The Safe Usage Of Derivatives In Risk Control

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"It's not derivatives causing the problem, but a lack of management controls, and process," (Leslie Rahl, a principal in a financial consulting firm in New York, cited in Bencivenga, 1994: 5). Risk management initiatives by several private sectors, work groups such as the Global Derivatives Study Group of Thirty (G30), the Basle Accords and the Capital Requirement Directives have evolved, with the aim of proposing recommendations for safe and effective derivatives use. All of these proposed initiatives put an emphasis on management controls (Adams & Runkle, 2000). However, although a number of reports on management control of derivatives have been published (see Table 2.4.1 and 2.4.2), two have specifically paved the way for other contributions by serving as a needed benchmark. These are, the "Derivatives: Practices and principles," by the G30, in July 1993, which made 20 recommendations aimed mainly for both the dealers and end-users on management and control of derivatives; and the "Risk management guidelines for derivatives" by Basel Committee on Banking Supervision (BCBS) and International Organisation of Securities Commission (IOSCO) in 1994, and principally aimed at banking organisations (Fernández-Laviada, Martínez-García and Montoya Del Corte, 2008).

Table 2.4.1 Risk Management and Control Documents

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Body regulators

Document

Date

USA

Office of the Comptroller Circular on risk management November 1993 of the Currency (OCC) for financial derivatives (BC-277)

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Q & A supplement May 1994

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Examination manual on risk management October 1994

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of financial derivatives

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Federal Reserve Board Examination memo on risk management

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and internal controls for trading activities December 1993

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of banking organisations

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Letter on evaluating the risk management and

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internal controls of securities and derivative March 1995

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contracts used in non-trading activities (SR-95-17)

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Securities Exchange Commission

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(SEC) / Commodity Futures Trading OTC derivatives oversight February 1994 Commission (CFTC)/Securities and

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Investments Board (SIB)

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Federal Deposit Insurance Examination guidance for financial derivatives May 1994 Corporation (FDICIA)

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General Accounting Office (GAO) Report on financial derivatives May 1994

International

Basel Committee on Banking Supervision Risk management guidelines for derivatives July 1994 International Organisation of Operational financial risk management control

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Securities Commissions (IOSCO) mechanisms for OTC derivatives activities of July 1994

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regulated securities firms

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Others

Office of Superintendent Financial institutions' derivatives best practices May 1995 of Canadian (OFSC)

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Bank Negara Malaysia Statement on applications by commercial banks January 1995

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to offer or trade derivative instruments

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Bank of England Report of the Board of Banking Supervision

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Inquiry into the circumstances of the collapse July 1995

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of Barings Bank

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Hong Kong Monetary Authority Derivatives trading internal control review March 1995

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Guideline on risk management of derivatives March 1996

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and other traded instruments

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Management, supervision and internal control May 1997

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guidelines for persons registered with or licensed

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by the securities and futures commission

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Source (Fernández-Laviada, Martínez-García and Montoya Del Corte, 2008)

Table 2.4.2 Risk Management and Control Documents

Trade associations and private bodies Documents Date Committee of Sponsoring Organisations Internal control - integrated framework COSO Report September 1992 of the Treadway Commission COSO enterprise risk management. September 2004

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Integrated framework

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Canadian Deposit Insurance Corporation Standards of sound business and financial practices: August 1993

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Internal control

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Canadian Institute of Chartered Guidance on control November 1995 Accountants (CICA) Guidance on assessing control. The CoCo principles 1997 Institute of Chartered Accountants in Internal control. Guidance for directors on the September 1999 England and Wales (ICAEW) Combined Code (Turnbull Guide)

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Body regulators Documents Date Banco de España, Asociación Española Consideraciones sobre los Sistemas de Control February 1997 de Banca (AEB) and Confederación Interno para la Actividad de Tesorería

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Española de Cajas de Ahorros (CECA)

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Bank of England Banks internal controls and the section 39 process February 1997 European Monetary Institute (EMI) Internal control systems of credit institutions July 1997 International Organisation of Securities Risk management and control guidance for May 1998 Commissions (IOSCO) securities and their supervision

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Comisión Nacional del Mercado de Valores Circular1/1998 sobre Sistemas Internos de Control, June 1998

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Seguimiento y Evaluación Continuada de Riesgos

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Basel Committee on Banking Supervision Framework for internal control systems in September 1998

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banking organisations

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Office of the Comptroller of Internal control. A guide for directors September 2000 the Currency (OCC)

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Securities Exchange Commission (SEC) Section 404 - Sarbanes-Oxley Act 2002

Source (Fernández-Laviada,Martínez-García and Montoya Del Corte, 2008)

Corporate Education

As stated above an example of initiatives targeting management control is the recommendations of the G30 (1992) directed at the OTC derivatives market. These recommendations are beneficial for corporations as well. In addition, many market participants have incorporated them into their own internal policies and procedures. The G30 (1992) proposes a four-step management control system process for safe derivative use. This recommendation involves education, policy implementation, and control. The first step for a sound and effective derivatives use is corporate education. In relation to derivatives and risk exposure, top management must ensure a proper education for those who are responsible for anything related to the said financial tools (Blanc, 1995). However, in the oil industry context, education process has been viewed as a small step in encouraging the producers into the market place. According to Cowan (1994), education helps to break down barriers and make the fearful known. However, changing the perspective of derivatives from one of wild speculation into prudent risk management will take some time. Nevertheless, what is needed is an informed and knowledgeable investor who best understands how and when to use derivatives and the firm's exposure to corresponding risk. In corporate education, one must have knowledge regarding the types of derivatives that are available, how each function within a particular investment strategy, the advantages, and disadvantages of each function as well as the firm's tolerance for loss (Adams & Runkle, 2000). J. Donald Rice Jr., president of Rice Financial Products Co., who has a B.S. in engineering from Kettering University and an M.B.A. with distinction from Harvard Business School, serves as an example of the importance of acquiring corporate education when dealing with the complexities of derivatives. His education helped shape his career as an architect of complex securities transactions, before striking out on his own. Rice was a founding member of Merrill Lynch's municipal derivatives products group, joining the brokerage and investment-banking powerhouse in 1985. He structured complicated transactions, such deals as a $200 million floating-to-fixed interest rate swap for a District of Columbia General Obligation refunding bond issue and a $148 million floating-to-fixed rate swap for the City of Philadelphia, which is the first done by a major city government, in 1990 (Cintron and Seals, 2000).

C. Setting of Corporate Derivatives Policy

The first phase of corporate education should be completed, for the objectives and directives in the second phase to be meaningful. The next step for safe derivatives use is the setting of a corporate derivatives policy. This risk management policy should be instituted with the active participation of both top management and the board of directors. It should be clear and concise, should explain the purpose for the use of derivatives, and include the extent to which derivatives will be used in pursuit of the overall business objectives (Blanc, 1995). The risk management policy should also establish specific and consistent risk management expectations by setting limits to market and credit risk exposure. Guidelines are also needed to minimise legal and liquidity risk. Finally, these policies should be communicated unambiguously and distributed in writing to those involved in any of the phases described in the G30's proposed management control system.

D. Implementation of Sound Investment Strategy

When a corporate derivatives policy has been set, the next step involves the implementation of an investment strategy with an overall purpose of aiding a corporation in meeting the goals established in the derivatives policy. The general rule should be to use derivatives as a means of shifting risk and not as a means of trading in risk. Specifically, the G30 (1992) recommends that: "derivative use should correspond in quantity, complexity, and risk with the objectives of the corporation; unnecessary risk should be avoided in the areas of speculation and leverage; derivatives should be used almost exclusively for protection; hedging strategies should involve views on market direction; investors should adjust exposures to risk rather than use derivatives to increase expected short term profits; and leveraging should be avoided in most cases because it magnifies the risk of a transaction." Other recommendations include: "the avoidance of the use of derivatives that are extremely complex; the need for highly qualified personnel who are appropriately trained and informed of the firm's investment strategy and tolerance for loss; the clear indication by the senior management of the lines of authority for decision-making; and to have a timely derivatives activities report given to senior management to keep them informed of the current derivatives investment status." In implementing these strategies, the active participation of the board of directors and senior management must be sought, and the implementation must be consistent with the board's authorisation.

Internal Control

The last step in the G30's proposed management control system involves the establishment and maintenance of a key set of internal controls. In this control phase, those involved in derivatives transactions must make sure that all of these transactions are authorised and in accord with the policies and strategies that have been enacted (Adams & Runkle, 1997). Moreover, it is further recommended that any deviations from these standards are reported (Adams & Runkle, 1997). Investors can accomplish this control mechanism through a valuation procedure that incorporates all of the relevant risk factors and produces a model of possible outcomes that are compared with actual performance (Nusbaum, 1995). The G30 (1992) also recommends that all of the analysed risk exposures be quantified using ranges and relative probabilities; all derivatives positions and risk exposures be monitored frequently and regularly by well-qualified and knowledgeable people; and derivatives transactions be collected and disbursed through a system of checks and balances. Moreover, GAO (1994) recommends that traders with customer contact, as well as administrative staff with accounting and operations responsibility should provide a desirable check on each other as long as each is independent of unwanted influences and each other. The literature above has consistently contended that derivatives are not inherently bad, but they can be inherently complex. This suggests that it is a must that boards of directors and top managements understand completely the complexities that derivatives pose, the uses of derivatives in their firms, and the requirement to monitor their associated risks. In a similar way, they need to understand that a control structure and systems, which are in keeping with derivatives complexities, are required in order to process the transactions adequately. Change is a factor in designing control. However, the effect of this on systems of internal controls still lacks understanding. An example of a major modification in the securities industry is the effect of the shorter settlement cycle of equity from five working days to three. "This change put pressure upon existing systems, procedures, and control structures and has been the main challenge to several firms in the industry." On a brighter side, the preliminary stages of this changeover passed smoothly, showing that the industry is adapting to these changing conditions (Marshall, 1995). According to Marshall (1995), a firm can apply internal control techniques used in other business areas to their derivatives activities. He continues by noting as an example an issue relating to the allegations of lax supervision that have been made in the Barings collapse case. Suggestions are made that the trader's supervisors was not knowledgeable about the products Mr. Leeson was trading. An effective assessment of supervision on trading would need to provide answer to the following: Who are the persons in charge of managing and monitoring the trading desk? Is the supervisor knowledgeable about the transactions being carried out? Does the supervisor understand the importance of controls and risk management, What are the supervisor's reporting lines? Are risk reports being prepared? Are the risk reports being adequately controlled to ensure accuracy? Does the firm have employees dedicated to risk management or/and is there a risk management committee, or both? and do these assume an oversight function (Marshall, 1995). Since derivatives are somewhat new, have distinctive characteristics, and are volatile, they may pose singular control problems. Therefore, they might require regular attention to ensure that there is a complete knowledge of their complexities by users and controllers (Marshall, 1995). Internal control is sometimes viewed as the practice and procedure that will enable the prevention of fraud and identification of error. It is seen that an internal audit is an essential element of a company that functions as a part of the internal control system (Silverstone and Davia, 2005). It is also seen as an instrument for identifying the risks and fraud related to the financial aspects of the company (Silverstone and Davia, 2005). Moreover, it serves as the guide for making decisions with regard to enhancements in securing the assets (Silverstone and Davia, 2005). However, more than that, internal control should be understood as a process by which firm's management and employees maintain business risks within acceptable boundaries. The vision held by management, of controls and their importance, is reflected in the strength of internal controls. To manage risks effectively requires knowledge and understanding of these risks (Marshall, 1995). The presence of such internal form of control is further emphasised in the report made by the BBS Report of 1995, which revealed that there is, in the case of Barings, a failure in terms of the internal control system of the said company (Hudson, 2000). More specifically, internal audit control is an essential addition in the formulation of a risk management strategy because it serves as the signal through which the perils associated with the use of derivatives are highlighted (Effros, 1998). The General Accounting Office (GAO) has been a vocal advocate of the value of a strong and practicable internal control structure to protect public interests. According to its Chief Accountant, Donald H. Chapin, a financial report is incomplete without a report on controls (Craig, 1995). In the US and Europe reports on financial status by a governments and the state include an account on internal control. The Federal government must have some comfort that procedures and policies exist to assure that the money is used as intended. Chapin stated in an interview, "I consider internal control reporting an essential element of financial reporting. Some users of financial statements, maybe many unsophisticated users, believe internal controls are already being dealt with as part of the financial statement audit. Silence by the auditor means to some that the control system is in fine shape. Little does the public understand that, in fact, less and less is being done by the auditor to verify that internal controls are sound" (Craig, 1995: 40). According to Fernández-Laviada, Martínez-García and Montoya Del Corte (2008), various authorities and international bodies, have drawn up a number of reports on the regulation and establishment of internal control. A few of these reports (Table 2.4.3) have been floating around financial firms, waiting for a homogeneous system for all sectors.

Table 2.4.3 Internal Control Documents

Trade associations and private bodies

Documents

Date

Committee of Sponsoring Organisations Internal control - integrated framework COSO Report September 1992 of the Treadway Commission COSO enterprise risk management. September 2004

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Integrated framework

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Canadian Deposit Insurance Corporation Standards of sound business and financial practices: August 1993

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Internal control

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Canadian Institute of Chartered Guidance on control November 1995 Accountants (CICA) Guidance on assessing control. The CoCo principles 1997 Institute of Chartered Accountants in Internal control. Guidance for directors on the September 1999 England and Wales (ICAEW) Combined Code (Turnbull Guide)

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Body regulators

Documents

Date

Banco de España, Asociación Española Consideraciones sobre los Sistemas de Control February 1997 de Banca (AEB) and Confederación Interno para la Actividad de Tesorería

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Española de Cajas de Ahorros (CECA)

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Bank of England Banks internal controls and the section 39 process February 1997 European Monetary Institute (EMI) Internal control systems of credit institutions July 1997 International Organisation of Securities Risk management and control guidance for May 1998 Commissions (IOSCO) securities and their supervision

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Comisión Nacional del Mercado de Valores Circular1/1998 sobre Sistemas Internos de Control, June 1998

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Seguimiento y Evaluación Continuada de Riesgos

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Basel Committee on Banking Supervision Framework for internal control systems in September 1998

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banking organisations

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Office of the Comptroller of Internal control. A guide for directors September 2000 the Currency (OCC)

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Securities Exchange Commission (SEC) Section 404 - Sarbanes-Oxley Act 2002

Source: (Fernández-Laviada, Martínez-García and Montoya Del Corte, 2008)

The SarbanesOxley Act 2002 in the US or the UK internal control frameworks beginning with the Cadbury Commission 1992 and more recently the Combined Code in 1999 and the BCBS are evidence the importance given to internal controls. They advocate strong internal control systems to help firms manage and control risks. This increasing interest can be partly attributed to the demise or large losses suffered by various firms, which Fernández-Laviada, Martínez-García and Montoya Del Corte (2008) suggest that with proper controls a substantial part of the losses could have been avoided.

Government Intervention

Periodically, situations that draw out concerns of market disruption and systemic risk arise in the financial markets. In these cases, according to Lamm (2001) the government must provide a favourable environment for the institutions and save them from any perceived crisis. For example, as a response to the crisis faced by LCTM, the US government came up with an agreement whereby financial firms injected $2.6 billion into LTCM, effectively allowing it to remain in business (McDonough, 1998). The government intervened with a rationale that the failure of LTCM could have created significant systemic risk problems (McDonough, 1998). However, much debate has emerged regarding this intervention and regarding the steps that should be taken to diminish the likelihood of similar situations arising in the future (The President's Working Group on Financial Markets, 1999). In this vein, Lamm (2001) argues that: (1) there is a need to go beyond the general sense of unease and the overall belief that there are looming negative systemic consequences of particular market events; and (2) greater definition of the conditions under which intervention would be considered by government officials should be spelled out in advance and known to market participants. This conclusion is based on an examination of some of the basics of trading in financial markets and identifies a number of benefits of having a more definitive policy regarding governmental intervention. According to Lamm (2001) more work needs to be done in creating a workable policy delineating the conditions under which governmental intervention would be appropriate. Greenspan (1998) contends that the existence of a clearer policy regarding governmental intervention would provide more confidence in the market, would allow market participants to better evaluate risk, and would provide more guidance and accountability for regulators. Finally, Lamm (2001) suggests that regulators should engage in rigorous regulation during crisis in order to promote sound practices for risk management.

Governance, Risk and Compliance (GRC)

Here, the role of governance, risk management, and compliance (GRC) is highlighted. These are considered as separate entities wherein governance is considered as the element wherein the top management identifies the objectives and consequently directs the efforts of the organisation towards the said goals (Purpura, 2007). As for risk management, it is considered as the compensatory factor that limits or diminishes the impact of risks for the firm (Purpura, 2007). Lastly, compliance would have to be the adherence of the organisation to the legal statutes and other regulations that are seen fit (Purpura, 2007). Among the actions required for the implementation of GRC are the following: 1) to organise and strengthen the policies, procedures, and controls; 2) preserve an oversight from the main level; 2) adhere to a decentralised form of administration and answerability; 4) provide a communication network that exists among the different levels; 5) "audit, monitor, and report"; 6) extend standardised support, resolution, and administration; and 7) execute continuous enhancement in the process (Purpura, 2007: 261). GRC is increasingly given priority and attention in businesses because of the security it gives to the company's reputation and value placed on the brand; power it brings to meeting the demands of the different stakeholders; expectations related with the three concepts enclosed within GRC; ability to respond to crisis and resolution of problems while the key management officials are safeguarded; and provision for an avenue where corporate responsibility is reflected and responsibilities as trustees are given importance (IT Governance Institute, 2007).

Training

In the researchers view this is the most effective way of avoiding fraud and manipulation. Continuous training empowers people to understand the market or instrument they are dealing with and enables them to raise the red flag when things are not as they should be. That is having a knowledgeable first line of defence, second line, third line and so on. The more down and up the line this goes, the better. As we have seen from past cases it is usually too late when the internal auditor, external auditor, regulator, compliance officer or the risk manager finds out things. This may be because they are alienated by other situations, they are not knowledgeable enough or they are not competent. Training however is also needed for these controllers. In fact many European financial authorities are now concentrating efforts on educating the public and also the financial users on all aspects of financial services. However, the education on derivatives is still very limited.

Change/improvement needed to ensure the safe use

One cannot expect to work and regulate in these financial markets with tools of the past. Tweaking the current systems will not work and new thinking is required. One has to be innovative, otherwise the next abused derivative will blindside controls. Literature and cases of derivative misuse, reveal that there is a need for improved prudential financial market regulations and better surveillance by the control departments (lines of defence) of companies (i.e. internal audit, risk management and compliance). The market is in need of smarter regulators and controllers since although they ask financial firms to report the potential impact of their activities and carry out both onsite and off-site compliance and audits, nothing seems to have worked. These changes should help in bringing about transparency and efficiency in the derivatives market, making it less vulnerable to disorders and misrepresentations and encourage the derivatives use as a risk management tool while discouraging their use for unproductive pursuits (Dodd, 2002). There is definitely a problem of transparency in reporting and registration requirements. Improvements here aim to provide the government and other regulatory and monitoring authorities with effective tools to help identify and prevent fraudulent transactions and manipulation (Dodd, 2002). Standards and regulations should be enhanced to ensure such. Another prudential regulatory measure that is needed requires investments and collateral as prerequisites. The capital serves as a buffer against the risks in the market and to control participants' aiming for investment strategies with higher profits, which entail greater risks (Dodd, 2002). On the other hand, the collateral provides the same purpose but it is applicable for the transactions and is not intended for the institutions (Dodd, 2002). In light of this, the non-financial corporations together with public units are required to provide collateral prerequisites when capital requirements are not asked for (Dodd, 2002). This has become a sensitive issue due to the inadequacies found in terms of the current practices in the market (Dodd, 2002). A significant number of companies engage in the trade of derivatives without guarantees in the form of collateral or more commonly known as "trading on capital" or trade with a high threshold of exposure before collateral is required (Dodd, 2002). Another risky practice is the use of illiquid assets as collateral and the requirement that a counterparty becomes "super-margined" in cases where its credit rating falls significantly (Dodd, 2002). This change requires a derivatives counterparty to post large amounts of additional collateral. That is a need for fresh capital just when the firm is having trouble with inadequate capital, thereby creating a crisis accelerator (Dodd, 2002). Another measure that should be taken into consideration involves orderly market provisions. That is, measures drawn-up from experiences in the derivatives and securities markets around the globe to facilitate a liquid, efficient market with a minimum of disruptions (Dodd, 2002). One must recognise the fact that the concerns about the derivatives markets in all financial systems are similar and therefore should apply, be enforced and instituted unilaterally in all countries, be it developing or developed (Dodd, 2002). Although, regulation is drawn-up and supervision is carried out in a more efficient manner when there is international cooperation, this is not a necessary condition. Moreover, there should be fewer objections by IMF, private financial firms or other laissez-faire policy advocates if these regulations are the same or similar to the ones adopted in established financial market economies (Dodd, 2002).

Registration and Reporting Requirements

The registration of derivatives dealers and brokers should be mandatory, as is the case with securities, banking and insurance firms. This enables the establishment of minimum competence levels for individuals (such as qualifications and exams) and standards for capital. This allows for the setting of monitoring and accountability procedures in order to deter fraud and theft (Dodd, 2002). Moreover, the reporting of derivative transactions should be a requirement to make the market more transparent. This consequently helps to produce a more efficient market and price discovery process (Dodd, 2002). The information that should be reported should include data related to cost, quantity, open interest, put-call volume and rations, maturity, instrument, underlying item, amounts traded between other dealers and with end-users, and collateral arrangements (Dodd, 2002). Reports on derivatives activities by publicly traded corporations should include enough detail to convey the actual, underlying economic properties and business purposes of business activities including any minority interests or special purpose entities. These derivatives should be reported by notional value (long and short), maturity, instrument and collateral arrangements, in such a way to bring off-balance sheet activities into the same light as balance sheet activities. This allows the investors to assess the firm's hedging level (under- or over-hedged) and whether it was primarily acting as a producer or wholesaler (Dodd, 2002). The reporting by derivative dealers and exchanges of large trader positions and entities that amass a critical size of open positions in a market should be made a requirement. Commodity Futures Trading Commission in the U.S. has found this strategy useful for the purpose of market surveillance (Dodd, 2002). The information from the report would have to be organised by the regulatory authorities with the purpose of identifying and preventing manipulations in the market (Dodd, 2002). However, there should be adequate safety measures used in order for the information on the players' strategies to be protected (Dodd, 2002). Only the non-proprietary information is to be made available to the market in order to enhance the transparency within those involved (Dodd, 2002). The data would be a picture of the whole. Encroachment into the privacy of the individual members will not be allowed and only the regulator has the capacity to view the proprietary information (Dodd, 2002). Even so, this is only to be used to enable the identification and prevention of manipulation from happening (Dodd, 2002). Thus, it is really important for information to be transparent and accessible to respective people who are involved for the purpose of enhancing the markets. This data would reflect the character of the market. However, there is a need to ensure that reporting requirements are enforced. This can be done by stipulating that any derivatives transaction that is not reported will not be actionable in a court of law. The aggregate information derived serves as the tool for understanding the market and preventing adverse outcomes that result from the trading activities. In summary, there is a need to have accurate, current and centralised information on the exposures and earnings arising from derivatives, which is accessible to all regulators. This information needs to be developed and maintained. (General Accounting Office GAO recommendations in the report of congress in May 1994) (Dodd, 2002).

Capital and Collateral Requirements

An update of all capital requirements should be maintained for all derivative users, especially for derivatives dealers that might not otherwise be registered as a financial institution. This to ensure that the amount of capital held is commensurate with the exposure to credit loss, potential future exposure and value at risk (VAR) (Dodd, 2002). Capital requirements can be used to restrict the mismatch between the currency composition or maturity of assets and liabilities (including both balance sheet and off-balance sheet positions) (Dodd, 2002). It serves as a regulatory tool on, but at the same time allows achieving greater level of returns through greater quantities of foreign currency and interest rate risk (Dodd, 2002). The capital functions as a buffer and a limit (Dodd, 2002). As a shock absorber, it lessens or mitigates the impact of negative outcomes that may be encountered by the firm (Dodd, 2002). As a limit, it keeps the firm from engaging into too much risk because the capital is proportion to the amount of risk that can be taken by the company (Dodd, 2002). It is essential so as not to allow the problem of one entity to spread to the others. This is especially true for the dealers in financial market since their failure can lead to problems in the market, example illiquidity (market freeze-up) or meltdown (Dodd, 2002). Thus, sufficient and applicable collateral (margin) should be posted and maintained on all derivatives transactions (Dodd, 2002). This functions like capital requirements and prevents the situation of one firm to affect the performance of the other and other transactions. It helps protect against the likelihood of default or other credit related losses, reducing the market's exposure to a freeze-up or meltdown (Dodd, 2002). The rate imposed for the collateral should be sufficient to cover for immediate short-term losses and should be in a liquid form such as cash or liquid government securities (Dodd, 2002). Any collateral that is not liquid or has high price volatility is not encouraged and should not be permitted (Dodd, 2002). Moreover, even alternatives such as performance bonds, letters of credit, or surety bonds should not be considered or discouraged (Dodd, 2002).

Orderly Market Rules

Fraud and manipulation are illegal and punishable under both civil and criminal laws and should be strictly prohibited. This is to maintain a high integrity for the prices established in the market to attract a greater degree of participation from the market and avoid wrong indicators to the economy (Dodd, 2002). In addition to this, the dealers of derivatives are required to act as markets makers and uphold binding bids and ask quotes throughout the trading day (Dodd, 2002). It is common practice policy observed by exchanges in the market and for OTCs (Dodd, 2002). "Know your customer" rules should become ingrained within the practices of those institutions conducting derivative transactions. This regulatory provision prevents fraud (such as blowing-up customers) and is currently in practice in other securities markets (Dodd, 2002). Restrictions on risk taking in the derivatives markets should be imposed by way of position limits. This should take the form of a trading policy (imposing limits on aspects such as dealer limits, trade limits, and position limits etc.) which can be drawn-up internally or imposed by way of regulation. Through this, the transactions involving "hot money" or carry trade is limited because they result in exchange rate and at times interest rate exposures (Dodd, 2002). Also as recommended by the GAO in their report to congress in May 1994 there should be comprehensive annual examinations of risk management systems. These are partially implemented by the recommendations of Basle II and the requirements in Europe of the Capital Requirement Directive (CRD). Moreover, this report recommends uniform and particular ideals intended for internal forms of control, management responsibilities and the harmonisation of disclosure, capital, examination and accounting standards (Dodd, 2002).
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