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Derivatives Exposure And The Monitoring Mechanisms Needed To Control Risk

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Derivatives- What Are The Risks and Possible Recourse For The Parties

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Derivatives- The Parties, Counterparties, Rights, Duties, Obligations, Risk and Recourse

May 21, 2012

by JSMaresca
posted in Cafe Libri: Reviewing Books & More

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Derivatives are becoming increasingly complex in the world economy. This article
explores the growing risks of derivatives and the existing monitoring mechanisms
to manage risk intelligently. Derivatives are becoming more pervasive in global finance.

U.S. commercial banks currently hold a notional value of $244 trillion in derivatives.
The world derivatives market may be in excess of $700 trillion. The actual trading exposure,
which is measured by VaR (Value at Risk), is about $700 million. The Net Current Credit Exposure (NCCE)
of commercial banks to derivatives is $353 billion, due to bilateral netting. Potential Future
Exposure (PFE) is $814 billion, bringing Total Credit Exposure (NCCE + PFE) to $1.2 trillion.
The total amount of Credit Derivatives outstanding is about $15 trillion.

Classic derivative transactions include swaps, futures/forwards, credit derivatives and options.
Swaps are used very much like the name suggests. That is to swap (exchange) cash flows at a
certain date. These types of derivatives are used principally for interest rate swaps, but can be
utilized to swap cash flows from equities, commodities, or foreign exchange currency.

A Forward transaction requires the party to buy or sell a certain equity, commodity or
foreign currency at a set price and point in time. Engaging in a future is almost
the same agreement as a forward. The position is usually opened on margin, and is traded
marked to market. The position may be closed out any time.

Credit Derivatives involve an assumption or a hedging of risk on any kind of asset, or liability.
Options give the owner a right to buy or sell the underlying security before or on the expiry date
at a specific price.

As far back as 2003, the OCC (Office of Comptroller of the Currency) issued
a report on the Fourth Quarter of 2003 bank derivatives. The 2003 report specified
classic risks in derivative transactions. These risks were a function of
counterparty exchange of nominal principal, volatility of interest rates and
currencies used to make contract payments, the maturity and liquidity of contracts
and the creditworthiness of counterparties to the transaction.

The OCC Fourth Quarter Report of 2003 set forth preferred ways to measure the degree
of risk quantitatively. The degree of risk is a function of aggregate trading positions,
asset and liability structures, data describing fair values and credit risk exposure, as well as
data on trading revenues and contractual maturities.

The OCC quarterly report of bank derivatives and trading revenues was based
on call report data by the insured commercial banks in the USA. The notional
amounts equal the nominal or face amount used to compute payments made on
swaps and other risk management products. This amount doesn't change hands.
Thus, the term nominal is used.

The Fourth Quarter of 2003 OCC report documented seven banks with the most
derivatives which comprised over 96% of the total derivatives in 573
commercial banks with derivatives. These derivatives were in futures,
swaps, options and credit derivatives.

The derivatives (notionals) by the type of user grew from $8 trillion dollars in
1990 to over $70 trillion dollars by 2003 and $244 trillion dollars today.

Counterparty risk exposure ignores collateral from
clients to secure exposures from derivative contracts.
A more meaningful analysis is to reduce the current
credit exposure by liquid collateral held against
exposures. This reduction is dependent upon the
timeliness of a reduction in the liquid collateral.
In addition, liquid collateral may change value
in an environment where the VIX index of volatility is rising.

Contract banks have agreements customarily
drawn by the legal counsel and experts in derivatives.
The agreements permit the financial institution to close out
the transaction if the counterparty cannot post
collateral according to the contract terms.

The limit of losses may be dependent upon the timeliness
of the financial institution close out of the transaction.
This gaping hole begs for a superior derivative strategy
program of implementation on the part of all parties
to these transactions. The process may be helped by
more definitive guidance from the Uniform Commercial Code
on derivative products since the UCC is an evolving
legal document.

More specifically, the UCC should be amended to define
general areas of derivative practice,
as well as rights, duties, responsibilities and recourse
of the major parties on derivative contracts. Another
possibility is to open another area of legal professional
practice called a Derivative Attorney.

In addition, the Comptroller of the Currency
may coordinate its findings on derivatives with the
Securities and Exchange Commission , as well as the
National Association of Securities Dealers.
At some point, a federal authority may be given
some discretionary/resolution authority to act or enhance
rule structures under emergency conditions.

A major theme of risk exposure involves drawing
air tight agreements which cover contingencies
on derivative contracts. Generally, the legal
counsel and derivative experts construct these
agreements. Since all parties to the transaction
have legal representation and experts, Courts may
be more disposed to "Let the buyer beware" since
the buyers and sellers have teams of hired experts in the
art of derivatives.

In closing, derivatives exposure is on the increase and
has been for over two decades. Procedurally, new areas
of practice should be set up to deal forthrightly with the
complexities of derivative practice instead of relying
solely on the construct of derivative contracts by
counterparties with no uniform legal superstructure in place.
The Uniform Commercial Code is the first place to consider
for setting clear legal definitions on complex derivative transactions.

Credits:
Article first published as <a href='http://blogcritics.org/politics/article/deri...-monitoring-mechanisms/'>Derivatives Exposure And The Monitoring Mechanisms Needed To Control Risk</a> on Blogcritics.