3:06 pm - Wednesday September 26, 2970

Disputed derivative transactions – Santander and Pourtuguese Rail Operator

I happened to read today a news item on disputed derivatives transactions.

It is reported therein, the dealers settled a crop of disputed derivatives trades with Portuguese state owned entities last year with one exception – Santander is set for a court battle with the country’s state backed (or owned?) rail operator, over a trade that critics describes as nonsensical.

I was surprised. The elements for my surprise are

– Derivative transactions are disputed
– State owned entity is now disputing its derivative transaction.

Even in this century there are entities and individuals who claim derivative-ignorant. I am yet to fathom out from where they derive this ignorance.

When they enter into a derivative transaction, they are all very confident that they would make money. When the transactions turn bad and sour, they try to wriggle out of such transactions so that they can pass on the losses to the counter party banks and financial institutions.

They believe in this and there fore they indulge in this one sided game – heads they win and tails others lose.

And there are few who side with and support them. The regulations and the jurisdictional jurisprudence included.

Why this?

Why this pampering of the so called greedy entities and individuals? Why provide an escape route in their misadventure?

Why support such unhealthy practices? Why side with such inefficient organisations and their management?

The deciding authorities should not, I repeat, should not agree to hear such cases when they are brought before them.

The regulators should impose hefty penalties for such ineligible appeals. In addition, the courts should straightaway dismiss such appeals.

The authorities, regulators and the courts should ask such entities and individuals only one question – if the derivative transactions turned out to be in their favor, what they would have done. Pocketed the profit and indulged in celebrations?

In this connection, I wish to share my thoughts on best practices for derivatives business

Best practices framework for derivatives practice include

– Derivatives policies and strategy formulation
– Exposure – Identification, measurement and management
– Transaction execution, confirmation and settlement
– Accounting policies, standards and business rules
– Governance – Reporting, Performance measurement

Before entering into a derivative transaction the following important clarifications are to be obtained

– Are there written policy guidelines describing the objectives and scope for the use of derivative products / instruments?
– What type of or kind of specific derivative products and strategies are permitted?
– Any outer limits prescribed for taking up these derivative transactions?
– Are these guidelines consistent with the overall strategy and do they conform to the types of operations?
– Does of the board of directions or other relevant oversight groups understand what risks are being consumed?
– Whether these authorizations for derivative transactions have been unambiguously understood and documented?
– Are there mechanisms to spot deviations? Whether these mechanisms are independent and sophisticated?
– Whether the management’s approval is necessary for binding the business organisation to a derivative transaction?
– Are there independent supervisory personnel responsible for developing, executing derivative strategies and transactions?
– Are there counter checks for derivative transactions taken up? How soon are they counter checked?
– Is there a methodology in place for measuring market risk associated with derivative transactions?
– Are there written limits on how much market risk can be assumed at any point?
– What are the liquidity implications?
– Is there any active secondary market for the derivative transactions?
– How wide is the bid ask spread?
– Are there prescribed limits for assuming credit risk?
– Is there an approved list of acceptable counter parties with appropriate sub limits for derivative types?
– Are there agreements or contracts in place to document and govern derivative transactions?
– Are these agreements in ISDA format and legally enforceable?
– Whether netting and settlement procedures are adequately covered?
– What are the accounting policies for derivative transactions?
– What are the prescriptions for periodical revaluation of derivative transactions?
– What are the disclosure norms for derivative transactions?
– What are the capital implications for derivative transactions?
– What are the reporting mechanisms?

These clarifications are to be provided satisfactorily by the banks, financial institutions and their customer counter parties.

Only when this done and appropriately documented, the derivative transactions should be taken up.

It looks like the basic business considerations are forgotten once the derivative transactions turn sour and the clients customers would like to get out such transactions.

This practice should not be allowed.

The courts and the regulators should come down very heavily on them.

They should be denied any favor and support.

Only then, order will return to the financial markets. Only this order can restore faith and trust in markets.

This is very badly needed now.

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