The full cooperation of business lines is needed to meet compliance goals. It is an
ongoing struggle to generate assistance and cooperation from the business side since
compliance is viewed as a fixed cost drag on profits. No matter now skilled the
compliance people nor how detailed the reports, there are business subtleties and
nuances that are known best by the business people. In the case of a money manager,
compliance may be focused on satisfying external regulations and overlook ‘fairness
issues’ relating to equal treatment for all investors.
You will obtain more cooperation from business line employees by making it
convenient to comply. Staff the compliance function adequately, give them cellular
phones and beepers. Ensure that you have an early and late shift, if necessary, to
cover the full trading day. Business people are notorious for making one feeble
attempt at compliance and not following up. Help ensure that they connect with
compliance the first time.
The derivatives industry is too dynamic for permanent organizational charts.
Never believe that having formal lines of communication will ever be sufficient by
themselves. Informal contact should supplement control measures and will allow
greater insight into risks being taken. When a potential error is spotted or an error
made repeatedly, it may be time to update the procedures and communicate those
changes. Some errors are correctable with certain efforts and there may not be a
need to elevate an error to a violation level if it is easily corrected or controlled.
You must ask proactive questions. Is the trader using derivatives in an authorized
fashion? Is he or she reducing risk the market has created or creating certain
exposures that force him to use derivatives to bring his exposure back into line? One
should closely monitor credit downgrades and mark-to-market changes. Will the
cheapest to deliver change dramatically for a specific futures contract or when it is
rolled to a new contract month?
Employees should be conditioned to report on possible problems or positions that
are deteriorating. Given some lead time, it may be possible to address pending
compliance issues if actions can be taken in advance of the possible violation. If a
transaction has just occurred, it may be possible to rectify the damage or ask that
deal be booked elsewhere with the consent of the client. To obtain full disclosure,
you need to maintain an open environment. They need to come to you with their
mistakes and problems. Be careful that unclear wording as to trading parameters
may enable traders to take unwanted liberties. One should also monitor the behavior
of traders. Measuring changes are an important control measure and one should
focus on new trends and new counterparties.
Some compliance issues are well known and can be planned for via compliance
calendars, e.g. periodic audits, regulatory reports, etc. There are often prealerted
situations, e.g. we are sending a new term sheet to five clients, and can you review
it first thing tomorrow morning? Others do not present themselves until a transaction
evolves into its final form. You want to prevent short cuts like an informal, unreviewed
term sheet being sent out and then followed by a full, properly completed term sheet.
Odds are that the informal term sheet will be the one retained by the client since the
major analysis may be done on the basis of the preliminary term sheet.
You want the compliance efforts to be systematic and comprehensive. You want it
done right every time. It is paramount to obtain full disclosure the first time.
Compliance often has to ferret out problems since there is an innate tendency by
business people to bend the rules. Business staff have to be encouraged to provide
information. At the same time, the compliance staff should have the expertise to
know what they should be looking for. The business people should not have to
‘spoonfeed’ the compliance staff: it is a recipe for a later, unhappy surprise.
The markets have a propensity to outpace existing regulations and internal guidelines.
Certainly, no one should presume that a control structure designed for plain
vanilla swaps will adequately adjust to leveraged or exotic swaps. Similarly, a credit
monitoring system geared to corporate exposure might not work as well for monitoring
hedge fund exposure since most investment-grade corporations borrow without
posting collateral and are generally not highly leveraged.
It is an innate human tendency to look for short cuts or rules of thumb in order to
simplify things. As elaborate or logical as a compliance system may be, people will
still finds ways to make it perfunctory or use less time, probably at a cost of stripping
away some of the safeguards. Sloppiness and inattention are culprits as well as a
general casual attitude.
The team environment is fostered with clearly written policies, which itemize the
requirements and explain the need for compliance. The compliance staff can alert
business staff to potential problems and steps to be taken to avoid problems. The
compliance staff, by responding quickly, authoritatively, and accurately, can help
foster this cooperation.
The compliance staff can also alert the business side to the costs of non-compliance.
With violations such as lack of supervision or non-disclosure, each occurrence
may be considered a separate violation. If there is a systematic flaw in the operations
process or sales process in an institution, they will be making the same
mistake many times. If each violation is serious enough the individual penalties
could add up.
Proper compliance means digging into the details of each transaction to be reviewed.
If the salesperson represents that a deal is just like a previous transaction, do not
accept that representation at face value. Buying a foreign pay security along with a
cross-currency swap back to US dollars is one thing. Buying all the shares of a
company whose only asset is the foreign pay security is another. Economically the
contractual cash flows are identical and the swap provides a valid hedge. In the
former case it is simply an interest payment, in the latter it may be construed as a
dividend payment and may cause withholding taxes to be paid in the foreign
jurisdiction. 510
3 Mayıs 2011 Salı
Implementing compliance policies
This section covers the proper implementation of policies and motivating employees
to implement these policies. It addresses the differing challenges of offering new
products to old and new customers as well as managing existing business and details
the training needed for employees.
to implement these policies. It addresses the differing challenges of offering new
products to old and new customers as well as managing existing business and details
the training needed for employees.
Implementing compliance policies
This section covers the proper implementation of policies and motivating employees
to implement these policies. It addresses the differing challenges of offering new
products to old and new customers as well as managing existing business and details
the training needed for employees.
to implement these policies. It addresses the differing challenges of offering new
products to old and new customers as well as managing existing business and details
the training needed for employees.
26 Nisan 2011 Salı
Outside money managers
An outside money manager can do an excellent investment job. The problems are
that they are typically off-site, have a different investment strategy, are not your
company employees, and their credit analysis and standards may be different from
those of your company.
The investment agreement and policies and procedures for the use of derivatives
must be carefully crafted. The policies must be comprehensible, focused, comprehensive
and enforceable. We are a contract-based society. It must be clear about what
has been delegated to other institutions and what fiduciary responsibilities we have
assumed (Erikson, 1996).
As we have reviewed, compliance policies developed and implemented within an
organization should be internally consistent and provide sufficient controls. When
funds are transferred for management to a partnership, affiliate, or outside money
manager, control becomes significantly more difficult. These legal divisions must be
respected and limited partners should be cautious not to direct the business and
infringe upon the rights of the general partner and so jeopardize tax and legal benefits
of the structure.
With any investment approach, there are typically multiple objectives and these
should be ranked by priority to ensure that the manager will follow guidelines. It is
prudent to evaluate how a hedging strategy will be viewed under various market
scenarios and whether end of year results or interim mark to market pricing has
priority. An equity collar to protect a stock position, will look poorly if the equity
market rises sharply. Although collars may be a prudent strategy, performance could
be several percentage points behind an unhedged equity position on an interim markto-
market basis.
To maintain independence, an investor cannot control a manager’s credit selections
as they are made. Rather one must set up a process that reflects desired parameters.
A common predicament is when an asset is sold by the investor and yet the outside
manager may buy it as attractive. How do you reconcile that to your board? If you
sell assets and incur a tax loss, one must wait the requisite period of time before
repurchasing them or else ‘wash sale’ rules may be invoked. What happens if an
outside manager buys those same assets in the market prior to the time limit? It
may jeopardize your tax strategy.
In order to avoid ‘delegating in the dark’, the proper controls must be communicated.
After all, your controls’ effectiveness will always be reviewed post facto. Reports
may not be available until days or weeks after the end of the reporting time period.
If reports arrive by fax and have to be reentered into your systems, it’s a process rife
with error.
With money managers, the following topics are especially important to focus upon:
Ω Clearly document fiduciary relationship
Ω Explicitly outline investment policy
Ω Summarize derivatives policy
Ω Agree on methodology for tracking performance
Ω Specify credit standards
Ω Select permitted counterparties
Ω Collateral usage
Ω Repo activity/leverage
Ω Types of reports and frequency
The investment manager contract should be clear and crisply written. The fee
schedule should be clearly agreed upon. Any ‘buzzwords’ should be defined. Proxy
hedges should be limited to specific circumstances. Leveraging should be prohibited
or controlled as deemed appropriate. If the outside manager uses futures contracts,
the activity may impact the treatment/status of the investor. The futures position
may need to be aggregated for reporting purposes.
The derivatives policy should be clearly summarized. Note that separate investment
guidelines and derivatives guidelines are commonly prepared for external managers.
Also the external manger should provide the client with a derivatives strategy statement
citing types of derivative to be used and for what purpose(s). The strategy statement
should be signed by the board of directors or its designate. The derivatives
products allowed should be clearly stated. Some firms categorize derivatives by level
of risk and depth of market. These categories are not permanent classification since
markets may become more developed over time, e.g. credit derivatives. In one classification
schema, ‘A’ derivatives are liquid and standardized products, ‘B’ are semi-liquid
and customized, and ‘C’ are leveraged or exotic products and so off limits. There is
room for the ‘B’ and ‘C’ products to migrate over time to a higher status. Limitations of
hedging to transaction specific as opposed to macro hedges should also be enumerated.
The methodology for tracking performance should be explicit. What is the benchmark/performance objective and how frequently can the portfolio rebalance?
What are investment guidelines, asset selection methodology, and portfolio composition/
allocation ranges? Define duration and spread parameters. What are the gain/
loss constraints? Tax guidelines? How will income be reinvested? It takes time to
invest sufficient amounts of money to achieve diversification. When do the standards
as to diversification kick in? Are you monitoring all purchases or the aggregate
impact on the portfolio?
Credit parameters are a common area of dispute. Is subordinated or junior paper
permitted? Is the credit test simply at inception or is it a maintenance test? Quality
ratings for individual securities and total portfolio? How are split ratings handled? If
a downgrade occurs, is there an automatic sale provision or is each investment
considered separately? Permitted counterparties are a companion issue. Must they
be from the same approved list of the investor or can the investment manager make
his or her own determination?
Collateral usage brings with it all the issues of monitoring, valuation, custody, and
rehypothecation. As the investor, you are one step removed from the investment process
already and this adds another layer of complexity to the outside manager. Repo
activity, leverage, and the writing of covered calls are all methods of enhancing income.
Depending on the risk tolerance of the investor and how restrictive the fiduciary guidelines
that the investor must follow, these may be avenues open for pursuit. 508
that they are typically off-site, have a different investment strategy, are not your
company employees, and their credit analysis and standards may be different from
those of your company.
The investment agreement and policies and procedures for the use of derivatives
must be carefully crafted. The policies must be comprehensible, focused, comprehensive
and enforceable. We are a contract-based society. It must be clear about what
has been delegated to other institutions and what fiduciary responsibilities we have
assumed (Erikson, 1996).
As we have reviewed, compliance policies developed and implemented within an
organization should be internally consistent and provide sufficient controls. When
funds are transferred for management to a partnership, affiliate, or outside money
manager, control becomes significantly more difficult. These legal divisions must be
respected and limited partners should be cautious not to direct the business and
infringe upon the rights of the general partner and so jeopardize tax and legal benefits
of the structure.
With any investment approach, there are typically multiple objectives and these
should be ranked by priority to ensure that the manager will follow guidelines. It is
prudent to evaluate how a hedging strategy will be viewed under various market
scenarios and whether end of year results or interim mark to market pricing has
priority. An equity collar to protect a stock position, will look poorly if the equity
market rises sharply. Although collars may be a prudent strategy, performance could
be several percentage points behind an unhedged equity position on an interim markto-
market basis.
To maintain independence, an investor cannot control a manager’s credit selections
as they are made. Rather one must set up a process that reflects desired parameters.
A common predicament is when an asset is sold by the investor and yet the outside
manager may buy it as attractive. How do you reconcile that to your board? If you
sell assets and incur a tax loss, one must wait the requisite period of time before
repurchasing them or else ‘wash sale’ rules may be invoked. What happens if an
outside manager buys those same assets in the market prior to the time limit? It
may jeopardize your tax strategy.
In order to avoid ‘delegating in the dark’, the proper controls must be communicated.
After all, your controls’ effectiveness will always be reviewed post facto. Reports
may not be available until days or weeks after the end of the reporting time period.
If reports arrive by fax and have to be reentered into your systems, it’s a process rife
with error.
With money managers, the following topics are especially important to focus upon:
Ω Clearly document fiduciary relationship
Ω Explicitly outline investment policy
Ω Summarize derivatives policy
Ω Agree on methodology for tracking performance
Ω Specify credit standards
Ω Select permitted counterparties
Ω Collateral usage
Ω Repo activity/leverage
Ω Types of reports and frequency
The investment manager contract should be clear and crisply written. The fee
schedule should be clearly agreed upon. Any ‘buzzwords’ should be defined. Proxy
hedges should be limited to specific circumstances. Leveraging should be prohibited
or controlled as deemed appropriate. If the outside manager uses futures contracts,
the activity may impact the treatment/status of the investor. The futures position
may need to be aggregated for reporting purposes.
The derivatives policy should be clearly summarized. Note that separate investment
guidelines and derivatives guidelines are commonly prepared for external managers.
Also the external manger should provide the client with a derivatives strategy statement
citing types of derivative to be used and for what purpose(s). The strategy statement
should be signed by the board of directors or its designate. The derivatives
products allowed should be clearly stated. Some firms categorize derivatives by level
of risk and depth of market. These categories are not permanent classification since
markets may become more developed over time, e.g. credit derivatives. In one classification
schema, ‘A’ derivatives are liquid and standardized products, ‘B’ are semi-liquid
and customized, and ‘C’ are leveraged or exotic products and so off limits. There is
room for the ‘B’ and ‘C’ products to migrate over time to a higher status. Limitations of
hedging to transaction specific as opposed to macro hedges should also be enumerated.
The methodology for tracking performance should be explicit. What is the benchmark/performance objective and how frequently can the portfolio rebalance?
What are investment guidelines, asset selection methodology, and portfolio composition/
allocation ranges? Define duration and spread parameters. What are the gain/
loss constraints? Tax guidelines? How will income be reinvested? It takes time to
invest sufficient amounts of money to achieve diversification. When do the standards
as to diversification kick in? Are you monitoring all purchases or the aggregate
impact on the portfolio?
Credit parameters are a common area of dispute. Is subordinated or junior paper
permitted? Is the credit test simply at inception or is it a maintenance test? Quality
ratings for individual securities and total portfolio? How are split ratings handled? If
a downgrade occurs, is there an automatic sale provision or is each investment
considered separately? Permitted counterparties are a companion issue. Must they
be from the same approved list of the investor or can the investment manager make
his or her own determination?
Collateral usage brings with it all the issues of monitoring, valuation, custody, and
rehypothecation. As the investor, you are one step removed from the investment process
already and this adds another layer of complexity to the outside manager. Repo
activity, leverage, and the writing of covered calls are all methods of enhancing income.
Depending on the risk tolerance of the investor and how restrictive the fiduciary guidelines
that the investor must follow, these may be avenues open for pursuit. 508
Business conduct policy
Employees need a roadmap to guide them and a typical conduct policy would address
the following issues:
Ω No insider trading
Ω No acceptance of gifts over a certain value
Ω No interested transactions with the company
Ω Whistleblower protection
Ω Salespersons shall not own stock of companies covered
Ω Traders shall not trade the same instrument for personal accounts that they trade
on the job
Ω Competitor contact parameters
Ω Comments to media
Ω Software development
Ω Client entertainment
Ω Confidential information
Policies are often too broad or simply written poorly. It is typically helpful to
provide examples when there is any likelihood of any misunderstanding or confusion.
pwdAlternatively, one may want to use an example to emphasize the significance of
a particular rule.
No employee should trade based on non-public information of information obtained
due to his or her unique relationship with a company. Even the appearance of
impropriety should be avoided. Salespersons cannot own customer stock simply to
ensure that there are no trades that can ‘tainted’ by possible access to confidential
information. In the same spirit, a trader cannot trade the same product for the
company that he or she trades for their own personal account. This discourages
moral hazard and the temptation to focus on personal positions to the detriment of
the company’s position. Competitors can be contacted as long as it is on a professional
basis and no laws are violated such as price fixing, collusion, etc. or the meetings
can be construed as creating a buying cartel.
Media comments and training tapes are two areas of special caution. Publicity is
generally good but you want to ensure that it is controlled and that there is no
inadvertent release of information. Moreover, there may be strategic initiatives that
are occurring unknown to the person providing media comments and those comments
may be misconstrued in retrospect. Training tapes are often given to hyperbole
and when taken out of context, may present a distorted view of company policies.
Client entertainment should be appropriate to the overall client–dealer relationship.
For clients similarly situated, the frequency and expense should be in a comparable
range. It is a preferred practice to accompany a client rather than send a client to an
event.
Salespersons may become privy to confidential information about a client. They
should be especially careful not to divulge the information especially if it is material,
non-public information. Conversely, compliance should ensure that spreadsheets
and dealers’ proprietary information are not being sent out to a customer via
facsimile, e-mail or other means without proper authorization. Any non-standard
information that does not fit into a prespecified template should be approved by
divisional compliance. There are two main cautions. The customer might rely on a
spreadsheet or adjust it for purposes/transactions for which it was not intended. In
addition, if there are any dealer trade secrets or protected information, it may lose
its protected status if it is widely or indiscriminately disseminated.
In the documentation of a transaction, a dealer should establish non-reliance on
the part of the end-user. Moreover, the dealer is not a financial advisor and each
party to the trade is acting independently and the end-user should determine that
transaction is an appropriate one. No guarantees or assurances as to the results of
the transaction should be made. Each party should have the authority to enter into
the transaction and take on the risks entailed in the specific transaction.
the following issues:
Ω No insider trading
Ω No acceptance of gifts over a certain value
Ω No interested transactions with the company
Ω Whistleblower protection
Ω Salespersons shall not own stock of companies covered
Ω Traders shall not trade the same instrument for personal accounts that they trade
on the job
Ω Competitor contact parameters
Ω Comments to media
Ω Software development
Ω Client entertainment
Ω Confidential information
Policies are often too broad or simply written poorly. It is typically helpful to
provide examples when there is any likelihood of any misunderstanding or confusion.
pwdAlternatively, one may want to use an example to emphasize the significance of
a particular rule.
No employee should trade based on non-public information of information obtained
due to his or her unique relationship with a company. Even the appearance of
impropriety should be avoided. Salespersons cannot own customer stock simply to
ensure that there are no trades that can ‘tainted’ by possible access to confidential
information. In the same spirit, a trader cannot trade the same product for the
company that he or she trades for their own personal account. This discourages
moral hazard and the temptation to focus on personal positions to the detriment of
the company’s position. Competitors can be contacted as long as it is on a professional
basis and no laws are violated such as price fixing, collusion, etc. or the meetings
can be construed as creating a buying cartel.
Media comments and training tapes are two areas of special caution. Publicity is
generally good but you want to ensure that it is controlled and that there is no
inadvertent release of information. Moreover, there may be strategic initiatives that
are occurring unknown to the person providing media comments and those comments
may be misconstrued in retrospect. Training tapes are often given to hyperbole
and when taken out of context, may present a distorted view of company policies.
Client entertainment should be appropriate to the overall client–dealer relationship.
For clients similarly situated, the frequency and expense should be in a comparable
range. It is a preferred practice to accompany a client rather than send a client to an
event.
Salespersons may become privy to confidential information about a client. They
should be especially careful not to divulge the information especially if it is material,
non-public information. Conversely, compliance should ensure that spreadsheets
and dealers’ proprietary information are not being sent out to a customer via
facsimile, e-mail or other means without proper authorization. Any non-standard
information that does not fit into a prespecified template should be approved by
divisional compliance. There are two main cautions. The customer might rely on a
spreadsheet or adjust it for purposes/transactions for which it was not intended. In
addition, if there are any dealer trade secrets or protected information, it may lose
its protected status if it is widely or indiscriminately disseminated.
In the documentation of a transaction, a dealer should establish non-reliance on
the part of the end-user. Moreover, the dealer is not a financial advisor and each
party to the trade is acting independently and the end-user should determine that
transaction is an appropriate one. No guarantees or assurances as to the results of
the transaction should be made. Each party should have the authority to enter into
the transaction and take on the risks entailed in the specific transaction.
Sales function checklist
Looking specifically at a dealer’s sales force, the following is a generalized checklist
of problem areas encountered:
Ω Market information
Ω Sales materials
Ω Term sheets
Ω Transactions
Ω Confirmations
Ω Valuations
Ω Warranties and representations
Ω Business conduct
Dealer salespeople should endeavor to ensure market information disseminated to
clients is obtained from sources believed reliable. Appropriate written disclaimers
should be employed. Salespeople should refrain from casting competitors in an
unfavorable light. Competitor comments should be limited to our credit department
has/has not changed its credit outlook on that name. As to derivatives transactions
activity, other customers’ names and activities should not be directly revealed
and any trade information should be shrouded sufficiently so that other clients’
confidentiality is preserved.
Derivatives sales materials should provide reasonable illustrations of the product.
The pricing over various scenarios should represent a valid range of scenarios and
assumptions should be clearly stated. Disclosure should provide all the relevant
information that is needed to enable a comprehensive analysis. The more standardized
the product, the more likely that standardized disclosure language may be
sufficient.
Term sheets should be accurate and disclose appropriate risks to consider. Pricing
and liquidity issues are especially important to mention. If the term sheet is being
sent out to multiple clients, it should be proofed carefully to remove any mention of
a specific company. The law department should approve standardized disclosures
and should be consulted for the one-off situations where a customized product is
involved. A legal department approval number with expiry date should be included.
For non-standard trades, it is often wise to do a ‘dry run’ if feasible and involve the
operations unit. Frequently there is a clearing issue or documentation issue or
details of the trade that turn out not to have been considered/finalized in advance.
It’s a preferred time to resolve these omissions before trade time. The completed
transaction should reflect the term sheet. ‘Bidding to miss’ (where a dealer makes
only a semi-interested bid for business) should be avoided since it hurts all parties
involved. The customer does not receive a true market price comparison, the bidder
may develop a bad reputation, and the winner does not get an accurate ‘cover’.
The following are items that should be clarified prior to time of trade:
Ω Exact legal name of the counterparty
Ω Verify credit availability
Ω End-user company has power to transact
Ω End-user employee has specific authority to transact
Ω Derivative is suitable given client’s size, sophistication, and risk profile
Ω End-user has analyzed or has the capacity to analyze the deal(s)
Ω Dealer is not acting as a fiduciary
Most large corporations have a large number of affiliates, partnerships, or joint
ventures. It is imperative that the dealer establishes who is the exact, legal counterparty
on a transaction. It will help determine the dealer’s legal rights in the event of
breach/non-performance. It is critically important to determine whether the enduser
is dealing in the name of its holding company, operating company, or other
corporate affiliate.
Credit availability should be obtained from a listing that is current. Some firms
rely on a printout from the previous day and do not have on-line capabilities to know
the full, current exposure. If credit approval is not preset, then salespeople need to
obtain current financials from client for the credit approval department. Even when
a dealer sells an option to an end-user, due diligence dictates that the dealer obtain
end-user financials as part of the ‘know your customer’ requirements.
Most corporate end-users are empowered by their charter to do almost anything.
Highly regulated industries like insurance companies and municipalities have significant
restrictions. The law department of the dealer should be comfortable with the
end-user’s power to contract or alternatively the dealer must ask for an amendment
to the charter or board approval or alternatively for a legal opinion from the enduser’s
counsel indicating that the contemplated transaction is permitted.
An end-user may have actual or apparent authority. The dealer should rely on
actual authority and the dealer should ask for a listing of approved traders. After the
trade, it may be prudent to ask for a certificate of incumbency of the end-user
employee/officer who signs the derivative confirmation.
Suitability does not simply mean that the end-user can use derivatives. Rather it
is a higher standard. Given the size, skill, and sophistication of the end-user (coupled
with its outside advisers if any) and in view of its risk appetite, past activity, etc. is
the deal appropriate? It is advisable to look inside the customer and establish that
the customer meets this suitability threshold.
One needs to ‘know the customer’. One should examine closely the economic
purposes for using derivatives. Some end-users in the past have used the swap
market to mask loans. A bank would make an upfront payment (or during the first
year) and the recipient would then repay the loan amount as part of the coupon
payments scheduled over the remaining life of the swap. In a similar vein, Merrill
Lynch currently is engaged in a lawsuit filed by the CFTC. Merrill is charged with
‘aiding and abetting’ Sumitomo to corner the copper market by providing a trading
account and more than a half billion dollars’ worth of financing and letters of credit.
The regulator charges that Merrill employees knew of the illegal conspiracy to corner
the copper market (Peteren, 1999).
The salesperson must be properly licensed and communication with the client
should be monitored periodically. Term sheets must be vetted to ensure sufficient
disclosures and disclaimer. It is important to note that adequacy of disclosure may
well vary with the complexity and risk of the product being sold. Although futures
contracts lend themselves to standardized disclosure, the OTC derivatives market
does not. Proper safeguards should be in place so that no side guarantees are being
made to the customer. Beware salespeople who are CPAs or JDs, since they may
cross the line and provide professional advice. One of the biggest sources of litigation
in the past has been the failure to adequately supervise the sales staff.
Confirmations should be timely and accurate. Typically in a large dealer, the
salesman, trader, and compliance/legal will review a confirmation before it is sent
out to the client. If a dealer is not able to send out a confirmation on a timely basis,
it should send out a preliminary confirmation. This would contain the name of the
product and a description of the transaction included essential information such as
notional amount, index, start and end date, and with the disclaimer that it is a
preliminary confirmation to be superseded by a formal confirmation. In times of
market turmoil, it sometimes occurs that confirmations are delayed. Given the lack
of written confirmation and fast moving markets, there exists the moral hazard where
a losing party denies the existence or terms of a deal. This can be combated most
effectively by securing a written confirmation.
Valuations sent to customers should always be written and qualified as whether it
is a firm price or an estimate. Whenever possible, it should also contain a reference
interest rate and/or volatility level along with date and time so that customer can
place the pricing in context.
of problem areas encountered:
Ω Market information
Ω Sales materials
Ω Term sheets
Ω Transactions
Ω Confirmations
Ω Valuations
Ω Warranties and representations
Ω Business conduct
Dealer salespeople should endeavor to ensure market information disseminated to
clients is obtained from sources believed reliable. Appropriate written disclaimers
should be employed. Salespeople should refrain from casting competitors in an
unfavorable light. Competitor comments should be limited to our credit department
has/has not changed its credit outlook on that name. As to derivatives transactions
activity, other customers’ names and activities should not be directly revealed
and any trade information should be shrouded sufficiently so that other clients’
confidentiality is preserved.
Derivatives sales materials should provide reasonable illustrations of the product.
The pricing over various scenarios should represent a valid range of scenarios and
assumptions should be clearly stated. Disclosure should provide all the relevant
information that is needed to enable a comprehensive analysis. The more standardized
the product, the more likely that standardized disclosure language may be
sufficient.
Term sheets should be accurate and disclose appropriate risks to consider. Pricing
and liquidity issues are especially important to mention. If the term sheet is being
sent out to multiple clients, it should be proofed carefully to remove any mention of
a specific company. The law department should approve standardized disclosures
and should be consulted for the one-off situations where a customized product is
involved. A legal department approval number with expiry date should be included.
For non-standard trades, it is often wise to do a ‘dry run’ if feasible and involve the
operations unit. Frequently there is a clearing issue or documentation issue or
details of the trade that turn out not to have been considered/finalized in advance.
It’s a preferred time to resolve these omissions before trade time. The completed
transaction should reflect the term sheet. ‘Bidding to miss’ (where a dealer makes
only a semi-interested bid for business) should be avoided since it hurts all parties
involved. The customer does not receive a true market price comparison, the bidder
may develop a bad reputation, and the winner does not get an accurate ‘cover’.
The following are items that should be clarified prior to time of trade:
Ω Exact legal name of the counterparty
Ω Verify credit availability
Ω End-user company has power to transact
Ω End-user employee has specific authority to transact
Ω Derivative is suitable given client’s size, sophistication, and risk profile
Ω End-user has analyzed or has the capacity to analyze the deal(s)
Ω Dealer is not acting as a fiduciary
Most large corporations have a large number of affiliates, partnerships, or joint
ventures. It is imperative that the dealer establishes who is the exact, legal counterparty
on a transaction. It will help determine the dealer’s legal rights in the event of
breach/non-performance. It is critically important to determine whether the enduser
is dealing in the name of its holding company, operating company, or other
corporate affiliate.
Credit availability should be obtained from a listing that is current. Some firms
rely on a printout from the previous day and do not have on-line capabilities to know
the full, current exposure. If credit approval is not preset, then salespeople need to
obtain current financials from client for the credit approval department. Even when
a dealer sells an option to an end-user, due diligence dictates that the dealer obtain
end-user financials as part of the ‘know your customer’ requirements.
Most corporate end-users are empowered by their charter to do almost anything.
Highly regulated industries like insurance companies and municipalities have significant
restrictions. The law department of the dealer should be comfortable with the
end-user’s power to contract or alternatively the dealer must ask for an amendment
to the charter or board approval or alternatively for a legal opinion from the enduser’s
counsel indicating that the contemplated transaction is permitted.
An end-user may have actual or apparent authority. The dealer should rely on
actual authority and the dealer should ask for a listing of approved traders. After the
trade, it may be prudent to ask for a certificate of incumbency of the end-user
employee/officer who signs the derivative confirmation.
Suitability does not simply mean that the end-user can use derivatives. Rather it
is a higher standard. Given the size, skill, and sophistication of the end-user (coupled
with its outside advisers if any) and in view of its risk appetite, past activity, etc. is
the deal appropriate? It is advisable to look inside the customer and establish that
the customer meets this suitability threshold.
One needs to ‘know the customer’. One should examine closely the economic
purposes for using derivatives. Some end-users in the past have used the swap
market to mask loans. A bank would make an upfront payment (or during the first
year) and the recipient would then repay the loan amount as part of the coupon
payments scheduled over the remaining life of the swap. In a similar vein, Merrill
Lynch currently is engaged in a lawsuit filed by the CFTC. Merrill is charged with
‘aiding and abetting’ Sumitomo to corner the copper market by providing a trading
account and more than a half billion dollars’ worth of financing and letters of credit.
The regulator charges that Merrill employees knew of the illegal conspiracy to corner
the copper market (Peteren, 1999).
The salesperson must be properly licensed and communication with the client
should be monitored periodically. Term sheets must be vetted to ensure sufficient
disclosures and disclaimer. It is important to note that adequacy of disclosure may
well vary with the complexity and risk of the product being sold. Although futures
contracts lend themselves to standardized disclosure, the OTC derivatives market
does not. Proper safeguards should be in place so that no side guarantees are being
made to the customer. Beware salespeople who are CPAs or JDs, since they may
cross the line and provide professional advice. One of the biggest sources of litigation
in the past has been the failure to adequately supervise the sales staff.
Confirmations should be timely and accurate. Typically in a large dealer, the
salesman, trader, and compliance/legal will review a confirmation before it is sent
out to the client. If a dealer is not able to send out a confirmation on a timely basis,
it should send out a preliminary confirmation. This would contain the name of the
product and a description of the transaction included essential information such as
notional amount, index, start and end date, and with the disclaimer that it is a
preliminary confirmation to be superseded by a formal confirmation. In times of
market turmoil, it sometimes occurs that confirmations are delayed. Given the lack
of written confirmation and fast moving markets, there exists the moral hazard where
a losing party denies the existence or terms of a deal. This can be combated most
effectively by securing a written confirmation.
Valuations sent to customers should always be written and qualified as whether it
is a firm price or an estimate. Whenever possible, it should also contain a reference
interest rate and/or volatility level along with date and time so that customer can
place the pricing in context.
Sell side versus buy side
The compliance structure tends to be highly formalized on the sell side but less so
on the buy side. Generally, the buy side has a single location and may not support
a full-time derivatives team. Indeed the derivatives person might be charged with
other duties as well. Control is more informal and subject to periodic oversight and
periodic audit inquiries.
The buy side should generally have an easier time in ensuring compliance. Often
they are not as heavily regulated an entity as a broker dealer. The number of
individuals involved is typically small. Since derivative products are often used solely
for risk-reducing purposes there is significantly less latitude for engaging in derivative
activities. The debate continues as to whether highly formalized controls are needed
by end-users. One industry study advises that ‘it is crucial to rely on established
reports and procedures, rather than culture or single individuals to sound the alarm’
(Risk Standards Working Group, 1996).
The danger is that the people on staff understand the product but the audit
function does not. Volumes are low and so the derivatives profile may be relatively
low. The cost–benefit of doing a compliance audit is not deemed worth while. The
obvious danger of this is shown by the off-site foreign affiliates of major banks that
have lost great sums using derivatives or securities. The speculation using Treasury
securities and forwards by Daiwa’s New York office is a classic example of the
difficulties faced in policing a remote office. Here a trader hid losses on US government
bond trades over a 10-year period which totaled over several billion dollars.
The sell side given its enormous size and multi-site locations tends to have
extensive formalized controls. Given that some of the trading sites are located in
foreign money centers, it frequently occurs that compliance is controlled initially by
on-site staff in each geographical location. Appropriate regional safeguards should
be in place and enforced and head office should be kept informed. Head office should
make periodic, comprehensive compliance reviews. The failure is often twofold–
regional oversight fails and head office fails to follow up. The classic case was Nick
Leeson who single-handedly bankrupted Barings plc. There the trader controlled
trading as well as funds disbursement for the Singapore office of a UK merchant bank.
Moreover, audit recommendations pointed out control lapses and recommended
corrective measures. These audit recommendations were never enacted and within
year, the firm was sold for a $1 to ING. A similar example with far fewer losses is
now unfolding for Merrill Lynch in 1999. Its Singapore office finds itself embroiled in
a scandal where a single private banker circumvented ‘Merrill’s accounting, compliance,
and auditing operations’ to engage in unauthorized trading using client funds
(McDermott and Webb, 1999). The regional director knew that something was amiss
but apparently did not pursue the issue.
on the buy side. Generally, the buy side has a single location and may not support
a full-time derivatives team. Indeed the derivatives person might be charged with
other duties as well. Control is more informal and subject to periodic oversight and
periodic audit inquiries.
The buy side should generally have an easier time in ensuring compliance. Often
they are not as heavily regulated an entity as a broker dealer. The number of
individuals involved is typically small. Since derivative products are often used solely
for risk-reducing purposes there is significantly less latitude for engaging in derivative
activities. The debate continues as to whether highly formalized controls are needed
by end-users. One industry study advises that ‘it is crucial to rely on established
reports and procedures, rather than culture or single individuals to sound the alarm’
(Risk Standards Working Group, 1996).
The danger is that the people on staff understand the product but the audit
function does not. Volumes are low and so the derivatives profile may be relatively
low. The cost–benefit of doing a compliance audit is not deemed worth while. The
obvious danger of this is shown by the off-site foreign affiliates of major banks that
have lost great sums using derivatives or securities. The speculation using Treasury
securities and forwards by Daiwa’s New York office is a classic example of the
difficulties faced in policing a remote office. Here a trader hid losses on US government
bond trades over a 10-year period which totaled over several billion dollars.
The sell side given its enormous size and multi-site locations tends to have
extensive formalized controls. Given that some of the trading sites are located in
foreign money centers, it frequently occurs that compliance is controlled initially by
on-site staff in each geographical location. Appropriate regional safeguards should
be in place and enforced and head office should be kept informed. Head office should
make periodic, comprehensive compliance reviews. The failure is often twofold–
regional oversight fails and head office fails to follow up. The classic case was Nick
Leeson who single-handedly bankrupted Barings plc. There the trader controlled
trading as well as funds disbursement for the Singapore office of a UK merchant bank.
Moreover, audit recommendations pointed out control lapses and recommended
corrective measures. These audit recommendations were never enacted and within
year, the firm was sold for a $1 to ING. A similar example with far fewer losses is
now unfolding for Merrill Lynch in 1999. Its Singapore office finds itself embroiled in
a scandal where a single private banker circumvented ‘Merrill’s accounting, compliance,
and auditing operations’ to engage in unauthorized trading using client funds
(McDermott and Webb, 1999). The regional director knew that something was amiss
but apparently did not pursue the issue.
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