By James Hamilton, J.D., LL.M.
In seminal remarks, Thomas F. Huertas, Director of Wholesale Firms and Banking at the UK Financial Services Authority said that the dramatic increase in hard-to-value illiquid derivatives threatens to overwhelm risk management practices at financial institutions. This is one of the best speeches that I have seen on managing the risk of derivatives.
Customized derivative products tend to be illiquid, noted the director, and they account for a high proportion of the value of derivatives on a bank's balance sheet. Since correct valuation is a cornerstone of risk management, he reasoned, this illiquidity makes risk management more difficult.
Interestingly, he observed that recently there have been instances of mismarking by traders of their derivatives books, leading to large losses for the banks involved. And, in the context of the discussion of best execution under MiFID, the industry is reported to have asserted that it cannot create benchmark prices for derivatives as they tend to be one-off products with no market. But if there is no market, questioned the director, how do firms mark to market and how does the industry value derivatives. More importantly, there is the issue of how regulators can be sure that firms are in fact valuing derivatives adequately for risk management purposes.
In an effort to answer these questions, the FSA conducted a hypothetical portfolio exercise with a number of investment banks. It is extremely noteworthy that this exercise revealed a wide dispersion in the value at risk that firms considered themselves to have in connection with an identical portfolio of structured derivatives. Separately, the director said that the FSA expects to provide a statement of good practice to the industry early next year; as well as to take action against firms that are not employing proper valuation techniques.