FSA intensifies scrutiny of OTC derivatives market

The UK’s Financial Services Authority (FSA) has warned investment banks and hedge funds that they need to address persistent weaknesses in the derivatives market.

Thomas Huertas, the FSA’s director of wholesale firms division and leader of the banking sector, used the keynote speech at the International Swaps and Derivatives Association’s regional conference in London on Tuesday to highlight three areas that the regulator is continuing to monitor closely: operations, risk management processes and dealing with customers.

Huertas’ remarks came in advance of next Wednesday’s meeting between the Federal Reserve Bank of New York and major derivatives firms, and in the context of strong growth in the derivatives market (See: Credit derivatives grow by 52% in first-half 2006, says Isda).

Huertas congratulated the industry on reducing the backlog of unconfirmed credit derivatives transactions, but said that it was unacceptable to have 20,000 trades unconfirmed 30 days or more after trade date and  5,000 unconfirmed 90 or more days after trade date.

 “You can expect the FSA to drill down with firms as to the value of such trades and query the netting and capital treatment of such trades,” he said, adding that regulators would be monitoring trade confirmations closely. “[Firms] should not be surprised if regulators weigh action against those that do not achieve these targets.”

The FSA also predicted that the operational risks already present in credit derivatives could develop in other asset classes, particularly equity derivatives, and cautioned: “[Banks] need to scale up their operations to the level of their trading or restrict the level of their trading to the capacity of their back office.”

Within risk management, Huertas warned that proper valuation techniques and collateral management processes needed to be implemented and said the FSA would conclude its research in these areas next year. Following some high profile mis-valuations, the FSA has been researching three streams of valuation practices in the industry and will “take action against firms that are not employing proper valuation techniques".

Huertas also said the FSA was now looking at whether movements in underlying market factors were adequately reflected in valuation methodologies. A statement of good practice for the industry is expected by early 2007. He also reported that the FSA’s work on collateral management systems and controls would be extended to a number of investment banks during the fourth quarter and a statement of good practice could be expected early next year.

On the customer-facing side, the FSA warned that mis-selling products and lax controls on customer information would be punished. Ensuring the client understands the product and its risks is crucial, especially with complex derivatives products. “Ignoring suitability… is a sure way to attract regulatory attention,” Huertas cautioned. He also said that banks needed to control customers’ confidential information and manage any conflicts of interest effectively, as they are in the cash markets.

He said: “That does not appear to be the case at all firms. Those who are lagging behind would be well advised to catch up quickly.” On best execution, the FSA is considering the industry’s views on implementing the Markets in Financial Instruments Directive (Mifid)’s requirements, but conceded that unpopular ‘benchmarking’ would not be compulsory. Further consultation can be expected in October.