Derivatives and operational risk

In 1993 the Group of Thirty (G30) provided 20 best-practice risk management
recommendations for dealers and end-users of derivatives. These have proved seminal
for many banks structuring their derivatives risk management functions, and
here we offer a personal selection of some key findings for operational risk managers
in institutions who may be less familiar with the report.
The G30 working group was composed of a diverse cross-section of end-users,
dealers, academics, accountants, and lawyers involved in derivatives. Input also
came from a detailed survey of industry practice among 80 dealers and 72 end-users
worldwide, involving both questionnaires and in-depth interviews. In addition, the
G30 provides four recommendations for legislators, regulators, and supervisors.
The G30 report noted that the credit, market and legal risks of derivatives capture
most of the attention in public discussion. Nevertheless, the G30 emphasized that
the successful implementation of systems operations, and controls is equally important
for the management of derivatives activities. The G30 stressed that the complexity
and diversity of derivatives activities make the measurement and control of those
risks more difficult. This difficulty increases the importance of sophisticated risk
management systems and sound management and operating practices These are
vital to a firm’s ability to execute, record, and monitor derivatives transactions, and
to provide the information needed by management to manage the risks associated
with these activities.
Similarly, the G30 report stressed the importance of hiring skilled professionals:
Recommendation 16 states that one should ‘ensure that derivatives activities are
undertaken by professionals in sufficient number and with the appropriate experience,
skill levels, and degrees of specialization’. The G30 also stressed the importance
of building best-practice systems. According to Recommendation 17, one should
‘ensure that adequate systems for data capture, processing, settlement, and management
reporting are in place so that derivatives transactions are conducted in an
orderly and efficient manner in compliance with management policies’. Furthermore,
‘one should have risk management systems that measure the risks incurred in their
derivatives activities based on their nature, size and complexity’.
Recommendation 19 emphasized that accounting practices should highlight the
risks being taken. For example, the G30 pointed out that one ‘should account for
derivatives transactions used to manage risks so as to achieve a consistency of income
recognition treatment between those instruments and the risks being managed’.