1. Derivatives instruments have become increasingly important to the overall risk profile and profitability of banking organisations throughout the world. Broadly defined, a derivatives instrument is a financial contract whose value depends on the values of one or more underlying assets or indexes. Derivatives transactions include a wide assortment of financial contracts, including forwards, futures, swaps and options. In addition, other traded instruments incorporate derivatives characteristics, such as those with imbedded options. While some derivatives instruments may have very complex structures, all of them can be divided into the basic building blocks of options, forward contracts or some combination thereof. The use of these basic building blocks in structuring derivatives instruments allows the transfer of various financial risks to parties who are more willing, or better suited, to take or manage them.
2. Derivatives contracts are entered into throughout the world on organised exchanges and through over-the-counter (OTC) arrangements. Exchange-traded contracts are typically standardised as to maturity, contract size and delivery terms. OTC contracts are custom-tailored to an institution's needs and often specify commodities, instruments and/or maturities that are not offered on any exchange. This document addresses banks' activities in both OTC and exchange-traded instruments.
3. Derivatives are used by banking organisations both as risk management tools and as a source of revenue. From a risk management perspective, they allow financial institutions and other participants to identify, isolate and manage separately the market risks in financial instruments and commodities. When used prudently, derivatives can offer managers efficient and effective methods for reducing certain risks through hedging. Derivatives may also be used to reduce financing costs and to increase the yield of certain assets. For a growing number of banking organisations, derivatives activities are becoming a direct source of revenue through "market-making" functions, position taking and risk arbitrage:
"market-making" functions involve entering into derivatives transactions with customers and with other market-makers while maintaining a generally balanced portfolio with the expectation of earning fees generated by a bid/offer spread;
position-taking, on the other hand, represents efforts to profit by accepting the risk that stems from taking outright positions in anticipation of price movements;
arbitrageurs also attempt to take advantage of price movements, but focus their efforts on trying to profit from small discrepancies in price among similar instruments in different markets.
4. Participants in the derivatives markets are generally grouped into two categories based primarily on their motivations for entering into derivatives contracts. End-users typically enter into derivatives transactions to achieve specified objectives related to hedging, financing or position taking on the normal course of their business operations. A wide variety of business enterprises are end-users. They include, but are not limited to, a broad range of financial institutions such as banks, securities firms and insurance companies; institutional investors such as pension funds, mutual funds and specialised investment partnerships; and corporations, local and state governments, government agencies and international agencies.
5. Intermediaries, which are sometimes referred to as "dealers", cater to the needs of end-users by "making markets" in OTC derivatives instruments. In doing so, they expect to generate income from transaction fees, bid/offer spreads and their own trading positions. Important intermediaries, or derivative dealers, include major banks and securities firms around the world. As intermediaries, banks have traditionally offered foreign exchange and interest rate risk management products to their customers and generally view derivatives products as a financial risk management service.
6. The basic risks associated with derivatives transactions are not new to banking organisations. In general, these risks are credit risk, market risk, liquidity risk, operations risk and legal risk. Because they facilitate the specific identification and management of these risks, derivatives have the potential to enhance the safety and soundness of financial institutions and to produce a more efficient allocation of financial risks. However, since derivatives also repackage these basic risks in combinations that can be quite complex, they can also threaten the safety and soundness of institutions if they are not clearly understood and properly managed.
7. Recognising the importance of sound risk management to the effective use of derivatives instruments, the following guidance is intended to highlight the key elements and basic principles of sound management practice for both dealers and end-users of derivatives instruments. These basic principles include:
- 1. Appropriate oversight by boards of directors and senior management;
- 2. Adequate risk management process that integrates prudent risk limits, sound measurement procedures and information systems, continuous risk monitoring and frequent management reporting; and,
- 3. Comprehensive internal controls and audit procedures.