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         I. Policy Overview


Framework for Voluntary Oversight

I. Policy Overview

I. Introduction

The "Derivatives Policy Group" (DPG) was formed at the suggestion of Chairman Arthur Levitt of the SEC in August, 1994. Shortly after its inception, Mary L. Schapiro, Chairman of the Commodity Futures Trading Commission, joined Chairman Levitt as the principal official sector contacts for the DPG.

The DPG was organized to respond to the interest that has been expressed by Congress, agencies and others with respect to public policy issues raised by the OTC derivatives activities of unregulated affiliates of SEC-registered broker-dealers and CFTC-registered futures commission merchants. These issues include the understandable interest in more meaningful information regarding the risk profile of professional intermediaries and the quality of their internal controls as well as a clearer articulation of the nature of their relationships with nonprofessional counterparties and related transactional responsibilities. The DPG's objective has been to formulate a voluntary oversight framework intended to address these public policy issues.

The DPG appreciates the cooperative spirit demonstrated by the SEC and the CFTC, under Chairmen Levitt and Schapiro's leadership, and by their senior staffs, in connection with the DPG's initiative to define a voluntary oversight framework for the OTC derivatives activities of unregulated securities firm affiliates. The DPG recognizes that the cooperation and support of the SEC and the CFTC does not imply that the respective Commissions endorse every element of the framework described in this paper. Nevertheless, the DPG believes that the overall framework articulated in this paper, taken as an entirety, will assist the SEC and the CFTC in evaluating the risks presented by the OTC derivatives activities of these firms in a meaningful and comprehensive manner.

In this regard, it is contemplated that the two agencies will coordinate their supervisory oversight of the firms and their activities. In that same spirit, the participating firms will make a good faith effort to respond to ad hoc requests by the agencies for additional necessary information that is not provided on a systematic basis under the framework.

This framework is premised on several key and interrelated factors.

    First, the DPG's initiative constitutes part of a process, not an event. The DPG views its initiative as an important part of a continuing evolution of policies and practices from which participating firms, as well as the SEC and the CFTC, will gain important experience and insights. In that process, and as the relevant markets inevitably evolve, the DPG anticipates further refinement and adaptation of the framework it is advocating.

    Second, in order to facilitate its analysis, the work of the DPG was divided into four major components. Although particular observers may focus on selective elements of the framework, the DPG views its initiative as an integrated whole in which the component parts complement each other.

    Third, the firms represented on the DPG are only six firms participating in a marketplace that is large, diverse and global. As a result, the DPG recognized the need to be sensitive to the competitive environment in which these activities occur.

The DPG believes that this initiative - undertaken in the spirit of voluntary self-regulation and the public interest - will provide the firms themselves and the agencies with information, tools and analysis that will contribute significantly to strengthened management, strengthened oversight and, above all, strengthened markets.

II. Chronology

The DPG held its organizational meeting on August 10, 1994. At that time, the group outlined a range of issues to be addressed based on topics of specific interest identified by Chairman Levitt. The DPG was also mindful of time constraints created by the significant interest in expeditious completion of the DPG's work.

In an effort to respond to the sense of urgency conveyed, the DPG and its associated firms devoted an enormous amount of effort to the project and completed its initial analysis at the end of November, 1994. In the ensuing three-month period, the DPG endeavored to refine and expand upon the framework identified in its initial deliberations.

As detailed below in this paper, the implementation of the full range of initiatives proposed by the DPG will be phased in over a number of months, beginning in the second quarter of 1995.

III. Scope of Work

The DPG's analytical framework consists of four interrelated components:

  • Management Controls. This component of the framework consists of the implementation of internal management controls for monitoring and measuring the various risks to which a firm may be exposed as a result of dealings in OTC derivative products, and the inclusion of an external audit and verification process. These controls, many of which are already in place, will be implemented individually by each firm and are designed to effectuate prudent risk management practices which, in combination with the other initiatives of the DPG, will enhance the risk management practices of the firms and the marketplace in general.

  • Enhanced Reporting. This component of the framework consists of the periodic submission to the SEC and the CFTC of a series of new quantitative reports covering credit risk exposures arising from OTC derivatives activities and related information.

  • Evaluation of Risk in Relation to Capital. This component of the framework consists of the development of a framework for estimating market and credit risk exposures arising from OTC derivatives activities with a view toward facilitating the evaluation of those risks and other relevant factors in relation to capital.

  • Counterparty Relationships. This component of the framework consists of guidelines for professional intermediaries with respect to their relationships with nonprofessional counterparties in connection with OTC derivatives transactions.

The DPG contemplates that the proposed framework would apply to any affiliate of an SEC-registered broker-dealer.

  • that is not subject to supervisory oversight with respect to capital;

  • that is primarily engaged in the business of holding itself out to unaffiliated counterparties as a professional intermediary willing to structure and enter into either side of an OTC derivative transaction as principal; and

  • whose OTC derivatives activities are likely to have a material impact, directly or indirectly, on its SEC-registered broker-dealer affiliate.

For these purposes, OTC derivative products would include: interest rate, currency, equity and commodity swaps, OTC options (including caps, floors and collars) and currency forwards.

The efforts of the DPG, and the encouragement and cooperative spirit expressed by Chairmen Levitt and Schapiro and by the senior staffs of the SEC and the CFTC, represent important - if not precedent-setting - initiatives in several respects.

  • The regulatory and supervisory community in the U.S. and abroad has, for some time, been seeking to find an acceptable method to assess the market risks associated with OTC derivative products. The DPG has concluded that the most appropriate method for making such assessments involves the use of the proprietary quantitative models of the firms. The work of the DPG, to its knowledge, represents the first generalized application of standards and verification procedures involving the use of such an approach. The DPG recognizes that its efforts in this area are evolutionary and not definitive, and anticipates significant future advances in the utilization of these techniques. Nevertheless, the DPG is hopeful that its initiatives in this area will help to encourage the further development of these techniques within the industry and the supervisory community in general.

  • The DPG also views its efforts to clarify the nature of the relationship between professional intermediaries and their nonprofessional counterparties as a constructive step in an area that raises fundamental and widely-debated issues of public policy. In this connection, the DPG hopes that its efforts will help stimulate the development of universal guidelines that would be adopted by all professional intermediaries. The firms represented on the DPG are fully prepared to continue their active participation in industry-wide efforts to achieve this objective.

  • Finally, the DPG believes that its efforts to articulate a comprehensive framework for voluntary oversight establishes an important step in the direction of a more flexible, yet effective, approach to the oversight of these activities and firms.

IV. Policy Framework

  1. Overview: Prudential Policies

    The major emphasis of the DPG and its working groups has been directed toward the identification of prudential policies relating to the safety and stability of the major professional intermediaries as well as the markets for OTC derivative products and their underlying financial instruments. Indeed, the common objective of the efforts in (1) management controls, (2) enhanced reporting, and (3) evaluation of risk in relation to capital is to provide senior management and the agencies with information and analyses that will permit both groups to more systematically and rigorously evaluate and control the risks associated with OTC derivative products. Accomplishing this objective will bolster the stability and integrity of the OTC derivatives market and reduce the danger of systemic events.

  2. Management Controls

    The DPG's primary objectives in the area of management controls have been to build upon existing controls and to provide a comprehensive framework for professional intermediaries in the OTC derivatives markets to implement their business judgments as to the appropriate scope and level of OTC derivatives activity they wish to undertake. The proposed framework has been carefully designed so as to provide a comprehensive outline of relevant considerations that is flexible enough to accommodate different organizational structures and different management philosophies and cultures.

    This approach has two central themes that the DPG believes to be critical to effective management controls: (1) the integrity of the risk measurement, monitoring and management process, and (2) clarification of accountability, at the appropriate organizational level, for the definition of the permitted scope of activity and level of risk. The practices require that each firm's board or equivalent governing body should itself adopt, or authorize another body to adopt, written guidelines addressing:

    • the scope of permitted OTC derivatives activity,

    • guidelines for acceptable levels of credit and market risk, and

    • the structure and appropriate independence of the risk monitoring and risk management processes and related organizational checks and balances.

    Senior managements would be required to allocate risk to business units within approved guidelines and to establish independent measuring and monitoring processes in order to manage risk within those guidelines. In addition, a process for independent external verification has been included to confirm periodically that adopted policies and procedures have in fact been implemented.

  3. Enhanced Reporting

    The DPG's focus with respect to enhanced reporting has been directed to determining the scope and extent of the information that would be appropriate and useful for voluntary oversight of the OTC derivatives business.

    The objective of the DPG was to provide a mechanism for reporting information that reflects the measurement and execution of prudent management policies and oversight functions established within the firms with respect to risk exposures. The information to be reported to the agencies falls primarily into two principal categories: credit concentration and portfolio credit quality. The contemplated quantitative reporting will permit a consistent measure of risk reporting among the firms and will enable the SEC and the CFTC to make informed assessments of the risks associated with OTC derivatives activities on both a systemic and firm-by-firm basis. The quantitative reporting will focus both on concentration issues and overall portfolio quality:

    • Credit concentration in the portfolio will be reported by separately identifying the top 20 net exposures on a counterparty-by-counterparty basis, with additional information being provided to enable a detailed assessment of the credit risk associated with a particular counterparty.

    • The credit quality of the portfolio will be reported by aggregating, by counterparty, gross and net replacement value and net exposure (after accounting for collateral and legally enforceable netting agreements), organized by credit rating category, by industry and by geographic location.

    In addition to the analyses of credit exposures, the firms will provide the SEC and the CFTC with net revenue data for the various derivative product lines or business units.

    Certain other information will also be supplied to the SEC and the CFTC in the context of the evaluation of risk in relation to capital discussed below.

  4. Evaluation of Risk in Relation to Capital

    The DPG's principal objective in regard to capital has been to identify a verifiable framework for the estimation of the market and credit risks associated with an OTC derivatives portfolio so as to facilitate the evaluation of such risks in relation to a firm's capital.

    1. Methodology.

      As is widely recognized, capital performs a number of functions. It serves as a source of liquidity and funding, and provides the financial cushion that permits firms to absorb losses without endangering the stability of markets and institutions more generally.

      The DPG recognizes that the marketplace creates incentives for professional intermediaries to commit capital to their OTC derivatives activities. It also recognizes that levels of capitalization must also be viewed, not in isolation, but in the context of the management control systems, sophistication, experience and other resources of the relevant firm.

      At the same time, the DPG acknowledges the supervisory interest in having a more systematic basis on which to evaluate the extent of risk to a firm's capital arising from the firm's OTC derivatives activities.

      As noted below in the discussion on the evaluation of risk in relation to capital, the DPG came directly to the view that the preferred methodology to be used in estimating the risk to capital consisted of the calculation of changes in portfolio values based on the firms' quantitative models. However, the task of developing a workable quantitative framework of this type had to overcome a number of obstacles, principally including the following:

        First, because the models are proprietary, they differ from firm to firm. Given these differences, the DPG had to develop a method to insure that the performance characteristics of all models used for these purposes would be broadly similar and rigorous. This was achieved by the development of minimum standards and audit and verification criteria that all models would have to satisfy in order to be used for performing the calculations designed to estimate the "capital at risk" associated with OTC derivatives activities. These minimum standards and verification techniques are, to the best of the knowledge of the DPG, the first such common standards to be developed for this purpose. As such, they are not the last word on this subject. Rather, the DPG anticipates that they will evolve with experience and the passage of time.

        Second, even with agreement on minimum standards and verification procedures, the use of such a quantitative methodology requires the acceptance of a common approach to calculating estimates of exposure or risk of loss associated with a given portfolio of derivative products.

      Selecting a common approach to calculating estimates of the risks associated with a portfolio of OTC derivative products will always entail an element of judgment. The DPG adopted as a reasonable estimate of capital at risk the maximum loss expected to be exceeded by a given portfolio of OTC derivative products once in every one hundred biweekly intervals.

      The DPG acknowledges that the predictive value of such a capital at risk estimate is imperfect as a capital standard for a number of reasons, including the following:

      1. The past, as captured by the correlations and covariances embodied in the model, is not a perfect guide to the future.

      2. Even if the model were a perfect guide to the future, the potential for loss beyond the estimated "risk of loss" remains. From a public policy perspective, these low probability events are the source of the greatest concern because such events are more likely to have systemic implications. To provide some insight into such events, the DPG would supplement the reporting of capital at risk with other estimates of potential loss arising from defined market stress scenarios.

      3. Finally, even if correlations and covariances do not change, and even if no low probability events occur, capital levels that merely match estimates of capital at risk for the OTC derivatives business of the firm would be expected to be exhausted within one hundred bi-weekly intervals.

      Despite these considerations, the DPG views its approach for estimating exposures due to market risk as a reasonable balance between prudence and practicality. The one percent/two-week threshold appears to be gaining favor in the international supervisory community. Additionally, the information regarding capital at risk is to be utilized by managers and supervisors alike in the context of the entire framework of initiatives advocated by the DPG.

      Finally, as a practical matter, it is widely recognized that no business entity can or should capitalize at a level certain to cover all conceivable contingencies.

      With regard to credit risk, the approach adopted by the DPG for estimating the capital at risk associated with current credit exposures is straightforward. The capital at risk in this context would equal the net replacement cost by counterparty (recognizing enforceable netting agreements and collateral held) multiplied by the applicable default ratio published by the rating agencies. These default ratios, based on historical data, take into account the average maturity of relevant contracts and the credit rating of the counterparty. The approach to estimating potential credit exposure retains the use of historic default ratios and also incorporates elements of the capital at risk approach for estimating market risk. For each counterparty, the firm would estimate the potential risk of loss or capital at risk on the basis of the one percent/two-week standard, with the derived amount serving as a proxy for potential credit risk. The derived amount would be multiplied by the appropriate default ratio. In no event would a default ratio below 0.001 be used in deriving estimates of credit risk.

      It is important to note that these computations of market and credit exposures are not, in and of themselves, a capital standard. The DPG recognizes that judgments about risk can be made only in the context of a systematic framework and believes that these quantitative analyses, together with effective management controls and enhanced reporting, will support the framework for firm and supervisory oversight of the risks associated with the OTC derivatives activities of professional intermediaries.

    2. Voluntary Oversight Practices and Policies.

      Under the proposed framework, over the next several months, the SEC and the CFTC will begin to receive from the participating firms enhanced quantitative reports, estimates of capital at risk, stress scenario data with respect to core market risk factors, and estimates of current and potential credit exposure. In addition, the SEC and the CFTC will receive model verification data on a recurring basis.

      The DPG believes that the resulting information flows to the SEC and the CFTC will substantially enhance each agency's understanding of the firms' OTC derivatives activities and the related risks associated with those activities.

      In light of this dramatically improved flow of information to the SEC and the CFTC, the DPG has concluded that, at this time, the implementation of a capital adequacy standard involving the use of rigid formulas linking capital at risk (or some multiple of capital at risk) to capital levels should be avoided. Thus, at this time, the DPG advocates a voluntary oversight approach under which the agencies and the senior managers of the individual firms would evaluate the estimates of credit and market risk on a case-by-case basis, taking into account a range of factors spelled out in the discussion on the evaluation of risk in relation to capital.

      As the firms and supervisory authorities gain more experience with this overall framework, and depending on the evolution of thinking and policies within the international community of supervisors, this approach to voluntary oversight may require further refinement or modification. For the present, however, the experience that will be gained with these new tools, techniques and approaches will constitute a significant advance in risk management and effective oversight.

  5. Counterparty Relationships

    The primary focus of the DPG in the area of counterparty relationships was to articulate guidelines for firms engaged on a principal basis as professional intermediaries in the OTC derivatives market with respect to their relationships with nonprofessional counterparties. The guidelines address a number of subjects, including: the promotion of public confidence; the provision of generic risk disclosure statements; clarification of the nature of the relationship between professional intermediaries and nonprofessional counterparties; and the preparation of marketing materials, transaction proposals, scenario and other analyses and valuations and quotations. The guidelines also address matters pertaining to the professional intermediary's internal policies, controls and supervision of personnel.

    In addition, the firms represented on the DPG have agreed to adopt the practice of providing new nonprofessional counterparties with a written statement identifying the principal risks associated with OTC derivatives activities and clarifying the nature of the relationship between the parties.

    The guidelines reflect the premise that the OTC derivatives market is predominantly an arm's-length market in which each counterparty has a responsibility to review and evaluate transactions and to obtain necessary information or professional assistance. The guidelines confirm that professional intermediaries should prepare marketing materials, transaction proposals, scenario and other analyses and transaction valuations in good faith and not so as to mislead recipients.

    At the core of the DPG's deliberations was the recognition that the market served by the professional community is intensely competitive. The DPG urges a universal approach to the conduct of counterparty relationships so that practices are uniform regardless of institutional function or geographic location.

    The absence of international and functional harmonization of practices relating to counterparty relationships will contribute to undesirable competitive inequalities, uncertainty and other anomalies. Thus the DPG's concluding comments urge the adoption of uniform and universal practices.

V. Implementation Schedule

Viewed as a whole, the initiatives of the DPG represent a significant undertaking. Conforming to the common reporting and other standards adopted by the DPG will require each of the participating firms to make major changes in internal software and systems even where the individual firm would otherwise be adequately supported by its current internal systems. For these reasons, the full implementation of the proposed framework will require several quarters, even in a setting in which all of the firms have assigned a very high priority to this initiative.

The implementation schedule planned by the DPG is summarized below:

I.Filing of reports described in Grids I­V of the enhanced reporting framework (excluding information regarding potential additional credit exposure). Reports as of the end of the firmís first fiscal quarter of 1995 to be filed within sixty days following the firm's fiscal quarter end.
II.Comprehensive enhanced credit and market risk filings to be provided to SEC and CFTC (including information regarding potential additional credit exposure). Reports as of the end of the firmís second fiscal quarter of 1995 to be filed by the end of the firm's third fiscal quarter of 1995. (Subsequent reports to be filed within sixty days following the firmís fiscal quarter end.)
III.Initiate comprehensive review of management controls in relation to DPG guidelines. Commenced.
IV.Audit report referenced in the discussion on evaluation of risk in relation to capital to be provided to SEC and CFTC. End of October 1995.
V.Audit verification of compliance with DPG management control guidelines. By the close of the firm's fiscal year 1995 (and each fiscal year thereafter).

While the implementation process as a whole will extend over several quarters the SEC and the CFTC will begin to receive new and important data and information from the six firms shortly after the end of each firm's first quarterly reporting date in 1995.

VI. Conclusion

Throughout the six months of its deliberations, the DPG was acutely aware of the competitive framework within which its initiatives would become operational. That competitive framework includes a wide range of domestic and foreign competitors, few of which are regulated by the SEC or the CFTC.

Given the competitive realities of the marketplace, the DPG hopes that these initiatives will serve as a stimulus to a more consistent and harmonious approach to the official oversight of these activities and markets that will apply across the spectrum of market participants, both nationally and internationally. Until greater consistency and harmony is achieved, there is a clear danger of a drift toward a climate which encourages market participants to seek out the most benign legal and regulatory regime - an outcome that can work only in the direction of increasing risk for all.

The DPG takes a genuine measure of pride and satisfaction in what it has accomplished in a very short period of time. It is, however, mindful that these steps must be viewed as a part of a larger and more evolutionary process in which practices and policies must continually adapt to a rapidly changing market environment. In this connection, the DPG views its efforts as a valuable contribution to the dual goals of greater stability and greater efficiency. Indeed, no entities have a larger interest in the stability and well-being of these markets than do the firms represented on the DPG.

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