FSA exposes back-office flaws

A “high level” of credit derivatives trades are going unconfirmed, sometimes for months, according to a warning by the Financial Services Authority (FSA), the UK’s financial regulator.

In February it wrote letters to chief executives of firms active in the over-the-counter (OTC) credit derivatives market after noting the worrying trend during recent supervisory work. “A number of firms in the fast-developing OTC credit derivatives market are failing to resource their back-office functions adequately to allow them to keep pace with the growth of their front-office business,” says Gay Huey Evans, the FSA’s capital markets sector leader.

While credit derivatives are an important tool for diversifying risk and bringing more liquidity to the credit market, she says, “with benefits come risks… If simple operational procedures are unable to keep up with the pace of market development, the risk that misunderstandings and uncertainty will negatively impact market confidence increases.”

Speed of growth in credit derivatives is at the root of the problem, according to the FSA. Data from the International Swaps and Derivatives Association illustrates this rapid growth clearly. Outstanding notional amounts in credit default swaps soared to $5.44 trillion at the end of the first half of 2004, a 44% growth from $3.78 trillion for the previous half-year.

Failure to confirm trades is a major cause of operational risk in the financial markets – and many cases of “rogue” or fraudulent trading using derivatives have been possible because of poor controls over trade confirmations.

A more likely result of failure to settle trades properly – but potentially equally as damaging – is that a firm may not be aware of its credit and market risk exposure at any given time.

Even the top investment banks are at fault in this area, says a spokesperson for the FSA, although it did not name specific banks. Tools at the FSA’s disposal to encourage firms to upgrade their systems include enforcement actions and fines. But that would be a “long way down the road”, says an FSA spokesperson.