The Derivative Middle Office: Middle Office Derivatives Business Regulations
Middle Office Financial Derivates Business Regulations (FDBR)
Overview of Middle Office FDBR
The Financial Derivates Business Regulations (FDBR) allow and regulate financial derivatives business and define the roles and requirements around the Derivative and Treasury Middle Office function. For financial institutions writing derivatives business, the primary supervisory authority remains the Central Bank. For purposes of clarification, the Central Bank has clearly delineated, “Derivates Business” into three distinct categories:
- Transactions undertaken for purposes of hedging asset and/or liability risks, or for varying overall risk profile;
- Transactions undertaken by Financial Institutions with clients and covered on a back-to-back basis on the same day. The motivation for such transactions lies in earning a spread as market risk is covered through the back-to-back transaction, and;
- Transactions undertaken to provide derivative trading services and quote prices to clients and other financial institutions resulting in the assumption of market risk.
Entities allowed to undertake derivative transactions have been classified into three distinct categories, with a stipulation that for each derivative transaction one of the entity must be a financial institution. The three categories include:
- End User Entities – typically includes customers of Banks, DFIs, NBFCs and other entities, who wish to hedge/alter the risk profile of their underlying exposure;
- Non-Market Maker Financial Institutions (NMIs) – includes those financial institutions that have been granted approval by the Central Bank to carry out derivatives business as defined under FDBR Regulation 5 (b), who wish to hedge their own positions and/or sell derivatives to other end users while covering the same position on a back-to-back basis with Authorised Derivates Dealers (intention of selling and covering is to earn a spread) and;
- Authorised Derivatives Dealers (ADDs) – includes those financial institutions that have been granted approval by the CENTRAL BANK to carry out derivatives business as defined under FDBR Regulation 5(c).
Although a large number of derivatives transactions exist, the Central Bank has restricted types of derivates to include only the following:
- Foreign Currency Options – G7 currencies only (no PKR/USD or PKR/Other Currency options to be offered), no limit on notional principal, not exceeding a maximum tenor of one year (except with prior approval of Central Bank), hedge not to exceed total principal/duration of underlying. All FX Options to be covered by ADDs and NMIs on a back to back basis, except that ADDs may purchase Vanilla FX Options with a maximum maturity of 6 months to cover their long/short positions;
- Forward Rate Agreements (net settling) – Domestic currency only, no limit on notional principal, not exceeding a maximum tenor of two years (except with prior approval of Central Bank), hedge not to exceed total principal/duration of underlying. Any domestic money market/debt market rate or interest rate implied in the FX forward market may be used provided computation methodology is objective, transparent and mutually acceptable to counterparties and is approved by the FMA. The FRA portfolio must be marked to market on a daily basis and;
- Interest Rate Swaps (net settling) – Domestic currency only, no limit on notional principal, not exceeding a maximum tenor of five years (except with prior approval of Central Bank), hedge not to exceed total principal/duration of underlying. Any domestic money market/debt market rate or interest rate implied in the FX forward market may be used provided computation methodology is objective, transparent and mutually acceptable to counterparties and is approved by the FMA.
Any derivative transaction envisaged apart from a – c listed above would require the express prior approval of the CENTRAL BANK.
5.2.1 Non-Market Maker Financial Institutions Middle Office
The CENTRAL BANK defines NMIs in the FDBR as follows:
“An NMI will include all Financial Institutions, which have been given the approval by CENTRAL BANK to carry out Derivatives Business stated under Regulation 5(b). These institutions can enter into derivative transactions with Authorized Derivative Dealers to hedge their own positions. While entering into transactions with their customers, these institutions must cover their positions on a back-to-back basis from an Authorized Derivative Dealer. These institutions must get a one time approval from its Board or Head Office / Regional Office to enter into such derivatives sale and provide a copy to CENTRAL BANK.”
NMIs are allowed to enter into derivate transactions to (i) hedge their own positions (counterparty ADD), and; (ii) earn a spread, by offering a derivative transaction to their customers which is covered (same day) through a back-to-back transaction with an Authorized Derivates Dealer.
5.2.2 NMI Eligibility Criteria and Framework Implications
The CENTRAL BANK has stipulated that for Financial Institutions to be authorized to sell derivative transactions to End-Users, the following aspects must be demonstrated (to the CENTRAL BANK):
- A risk management framework;
- Existence and Independence of:
- Front Office,
- Mid-Office and,
- Back Office,
- Front Office,
with distinct/separate reporting lines and headed by different individuals.
Requisite understanding of derivative transactions by Individuals dealing in derivatives business in the front, middle and back offices.
- The derivative business unit to be located in Treasury’s main dealing room from where it will carry out all derivative business.
- A sound risk management system in relation to derivative transactions.
- An effective internal control system in relation to derivative transactions.
- For a foreign bank branch applying to conduct derivative business, its home country regulatory authority has the appropriate supervisory framework in place. It shall also obtain from its head office or regional headquarters, a formal authorization for conducting derivative business which includes transaction types and limits for such derivative business.
- A Derivatives Selling Policy Manual, and;
- Fulfillment of any other requirements as stipulated by the State Bank of Pakistan.
5.2.3 A risk management framework to identify and address credit and operational risks arising out of derivatives selling activity. The central premise of risk management is the concept that the Board of Directors and senior management must take responsibility for and ensure that the financial risks encountered by the organization in its operations are appropriately managed. This generally takes the form of:
- Establishing risk management policies;
- Allocating capital against risks and managing this risk capital over time, and
- Establishing a risk management process and structure to ensure adherence to policies.
The implications of a framework to manage risks is established through an understanding of the nature of the derivatives business. It is expected that senior management of an NMI understands the risks of engaging in derivative transactions since it is the responsibility of senior management to review and approve policies, procedures, organization and authorization of the business operation system and risk management system.
It is further expected that senior management will supervise and manage the derivative business through access to information in respect of risks through an independent risk management function and a sound examination and report system.
Senior management should adopt standards and methods for measuring risks of its derivative business which are appropriate for such institutions, and should periodically review and update risk exposure limits, stop loss limits and contingency plans for derivative transactions pursuant to the overall strength, amount of tier-1 capital, profit-making ability and the operation policies of such institution, as well as the estimation of market risks. Accordingly, senior management should also establish procedures for supervising and handling these limits.
Based on the scale and types of derivative transactions, adequate arrangements for liquidity should be made to ensure the ability to perform contractual obligations even under extraordinary market conditions.
Existence and Independence of (i) Front Office, (ii) Middle Office and, (iii) Back Office,
with distinct/separate reporting lines and headed by different individuals. As a concept, the Middle Office evolved out of the G-30 recommendations. It entails the creation of an intermediate function located between the Front Office and the back office with responsibility for risk management. This structure entails a split of responsibilities as follows:
- Front office – encompassing trading (proprietary trading, market-making, arbitrage, market-making/client facilitation) and sales (transaction structuring and sales/product distribution).
- Back office/operations – encompassing transaction processing (confirmation, settlement, funding, payments and clearing), documentation and accounting (profit/loss determination, cash movements, reconciliations).
- Middle Office – encompassing activities not covered by either the front of back office/operations functions. These activities typically include:
- Risk management including market risk
- Risk Administration, including risk limits, limit compliance, risk reporting and performance analysis
- Credit risk enhancement, including collateral operations
- Review/approval of new products
- Regulatory capital compliance/management
- Risk management including market risk
The middle office is seen as an interface between the trader and the back office. It is also seen as an interface between derivatives/complex product professionals and senior management.
The CENTRAL BANK has mandated that the front, middle and back offices be headed by different individuals with separate reporting lines.
5.2.4 Front Office
The front office functions are largely focused on sales/structuring and trading activities. The focus within sales/structuring includes transaction structuring and sales support. The activity emphasizes work undertaken by corporate derivatives dealers/sales or marketing staff involved in the identification of counterparties, marketing to counterparties and structuring of transactions. The key operational requirements of the activities include:
- Availability of pricing and valuation models to trade/structure and price transactions as required.
- Information on existing transactions with various counterparties.
- Research and market rates/prices.
It is evident that clear standards should be formulated regarding qualifications of dealers, analysts and other staff. Sales and other relevant staff need to be equipped with appropriate training that should correspond to the complexity of derivative transactions and risk management, so as to ensure that necessary skills and qualifications are developed.
Relevant policies to assess the suitability of counterparties should be formulated, including assessment of whether (i) counterparties fully understand the terms of the contracts and their corresponding obligations under the contracts, and (ii) proposed derivative transactions are consistent with the objectives of the counterparties. When conducting derivative transactions with institutions and individuals (the end users), risks involved in derivative transactions should be disclosed, and written confirmation from such institutions or individuals is to be obtained in order to ensure that they have understood and have the ability to bear the risks in these derivative transactions. The information to be disclosed to such institutions or individuals should include at least the following:
- Contents of the derivative contracts and a summary of the risks involved, and;
- Significant factors that may affect the potential loss arising out of the derivative transaction.
An NMI shall be entitled to rely in good faith and in a reasonable manner on formal written documents provided by its counterparties.
NMIs may properly and reasonably use collateral or other credit risk reduction techniques to reduce the credit risk of its counter parties, adopt proper measures and models to assess the credit risk and adopt risk control measures accordingly.
5.2.5 Back Office/Operations
Back office or settlement functions process, settle and administer transactions. The focus is process-oriented, and over time these support functions have become broad based. The functions encompassed are still similar to those performed traditionally, but the functional scope has broadened to include control issues, risk management and compliance. The focus has changed to emphasize efficiency/cost of processing, management/control and supporting business activities.
A requirement of the FDBR is the setting up of a sound operational risk control mechanism and system to strictly control for any operational risk issues. Although there are multiple definitions of operational risk, it may be useful to define it as the risk of financial loss arising either directly or indirectly from operational failure. Operational failure is taken to cover processing or systems/technology failures, deliberate actions or errors/omissions of personnel, legal/documentation failure or adverse changes in regulatory requirements affecting relevant transactions.
Major causes of operational failure may include:
- Lack of adequate management oversight and accountability, and failure to develop a strong culture of control;
- Inadequate assessment of the risk of certain banking activities, whether on or off-balance sheet;
- Absence, or failure of key control activities such as segregation of duties, approvals, verifications, reconciliation and reviews of operating performance;
- Inadequate communication of information between levels of management within the organization, especially in the upward communication of problems, and;
- Inadequate or ineffective audit programmes and other monitoring activities.
Even though the actual quantification of operational risk is difficult and no time tested standard or widely accepted market methodology is available, the use of risk indicators involving the identification of specific factors (for example, error rates, transaction volume, processing delays, staff turnover, staff training expenditure, etc) that are predictive of operational failure may prove practical. Given that factors that cause operational failure are a combination of internal factors, the premise of this approach (risk indicators) is that the identified factors are generally indicative of stresses that are likely to result in operational failure.
Management of operational risk is generally structured as a multi-tiered process. The major focus is on the use of internal controls and improvements in the overall control environment designed to lower the risk of operational failures. Some organizations have begun to systematically allocate capital against operational risk and establish/monitor operational risk limits. The use of insurance/external hedges of operational risk is also growing.
NMIs are expected to have an effective internal control system in place in respect of their derivate business. Internal controls typically form the basic technique for management of operational risk. The objective is to improve the control, performance and quality of all operational processes. This generally takes two forms:
- Implementing a set of specific control mechanisms, and;
- Creating and maintaining a control environment consistent with the reduction of operational risk.
The key components of internal controls are a set of cohesive and integrated control mechanisms designed to reduce the incidence of high frequency low severity losses and avoid low frequency high severity losses from operational failures. The basic control mechanisms used in processing/systems and also legal/documentation/regulatory risks are listed below.
- Separation of functions;
- Transaction verification;
- Verification of inputs/market data;
- Reconciliation procedures;
- Transaction management systems;
- Amendment procedures;
- Authorisation structures;
- Reconciliation to cash;
- System control, and;
- Internal and external audits;
The control techniques are designed to prevent errors or failures and to ensure that adequate processes are in place to detect any errors. The controls are a mixture of organizational strategic (structure) and operating policies/procedures.
5.2.6 Requisite understanding of derivative transactions by individuals dealing in derivatives business in the front, middle and back offices. This is a crucial requirement for the derivatives business as there needs to be a focus on the need to match staff expertise with the requirements. Hiring of staff with appropriate education, training programs and continuing education/training is required to maintain skill levels.
5.2.7 A sound risk management system in relation to derivative transactions. The system should be able to accurately reflect/evaluate the credit/counterparty risk at the end of each day. Proper risk assessment methods or models to assess the market risk of derivative transactions should be used and market risk should be managed on the basis of marked-to-market principles. NMIs are also expected to adjust the scale of their derivative business, the types of transactions and the level of risk exposure accordingly.
5.2.8 A Derivatives Selling Policy Manual is mandated by the CENTRAL BANK as a requirement to obtaining approval for an NMI. At a minimum, the Derivates Selling Policy Manual should contain:
- Scope of Derivatives activities, types of services & products to be offered to clients;
- Procedures for evaluating client suitability;
- Authorities and responsibilities of:
- Board of Directors
- Management Committees
- Chief Executive Officer
- Other Senior Officers
- Department Managers, and
- Trading or Dealing Room Officers/Staff
- Policies and procedures to govern selling & documentation;
- Policies and procedures for controlling and measuring risk including, as a minimum:
- Counterparty and Gap Limits
- Mark-to-Market policies & procedures
- Internal Control and Audit Policies;
- Policy review frequency;
- System of Financial and Regulatory reporting;
- Job Descriptions of and minimum qualification standards for key positions, and;
- Technical competence of key officers/traders responsible for derivatives.
5.2.9 Reporting, Disclosure, and Other Requirements
Reporting requirements for NMIs include:
- Submission to the CENTRAL BANK of reports and related statements in respect of derivative transactions as prescribed by the Banking Supervision Department.
Disclosure requirements for NMIs include:
- Disclosure of disclose risks, losses, profit variations of derivative business and any extraordinary situations according to the financial disclosure requirements in force.
- In the absence of any specific requirements of the State Bank of Pakistan, or the Institute of Chartered Accountants of Pakistan, accounting treatment and disclosure of derivatives transaction will be, in accordance with International Accounting Standards.
Other requirements for NMIs include:
- No derivative transaction will be executed by ADDs/NMIs unless International Swaps and Derivatives Association (ISDA) Agreement has been exchanged with the counterparty.
- The CENTRAL BANK can examine materials and statements of NMIs in relation to derivative business at any time, and periodically examine whether the categories of derivative transactions engaged in are appropriate in the context of their risk management systems, internal control systems and business processing systems.
NMIs are required to maintain all transaction records and relevant documents, accounts, original receipts, telephone recordings and other information in relation to its derivative transactions. Telephone recordings shall be maintained for no less than half a year. Other materials are required to be preserved for at least five years after the termination of contracts for review purposes unless laws/regulations mandate a longer timeframe.