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.