changing the approach and tools necessary to operate in these markets.
Energy price hedging in oil can be traced back to the introduction of the first
heating oil contracts on NYMEX in 1978 and the development of oil derivative
products in the mid-1980s, in particular with the introduction of the ‘Wall Street
Refiners’ including the likes of J. Aron and Morgan Stanley who developed derivative
products such as ‘crack’ spreads which reflected the underlying economics of refineries.
While the traditional risk management techniques of oil companies changed
radically in the 1970s and 1980s the traditional model for managing gas and power
risk remained one of pass through to a captive customer group well into the 1990s.
In gas and electricity, regionalized regulated utility monopolies have traditionally
bought long-term contracts from producers and passed the costs onto their retail
base. The focus was on what the correct costs to pass through were and what
‘regulatory pact’ should be struck between regulators and the utilities. Starting with
a politically driven trend away from government ownership in the 1980s and early
1990s, this traditional model is now changing rapidly in the USA, Europe, Australia,
Japan and many other parts of the world.
Apart from the underlying shift in economic philosophy, the primary driver behind
the change in approach has been the dramatic price uncertainty in the energy
markets. Large price movements in the only unregulated major energy market, oil,
left utilities with increasing uncertainty in their planning and thus an increasing
financial cost of making incorrect decisions. For instance, the worldwide move by
utilities towards nuclear power investments as a means to diversify away from the
high oil prices in the 1970s led to significant ‘above market’ or stranded costs for
many utilities.
Energy risk management
This chapter focuses on the challenges facing a risk manager overseeing an energy
portfolio. It sets out a general overview of the markets as they relate to risk management
and the risk quantification and control issues implicit in an energy portfolio.
The energy markets are extremely intricate, rich in multiple markets, liquidity
problems, extreme volatility issues, non-normal distributions, ‘real’ option pricing
problems, mark-to-model problems, operational difficulties and data management
nightmares. The market, to use the academic understatement, is complex and
challenging but most of all it is extremely interesting. In particular, this chapter will
focus on the challenges in the electricity market, which is by far the largest market
within energy1 and exhibits most of the problems faced by energy risk managers,
whether in power or not.
portfolio. It sets out a general overview of the markets as they relate to risk management
and the risk quantification and control issues implicit in an energy portfolio.
The energy markets are extremely intricate, rich in multiple markets, liquidity
problems, extreme volatility issues, non-normal distributions, ‘real’ option pricing
problems, mark-to-model problems, operational difficulties and data management
nightmares. The market, to use the academic understatement, is complex and
challenging but most of all it is extremely interesting. In particular, this chapter will
focus on the challenges in the electricity market, which is by far the largest market
within energy1 and exhibits most of the problems faced by energy risk managers,
whether in power or not.
21 Haziran 2011 Salı
Special issues
There should be frequent interaction between the risk managers and the and
compliance unit. Risk managers can alert compliance to risk concentrations as well
as large risk changes. Conversely, compliance violations may serve as an early
warning for the risk managers that analysis or operations controls may be
insufficient.
Both internal and external auditors provide a fresh perspective on compliance
and documentation controls. Regulators frequently refer to external auditors’ work
papers. Since work papers may be accessed by the regulators, it is important to
review problem areas or challenges cited in these reports. On a cautionary note,
one should not always rely on the conclusions of external auditors. Often they are
not tough enough, especially if they have been reviewing the same firm for many
years. They may become complacent. Alternatively, in a merger situation, there is
the moral hazard risk that the auditors may be less confrontational if they fear
losing the company’s business. Audits typically occur on an annual basis but rarely
more frequently. One should ensure that the day-to-day gets done properly and a
year between recommendations of changes and the next audit may be too long a
time.
The required implementation of FAS 133, delayed until after June 2000, will
necessitate extensive new documentation requirements for individual companies.
The exact contours of these requirements are still being worked out by a FAS working
group and interested parties. Each derivatives hedge will need to be classified, e.g.
as a fair value or cash flow hedge and each hedge will need to be tested periodically
for effectiveness. The economic performance of the hedge will be divided into ineffective
and effective components, assuming it is not a perfect offset. New subledger
accounts need to be created to record these entries and income and/or equity
volatility is likely occur due to these changes. High-volume users will need to integrate
FAS 133 classification directly into the reporting systems. An ironic result of FAS
133 is that the accounting hurdles to qualify for hedge accounting may well be more
stringent that legal requirements authorizing the use of derivatives for some endusers.
Since the new changes are so fundamental, it is likely that a new accounting
policy manual will need to be written to incorporate all the contemplated changes.
Ensuring consistent usage and treatments across portfolios will create new compliance
hurdles.
Y2K preparations have received endless attention in the popular media and industry
meetings. Business resumption plans and back-up systems are an integral part
of theses efforts. Special issues to be addressed include the need to maintain ready
(manual) access to trade confirmations, ISDA master agreements, cash forecast
reports, credit line availability, etc. The prompt receipt of and sending of trade
confirmations is a crucial control to establishing contractual rights.
Summary
Compliance and documentation controls are rarely popular topics. In the area of
derivatives, controls are complicated by overlapping or inconsistent regulatory oversight.
One senior attorney termed the complicated US regulatory system as a ‘bifurcated
mess’ (Russo, 1994). Compliance extends beyond addressing regulators’
guidance or adherence to internal polices; other agencies can exercise oversight.
Witness First Union Corp.’s problems for violating US Treasury auction rules. These
violations were against restrictions prohibiting the prior resale of Treasuries bought
via no-competitive bids at government auction. Although the US Treasury did not
have regulatory oversight and was not on the ‘radar screen’, it still was able to enforce
sanctions against First Union (Vames, 1999).
Compliance serves an especially valuable role in safeguarding the reputation of a
firm and ensuring that there are no nasty surprises. There is a variety of compliance
infrastructures and the most workable ones have the flexibility to respond to market
and regulatory changes. Large compliance problems do not typically result as the
result of a single transaction but of a pattern of action that develops over time. Onsite
monitoring helps discourage these patterns of behavior. The support of business
lines should be sought and they should be involved in the writing of the compliance
policies. Compliance controls should be on-site, comprehensive, linked to the business,
and coordinated by a central compliance unit. Effective controls can help
reduce capital needed for the business.
Compliance must examine the microlevel transactions as well as the macrolevel
(e.g. credit concentrations.) Partnerships, joint ventures, and third-party sales forces
are especially troublesome since a firm’s money and reputation are on the line and
the firm may have limited oversight of compliance controls.
Compliance management can be costly and may absorb valuable resources, and
regulators are cognizant of this. In the future, regulators will likely rely more on
internal business reports and function more as supervisors than regulators. This
oversight should allow examination to be more streamlined and to focus on existing
and emerging problem areas (Wixted, 1987). Regulators will ask for special exposure
reports as new crises emerge and a firm’s data systems must be able to run these
special queries.
The goal of compliance is not to achieve a minimum passing grade. Rather it is to
ensure that regulations are being followed, internal policies and procedures are being
adhered to, effective controls are in place, and that timely and accurate information
is being provided to senior management and ultimately to the board. If a company
performs its compliance duties well, the controls will be professional and unobtrusive,
and enable senior management to focus on other business concerns. The best
compliance efforts are those that will keep pace with the ever-expanding derivatives
markets.
Notes
1 OCC, release 96.2, occ.treas.gov
2 Enterprise Risk Management, Glyn Holton, p. 7, contingencyanalysis.com
3 Several large US life insurers have implemented enhanced compliance policies due to the
sales practices scandal of the early 1990s. (Salesforces often view them as quite burdensome
since every new sale is checked as opposed to a spot-checking process.) Several companies
received large fines from state regulators due to the manner in which policies were sold to
the public. Although derivatives were not involved, the lack of disclosure is analogous to
derivative sales problems.
4 Charges were based on the ‘books and records’ provision of the Securities Exchange Act of
1934.
5 ISDA stands for International Swaps and Derivatives Association, Inc. and IFEMA for International
Foreign Exchange Master Agreement. Standard contract forms created by these
industry groups are used as the basis for documenting the rights and duties of parties to
over-the-counter derivatives contracts.
6ABN’s New York office discovered the misvaluations of foreign currency call options held by
a FX options trader. In the news stories published, it was indicated that the implied volatilities
of options held were overstated in order to hide losses.
7 There is a wealth of guidance in the area of derivative risk control. Several regulatory
organizations as well as private industry groups have produced excellent suggestions and
guidelines for writing risk policies. Most prominent are Group of 30, the Federal Reserve,
the OCC, and others as well as the Risk Standards Working Group (focusing on money
managers).
8 By David E. Aron, an associate in the futures and derivatives practice at Dechert Price &
Rhoads in Washington, DC, and Jeremy Bassil, an associate in the Financial Services
Department at Titmuss Sainer Dechert in London.
Appendix: US and UK regulatory schemes
Table A1 Major US regulatory oversight
Commercial bank (depending on charter)
Federal Reserve Board and local Fed OCC (depending on charter)
State Banking Department (depending on charter)
FDIC
Insurance company (pension fund monies trigger ERISA laws)
State Insurance Department
NAIC
SEC
NASD
Investment bank
SEC
State securities (blue sky) laws
NASD
Exchanges and their clearing corporations (e.g. NYSE)
Banking Regulator (if bank sub)
CFTC and commodities exchanges
Table A2 Current major UK regulatory oversight8
Commercial or investment banka
Bank of England (BoE)b
Financial Services Authority (FSA)c
Insurance companyd
Her Majesty’s Treasury (HMT)e
Pesonal investment authority (PIA)f
Retail brokerage
SFAg
PIA
aInsofar as commercial or investment banks (or other entities in this table)
conduct certain activities, they may also be regulated by the Investment
Management Regulatory Organization (investment management) or
Securities and Futures Authority (SFA) (e.g. corporate finance).
bHas only general market protection authority – regulates the banking
system, the money supply and payment systems.
cRegulates authorization and supervision.
dLloyd’s and other commercial insurers are generally unregulated.
eResponsible fo prudential and related regulation.
fRegulates intermediaries marking investment products to retail customers
and regulates the product providers themselves.
gRegulates broker-dealers.
Table A3 UK regulatory oversight upon enactment of the Financial
services and Markets Billa,8
Commercial or investment bank
BoE
FSA
Insurance company
FSAb
Retail brokerage
FSAc
aThe Financial Services and Markets Bill is expected to be enacted by
early 2000.
bWill assume current authority of HMT and PIA; regulation of Lloyd’s and
other commercial insurers is being considered.
c Will assume current authority of SFA and PIA.
References
Basel Committee on Banking Supervision (1998) Framework for the evaluation of
internal control systems, Basel, January, p. 15.
Erikson, J. O. (1996) ‘Lessons for policymakers and private practitioners in risk
management’, Derivatives and Public Policy Conference, frbchi.org, p. 54.
Ewing, T. and Bailey, J. (1999) ‘Dashed futures: how a trading firm’s founders were
blindsided by a bombshell’, Wall Street Journal, 18 February, C1.
McDermott, D. and Webb, S. (1999) ‘How Merrill wished upon a star banker and
wound up in a Singapore sling’, Wall Street Journal, 21 May, C1.
OCC Comptroller’s Handbook (1997) ‘Risk management of financial derivatives’,
Washington, DC, January. occ.treas.gov, p. 64.
Peteren, M. (1999) ‘Merrill charged with 2d firms in copper case’, New York Times,
21 May, d7.
Risk Standards Working Group (1996) Risk Standards for Institutional Investment
Managers and Institutional Investors, p. 19, cmra.com.
Russo, T. A. (1996) Address to Futures Industry Association, 4 March.
Singer, J. (1999) ‘Credit Suisse apologizes for blocking Japan probe’, Bloomberg
News Service, 21 May.
Vames, S. (1999) ‘Some public penance is payment in full for breaking rules’, Wall
Street Journal, 20 May, C20.
Wixted, J. J., Jr (1987) ‘The future of bank regulation’, Federal Reserve Bank of
Chicago, 18 July, address to the Iowa Independent Bankers Annual Meeting and
Convention, frbchi.org, p. 8. 524
compliance unit. Risk managers can alert compliance to risk concentrations as well
as large risk changes. Conversely, compliance violations may serve as an early
warning for the risk managers that analysis or operations controls may be
insufficient.
Both internal and external auditors provide a fresh perspective on compliance
and documentation controls. Regulators frequently refer to external auditors’ work
papers. Since work papers may be accessed by the regulators, it is important to
review problem areas or challenges cited in these reports. On a cautionary note,
one should not always rely on the conclusions of external auditors. Often they are
not tough enough, especially if they have been reviewing the same firm for many
years. They may become complacent. Alternatively, in a merger situation, there is
the moral hazard risk that the auditors may be less confrontational if they fear
losing the company’s business. Audits typically occur on an annual basis but rarely
more frequently. One should ensure that the day-to-day gets done properly and a
year between recommendations of changes and the next audit may be too long a
time.
The required implementation of FAS 133, delayed until after June 2000, will
necessitate extensive new documentation requirements for individual companies.
The exact contours of these requirements are still being worked out by a FAS working
group and interested parties. Each derivatives hedge will need to be classified, e.g.
as a fair value or cash flow hedge and each hedge will need to be tested periodically
for effectiveness. The economic performance of the hedge will be divided into ineffective
and effective components, assuming it is not a perfect offset. New subledger
accounts need to be created to record these entries and income and/or equity
volatility is likely occur due to these changes. High-volume users will need to integrate
FAS 133 classification directly into the reporting systems. An ironic result of FAS
133 is that the accounting hurdles to qualify for hedge accounting may well be more
stringent that legal requirements authorizing the use of derivatives for some endusers.
Since the new changes are so fundamental, it is likely that a new accounting
policy manual will need to be written to incorporate all the contemplated changes.
Ensuring consistent usage and treatments across portfolios will create new compliance
hurdles.
Y2K preparations have received endless attention in the popular media and industry
meetings. Business resumption plans and back-up systems are an integral part
of theses efforts. Special issues to be addressed include the need to maintain ready
(manual) access to trade confirmations, ISDA master agreements, cash forecast
reports, credit line availability, etc. The prompt receipt of and sending of trade
confirmations is a crucial control to establishing contractual rights.
Summary
Compliance and documentation controls are rarely popular topics. In the area of
derivatives, controls are complicated by overlapping or inconsistent regulatory oversight.
One senior attorney termed the complicated US regulatory system as a ‘bifurcated
mess’ (Russo, 1994). Compliance extends beyond addressing regulators’
guidance or adherence to internal polices; other agencies can exercise oversight.
Witness First Union Corp.’s problems for violating US Treasury auction rules. These
violations were against restrictions prohibiting the prior resale of Treasuries bought
via no-competitive bids at government auction. Although the US Treasury did not
have regulatory oversight and was not on the ‘radar screen’, it still was able to enforce
sanctions against First Union (Vames, 1999).
Compliance serves an especially valuable role in safeguarding the reputation of a
firm and ensuring that there are no nasty surprises. There is a variety of compliance
infrastructures and the most workable ones have the flexibility to respond to market
and regulatory changes. Large compliance problems do not typically result as the
result of a single transaction but of a pattern of action that develops over time. Onsite
monitoring helps discourage these patterns of behavior. The support of business
lines should be sought and they should be involved in the writing of the compliance
policies. Compliance controls should be on-site, comprehensive, linked to the business,
and coordinated by a central compliance unit. Effective controls can help
reduce capital needed for the business.
Compliance must examine the microlevel transactions as well as the macrolevel
(e.g. credit concentrations.) Partnerships, joint ventures, and third-party sales forces
are especially troublesome since a firm’s money and reputation are on the line and
the firm may have limited oversight of compliance controls.
Compliance management can be costly and may absorb valuable resources, and
regulators are cognizant of this. In the future, regulators will likely rely more on
internal business reports and function more as supervisors than regulators. This
oversight should allow examination to be more streamlined and to focus on existing
and emerging problem areas (Wixted, 1987). Regulators will ask for special exposure
reports as new crises emerge and a firm’s data systems must be able to run these
special queries.
The goal of compliance is not to achieve a minimum passing grade. Rather it is to
ensure that regulations are being followed, internal policies and procedures are being
adhered to, effective controls are in place, and that timely and accurate information
is being provided to senior management and ultimately to the board. If a company
performs its compliance duties well, the controls will be professional and unobtrusive,
and enable senior management to focus on other business concerns. The best
compliance efforts are those that will keep pace with the ever-expanding derivatives
markets.
Notes
1 OCC, release 96.2, occ.treas.gov
2 Enterprise Risk Management, Glyn Holton, p. 7, contingencyanalysis.com
3 Several large US life insurers have implemented enhanced compliance policies due to the
sales practices scandal of the early 1990s. (Salesforces often view them as quite burdensome
since every new sale is checked as opposed to a spot-checking process.) Several companies
received large fines from state regulators due to the manner in which policies were sold to
the public. Although derivatives were not involved, the lack of disclosure is analogous to
derivative sales problems.
4 Charges were based on the ‘books and records’ provision of the Securities Exchange Act of
1934.
5 ISDA stands for International Swaps and Derivatives Association, Inc. and IFEMA for International
Foreign Exchange Master Agreement. Standard contract forms created by these
industry groups are used as the basis for documenting the rights and duties of parties to
over-the-counter derivatives contracts.
6ABN’s New York office discovered the misvaluations of foreign currency call options held by
a FX options trader. In the news stories published, it was indicated that the implied volatilities
of options held were overstated in order to hide losses.
7 There is a wealth of guidance in the area of derivative risk control. Several regulatory
organizations as well as private industry groups have produced excellent suggestions and
guidelines for writing risk policies. Most prominent are Group of 30, the Federal Reserve,
the OCC, and others as well as the Risk Standards Working Group (focusing on money
managers).
8 By David E. Aron, an associate in the futures and derivatives practice at Dechert Price &
Rhoads in Washington, DC, and Jeremy Bassil, an associate in the Financial Services
Department at Titmuss Sainer Dechert in London.
Appendix: US and UK regulatory schemes
Table A1 Major US regulatory oversight
Commercial bank (depending on charter)
Federal Reserve Board and local Fed OCC (depending on charter)
State Banking Department (depending on charter)
FDIC
Insurance company (pension fund monies trigger ERISA laws)
State Insurance Department
NAIC
SEC
NASD
Investment bank
SEC
State securities (blue sky) laws
NASD
Exchanges and their clearing corporations (e.g. NYSE)
Banking Regulator (if bank sub)
CFTC and commodities exchanges
Table A2 Current major UK regulatory oversight8
Commercial or investment banka
Bank of England (BoE)b
Financial Services Authority (FSA)c
Insurance companyd
Her Majesty’s Treasury (HMT)e
Pesonal investment authority (PIA)f
Retail brokerage
SFAg
PIA
aInsofar as commercial or investment banks (or other entities in this table)
conduct certain activities, they may also be regulated by the Investment
Management Regulatory Organization (investment management) or
Securities and Futures Authority (SFA) (e.g. corporate finance).
bHas only general market protection authority – regulates the banking
system, the money supply and payment systems.
cRegulates authorization and supervision.
dLloyd’s and other commercial insurers are generally unregulated.
eResponsible fo prudential and related regulation.
fRegulates intermediaries marking investment products to retail customers
and regulates the product providers themselves.
gRegulates broker-dealers.
Table A3 UK regulatory oversight upon enactment of the Financial
services and Markets Billa,8
Commercial or investment bank
BoE
FSA
Insurance company
FSAb
Retail brokerage
FSAc
aThe Financial Services and Markets Bill is expected to be enacted by
early 2000.
bWill assume current authority of HMT and PIA; regulation of Lloyd’s and
other commercial insurers is being considered.
c Will assume current authority of SFA and PIA.
References
Basel Committee on Banking Supervision (1998) Framework for the evaluation of
internal control systems, Basel, January, p. 15.
Erikson, J. O. (1996) ‘Lessons for policymakers and private practitioners in risk
management’, Derivatives and Public Policy Conference, frbchi.org, p. 54.
Ewing, T. and Bailey, J. (1999) ‘Dashed futures: how a trading firm’s founders were
blindsided by a bombshell’, Wall Street Journal, 18 February, C1.
McDermott, D. and Webb, S. (1999) ‘How Merrill wished upon a star banker and
wound up in a Singapore sling’, Wall Street Journal, 21 May, C1.
OCC Comptroller’s Handbook (1997) ‘Risk management of financial derivatives’,
Washington, DC, January. occ.treas.gov, p. 64.
Peteren, M. (1999) ‘Merrill charged with 2d firms in copper case’, New York Times,
21 May, d7.
Risk Standards Working Group (1996) Risk Standards for Institutional Investment
Managers and Institutional Investors, p. 19, cmra.com.
Russo, T. A. (1996) Address to Futures Industry Association, 4 March.
Singer, J. (1999) ‘Credit Suisse apologizes for blocking Japan probe’, Bloomberg
News Service, 21 May.
Vames, S. (1999) ‘Some public penance is payment in full for breaking rules’, Wall
Street Journal, 20 May, C20.
Wixted, J. J., Jr (1987) ‘The future of bank regulation’, Federal Reserve Bank of
Chicago, 18 July, address to the Iowa Independent Bankers Annual Meeting and
Convention, frbchi.org, p. 8. 524
Automating processes
Automating processes for the benefit of compliance is a difficult sell in most organizations.
It costs money and compliance is not a revenue area. Compliance often finds
itself looking to risk management reports generated for different purposes in order
to track activities and transactions. Information may indeed be available but the
focus of the data architects was on different goals. A common hurdle is that
reconciliation are done manually to end reports and not to source input. This causes
the similar reconciliation to be preformed periodically and sometimes previous
corrections are omitted in later reports and have to be redone.
Risk management reports may utilize different standards of accuracy since those
reports are focused more on economic exposure as opposed to legal risks and
documentation risks. The reports will likely focus on end-of-day or reporting period
rather than providing equal focus with intraday trades and closed-out positions.
Obviously any computer report will not provide the reader with the context for the
decision nor whether sufficient disclosure occurred nor what suitability checks were
performed.
Given the variety of systems and derivative instruments available, there may not
be a ready ability to perform an electronic file transfer. The alternative is to work
with existing reports and often a rekeying the data into a spreadsheet format. If the
number of transactions are too cumbersome then a possible approach is to sample
typical transactions and test the thoroughness and timeliness of the supporting
documentation.
With the proliferation of databases, these are useful tools to help standardize
documentation and disclosure. A database can provide a sample of standardized
disclosures and consistent templates for term sheets. One should require that all
term sheets sent out be copied and retained by a compliance unit.
When compliance standards and controls are set too high, it can engender resistance,
avoidance, or a hesitation to do something profitable and in the best interests
of the shareholders. The following are several examples of processes or procedures
that were counterproductive.
An end-user established an elaborate approval process for the approval of foreign
exchange forwards. Only a couple of senior managers could authorize transactions.
Given the difficulty of getting a time slot to see the senior people and the elaborate
form, the employee simply waited until the forward exposure became a spot transaction.
He then executed in the market and avoided the approval process. The trader
was not held accountable for gains or losses on unhedged positions and so expediency
ruled.
In another case, a company allowed only its CEO to authorize the use of the
company’s guarantee. Given the inability to schedule time with the CEO and the
smaller relative size of the transaction that need a guarantee, the profitable opportunity
was allowed to be passed by.
In another situation, the SVP level in a company could approve expenditures up
to a limited dollar amount on IT systems, otherwise it went to the board for approval.
A derivatives monitoring system was needed. So the need was split into different
budget cycles. The result was two systems that did not provide a consistent valuation
and monitoring capabilities to the derivatives holdings.
In another case, an end-user in a highly regulated industry wanted to buy receiver
swaptions in order to hedge MBS prepayment risk in the event of lower rates. There
was no specific authorization or prohibition in the law as to the use of swaptions.
The in-house legal department refrained from going for regulatory approval since
derivatives were considered to have too high a profile and the company wanted to
avoid additional oversight requirements. So no hedges were ever done.
The highest comfort level possible is obtained by performing a compliance audit.
Although onerous and time-consuming, it’s the best approach. If practical, randomly
select several days a month where you review each transaction that occurred and
‘track through’ the process to ensure that all procedures were adequately followed.
Look more closely than simply verifying that all documents were signed. How
many revisions occurred (were they material), was there a delay in the sign-off
confirmations? Were intraday or overnight position limits breached? Did the market
trigger the violation or was it an active breach? How long did the breach languish?
Was the breach properly escalated? Did management reports contain all the required
information? Were exceptions properly noted? Is there a compliance calendar? Were
regulatory reports filed on time?
Each salesperson should be able to provide a listing of active clients and deactivate
old customers. Old authorizations or documentation that becomes stale should be
reviewed automatically. On an annual basis, a compliance staffer should review the
documentation file to ensure that it remains adequate and there are no omissions.
Companies are rarely blindsided by regulatory change, rather it is the failure to
adequately prepare to accommodate the change that is the problem.
Consistency in approach and effort is a critical standard for effective compliance
oversight. It is inconsistent controls that create the opportunity for problems to
occur, fester, and multiply. Critical to success is a good personal and working
relationship between the business side and compliance ‘crew’. If personality conflicts
occur or egos clash, then the each side may work at cross-purposes or simply revert
to a ‘help only if asked’ approach. Effectiveness only occurs with consistent teamwork
and trust.
It costs money and compliance is not a revenue area. Compliance often finds
itself looking to risk management reports generated for different purposes in order
to track activities and transactions. Information may indeed be available but the
focus of the data architects was on different goals. A common hurdle is that
reconciliation are done manually to end reports and not to source input. This causes
the similar reconciliation to be preformed periodically and sometimes previous
corrections are omitted in later reports and have to be redone.
Risk management reports may utilize different standards of accuracy since those
reports are focused more on economic exposure as opposed to legal risks and
documentation risks. The reports will likely focus on end-of-day or reporting period
rather than providing equal focus with intraday trades and closed-out positions.
Obviously any computer report will not provide the reader with the context for the
decision nor whether sufficient disclosure occurred nor what suitability checks were
performed.
Given the variety of systems and derivative instruments available, there may not
be a ready ability to perform an electronic file transfer. The alternative is to work
with existing reports and often a rekeying the data into a spreadsheet format. If the
number of transactions are too cumbersome then a possible approach is to sample
typical transactions and test the thoroughness and timeliness of the supporting
documentation.
With the proliferation of databases, these are useful tools to help standardize
documentation and disclosure. A database can provide a sample of standardized
disclosures and consistent templates for term sheets. One should require that all
term sheets sent out be copied and retained by a compliance unit.
When compliance standards and controls are set too high, it can engender resistance,
avoidance, or a hesitation to do something profitable and in the best interests
of the shareholders. The following are several examples of processes or procedures
that were counterproductive.
An end-user established an elaborate approval process for the approval of foreign
exchange forwards. Only a couple of senior managers could authorize transactions.
Given the difficulty of getting a time slot to see the senior people and the elaborate
form, the employee simply waited until the forward exposure became a spot transaction.
He then executed in the market and avoided the approval process. The trader
was not held accountable for gains or losses on unhedged positions and so expediency
ruled.
In another case, a company allowed only its CEO to authorize the use of the
company’s guarantee. Given the inability to schedule time with the CEO and the
smaller relative size of the transaction that need a guarantee, the profitable opportunity
was allowed to be passed by.
In another situation, the SVP level in a company could approve expenditures up
to a limited dollar amount on IT systems, otherwise it went to the board for approval.
A derivatives monitoring system was needed. So the need was split into different
budget cycles. The result was two systems that did not provide a consistent valuation
and monitoring capabilities to the derivatives holdings.
In another case, an end-user in a highly regulated industry wanted to buy receiver
swaptions in order to hedge MBS prepayment risk in the event of lower rates. There
was no specific authorization or prohibition in the law as to the use of swaptions.
The in-house legal department refrained from going for regulatory approval since
derivatives were considered to have too high a profile and the company wanted to
avoid additional oversight requirements. So no hedges were ever done.
The highest comfort level possible is obtained by performing a compliance audit.
Although onerous and time-consuming, it’s the best approach. If practical, randomly
select several days a month where you review each transaction that occurred and
‘track through’ the process to ensure that all procedures were adequately followed.
Look more closely than simply verifying that all documents were signed. How
many revisions occurred (were they material), was there a delay in the sign-off
confirmations? Were intraday or overnight position limits breached? Did the market
trigger the violation or was it an active breach? How long did the breach languish?
Was the breach properly escalated? Did management reports contain all the required
information? Were exceptions properly noted? Is there a compliance calendar? Were
regulatory reports filed on time?
Each salesperson should be able to provide a listing of active clients and deactivate
old customers. Old authorizations or documentation that becomes stale should be
reviewed automatically. On an annual basis, a compliance staffer should review the
documentation file to ensure that it remains adequate and there are no omissions.
Companies are rarely blindsided by regulatory change, rather it is the failure to
adequately prepare to accommodate the change that is the problem.
Consistency in approach and effort is a critical standard for effective compliance
oversight. It is inconsistent controls that create the opportunity for problems to
occur, fester, and multiply. Critical to success is a good personal and working
relationship between the business side and compliance ‘crew’. If personality conflicts
occur or egos clash, then the each side may work at cross-purposes or simply revert
to a ‘help only if asked’ approach. Effectiveness only occurs with consistent teamwork
and trust.
Centralized data gathering
Compliance casts a wide net but there are events and occurrences that can slip
through the interstices. A major pitfall of centralized data gathering is the wide
variety of derivatives products offered and the need to standardize the data. This
aggregation process can come at a cost of accuracy in the details of individual
transactions. The derivatives business has evolved dramatically and controls and
compliance efforts may fail to keep pace.
Business and technical support often falls into strict control units or divisions and
there is little overlap with other units. The systems requirements are often developed
devoid of ensuring compatibility within the entire organization. Since the same
salesperson can often sell products on behalf of a number of legal entities, effective
control becomes more problematic. Data fields, reports, etc. can mean different
things or be used for different purposes within different parts of an organization.
Information is often aggregated for risk management or accounting purposes and it
becomes difficult to isolate all the details of individual transactions. A related problem
occurs when holding are managed by an outside manager and the numbers need to
be manually ‘rolled into’ total holdings reports.
With specially tailored transactions, there may be special provisions or options
that cannot be recorded in the existing systems. As a result they may not appear on
a regular report. For simplicity, information may be ordered by stated maturity date
and not include other pertinent data. A major challenge is that report cutoff times
are often different and a good deal of time is spent on needless reconciliation. There
may be classification overlaps as well. Trusts, partnerships and affiliates and custody
agents may all figure in the equation and one may not readily obtain a complete
listing of all positions held.
To ensure that all data is being collected, one should obtain process flow diagrams
covering all product and customer flows. Lists of reports and samples of each reports
should be obtained to ensure completeness. Special attention should be paid to
reports whose formats or scope change over time since this may trigger unintended
omissions or other unhappy consequences.
Typical problem signs occur when you sometimes have the original trade documents
and sometimes copies. This indicates a lack of consistency or control. All
transactions should be serial numbered or time stamped in order to enable crosschecking
with market levels and credit limits. Files that contain only part of
the required documents or inconsistency in contents and storage locations of the
files should also cause concern. One should be especially alert for backdated
approvals.
One should also obtain a document-aging list. A signed document gives protection
against breaches since it provides the written terms of the deal and often the four
corners of the document may be the exclusive basis for determining the terms
and condition of the contract. If unsigned documents are outstanding longer than
60 days, you may want to reconsider doing another deal with the same counterparty.
through the interstices. A major pitfall of centralized data gathering is the wide
variety of derivatives products offered and the need to standardize the data. This
aggregation process can come at a cost of accuracy in the details of individual
transactions. The derivatives business has evolved dramatically and controls and
compliance efforts may fail to keep pace.
Business and technical support often falls into strict control units or divisions and
there is little overlap with other units. The systems requirements are often developed
devoid of ensuring compatibility within the entire organization. Since the same
salesperson can often sell products on behalf of a number of legal entities, effective
control becomes more problematic. Data fields, reports, etc. can mean different
things or be used for different purposes within different parts of an organization.
Information is often aggregated for risk management or accounting purposes and it
becomes difficult to isolate all the details of individual transactions. A related problem
occurs when holding are managed by an outside manager and the numbers need to
be manually ‘rolled into’ total holdings reports.
With specially tailored transactions, there may be special provisions or options
that cannot be recorded in the existing systems. As a result they may not appear on
a regular report. For simplicity, information may be ordered by stated maturity date
and not include other pertinent data. A major challenge is that report cutoff times
are often different and a good deal of time is spent on needless reconciliation. There
may be classification overlaps as well. Trusts, partnerships and affiliates and custody
agents may all figure in the equation and one may not readily obtain a complete
listing of all positions held.
To ensure that all data is being collected, one should obtain process flow diagrams
covering all product and customer flows. Lists of reports and samples of each reports
should be obtained to ensure completeness. Special attention should be paid to
reports whose formats or scope change over time since this may trigger unintended
omissions or other unhappy consequences.
Typical problem signs occur when you sometimes have the original trade documents
and sometimes copies. This indicates a lack of consistency or control. All
transactions should be serial numbered or time stamped in order to enable crosschecking
with market levels and credit limits. Files that contain only part of
the required documents or inconsistency in contents and storage locations of the
files should also cause concern. One should be especially alert for backdated
approvals.
One should also obtain a document-aging list. A signed document gives protection
against breaches since it provides the written terms of the deal and often the four
corners of the document may be the exclusive basis for determining the terms
and condition of the contract. If unsigned documents are outstanding longer than
60 days, you may want to reconsider doing another deal with the same counterparty.
Build on existing reports
A major challenge is simply to track changes and rejig reports and information to
accommodate changing regulatory needs and senior management requests. Given
the likelihood of unanticipated situations in the future, reports must be built to be
flexible with a variety of key fields or sorting methodologies. Query tools should
make reporting quite flexible. The range of reports frequently requested are market
or credit exposure by instrument, by counterparty, by industry, by country, by
maturity, etc. Depending on where the latest ‘crisis’ occurs, requests will change
accordingly.
In most companies there are official board reports that are prepared for use by the
board of directors. Generally the law department will review them to certify that all
transactions were done in compliance with applicable law and in compliance with
internal policies and authorizations. When a compliance problem occurs, the board
needs to know the nature and scope of the problem. A major pitfall is that board
meetings tend to be heavily scripted and have full agendas and focus on compliance,
other than audit reviews, may not be given high priority.
In order to ensure compliance success, the staff needs to inventory those items
and processes to be monitored. The need here is to cast as wide a net as is
appropriate. To monitor properly, one needs to know who the players are, what
instruments do they use, and how the work is organized. The following is a sample
listing of the types of reports that would be needed:
1 Aggregate volume and profitability numbers
2 Itemized information on all trades
3 VaR and scenarios results
4 Limits violation reports
5 New customer listing
6 Turnover in staff (front and back office)
7 Systems failure reports
8 UOR unusual occurrence reports (catchall)
9 Trend analysis
10 Sample term sheets used
Other relevant reports are error logs, limit violations and revenue reports. Unsigned
document aging reports are also important. These monitoring reports should be
viewed in the context of how they enable the proper timing of regulatory review and
reporting. Given the ease of renaming products for regulatory purposes, compliance
staff are well advised to request risk reports as well. Measurement of economic
exposure in the risk reports might shed more light on the true nature of some
derivative instruments.
accommodate changing regulatory needs and senior management requests. Given
the likelihood of unanticipated situations in the future, reports must be built to be
flexible with a variety of key fields or sorting methodologies. Query tools should
make reporting quite flexible. The range of reports frequently requested are market
or credit exposure by instrument, by counterparty, by industry, by country, by
maturity, etc. Depending on where the latest ‘crisis’ occurs, requests will change
accordingly.
In most companies there are official board reports that are prepared for use by the
board of directors. Generally the law department will review them to certify that all
transactions were done in compliance with applicable law and in compliance with
internal policies and authorizations. When a compliance problem occurs, the board
needs to know the nature and scope of the problem. A major pitfall is that board
meetings tend to be heavily scripted and have full agendas and focus on compliance,
other than audit reviews, may not be given high priority.
In order to ensure compliance success, the staff needs to inventory those items
and processes to be monitored. The need here is to cast as wide a net as is
appropriate. To monitor properly, one needs to know who the players are, what
instruments do they use, and how the work is organized. The following is a sample
listing of the types of reports that would be needed:
1 Aggregate volume and profitability numbers
2 Itemized information on all trades
3 VaR and scenarios results
4 Limits violation reports
5 New customer listing
6 Turnover in staff (front and back office)
7 Systems failure reports
8 UOR unusual occurrence reports (catchall)
9 Trend analysis
10 Sample term sheets used
Other relevant reports are error logs, limit violations and revenue reports. Unsigned
document aging reports are also important. These monitoring reports should be
viewed in the context of how they enable the proper timing of regulatory review and
reporting. Given the ease of renaming products for regulatory purposes, compliance
staff are well advised to request risk reports as well. Measurement of economic
exposure in the risk reports might shed more light on the true nature of some
derivative instruments.
Purpose and range of reports
Reports serve as the lifeblood of any organization. Their purpose is to inform
management and staff as to past activity, current positions and profitability and to
measure performance versus budget. In addition, the reports provide a basis for
guidance and planning future activity. Market and credit risk are likely two of the
largest risks that an institution faces and these risks are often analyzed from a
patchwork of reports. Reports are focused primarily on providing an accurate reflection
of current positions and providing mark-to-market valuations and exposures.
The reports often provide static, snapshots of positions as of a cut-off time. Those
focusing specifically on compliance needs are generally less available.
Reports should provide aggregate numbers certainly, but they should be accompanied
with supporting trend analysis. There should be sufficient detail to enable
management to determine if the composition of the business is changing. This can
have a significant impact on future business plans as well as alerting compliance to
refocus some of its resources. It is axiomatic that the reports generated for management
originate from departments independent of the trading activity.
Regulators have an evolving focus today. Since management has specific informational
needs, the reporting is primarily geared to business requirements. There is a
realization among regulators now that there is a benefit to be achieved by focusing
more on management’s own reports rather than creating entirely new reports for the
regulatory agencies.
In addition, regulators are more open to the concept of sharing information among
themselves (to the extent legally possible) and in some cases even relying on the
expertise and analysis of another regulator, especially a foreign one. Although the
regulators are cognizant of the cost of providing special reports to regulators, they
have little choice in times of financial crisis but to request ad-hoc reports. This
occurred with the hedge funds being scrutinized closely during the Long Term
Capital Management crisis in 1998. Regulators asked for special reports keyed to
counterparty concentrations as well as exposures to specific markets from hedge
funds and counterparty banks.
To this end, an essential listing of documents and reports needed by divisional
compliance would be as follows:
Ω Organizational chart of business unit and divisional groups
Ω Work processes mapped out
Ω Current compliance manuals
Ω Compliance databases
Ω Copies of applicable regulations
Ω Copies of corporate authorizations
Ω List of authorized traders
Ω List of permitted products
Ω Approved counterparty list
Ω List of signed ISDA/IFEMA agreements
Ω Listing of available reports (e.g. credit line usage, exception reports)
Ω List of brokers used
Ω List of bank accounts
Ω List of custodians
Ω List of safety deposit boxes
Ω List of repo agreements signed
Ω Document aging list
The central compliance unit is typically focused on more firmwide issues. The
unit would likely work closely with the law department on setting policies for
implementation by the divisional compliance units. Central compliance typically
focuses on the following:
Ω Outside money managers
Ω List of approved signatories (internal)
Ω Certificates of incumbency
Ω Filings required for regulatory agencies
Ω Disaster recovery plans/business resumption plans
Ω Coordination of internal audit recommendations
The law department’s focus would include some of the following issues:
Ω Software contracts
Ω Data vendor contracts
Ω Insurance coverage
Ω Bonding
The lists of documents and reports represent the initial step of the compliance
review. Using an ISDA master agreement as an example, the law department should
create a template as to the preferred language and range of alternative language
permitted. It is advisable that there be a large degree of standardization as to the
ISDA contracts that are signed. Whenever there are omissions or variations in
language, they may expose the company to additional legal risk. Legal planning
becomes more difficult since outcomes may be less certain if contracts need to be
enforced and there is no uniformity of terms among the agreements that one
institution has negotiated. As the credit derivatives market experienced in 1998, lack
of uniformity of interpretation by signatories to a contract is another impediment to
limiting risk. Whether certain sovereigns experienced a default remains a matter in
dispute.
The legal agreement is not the end point. The organization must have a strong
operations team to monitor the implementation of the terms of the contract. Let’s
use, as an example, an agreement to post collateral. Some derivatives contracts have
springing collateral language. Operations has to verify receipt of collateral, often by
trustee if it is a tripartite agreement. They must determine that it is acceptable
collateral, value it, and they may need to perfect an interest in the collateral as well.
The analysis should not end with the question, has collateral been posted?
With posting of collateral or mark-to-market triggers, it may be preferable not to
key them to counterparty credit grades. If a major dealer were to get downgraded
then everyone’s collateral or termination trigger might be invoked at the same time.
It may be more prudent to require language that calls for an automatic posting of
collateral if exposure rises above a preset limit. If it is simply a right to be exercised,
a ‘tickler system’ might not catch the change. With a mandatory posting of collateral,
your firm is less susceptible to the moral suasion of a senior officer of the other
company calling and requesting that the demand to post collateral be waived. You
can always decline to exercise your right but you should avoid having the situation
of needing to assert a right that is not clear-cut or that could forseeably force the
counterparty into bankruptcy.
Tracking the aging and disposition of unsigned documents is an important
preventative control. Deals may be fully negotiated but the contract memorializing
the terms may remain unsigned. Alternatively, ISDAs could be signed but a term
might be unilaterally initialed and so not fully agreed upon. Some firms require the
counterparty to sign a one-page acknowledgement agreeing to all terms of the
confirmation. This approach precludes a counterparty from initialing a change on
page 2 or 3 in the confirmation and faxing it back and the change being overlooked.
Months or years later, the initialed contract term might become a source of contention
and no final agreement would be documented for that contract term. A fully signed
contract should provide each party with a clearer legal position in the event of a
breach.
Another problem area exists when there is no signed ISDA in place between
counterparties or where the terms of the swap confirmation are made to supercede
the terms of the ISDA master agreement. It may be appropriate but you want to
ensure that the desired results occur. The law department should review the master
agreement and the swap supplement language. If an unsigned deal confirmation
remains outstanding for a long period of time, an overly efficient officer may just sign
them to reduce the backlog. Some end-users simply sign off on master agreements
without examining or understanding all the ramifications of various terms agreed.
They may even agree to netting across entities in same corporate family without
evaluating the appropriateness of such action.
management and staff as to past activity, current positions and profitability and to
measure performance versus budget. In addition, the reports provide a basis for
guidance and planning future activity. Market and credit risk are likely two of the
largest risks that an institution faces and these risks are often analyzed from a
patchwork of reports. Reports are focused primarily on providing an accurate reflection
of current positions and providing mark-to-market valuations and exposures.
The reports often provide static, snapshots of positions as of a cut-off time. Those
focusing specifically on compliance needs are generally less available.
Reports should provide aggregate numbers certainly, but they should be accompanied
with supporting trend analysis. There should be sufficient detail to enable
management to determine if the composition of the business is changing. This can
have a significant impact on future business plans as well as alerting compliance to
refocus some of its resources. It is axiomatic that the reports generated for management
originate from departments independent of the trading activity.
Regulators have an evolving focus today. Since management has specific informational
needs, the reporting is primarily geared to business requirements. There is a
realization among regulators now that there is a benefit to be achieved by focusing
more on management’s own reports rather than creating entirely new reports for the
regulatory agencies.
In addition, regulators are more open to the concept of sharing information among
themselves (to the extent legally possible) and in some cases even relying on the
expertise and analysis of another regulator, especially a foreign one. Although the
regulators are cognizant of the cost of providing special reports to regulators, they
have little choice in times of financial crisis but to request ad-hoc reports. This
occurred with the hedge funds being scrutinized closely during the Long Term
Capital Management crisis in 1998. Regulators asked for special reports keyed to
counterparty concentrations as well as exposures to specific markets from hedge
funds and counterparty banks.
To this end, an essential listing of documents and reports needed by divisional
compliance would be as follows:
Ω Organizational chart of business unit and divisional groups
Ω Work processes mapped out
Ω Current compliance manuals
Ω Compliance databases
Ω Copies of applicable regulations
Ω Copies of corporate authorizations
Ω List of authorized traders
Ω List of permitted products
Ω Approved counterparty list
Ω List of signed ISDA/IFEMA agreements
Ω Listing of available reports (e.g. credit line usage, exception reports)
Ω List of brokers used
Ω List of bank accounts
Ω List of custodians
Ω List of safety deposit boxes
Ω List of repo agreements signed
Ω Document aging list
The central compliance unit is typically focused on more firmwide issues. The
unit would likely work closely with the law department on setting policies for
implementation by the divisional compliance units. Central compliance typically
focuses on the following:
Ω Outside money managers
Ω List of approved signatories (internal)
Ω Certificates of incumbency
Ω Filings required for regulatory agencies
Ω Disaster recovery plans/business resumption plans
Ω Coordination of internal audit recommendations
The law department’s focus would include some of the following issues:
Ω Software contracts
Ω Data vendor contracts
Ω Insurance coverage
Ω Bonding
The lists of documents and reports represent the initial step of the compliance
review. Using an ISDA master agreement as an example, the law department should
create a template as to the preferred language and range of alternative language
permitted. It is advisable that there be a large degree of standardization as to the
ISDA contracts that are signed. Whenever there are omissions or variations in
language, they may expose the company to additional legal risk. Legal planning
becomes more difficult since outcomes may be less certain if contracts need to be
enforced and there is no uniformity of terms among the agreements that one
institution has negotiated. As the credit derivatives market experienced in 1998, lack
of uniformity of interpretation by signatories to a contract is another impediment to
limiting risk. Whether certain sovereigns experienced a default remains a matter in
dispute.
The legal agreement is not the end point. The organization must have a strong
operations team to monitor the implementation of the terms of the contract. Let’s
use, as an example, an agreement to post collateral. Some derivatives contracts have
springing collateral language. Operations has to verify receipt of collateral, often by
trustee if it is a tripartite agreement. They must determine that it is acceptable
collateral, value it, and they may need to perfect an interest in the collateral as well.
The analysis should not end with the question, has collateral been posted?
With posting of collateral or mark-to-market triggers, it may be preferable not to
key them to counterparty credit grades. If a major dealer were to get downgraded
then everyone’s collateral or termination trigger might be invoked at the same time.
It may be more prudent to require language that calls for an automatic posting of
collateral if exposure rises above a preset limit. If it is simply a right to be exercised,
a ‘tickler system’ might not catch the change. With a mandatory posting of collateral,
your firm is less susceptible to the moral suasion of a senior officer of the other
company calling and requesting that the demand to post collateral be waived. You
can always decline to exercise your right but you should avoid having the situation
of needing to assert a right that is not clear-cut or that could forseeably force the
counterparty into bankruptcy.
Tracking the aging and disposition of unsigned documents is an important
preventative control. Deals may be fully negotiated but the contract memorializing
the terms may remain unsigned. Alternatively, ISDAs could be signed but a term
might be unilaterally initialed and so not fully agreed upon. Some firms require the
counterparty to sign a one-page acknowledgement agreeing to all terms of the
confirmation. This approach precludes a counterparty from initialing a change on
page 2 or 3 in the confirmation and faxing it back and the change being overlooked.
Months or years later, the initialed contract term might become a source of contention
and no final agreement would be documented for that contract term. A fully signed
contract should provide each party with a clearer legal position in the event of a
breach.
Another problem area exists when there is no signed ISDA in place between
counterparties or where the terms of the swap confirmation are made to supercede
the terms of the ISDA master agreement. It may be appropriate but you want to
ensure that the desired results occur. The law department should review the master
agreement and the swap supplement language. If an unsigned deal confirmation
remains outstanding for a long period of time, an overly efficient officer may just sign
them to reduce the backlog. Some end-users simply sign off on master agreements
without examining or understanding all the ramifications of various terms agreed.
They may even agree to netting across entities in same corporate family without
evaluating the appropriateness of such action.
Reporting and documentation controls
This section outlines a full range of compliance and document reports that are
typically needed. It focuses on building from existing information sources and how
to automate some of the processes. The section ends with a review of how to perform
periodic evaluations as to effectiveness.
typically needed. It focuses on building from existing information sources and how
to automate some of the processes. The section ends with a review of how to perform
periodic evaluations as to effectiveness.
Reporting and documentation controls
This section outlines a full range of compliance and document reports that are
typically needed. It focuses on building from existing information sources and how
to automate some of the processes. The section ends with a review of how to perform
periodic evaluations as to effectiveness.
typically needed. It focuses on building from existing information sources and how
to automate some of the processes. The section ends with a review of how to perform
periodic evaluations as to effectiveness.
Reporting and documentation controls
This section outlines a full range of compliance and document reports that are
typically needed. It focuses on building from existing information sources and how
to automate some of the processes. The section ends with a review of how to perform
periodic evaluations as to effectiveness.
typically needed. It focuses on building from existing information sources and how
to automate some of the processes. The section ends with a review of how to perform
periodic evaluations as to effectiveness.
17 Haziran 2011 Cuma
Enforcing sanctions
One of the worst sins by management is to not ‘rap knuckles’ when violations occur
or to treat malefactors unequally. Management should prioritize what compliance
goals are sacrosanct and which are less significant. Violation of a credit limit is less
culpable typically if it occurs due to a movement in the market as opposed to the act
of booking a deal that violates the credit limit. (Note that passive credit violations
can be a problem, however, when the underlying instrument is illiquid.) If a salesperson
makes an inadvertent representation that does not go to the heart of the deal
(risk, liquidity, etc.) but rather who he or she actually believed was active in the
market, that is likely not culpable.
Regulators will often look favorably on a situation where a firm brings them the
violation and make an effort to rectify the error(s) and/or make the counterparty
financially whole. You must be able to document that there was no inordinate delay
between the time of the discovery and the time when steps were taken to address the
issue. Taking the opposite tack of hiding violations is a recipe for disaster. In the
Salomon bid-rigging scandal of the early 1990s, the penalties were especially severe
since the Treasury Department alleged that a senior Salomon officer had denied
auction violations directly while visiting Treasury officials in DC. More recently, the
Credit Suisse Group in 1999 ‘has apologized to Japanese regulators for [previously]
obstructing an investigation’. The inquiry ‘focuses on allegations’ that Credit Suisse
aided Japanese clients to hide losses from investments (Singer, 1999).
Compliance review must be formalized and easy to implement. One should always
ask the open-ended question, is there anything else I should know or anything else
that would be useful to know? The onus should be on the line of business to ‘come
clean’. If sanctions are never or rarely imposed for violations then the day-to-day and
annual compliance sign-off becomes a sham. The attitude of the business people
becomes simply ‘don’t get caught’.
Transactions can appear to fall within the standard guidelines yet are special
animals. One should be alert for special items like off-market derivatives where the
premium or discount functions as a borrowing or deposit by the counterparty. If the
salesperson does not alert or volunteer this type of information, the sanctions should
be severe for this type of ‘bending the rules’. 513
or to treat malefactors unequally. Management should prioritize what compliance
goals are sacrosanct and which are less significant. Violation of a credit limit is less
culpable typically if it occurs due to a movement in the market as opposed to the act
of booking a deal that violates the credit limit. (Note that passive credit violations
can be a problem, however, when the underlying instrument is illiquid.) If a salesperson
makes an inadvertent representation that does not go to the heart of the deal
(risk, liquidity, etc.) but rather who he or she actually believed was active in the
market, that is likely not culpable.
Regulators will often look favorably on a situation where a firm brings them the
violation and make an effort to rectify the error(s) and/or make the counterparty
financially whole. You must be able to document that there was no inordinate delay
between the time of the discovery and the time when steps were taken to address the
issue. Taking the opposite tack of hiding violations is a recipe for disaster. In the
Salomon bid-rigging scandal of the early 1990s, the penalties were especially severe
since the Treasury Department alleged that a senior Salomon officer had denied
auction violations directly while visiting Treasury officials in DC. More recently, the
Credit Suisse Group in 1999 ‘has apologized to Japanese regulators for [previously]
obstructing an investigation’. The inquiry ‘focuses on allegations’ that Credit Suisse
aided Japanese clients to hide losses from investments (Singer, 1999).
Compliance review must be formalized and easy to implement. One should always
ask the open-ended question, is there anything else I should know or anything else
that would be useful to know? The onus should be on the line of business to ‘come
clean’. If sanctions are never or rarely imposed for violations then the day-to-day and
annual compliance sign-off becomes a sham. The attitude of the business people
becomes simply ‘don’t get caught’.
Transactions can appear to fall within the standard guidelines yet are special
animals. One should be alert for special items like off-market derivatives where the
premium or discount functions as a borrowing or deposit by the counterparty. If the
salesperson does not alert or volunteer this type of information, the sanctions should
be severe for this type of ‘bending the rules’. 513
New product review
A product risk committee will likely include representatives from the following
disciplines: sales, trading, systems, credit, funding, documentation, legal, risk management,
audit, tax, accounting, compliance, and operations areas. New products
are especially fraught with compliance risk. Many disciplines are involved and it’s
not just the nature of the risk but who buys it and how it’s sold. The targeted client
bases might not be the ones who ultimately buy the product. Assuming it is, however,
in what manner will they use it and what economic and liquidity risks need to be
disclosed? Will the sale of this product curtail the sale of other products or alternatively
spur more sales? Distribution channels are important. Will the sales be direct
or will a broker or third party represent the firm?
Trading must present how they intend to hedge the product and review and
track correlation analysis using historic data. These correlation assumptions and
backtesting must be performed over a sufficiently long time horizon to ensure that
the results provide a high level of confidence.
Systems are typically a weak link and may be inadequate for the new task at hand.
A trade may be jerry-rigged into existing systems and entered in several pieces in
order to capture the position (e.g. LIBOR in arrears originally had to be entered by
section into most systems). Systems must specify how the trade will be captured and
what reports can be created and whether it can be included in the master reports.
Over time, this ‘band aid’ approach may falter. Accurate exposure numbers may not
be available if the system is weak. Additionally, people are often not alert to a
changing product mix or get distracted by other priorities.
Credit should review the expected counterparty exposure and advise whether the
exposure can be netted or treated separately. Compliance will review sales material
and term sheets to ensure conformity with external regulations and internal guidelines.
There may be a need to amend existing general authorizations of the company
in order to market the product.
The funding unit will need to determine how much capital will be used or allocated
for the product. Will the money be needed at inception or over the life of the trade?
Credit exposure may grow gradually or immediately. It may be concentrated in
specific industries and the bank may find itself with an over-concentration of risk. A
related issue is the operations unit’s ability to process the transaction and monitor
it on a regular basis. If market share is concentrated in a few hands, it may be
difficult to competitive pricings.
Documentation staff must determine whether they will be able to use an ISDA
Master Agreement or whether there will be a need for more tailored documentation.
The law department needs to determine that it is a permitted product and how it
should be sold. Compliance must determine how they will they track the new product.
Risk management must determine how they will measure the new risk. One big
hurdle is where to obtain reference prices. If it is a new product, there may be few
players making a market. Typically there are not insignificant liquidity problems
encountered with the introduction of new products.
disciplines: sales, trading, systems, credit, funding, documentation, legal, risk management,
audit, tax, accounting, compliance, and operations areas. New products
are especially fraught with compliance risk. Many disciplines are involved and it’s
not just the nature of the risk but who buys it and how it’s sold. The targeted client
bases might not be the ones who ultimately buy the product. Assuming it is, however,
in what manner will they use it and what economic and liquidity risks need to be
disclosed? Will the sale of this product curtail the sale of other products or alternatively
spur more sales? Distribution channels are important. Will the sales be direct
or will a broker or third party represent the firm?
Trading must present how they intend to hedge the product and review and
track correlation analysis using historic data. These correlation assumptions and
backtesting must be performed over a sufficiently long time horizon to ensure that
the results provide a high level of confidence.
Systems are typically a weak link and may be inadequate for the new task at hand.
A trade may be jerry-rigged into existing systems and entered in several pieces in
order to capture the position (e.g. LIBOR in arrears originally had to be entered by
section into most systems). Systems must specify how the trade will be captured and
what reports can be created and whether it can be included in the master reports.
Over time, this ‘band aid’ approach may falter. Accurate exposure numbers may not
be available if the system is weak. Additionally, people are often not alert to a
changing product mix or get distracted by other priorities.
Credit should review the expected counterparty exposure and advise whether the
exposure can be netted or treated separately. Compliance will review sales material
and term sheets to ensure conformity with external regulations and internal guidelines.
There may be a need to amend existing general authorizations of the company
in order to market the product.
The funding unit will need to determine how much capital will be used or allocated
for the product. Will the money be needed at inception or over the life of the trade?
Credit exposure may grow gradually or immediately. It may be concentrated in
specific industries and the bank may find itself with an over-concentration of risk. A
related issue is the operations unit’s ability to process the transaction and monitor
it on a regular basis. If market share is concentrated in a few hands, it may be
difficult to competitive pricings.
Documentation staff must determine whether they will be able to use an ISDA
Master Agreement or whether there will be a need for more tailored documentation.
The law department needs to determine that it is a permitted product and how it
should be sold. Compliance must determine how they will they track the new product.
Risk management must determine how they will measure the new risk. One big
hurdle is where to obtain reference prices. If it is a new product, there may be few
players making a market. Typically there are not insignificant liquidity problems
encountered with the introduction of new products.
Existing business
Compliance cannot realistically control every transaction nor all activities. The focus
of resources must be driven by a cost/benefit analysis of where the highest probability
of risk and loss might occur. Table 17.1 indicates the situations where one may likely
have a greater risk than normal. Well-established clients using standard products
for true risk-reducing purposes is probably not a problem area. Other variations
appear to have a greater likelihood of problems.
Table 17.1 Analysis of risks
Derivative Customer Oversight
Plain vanilla swap New Medium
Established Low
Government entity High
Swaption/options sold to client New Low
Established Low
Government entity High
Swaption/options purchased from client New High
Established Medium
Government entity High
Semi-liquid/new instrument type New High
Established High
Government entity High
One should monitor credit exposure and documentation aging schedules. Specific
attention should be paid that documents are appropriately signed (certificate of
incumbency) and not altered and or simply initialed. Option expiry/exercise notices
also merit a ‘tickler system’. The pricing methodologies of some options may make it
difficult to value but one should be at least alerted to the possibility of exercise.
of resources must be driven by a cost/benefit analysis of where the highest probability
of risk and loss might occur. Table 17.1 indicates the situations where one may likely
have a greater risk than normal. Well-established clients using standard products
for true risk-reducing purposes is probably not a problem area. Other variations
appear to have a greater likelihood of problems.
Table 17.1 Analysis of risks
Derivative Customer Oversight
Plain vanilla swap New Medium
Established Low
Government entity High
Swaption/options sold to client New Low
Established Low
Government entity High
Swaption/options purchased from client New High
Established Medium
Government entity High
Semi-liquid/new instrument type New High
Established High
Government entity High
One should monitor credit exposure and documentation aging schedules. Specific
attention should be paid that documents are appropriately signed (certificate of
incumbency) and not altered and or simply initialed. Option expiry/exercise notices
also merit a ‘tickler system’. The pricing methodologies of some options may make it
difficult to value but one should be at least alerted to the possibility of exercise.
Ensuring trained sales staff
During the applicant process and before a salesperson starts employment, the central
compliance/human resources should perform a due diligence check on the potential
employee. This review includes a background check including credit history and
verification of past employment and education.
Once hired, central compliance will oversee the license application requirements
and sponsor the employee for testing. Once the appropriate tests (typically Series 7
and Series 63) are passed, the employee will be approved for contact with customers.
Given the variety of disciplines involved in creating and selling derivatives it is a
prudent precaution that all individuals involved in packaging or assembling are
appropriately licensed. In some companies, anyone on the trading floor must be
licensed in order to avoid any inadvertent lapses. In light of employee turnover
due to mergers and market changes, some employees may arrive pretrained and
prelicensed. Special attention should be given to ensuring that these experienced
employees are trained in how your firm focuses on compliance and what standard is
required. These employees may have learned various short cuts or expedited processes
and you want to ensure these processes fall within your requirements. As a
business person is licensed, there is also a need to train them in the internal policies
and practices of the firm.
There should be a compliance manual disseminated by e-mail or resident in a
database. In addition, a hard-copy manual should be retained for reference within
the employee’s immediate work area. Updates to compliance procedures should be
prominently noted, numbered, dated, and sent by e-mail and hard copy. The manual
should contain an appendix with an organizational chart indicating clearly who has
the supervisory role and both the employee and supervisor should confirm that
relationship in writing on an annual basis. Formalized checklists should be provided
to help guide the salespeople and traders to operate within the guidance provided. It
is best to have a continuously updated distribution list so that those who need to
know, get the message.
The compliance information should be standardized to ensure that the same
requirements are disseminated and known throughout the firm. It should be perceived
as being part of the job, part of normal, required activities. Because things
are getting done should not end the inquiry. It may be due to the Herculean efforts
by a few that the job is accomplished or perhaps it is being done informally without
proper documentation.
compliance/human resources should perform a due diligence check on the potential
employee. This review includes a background check including credit history and
verification of past employment and education.
Once hired, central compliance will oversee the license application requirements
and sponsor the employee for testing. Once the appropriate tests (typically Series 7
and Series 63) are passed, the employee will be approved for contact with customers.
Given the variety of disciplines involved in creating and selling derivatives it is a
prudent precaution that all individuals involved in packaging or assembling are
appropriately licensed. In some companies, anyone on the trading floor must be
licensed in order to avoid any inadvertent lapses. In light of employee turnover
due to mergers and market changes, some employees may arrive pretrained and
prelicensed. Special attention should be given to ensuring that these experienced
employees are trained in how your firm focuses on compliance and what standard is
required. These employees may have learned various short cuts or expedited processes
and you want to ensure these processes fall within your requirements. As a
business person is licensed, there is also a need to train them in the internal policies
and practices of the firm.
There should be a compliance manual disseminated by e-mail or resident in a
database. In addition, a hard-copy manual should be retained for reference within
the employee’s immediate work area. Updates to compliance procedures should be
prominently noted, numbered, dated, and sent by e-mail and hard copy. The manual
should contain an appendix with an organizational chart indicating clearly who has
the supervisory role and both the employee and supervisor should confirm that
relationship in writing on an annual basis. Formalized checklists should be provided
to help guide the salespeople and traders to operate within the guidance provided. It
is best to have a continuously updated distribution list so that those who need to
know, get the message.
The compliance information should be standardized to ensure that the same
requirements are disseminated and known throughout the firm. It should be perceived
as being part of the job, part of normal, required activities. Because things
are getting done should not end the inquiry. It may be due to the Herculean efforts
by a few that the job is accomplished or perhaps it is being done informally without
proper documentation.
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