UK's FSA Concerned about Sloppy OTC Back-Office Work

LONDON (HedgeWorld.com)--The Financial Services Authority of the United Kingdom announced that it has become concerned about the back-office systems and controls in the market for over-the-counter credit derivatives.

The Feb. 22 announcement specifically described unsigned confirmations outstanding between counterparties for OTC credit derivatives, the volume of which has come to threaten misunderstandings and uncertainties that in turn could weaken market confidence.

The FSA also sent a letter to the chief executives of major participants in the U.K. credit derivatives markets outlining their responsibilities.

"We ask you to consider your firm's operational processes and risk management frameworks--" the letter said, "and the resourcing of these in relation to credit derivatives--to assess their robustness in this rapidly evolving market. Confirmations and other documentation should be issued and affirmed promptly after the transaction has been agreed."

Janet Tavakoli, a consultant and expert witness on structured financial products, said she is surprised the FSA only now is finding out about such delays and uncertainties.

"Ironically," she said, "I can envision a scenario in which customized transactions get signed off on more quickly," than transactions using standardized language as provided by the International Swaps and Derivatives Association's forms. She said she encourages counterparties to rewrite the standard agreements.

"In my experience the one-on-one agreements get signed quickly because the parties are on top of it and the signatories are in charge and are doing the talking, but that" she added, "may not always be the case."

The FSA's letter to chief executives, signed by the director of the FSA's markets division, Gay Huey Evans, made reference to ISDA's ongoing "strategic plan to tackle outstanding confirmations in OTC derivatives." It said that it plans to monitor the progress of that plan. "Our supervisors will be giving particular attention to the quality of management information and its use by senior management."

Mr. Evans' letter is part of a trend of intensifying international scrutiny of back-office execution by regulators. The Joint Forum, a cross-sectoral group combining the Basel Committee, the International Organization of Securities Commissions and the International Association of Insurance Supervisors, reported on the results of its investigation into credit risk transfer in October 2004. The Joint Forum made several recommendations. It said, for example, that "market participants should aggressively continue their efforts toward standardisation of documentation, including for [collateralized debt obligations] and other more complex products."

As the Joint Forum also observed, hedge funds play a widening role in the OTC derivatives market. Part of the hedge fund presence, its report noted, consists of "two-way trading ... for example to exploit opportunities relative to bonds and other fixed-income instruments." But increasingly hedge funds are "holding equity tranches of CDOs and participating in correlation-related trading more generally."

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.

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