This article describes some of the most important steps before, during and after entering into derivatives transactions. It may help build long-term relationships and help you avoid some of the difficult problems that have beset derivatives marketers and traders. However, this is just a guide. It highlights issues rather than answers them.
General Reminders
* Never enter into any transaction that you do not fully
comprehend.
* Understand your customer's broad goals and needs.
* Know in detail your firm's policies and procedures.
* Be wary of transactions that claim to produce revenue or
returns that are significantly in excess of the norm.
* Never enter into a transaction that has the potential to
adversely affect the reputation of you or your firm.
* Do not participate in transactions if you suspect the
customer is attempting to circumvent tax, accounting,
regulatory or legal requirements.
* Involve all relevant internal groups.
* Do not make promises or definitive statements about the
financial outcomes of the transaction.
* Reconcile the needs and interests of each party to the
transaction.
* Avoid customers that are unduly demanding, inflexible or
difficult.
* Save every piece of paper and e-mail that you send to the client.
* Address all relevant aspects of the transaction, not just the
financial terms.
Pre Trade
* Identify the customer's exact legal name and identity.
* Assess your customer's authority to enter the transactions.
* Confirm the customer has received any required risk
disclosure statements.
* Check you have the authority to execute transactions on
behalf of your firm.
* Understand the implications of the customer's jurisdiction
and location.
* Understand the market risk of the transaction and suggest
the customer does the same.
* Ensure that your firm has carefully evaluated the credit risk
of the entire relationship with the customer.
* Address the master agreement issues.
* Send the customer a written description of the proposed
transaction or the actual form of confirmation.
* Take special care regarding any non-standard provisions that
the customer may require.
* Check on any margin requirements or implications.
* Explain to the customer the basis for the pricing of the
transaction.
At Trade
* Confirm that all internal parties have a consistent
understanding of the transaction.
* Conduct your conversations on a taped line, if available.
* Execute the transaction only with a familiar contact.
* Make sure any brokers or intermediaries are approved.
* Go over the trade terms with your customer point
by point.
* Confirm the existence and status of the master agreement.
* Address any critical conditions relating to the
confirmation.
Post Trade
* Process trading tickets without delay.
* Enter the transaction terms into the trading systems.
* Notify the confirmations unit if the confirmation requires
special attention.
* Carefully review the draft confirmation.
* Follow up with the customer on any outstanding issues
relating to the confirmation and master agreement until
these documents have been signed.
* Verify the trade terms against your firm's books
and records.
* Maintain orderly copies of the final version of the
confirmation.
* Verify the market values of the transactions.
* Watch for critical dates where action is required
(i.e., option exercises).
* In retrospect, evaluate the effectiveness of the transaction
for both your firm and the client.
Conclusion
Some common themes emerge from this list of points: clarity, accuracy, disclosure, preparation and fairness. If derivatives professionals aspire to these values, these markets will attract and retain participants, along with capital and liquidity.
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This week's Risk Management Focus was written
by Charles A. Fishkin, a board member of the International Association of Financial Engineers.
