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’,
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Peteren, M. (1999) ‘Merrill charged with 2d firms in copper case’, New York Times,
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Risk Standards Working Group (1996) Risk Standards for Institutional Investment
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Russo, T. A. (1996) Address to Futures Industry Association, 4 March.
Singer, J. (1999) ‘Credit Suisse apologizes for blocking Japan probe’, Bloomberg
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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
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