Derivatives For Regulators' Seminar
20 March 1995 |   By : Dato' Dr. Mohd. Munir Abdul Majid, Chairman, Securities Commission, Malaysia

Good evening and thank you for coming to Langkawi to participate in this event. A conference of this nature is very timely. Recent losses in derivatives have captured public attention all over the world. Gibson Greeting Cards, Proctor and Gamble, Air Products, Showa Shell, Orange County and Barings have acquired a different connotation in recent years. And lest it be said that these are problems related to the developed markets, Sinar Mas, Berjaya Cayman, and Taiwan's Overseas Chinese Bank will serve to remind us that emerging markets are not spared as well.

These names highlight the diverse circumstances under which losses with derivative products can occur. This should come as no surprise as derivatives are now used by a wide variety of institutions -- banks, insurance companies, corporations as well as government agencies all around the world. Likewise, there are a myriad of instruments available to the hedger, investor and speculator from plain vanilla products such as fixed-to-floating rate swaps and stock index futures to the more exotic constant maturity swaps, index amortization swaps, collateralized mortgage obligations and foreign exchange break forwards.

Given that the same or similar products can be traded in a number of jurisdictions, on exchanges or over the counter, involving financial institutions, insurance companies, corporations who are in turn regulated by different authorities, at home and abroad, you can appreciate the magnitude of the challenges facing us as regulators.

This tangled web of products, users, jurisdictions and regulators is not helped by the public perception that derivatives are dangerous and difficult products to understand, let alone regulate, and that regulators are always one step behind the market. No wonder that the tabloids, and even some otherwise serious and sagacious journals, have been having a field day with the "d" word, attributing it to the Prince of Darkness. Derivatives are fast attaining the reputation of a regulatory no-fly zone, where the failure of users and intermediaries rule, and regulators watch helplessly from the sidelines.

This perception is simply not true. As you would have learnt from the course today, and I gather you will discuss the subject in greater detail tomorrow, derivatives are useful, can be understood, and can indeed be risk managed by their issuers, users and regulators. However, it is not possible for anyone to guarantee the public that there will be no derivative losses in the future. For as long as greed, fear, ego and foolishness exist, there will always be the possibility that derivatives could be abused. To the extent that lawyers tell us it is not possible to outlaw fraud, it is also not possible to eliminate the abuse of derivatives through regulation. However, putting a lid on excessive speculation is very much in the domain of possibility, and should be on the agenda of all regulators who are intending to introduce derivatives in their jurisdictions for the first time. Through the monitoring of concentrations of large positions both on the derivative and cash markets, as well as position and price limits, excessive speculation can be curbed.

The regulatory fraternity can also improve the current state of affairs relating to sales practices, market regulation, capital adequacy, risk management, disclosure standards and the whole host of measures designed to make the trading of derivatives more secure. Indeed, I would say that the incidences of failure have been too many, and there is a pressing need for industry and regulators to work together to see how the situation can be improved.

It is absolutely critical that we as regulators do not give in to an attitude of hopelessness, and helplessness by believing that derivatives are too difficult and dangerous to be properly regulated. Perhaps this attitude is spawned by popular accounts that an understanding of the pricing and risk management of derivatives requires a PhD. in particle physics or numerical analysis. To be sure, if you were involved in the pricing of exotics, some advanced mathematics and statistics wouldn't hurt, but I will aver that many of the products that are widely used are based on building blocks that can be taken apart and intuitively understood. Another way of looking at the problem is to observe that spectacular failures can be caused by some very simple products-- the Barings incident is but one example. Hence, complexity is certainly not the main issue.

Almost a year ago today, Fortune Magazine came up with a piece on derivatives entitled "The Risk that wouldn't go away". As a subhead to that title, it said "Like alligators in a swamp, derivatives lurk in the global economy....". It is indeed true that derivatives wouldn't go away because they are useful and very much a part of the landscape of any modern financial system. It is equally true that derivatives offer built-in leverage, and could have contagion effects on markets other than the ones;' they trade on. But so do many products, be they financial products or otherwise. To paraphrase Arthur Levitt, Chairman of the US SEC, derivatives are like electricity. If we have been trained and conditioned as children to respect the electromotive force of a high voltage current, and how it can be applied in making machines move at the flick of a switch, we have also been taught the unfortunate effect that even a short exposure to it could bring, especially if a conductor like water is present and if there is no insulation. So too should we be taught to respect the rewards and risks of using derivatives without adequate protection.

Hence, leverage by itself is not the problem. After all, other financial instruments also offer leverage. The problem we face is not new. Indeed, recent events call to mind the problems of a smallish German Bank called Herstatt that learnt to its grief what unsupervised leverage could do, albeit in a totally different market -- the foreign exchange market, and in a completely different context-- a world adjusting to floating exchange rates. Despite the differences in circumstances, there is a common thread, and it is the combination of leverage and poor internal controls that needs to be managed.

Likewise, contagion effects by themselves are not new. Banking regulators have been dealing with the problems of gridlock and the loss of confidence resulting from one illiquid member of the banking system for a very long time now. Capital adequacy, firewalls, account segregation and frequent examination are but some of the tools that have been evolved to deal with the problem.

What then do we need to bear in mind as regulators of either cash or derivatives markets? What are the essential elements of regulation and best practices that we need to develop for the introduction of derivatives into emerging markets? Let me highlight five areas:

  • promoting market integrity;
  • fostering good practices in managing operating and settlement risks;
  • attaining investor protection by promoting ethical sales practices, and the implementation of licensing procedures;
  • encouraging better disclosure practices; and
  • last but not least, mount a comprehensive and relevant educational effort in conjunction with industry

First and foremost, we need to uphold the integrity of markets. This involves establishing a robust clearing and settlements system, together with well capitalized market intermediaries. A distinguished feature of exchange traded derivatives is the role of the clearing house in managing credit and market risks through a margining system. The clearing house becomes the effective risk management centre for the exchange. Setting the appropriate levels of margins involves balancing the conflicting objectives of having low margins to promote liquidity in trading and setting high margins to ensure safety to the system in the event of defaults. One possible solution is to implement a risk based margining system which calculates margins using a portfolio valuation model, and enables these margins to be stress tested. Market intermediaries should adhere to minimum capital requirements that are designed to cover their normal operations and the volume of business they do.

Operating risk must be managed to minimize exposure to loss as result of inadequate risk management and internal controls by firms using derivatives. This risk category encompasses a wide variety of nuts and bolts operations that are central to the use of derivatives. At the highest level, lack of involvement by a firm's senior management itself is an operating risk. One good practice is to have an independent back office responsible for overseeing risk exposures. This acts as a check and balance to dealers who, under pressure to generate profits, may succumb to the temptation to hide their true position and risk exposures. At a more mundane level, inadequacies in documentation, credit controls and position limits can expose a firm to the risk of loss. Back office personnel need to be trained to handle trade confirmations, documentation, payments and accounting.

A more subtle operational problem is the reliance on one or a few highly specialized individuals. The loss of an individual could wreak havoc to the operations if there are insufficient back up skills. Further, compensation and remuneration packages of traders should be set carefully. Whilst the objective of generous compensation schemes is to reward and maintain key staff, one wonders whether a scheme which pays special attention to "star traders" will not also encourage traders to make imprudent and massive trading bets, especially around the time when bonuses are set, more so if trading losses can be rolled over, and the recognition of loss can be delayed in a legitimate fashion.

Let me now turn to the next important area -- that of investor protection. A significant element of customer protection is to monitor the sales practices adopted by market intermediaries. As a start, effort should be made to ensure that investors and users understand the costs and risks in using derivatives prior to opening of customer accounts. Some derivative dealers may wish to hide behind the complexity of the products they offer. They should be discouraged from doing so. They may indeed try to sell to customers extremely complex structured trades and deploy in their sales kit those elegant hockey stick diagrams of payoff, and more. Whilst each part of a structured derivative formula is carefully built around the transfer of risk, it is sometimes not clear to the gullible client to whom, and which risk is being transferred, and how much the taking on of risks could cost in volatile situations. My suggestion to clients and regulators in reviewing the sales pitch of derivative dealers is to ask the question proposed by Richard Farrant of Bank of England who said, "I do not for one moment suggest that you have got it all wrong. What I do ask, with boring repetitiveness, is: are you sure that you have got it all right?". In this regard, I am told that six securities houses in the US have ventured to submit to the SEC a set of voluntary sales practice standards in relation to OTC derivatives. More efforts of this sort are needed not only in the US, but also in this part of the world, especially when banks and securities houses are selling to corporate clients.

Investor protection also comes from ensuring that only fit and proper firms and intermediaries are registered and allowed to trade. Firms should be adequately capitalized, and be subject to regular examination by exchanges and clearing houses to ensure that they put their customers' interests before their own, and adhere to good housekeeping practices such as record keeping, account segregation and implement a vigilant programme of self-compliance. Representatives should be competent, possess integrity and should be subject to re-registration that would strive to keep out errant, incompetent or unprofessiona1 individuals.

Good disclosure practices are key in making derivatives safer, and better understood. Some say that financial reports should begin with the phrase, "Once upon a time.....". Accrual based accounting is a framework that matches revenue with expenses; and whilst this provides a very useful way to measure profits, it does not always provide helpful balance sheet information. In particular, it provides limited information about off-balance sheet transactions, including credit exposures to counterparties. For example it reflects the exposure on a swap only to the next payment date, rather than the full extent of economic exposure. In addition, accrual accounting does not take into account unrealized profits and losses arisinc from movement in market rates between transaction and balance sheet reporting dates. These difficulties have led some jurisdictions to introduce market-value-based accounting for financial instruments. However there is still little guidance on requiring greater disclosures of off-balance sheet risk inherent in derivatives except for footnote disclosures as contingent assets or liabilities. Regulators should work with standard setters to expedite the establishment of disclosure and accounting standards relating to derivatives in their jurisdictions.

Providing relevant education is something the whole industry needs to work on, and the regulator has a role to play as well. The operative word is relevant. As with many things in life, a little knowledge of derivatives could be a dangerous thing. One can memorize all the arcane terminology so as not to confuse a straddle with a strangle, and then go on to repeat the litany of delta, gamma, vega, theta and rho.

That may impress your friends at a cocktail party but means very little, if you are a user, representative or regulator. To my mind, relevant education for a derivative user means getting him to understand what derivatives can do for him to hedge and manage his risks. For a representative, relevant education involves understanding the financial capacity and the risk-reward preferences of his client in relation to the products that are offered. For a regulator, relevant education involves all the knowledge and experience that enables him to strike a good balance between ensuring integrity for derivative products, and permitting innovation and market development to continue.

Let me give you an example of how we at the Commission have participated in the education process. Prior to the introduction of exchange traded derivatives, the Commission worked with the nascent derivatives exchanges in setting out a syllabus that would ensure that derivative dealers will demonstrate minimum competency levels that pertain to our markets before they are registered and allowed to begin trading. We were assisted in this effort by the Chicago Mercantile Exchange and the Chicago Board Options Exchange. In April this year, we will introduce the utility of derivatives to corporate treasurers, finance directors as well as other users through a five-day workshop on financial derivatives and risk management, in collaboration with the Options Clearing Corporation and some of its member exchanges. We have plans to address the field of disclosure, accounting standards and tax through another specialized workshop in May. To widen the understanding of derivatives amongst corporate leaders and members of the public, derivatives will become the theme of our annual capital market conference this year. The media has also been given attention through a series of background briefings and articles written by Commission staff on the subject of derivatives. This is just the beginning, as we intend to widen the scope of our education efforts in the years ahead though our Securities Industry Development Centre, which as you know was instrumental in organizing this conference.

The recent Baring debacle particularly has heightened concern over trading in derivatives. Our Prime Minister and the Deputy Prime Minister, as Minister of Finance, have recently underlined the need for caution and care in the introduction of trading in derivatives in this country. We must all take into account their concern and advice, and act in the spirit they have been given.

In preparing for the introduction of exchange traded derivatives over the past two years, the Securities Commission has taken very seriously its regulatory responsibilities under the Futures Industry Act, 1993. Indeed in its very first year of existence, the Commission undertook a thorough review of the Act and last year proposed amendments to cover identified loopholes, impediments, insufficiency of powers and regulatory deficiencies which will have to be addressed before trading starts.

Many will remember that, well before the Barings incident occurred, the Commission insisted on a common clearing house for better risk management, as two derivatives exchanges are to be established. The Commission has also required the segregation of accounts up to the clearing house, and that proprietary and client position be distinguished. It is also planning for inter-market surveillance system to be put in place between cash and derivatives markets. In a situation where large positions can be run up by the same intermediary at two clearing houses of two exchanges which appear to be ignorant of what was happening on the other's turf, the Commission calls for between communications and exchange of information between the exchanges, clearing houses and regulators. The Barings experience should serve to underline this appeal and the Commission's earlier insistence on a common clearing house for KLOFFE and KLFM.

Other steps taken and, to be taken by the Commission, not necessarily exhaustively, are:

  • Developing position limits to prevent excessive speculation;
  • Introducing circuit breakers in the trading of securities and equity derivatives;
  • Establishing a daily "mark-to-market" margining system in the clearing house, with intra-day margin calls when necessary;
  • Imposing capital adequacy and liquid funds requirements for clearing members based on daily positions;
  • Establishing better sales practice standards for broker-dealers;
  • Requirement for brokers to maintain segregated accounts;
  • Overseeing the development of appropriate "middle-office" software for brokers to better manage operational risks;
  • Approving a licensing regime that will involve compulsory exams for individual representatives as a prerequisite to the granting of representatives licences;
  • Reviewing and establishing accounting and disclosure standards relating to derivatives activities undertaken by corporations; and
  • Putting in place a securities lending framework for failed trades and to enable collaterized hedging to take place.

These measures are both prudential and facilitative in content. The regulator must not seek to establish order and stability by ensuring no movement. At the same time, it should also be emphasized the healthy growth of the markets depends on all parties performing their designated responsibilities well - i.e. the issuers, the intermediaries and users, and the regulators. It is also not sufficient that we have all these responsibilities and undertakings on paper and in the system, if everyone is not actually effecting them on a daily basis.
Thus, a regulator can only put so much in place to reduce to the absolute minimum the likelihood of abuse. Every participant in the market has to play his role, and this means individuals and not just impersonal institutions. A regulator who goes around proclaiming he has a foolproof and failproof system that guarantees against any system failure or scandal should be sent off packing, as he clearly does not truly understand the intricacies of trading and the market as well as their relationship with the wider financial system. Never be so arrogant as to say never, because then you could very well be asking for it.

What is clear is that we must all do our job to the very best of our ability, after identifying our objectives and the performance standards that must be met. What is also clear is that we must all work closely together to protect and develop the system - issuers and corporations, traders intermediaries and investors, and regulators, both oversight and front-line.

The Securities Commission hopes that events such as this will help to focus and concentrate minds on the main issues of developing the capital market. The process is a continuing one. The Commission is also privileged to chair the Working Group dealing with derivatives in the Emerging Markets Committee of the International Organizations of Securities Commissions (IOSCO), and its lead position has been useful in regard to tapping on the experiences of the more mature markets and sharing ideas with regulators from other emerging markets also planning to introduce exchange-traded derivatives in their jurisdictions.

Let me close by thanking Glenn Satty from Swiss Bank Corporation and Patrick Conroy from Hong Kong Securities and Futures Commission for their voluntary contribution in sharing their wisdom and experience with us. I would also like to recognize the hard work that the staff of the SIDC and the Commission have put in towards the organization of this event. We hope you have found it useful, and we look forward to receive your feedback on how best we can work together in; developing and regulating derivatives markets in our country.

Thank you.
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