The Financial Services Authority is asking fund managers to improve how they monitor risks involved with derivative transactions.
“Incomplete monitoring and fractured reporting of risks makes it difficult for the firm to see a complete picture of its risks in a timely fashion,” said the U.K.’s securities regulator in a recently released draft proposal. Comments are due by December 20.
Among the key recommendations: documentation of processes for oversight of risk exposures; auditing of third party providers; monitoring of counterparty risk and implementation of a “trigger process” to actively review exposures to other firms if they rise above certain fund and firmwide levels; independent valuations of derivatives; and use of “appropriate legal documentation” such as the International Swaps and Derivatives Association’s master agreement when executing swaps transactions.
“Over the past two years, much of the change within the landscape of financial services has been framed around the crystallization of counterparty risk,” said the FSA. “The bankruptcy of Lehman Brothers in September 2008 stands as a reminder of how real and systemic counterparty risk is.”
The FSA also wants asset managers to improve their collateral management procedures. “Firms which do not accept collateral should have a process for determining when it is prudent to mitigate large unrealized profit on an OTC derivative position,” said the regulator. “The minimum transfer amount for a derivative exposure should be proportionate to the size of the fund and creditworthiness of the counterparty.”
In addition, said the FSA, asset managers should only accept or post collateral they can easily price and monitor the collateral posted with their prime brokers.
The FSA based its recommendations on a survey of 12 unnamed asset managers ranging in size from 11 billion British pound sterling ($17.4 billion) to 167 billion British pound sterling ($263.8 billion). Because the asset managers had different definitions and frequencies of market and counterparty risk, there was no uniform oversight. Among the most divergent practices were procedures involving unsettled trades; margins and monitoring of collateral with prime brokers.
The FSA’s proposals come amidst regulatory mandates on both sides of the Atlantic calling for greater oversight of over-the-counter derivative transactions. That includes relying on exchanges or electronic trading venues, centralized clearinghouses and trade repositories to store data on executed transactions.