Recommendation 13: Master Agreements

Dealers and end-users are encouraged to use one master agreement as widely as possible with each counterparty to document existing and future derivatives transactions, including foreign exchange forwards and options. Master agreements should provide for payments netting and close-out netting, using a full two-way payments approach.

Participants should use one master agreement with each counterparty. That agreement should provide for close-out and settlement netting as widely as possible to document derivatives transactions. In particular, there is substantial scope for reducing credit risk by including foreign exchange forwards and options under master agreements along with other derivatives transactions.

A single master agreement that documents transactions between two parties creates the greatest legal certainty that credit exposure will be netted. The use of multiple master agreements between two parties introduces the risk of "cherry-picking" among master agreements (rather than among individual transactions); and the risk that the right to set off amounts due under different master agreements might be delayed. Dealers and end-users will be well served by using a single master agreement with counterparties to document as many derivatives transactions as law or regulation permit. The practices of using separate agreements for each transaction between two parties, or standard terms that do not constitute a master agreement, are not good practices and should be discontinued. According to the Survey, two-fifths of all dealers now document derivatives transactions under a multi-product master, and more plan to do so in the future.

Full two-way payments, as opposed to limited two-way payments, is now the preferred payments approach in master agreements. Under full two-way payments, the net amount calculated through the netting provisions in a bilateral master agreement is due regardless of whether it is to, or from, the defaulting party. Under limited two-way payments, the defaulting party is not entitled to receive anything, even if the net amount is in its favor. This discourages default and enhances cross-product and cross-affiliate set-off. However, when master agreements cover a wide range of derivatives transactions, the benefits created by increasing the certainty about the value of a net position under full two-way payments outweigh any possible benefits under limited two-way payments.

Recommendation 14: Credit Enhancement

Dealers and end-users should assess both the benefits and costs of credit enhancement and related risk-reduction arrangements. Where it is proposed that credit downgrades would trigger early termination or collateral requirements, participants should carefully consider their own capacity and that of their counterparties to meet the potentially substantial funding needs that might result.

Credit risk reduction arrangements can be useful in the management of counterparty credit risk. These include collateral and margin arrangements; third-party credit enhancement such as guarantees or letters of credit; and structural credit enhancement through the establishment of special-purpose vehicles to conduct derivatives business.

The Survey indicates that about two-thirds of dealers are prepared to accept credit enhancement with cash or securities as collateral, and over three-quarters accept a third party guarantee or enhancement. Reflecting strong dealer credit ratings, only one-third are prepared to provide cash or securities collateral and only 10% or so will offer a third party guarantee.

Enforceability

Recommendation 15: Promoting Enforceability

Dealers and end-users should work together on a continuing basis to identify and recommend solutions for issues of legal enforceability, both within and across jurisdictions, as activities evolve and new types of transactions are developed.

Dealers regularly develop new types of transactions, and new technologies are developed to confirm them. These developments may not fit clearly within the current legal framework in the jurisdictions where transactions occur. Therefore, dealers and end-users should continue to work together to evaluate developments in light of existing laws to assess what legal issues may arise. They should take the initiative to ensure that risks arising from these developments can be properly handled through analysis, market practices, documentation and, when necessary, legislation.

Enforceability of netting provisions is considered a serious concern by 43% of dealer senior management responding to the Survey, and another 45% consider it to be of some concern. It also is considered a serious issue by management of many end-users.

Recommendation 16: Professional Expertise

Dealers and end-users must ensure that their derivatives activities are undertaken by professionals in sufficient number and with the appropriate experience, skill levels, and degrees of specialization. These professionals include specialists who transact and manage the risks involved, their supervisors, and those responsible for processing, reporting, controlling, and auditing the activities.

To establish good management, derivatives activities must be staffed by talented, well-trained, and responsible professionals. There is a danger, however, in relying on a few specialists, and it is essential that their managers understand not only derivatives but also the broader business context.

Derivatives support functions are technical and generally require a level of expertise higher than for other financial instruments or activities. Respondents to the Survey expressed concern that, while they are satisfied with the quality of staff in line derivatives activities, the quality of support staff lags. Developing expertise through training programs and appropriate standards of professionalism is encouraged.

The Survey indicates that, for the majority of respondent dealers, senior management is confident about the general quality of its derivatives professionals. To the extent it is concerned about issues of professionalism, it is more worried about its own lack of understanding, about insufficient understanding of derivatives by other functions, and about overreliance on a few specialists.

Recommendation 17: Systems

Dealers and end-users must ensure that adequate systems for data capture, processing, settlement, and management reporting are in place so that derivatives transactions are conducted in an orderly and efficient manner in compliance with management policies. Dealers should have risk management systems that measure the risks incurred in their derivatives activities including market and credit risks. End-users should have risk management systems that measure the risks incurred in their derivatives activities based upon their nature, size, and complexity.

The size and scope of the required systems will depend upon the nature and scale of an organization's derivatives transactions.

For dealers, operating efficiency and reliability are enhanced through the development of systems that minimize manual intervention. Those benefits are particularly significant for dealers with a large volume of activity and a high degree of customization of transactions. At the moment, confirmations of transactions, for example, are automated for about 40% of dealers, some 10% are partially automated, and another 45% rely on manual systems. Eighty percent plan to automate their confirmations completely. In addition, large dealers have made significant investments to integrate back- and front-office systems for derivatives with their firms' other management information systems. Dealers that have done so have found that the integration further enhances operating efficiency and reliability.

While end-users may invest less extensively in their systems than dealers do, these should still be sufficient to group exposures and analyze aggregated risk in a meaningful and useful way.

Recommendation 18: Authority

Management of dealers and end-users should designate who is authorized to commit their institutions to derivatives transactions.

Authority may be delegated to certain individuals or to persons holding certain positions within the firm. Management may choose to limit authority to certain types of transactions, for example to certain maturities, amounts, or types of underlying risks. It is essential that this information be understood within the firm.

Participants should communicate information on which individuals have the authority to commit to counterparties. They should recognize, however, that the legal doctrine of "apparent authority" may govern the transactions they enter into, and that there is no substitute for appropriate internal controls.

Two-thirds of dealers responding to the Survey involve senior management in authorizing traders to commit the firm.

Accounting and Disclosure

Recommendation 19: Accounting Practices

International harmonization of accounting standards for derivatives is desirable. Pending the adoption of harmonized standards, the following accounting practices are recommended:

• Dealers should account for derivatives transactions by marking them to market, taking changes in value to income each period.
• End-users should account for derivatives used to manage risks so as to achieve a consistency of income recognition treatment between those instruments and the risks being managed. Thus, if the risk being managed is accounted for at cost (or, in the case of an anticipatory hedge, not yet recognized), changes in the value of a qualifying risk management instrument should be deferred until a gain or loss is recognized on the risk being managed. Or, if the risk being managed is marked to market with changes in value being taken to income, a qualifying risk management instrument should be treated in a comparable fashion.
• End-users should account for derivatives not qualifying for risk management treatment on a mark-to-market basis.
• Amounts due to and from counterparties should only be offset when there is a legal right to set off or when enforceable netting arrangements are in place.

Where local regulations prevent adoption of these practices, disclosure along these lines is nevertheless recommended.

Accounting policies for derivatives vary widely around the world. In some countries there are local accounting standards that address accounting for derivatives; in other countries there are no specific standards and a variety of customs and practices has developed. In view of the global nature of derivatives, it is desirable to achieve some harmonization of accounting treatment to assist in clarifying the financial statements of dealers and end-users.

The recommendation for dealers to account for changes in the value of their derivatives positions in income during each period has become standard in many, although not all, countries. It provides a better representation of the economic effects of such positions than other methods.

The recommended accounting treatment for end-users using derivatives to manage risks, referred to as "risk management accounting," is also a standard treatment. It has evolved in many countries, at least in a modified form, as a response to anomalies in the existing accounting framework. Traditionally in some countries, this accounting treatment has been applied solely to transactions undertaken to reduce risks, usually referred to as "hedges."

Policies must define when financial instruments are eligible for risk management accounting to ensure that the method is not abused. Among a majority of dealers who responded to the Survey, senior management thought inconsistency of accounting standards with the economics of the business were either of serious or some concern.

Recommendation 20: Disclosures

Financial statements of dealers and end-users should contain sufficient information about their use of derivatives to provide an understanding of the purposes for which transactions are undertaken, the extent of the transactions, the degree of risk involved, and how the transactions have been accounted for. Pending the adoption of harmonized accounting standards, the following disclosures are recommended:

• Information about management's attitude to financial risks, how instruments are used, and how risks are monitored and controlled.
• Accounting policies.
• Analysis of positions at the balance sheet date.
• Analysis of the credit risk inherent in those positions.
• For dealers only, additional information about the extent of their activities in financial instruments.

The Survey shows that the quality of financial statement disclosure about derivatives transactions varies even more widely than the accounting policies that are applied. Until local standards-setting bodies can adopt harmonized standards, there is a need to improve the quality of financial statement disclosure concerning transactions in both derivatives and cash market instruments.

Its qualitative nature dictates that information about management's attitude to financial risks, how instruments are used, and how risks are monitored and controlled, should appear in the management analysis section of the annual report. The remaining information should appear in the footnotes to the financial statements and be commented on as appropriate in the management analysis.

This recommendation is not apparently precluded by accounting regulations in any country and its early adoption is encouraged.

Inadequate public disclosure of exposures of counterparties is of some concern, or of serious concern, to about three-fifths of senior management among dealers responding to the Survey.

Recommendations for Legislators, Regulators, and Supervisors

Recommendation 21: Recognizing Netting

Regulators and supervisors should recognize the benefits of netting arrangements where and to the full extent that they are enforceable, and encourage their use by reflecting these arrangements in capital adequacy standards. Specifically, they should promptly implement the recognition of the effectiveness of bilateral close-out netting in bank capital regulations.

The bilateral or multilateral netting of contractual payments due on settlement dates, and of unrealized losses against unrealized gains in the event of a counterparty's default, is the most important means of mitigating credit risk. By reducing settlement risk as well as credit exposures, netting contributes to the reduction of systemic risk.

Significant efforts have been made to develop standard master agreements that effect netting across the full range of derivatives products. Nonetheless, the enforceability of such netting provisions remains among the highest concerns of senior management of derivatives dealers, according to the Survey.

Regulators and supervisors should officially recognize netting where and to the full extent it is enforceable, and reflect these arrangements in the capital standards. In this way, regulators and supervisors will stimulate efforts to resolve uncertainties where they exist and will create tangible incentives for using this most important method of reducing counterparty risk.

An important step in implementing this recommendation was taken in April of this year when the Basle Committee released a Consultative Paper that included a proposal for recognizing the effectiveness of close-out netting. This is an amendment to the agreed framework for measuring bank capital adequacy (the "Basle Accord") published by the Basle Committee in July 1988. When the consultation period for this proposal has ended, the national supervisory authorities represented on the Basle Committee should recognize and implement bilateral close-out netting for capital purposes.

Recommendation 22: Legal and Regulatory Uncertainties

Legislators, regulators, and supervisors, including central banks, should work in concert with dealers and end-users to identify and remove any remaining legal and regulatory uncertainties with respect to:

• The form of documentation required to create legally enforceable agreements (statute of frauds).
• The capacity of parties, such as government entities, insurance companies, pension funds, and building societies, to enter into transactions (ultra vires).
• The enforceability of bilateral close-out netting and collateral arrangements in bankruptcy.
• The enforceability of multibranch netting arrangements in bankruptcy.
• The legality/enforceability of derivatives transactions.

These five main enforceability risks are analyzed for nine major jurisdictions in Appendix II (bound separately). Regulators and legislators in these jurisdictions should remove the remaining uncertainties that have been identified. In other countries, market participants, regulators, and legislators should work to identify and resolve any similar legal risks. These efforts should be conducted on a continuing basis, to account for new types of derivatives transactions and new technologies. It is important to approach these issues aggressively so that the largest risks faced by dealers and end-users are not legal risks from legal systems that have not kept pace with financial developments.

Further work on the enforceability in bankruptcy or insolvency of bilateral netting and collateral arrangements is particularly important if the credit risk reduction techniques for derivatives are to evolve. These techniques are essential building blocks for enforceable multilateral netting arrangements, if that is a direction participants choose to take.

Recommendation 23: Tax Treatment

Legislators and tax authorities are encouraged to review and, where appropriate, amend tax laws and regulations that disadvantage the use of derivatives in risk management strategies. Tax impediments include the inconsistent or uncertain tax treatment of gains and losses on the derivatives, in comparison with the gains and losses that arise from the risks being managed.

In most, if not all jurisdictions, the tax treatment being applied to derivatives transactions dates back to before they came into general use. This can lead to considerable uncertainty in determining how gains and losses associated with these instruments should be taxed depending upon their use.

These uncertainties and inconsistencies present real difficulties to organizations that seek to use derivatives to manage risks in their businesses. Confusion can discourage them from pursuing commercially sensible risk management strategies.

Recommendation 24: Accounting Standards

Accounting standards-setting bodies in each country should, as a matter of priority, provide comprehensive guidance on accounting and reporting of transactions in financial instruments, including derivatives, and should work towards international harmonization of standards on this subject. Also, the International Accounting Standards Committee should finalize its accounting standard on Financial Instruments.

At present no country has accounting and reporting standards that comprehensively address all financial instruments, including derivatives. Even in those countries where development of accounting standards is considered far advanced, there are gaps or inconsistencies between different standards. This is an area where action needs to be taken as a matter of priority.

In a number of countries, accounting standards-setters have recognized the need to improve accounting standards in this area and some have commenced work. Furthermore, the International Accounting Standards Committee (IASC) has issued an exposure draft on Financial Instruments (E40) and presently intends to finalize an accounting standard by the end of 1993.

In addressing the accounting and disclosure requirements for financial instruments, the IASC and national accounting standards-setters are encouraged to address the problems of accounting for risk management activities. Most existing accounting regulations were formulated before recent advances in risk management strategies. This poses considerable practical problems, both to end-users and dealers. Developments in accounting regulations have not kept pace with changes in the way risk is managed.

In some countries, the accounting standards that govern the eligibility for hedge accounting treatment of hedges of anticipated transactions may be too restrictive: some relaxation should be permitted, subject to safeguards to prevent abuse.

Similarly, accounting standards should deal with risk management in a broad sense and not deal just with risk reduction (hedging) which is only one aspect of risk management. Risk management strategies are increasingly being used by both financial and nonfinancial institutions to achieve an acceptable risk profile, but not necessarily a reduced level of risk. Concern over current accounting regulations is deterring some organizations from pursuing commercially sensible risk management strategies. While standards are necessary to ensure that risk management accounting is not abused, it is essential that accounting standards respond to modern risk management techniques.