Reserve Bank of India (RBI) issued fresh directions called draft Reserve Bank of India (Market-makers in OTC Derivatives) Directions, 2020 vide Notification No. FMRD.FMD.XX/2020-21 dated December XX, 2020 which is reproduced from the web site of RBI as under:
Let us examine the draft directions which can be commented upon by you and sent with your observations to email@example.com. For understanding the expanse of RBI directions, certain basic presumptions as explained therein as under need to be kept in mind:
To a pointed question, what does it mean by” electronic trading platform” which has been extensively used in the directions, the following explanation has been given by RBI?
“‘Electronic Trading Platform (ETP)’ shall have the same meaning assigned to it in section 2(1)(iii) of the Electronic Trading Platforms (Reserve Bank) Directions, 2018 dated October 05, 2018, as amended from time to time.”
Let us go ahead with the details of RBI prescriptions.
What do these directions deal with?
In pursuance of the announcement made in the Statement on Developmental and Regulatory Policies dated December 04, 2020, regarding the review of Comprehensive Guidelines on Derivatives, the Reserve Bank of India released these directions which are in draft form which will get a final form after receipt of comments from stakeholders. Yes, they deal with comprehensive guidelines on derivatives.
Can we touch on the general governance of the Board of Directors or the top management of the market maker who would introduce derivative products?
By having a strong commitment to risk management, the Board of Directors (BOD) or the top management of market maker who would introduce derivative products are to ensure the introduction of:
The written policies which define the overall framework within which the derivative business shall be conducted and the related risks managed by BOD are to contain the following aspects:
1. Establishing the entity’s overall appetite for taking risk and ensuring that it meets its strategic objectives, capital strength, and management capability to hedge or transfer risk effectively and expeditiously with no loss to the organization
2. To define the approved derivative products/activities and allocate the broad product category-wise risks within the overall risk appetite or risk limit sanctioned for the derivative business. This is one of the most important functions of the BOD/Top management since huge losses were incurred on account of blurred policies which failed to limits of risks to be undertaken and at what levels?
3. Let me reproduce the directions of RBI for establishing policies as under:
“To establish policies for: i. Introduction of new OTC derivative products based on the broad principles enumerated in section 4 of these Directions;
ii. Conduct of pre-trade due diligence based on the broad principles enumerated in section 5(I)(iii) of these Directions;
iii. Risk management based on the broad principles enumerated in section 6 of these Directions;
iv. Internal control based on the broad principles enumerated in section 7 of these Directions; and v. Conduct of internal audit based on the broad principles enumerated.”
Let us deal with in detail sections 4, 5, 6, and 7 mentioned above for explanation.
Product due diligence, pricing, and valuation
The policy for the introduction of new OTC derivative products shall include the process for evaluation and approval of new products which will be approved by the Board of Directors.
Due diligence to be carried out at the time of introduction of a new product shall encompass an assessment aspect like the objectives of the product, type of targeted client, key risks of said client and the costs and fees to be incurred by the client. It is expected that the associated risks and pricing of the product shall be properly documented.
The Chief Compliance Officer (CCO) and the Chief Risk Officer (CRO) shall be involved in the approval of the products.
You do have the right to know how the pricing would be done.
Pricing and valuation
i. All products would be priced independently and the fair value of the products will be based either on marking the product (or its component(s)) to market or marking the product (or its component(s)) to a model.
ii. What does the product disclosure statement to be provided to the user contain?
It would contain features, including components (if any) and termination/unwinding options along with related conditions and costs, benefits, risks, and an illustration of how the product works for the client.
Who is likely to be the client to use the derivative products?
RBI emphatically quotes the following qualifications or attributes of a client.
Let me quote the exact words which throw the light on its expectations of the client.
“User appropriateness: A product shall be offered only to those users:
i. Who has the necessary knowledge and experience to understand the nature and risks of the product;
ii. Who has the financial ability to bear these risks; and?
iii. Whose business, financial operations, skills, sophistication, risk management framework (including risk management policy approved by the Board of Directors or equivalent forum) and internal policies are consistent with the product being offered.”
It is obvious from the details given by RBI that only an appropriate client would use the products and proper care would be chosen to select the client.
RBI directions do include details of trade conduct and post-trade conduct expected of the market makers. However, its coverage of risk management which is an inherent part of an offer of usage of derivative products attracted me, once, part of currency dealers of a leading nationalized bank which was very well conservative but made adequate money in its foreign exchange dealings but never offered derivative products which were not authorized in India then.
i. Risks in the derivative business shall be monitored and controlled independently and distanced from the control and influence of the trading and sales function.
ii. Various types of risk to which the entity is exposed on account of its derivative business lines and products, especially structured products, shall be identified and risk tolerance level should be set.
iii. Processes shall be established to manage risks in light of the risk tolerance level. The inter-relationship between the different types of risks shall be taken into account.
iv. A clear and comprehensive set of limits to control risks shall be established.
v. Stress testing of risk positions shall be conducted.
vi. Effective policies, procedures, and controls shall be implemented to manage the model risk.
vii. Legal risk, i.e., the risk that a derivative contract shall not be legally enforceable, should be recognized and the market-makers should seek to manage the same by use of standard documentation (e.g., the ISDA master agreement). Specific documentation, if used, should be subject to independent legal advice.
viii. Counterparty credit risk from the derivative contract should be recognized and the maker-makers should seek to manage the same by undertaking counterparty credit assessment and, wherever permitted, by collecting appropriate collateral from the user.”
(This is one of the most important directions to be read again and again by all stakeholders like bankers, derivative using clients, or foreign exchange dealers who usually lose billions of US dollars due to lack of risk management directions not clearly laid down or ignored by supervising officials due to regular income arising out of this type of business. One may simply remember the rogue dealer Nick Leeson, a rising trader at England’s Barings Bank in 1995 which lost $ 1.3 billion in its risky derivatives and unauthorized derivative trades due to his unauthorized ways of functioning. The bank, one of the oldest in the world failed in its governance standards resulting in its closure.)
Let me add that policies and procedures shall be established to apply internal controls at various stages in the workflow of processing and monitoring transactions in terms of requirements stipulated in circular no. FE.CO.FMD.No.18380/02.03.137/2010-11 dated February 3, 2011 on Internal Control Guidelines, as amended from time to time.
What about internal audit, another essential feature of derivative products?
I may add that derivative business shall be subjected to internal audit to review the adequacy and test the success of the risk management system and internal controls.
I may enlist some of the most important tasks of internal audit in this area of business.
a.To investigate unusual occurrences such as significant breaches of limits, unauthorized trades and unreconciled valuation or accounting differences; To do this, proper limits of operations of the persons involved should be clearly specified and also followed.
b. To confirm the reliability and timeliness of information reported to senior management and the board of directors;
c.To trace and verify information provided on risk exposure reports to the underlying data sources;
d. To appraise the efficaciousness of the risk management process and independently verify whether model risk management practices are comprehensive in nature
e. To assess the adequacy of the derivative valuation process and ensure that it is performed by parties independent of risk-taking activities; To have various occasions as auditing samples is very important.
f. Testing derivative valuation reports for accuracy, analyzing the product disclosure statements, and risk disclosure statements provided to users would also become part of internal audit functions.
We know that the internal audit function reports to the audit committee with direct access to top management or BOD.
Though RBI directions have prescribed two years as the minimum period of maintenance of records electronically or otherwise, these records involve huge value transactions necessitating frequent references, for regulatory purposes, or for study purposes. A long-term policy to maintain them may be approved by BOD or top management.
It is appreciable to know that RBI has finalized its comprehensive guidelines on derivatives which enable the financial institutions, foreign trade stakeholders, academicians who act as consultants, or the governments who deal with foreign trade. With massive frauds that ensnared the leading financial institutions in the recent past, it is expected that strict implementation of its guidelines amply explained would save huge resources. I would clearly advise the usage of the top-quality software, employment of the best talents in it, availing the services of the best risk management personnel which is a rare breed in our nation, and an overall commitment to use or evolve derivative products which may enrich or endanger the very existence of corporates. They are double-edged products requiring excessive caution and adequate monitoring at various levels.
Having quoted extensively from RBI communication, as a student of foreign exchange for the past 5 decades, these are my personal views. Neither legal nor consulting in nature, taxguru.in, RBI or I am not responsible for anyone. One should refer to legal consultation for proper guidance. One expects only experts to deal with derivatives and would take adequate care and legal help.