1. The following sections present sound practices for the specific components of an institution's risk management process in the context of each of the risks involved in derivatives activities.

Credit risk (including settlement risk)

2. Broadly defined, credit risk is the risk that a counterparty will fail to perform on an obligation to the institution. The institution should evaluate both settlement and pre-settlement credit risk at the customer level across all products. On settlement day, the exposure to counterparty default may equal the full value of any cash flows or securities the institution is to receive. Prior to settlement, credit risk is measured as the sum of the replacement cost of the position, plus an estimate of the institution's potential future exposure from the instrument as a result of market changes. Replacement cost should be determined using current market prices or generally accepted approaches for estimating the present value of future payments required under each contract, given current market conditions.

3. Potential credit risk exposure is measured more subjectively than current exposure and is primarily a function of the time remaining to maturity and the expected volatility of the price, rate or index underlying the contract. Dealers and large derivatives participants should assess potential exposure through simulation analysis or other sophisticated techniques, which, when properly designed and implemented can produce estimates of potential exposure that incorporate both portfolio-specific characteristics and current market conditions. Smaller end-users may measure this exposure by using ";add-ons" based on more general characteristics. In either case, the assumptions underlying the institution's risk measure should be reasonable and if the institution measures exposures using a portfolio approach, it should do so in a prudent manner.

4. An institution may use master netting agreements and various credit enhancements, such as collateral or third-party guarantees, to reduce its counterparty credit risk. In such cases, an institution's credit exposures should reflect these risk-reducing features only to the extent that the agreements and recourse provisions are legally enforceable in all relevant jurisdictions. This legal enforceability should extend to any insolvency proceedings of the counterparty. The institution should be able to demonstrate that it has exercised due diligence in evaluating the enforceability of these contracts and that individual transactions have been executed in a manner that provides adequate protection to the institution.

5. Credit limits that consider both settlement and pre-settlement exposures should be established for all counterparties with whom the institution conducts business. As a matter of general policy, business with a counterparty should not commence until a credit line has been approved. The structure of the credit-approval process may differ among institutions, reflecting the organisational and geographic structure of each institution. Nevertheless, in all cases, it is important that credit limits be determined by personnel who are independent of the derivatives function, that these personnel use standards consistent with those used for other activities and that counterparty credit lines are consistent with the organisation's policies and consolidated exposures.

6. If credit limits are exceeded, exceptions should be resolved according to the institution's policies and procedures. In addition, the institution's reports should adequately provide traders and credit officers with relevant, accurate and timely information about the credit exposures and approved credit lines.

7. Similar to bank loans, OTC derivatives products can have credit exposures existing for an extended period. Given these potentially long-term exposures and the complexity associated with some derivatives instruments, an institution should consider the overall financial strength of its counterparties and their ability to perform on their obligations.

Market risk

8. Market risk is the risk to an institution's financial condition resulting from adverse movements in the level or volatility of market prices. The market risks created - or hedged - by a future or swap are familiar, although not necessarily straightforward to manage. They are exposures to changes in the price of the underlying cash instrument and to changes in interest rates. By contrast, the value of an option is also affected by other factors, including the volatility of the price of the underlying instrument and the passage of time. In addition, all trading activities are affected by market liquidity and by local or world political and economic events.

9. Market risk is increasingly measured by market participants using a value-at-risk approach, which measures the potential gain or loss in a position, portfolio or institution that is associated with a price movement of a given probability over a specified time horizon. The institution should revalue all trading portfolios and calculate its exposures at least daily. Although an institution may use risk measures other than value-at-risk, the measure used should be sufficiently accurate and rigorous, and the institution should ensure that it is adequately incorporated into its risk management process.

10. An institution should compare its estimated market risk exposures with actual behaviour. In particular, the output of any market risk models that require simulations or forecasts of future prices should be compared with actual results. If the projected and actual results differ materially, the assumptions used to derive the projections should be carefully reviewed or the models should be modified, as appropriate.

11. The institution should establish limits for market risk that relate to its risk measures and that are consistent with maximum exposures authorised by its senior management and board of directors. These limits should be allocated to business units and individual decision makers and be clearly understood by all relevant parties. Exceptions to limits should be detected and adequately addressed by management. In practice, some limit systems may include additional elements such as stop-loss limits and guidelines that may play an important role in controlling risks.

12. An institution whose derivatives activities are limited in volume and confined to end-user activities may need less sophisticated risk measurement systems than those required by a dealer. Senior management at such an institution should ensure that all significant risks arising from its derivatives transactions can be quantified, monitored and controlled. At a minimum, risk management systems should evaluate the possible impact on the institution's earnings and capital which may result from adverse changes in interest rates and other market conditions that are relevant to risk exposure and the effectiveness of derivatives transactions in the institution's overall risk management.

Liquidity risk

13. An institution faces two types of liquidity risk in its derivatives activities: one related to specific products or markets and the other related to the general funding of the institution's derivatives activities. The former is the risk that an institution may not be able to, or cannot easily, unwind or offset a particular position at or near the previous market price because of inadequate market depth or because of disruptions in the marketplace. Funding liquidity risk is the risk that the institution will be unable to meet its payment obligations on settlement dates or in the event of margin calls. Because neither type of liquidity risk is necessarily unique to derivatives activities, management should evaluate these risks in the broader context of the institution's overall liquidity. When establishing limits, the institution should be aware of the size, depth and liquidity of the particular market and establish guidelines accordingly.

14. In developing guidelines for controlling liquidity risks, an institution should consider the possibility that it could lose access to one or more markets, either because of concerns about the institution's own creditworthiness, the creditworthiness of a major counterparty or because of generally stressful market conditions. At such times, the institution may have less flexibility in managing its market, credit and liquidity risk exposures. An institution that makes markets in over-the-counter derivatives or that dynamically hedges its positions requires constant access to financial markets and that need may increase in times of market stress. The institution's liquidity plan should reflect the institution's ability to turn to alternative markets, such as futures or cash markets, or to provide sufficient collateral or other credit enhancements in order to continue trading under a broad range of scenarios.

15. An institution that participates in over-the-counter derivatives markets should assess the potential liquidity risks associated with the early termination of derivatives contracts. Many forms of standardised contracts for derivatives transactions allow counterparties to request collateral or to terminate their contracts early if the institution experiences an adverse credit event or a deterioration in its financial condition. In addition, under conditions of market stress, customers may ask for the early termination of some contracts within the context of the dealer's market making activities. In such situations, an institution that owes money on derivatives transactions may be required to deliver collateral or settle a contract early and possibly at a time when the institution may face other funding and liquidity pressures. Early terminations may also open up additional, unintended, market positions. Management and directors should be aware of these potential liquidity risks and should address them in the institution's liquidity plan and in the broader context of the institution's liquidity management process.

Operations risk

16. Operations risk is the risk that deficiencies in information systems or internal controls will result in unexpected loss. This risk is associated with human error, system failures and inadequate procedures and controls. This risk can be exacerbated in the case of certain derivatives because of the complex nature of their payment structures and calculation of their values.

17. The board of directors and senior management should ensure the proper dedication of resources (financial and personnel) to support operations and systems development and maintenance. The operations unit for derivatives activities, consistent with other trading and investment activities, should report to an independent unit and should be managed independently of the business unit. The sophistication of the systems support and operational capacity should be commensurate with the size and complexity of the derivatives business activity.

18. Systems support and operational capacity should be adequate to accommodate the types of derivatives activities in which the institution engages. This includes the ability to efficiently process and settle the volumes transacted through the business unit, to provide support for the complexity of the transactions booked and to provide accurate and timely input. Support systems and the systems developed to interface with the official databases should generate accurate information sufficient to allow business unit management and senior management to monitor risk exposures in a timely manner.

19. Systems needs for derivatives activities should be evaluated during the strategic planning process. Current and projected volumes should be considered together with the nature of the derivatives activity and the user's expectations. Consistent with other systems plans, a written contingency plan for derivatives products should be in place.

20. With the complexity of derivatives products and the size and rapidity of transactions, it is essential that operational units be able to capture all relevant details of transactions, identify errors and process payments or move assets quickly and accurately. This requires a staff of sufficient size, knowledge and experience to support the volume and type of transactions generated by the business unit. Management should develop appropriate hiring practices and compensation plans to recruit and retain high calibre staff.

21. Systems design and needs may vary according to the size and complexity of the derivatives business. However, each system should provide for accurate and timely processing and allow for proper risk exposure monitoring. Operational systems should be tailored to each institution's needs. Limited end-users of derivatives may not require the same degree of automation needed by more active trading institutions. All operational systems and units should adequately provide for basic processing, settlement and control of derivatives transactions.

22. The more sophisticated the institution's activity, the more need there is to establish automated systems to accommodate the complexity and volume of the deals transacted, to report position data accurately and to facilitate efficient reconciliation.

23. Segregation of operational duties, exposure reporting and risk monitoring from the business unit is critical to proper internal control. Proper internal control should be provided over the entry of transactions into the database, transaction numbering, date and time notation and the confirmation and settlement processes. Operational controls should also be in place to resolve disputes over contract specifications. In this regard, an institution must ensure that trades are confirmed as quickly as possible. The institution should monitor the consistency between the terms of a transaction as they were agreed upon and the terms as they were subsequently confirmed.

24. The operations department, or another unit or entity independent of the business unit, should be responsible for ensuring proper reconciliation of front and back office databases on a regular basis. This includes the verification of position data, profit and loss figures and transaction-by-transaction details.

25. The institution should ensure that the methods it uses to value its derivatives positions are appropriate and that the assumptions underlying those methods are reasonable. The pricing procedures and models the institution chooses should be consistently applied and well-documented. Models and supporting statistical analyses should be validated prior to use and as market conditions warrant.

26. Management of the institution should ensure that a mechanism exists whereby derivatives contract documentation is confirmed, maintained and safeguarded. An institution should establish a process through which documentation exceptions are monitored and resolved and appropriately reviewed by senior management and legal counsel. The institution should also have approved policies that specify documentation requirements for derivatives activities and formal procedures for saving and safeguarding important documents that are consistent with legal requirements and internal policies.

27. Although operations risks are difficult to quantify, they can often be evaluated by examining a series of "worst-case" or "what if" scenarios, such as a power loss, a doubling of transaction volume or a mistake found in the pricing software for collateral management. They can also be assessed through periodic reviews of procedures, documentation requirements, data processing systems, contingency plans and other operational practices. Such reviews may help to reduce the likelihood of errors and breakdowns in controls, improve the control of risk and the effectiveness of the limit system and prevent unsound marketing practices and the premature adoption of new products or lines of business. Considering the heavy reliance of derivatives activities on computerised systems, an institution must have plans that take into account potential problems with its normal processing procedures.

Legal risk

28. Legal risk is the risk that contracts are not legally enforceable or documented correctly. Legal risks should be limited and managed through policies developed by the institution's legal counsel (typically in consultation with officers in the risk management process) that have been approved by the institution's senior management and board of directors. At a minimum, there should be guidelines and processes in place to ensure the enforceability of counterparty agreements.

29. Prior to engaging in derivatives transactions, an institution should reasonably satisfy itself that its counterparties have the legal and necessary regulatory authority to engage in those transactions. In addition to determining the authority of a counterparty to enter into a derivatives transaction, an institution should also reasonably satisfy itself that the terms of any contract governing its derivatives activities with a counterparty are legally sound.

30. An institution should adequately evaluate the enforceability of its agreements before individual transactions are consummated. Participants in the derivatives markets have experienced significant losses because they were unable to recover losses from a defaulting counterparty when a court held the counterparty had acted outside of its authority in entering into such transactions. An institution should ensure that its counterparties have the power and authority to enter into derivatives transactions and that the counterparties' obligations arising from them are enforceable. Similarly, an institution should also ensure that its rights with respect to any margin or collateral received from a counterparty are enforceable and exercisable.

31. The advantages of netting arrangements can include a reduction in credit and liquidity risks, the potential to do more business with existing counterparties within existing credit lines and a reduced need for collateral to support counterparty obligations. The institution should ascertain that its netting agreements are adequately documented and that they have been executed properly. Only when a netting arrangement is legally enforceable in all relevant jurisdictions should an institution monitor its credit and liquidity risks on a net basis.

32. The institution should have knowledge of relevant tax laws and interpretations governing the use of derivatives instruments. Knowledge of these laws is necessary not only for the institution's marketing activities but also for its own use of these products.

Basle, July 1994