Recommendation A on Risk Management Associated with Banks Entering into Derivatives Market Transactions

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Financial Supervision Commission

Recommendation A concerning the management of risk associated with banks entering into transactions in the derivatives market

Warsaw, 2010

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INTRODUCTION
The purpose of this document is to indicate to banks good practices in the field of risk management related to derivatives (whose value depends on the development of price parameters related to market risk), as well as to define the rules that should be taken into account in dealings with clients who enter into or have entered into such transactions. The recommendations presented below aim to highlight the necessity of taking into account the following elements in the bank's risk management process:

• the purpose of entering into derivatives transactions
  o hedging own positions (in particular, managing the asset and liability structure); o arbitrage and speculation on own account; o execution of client orders;
• the specificity of the client;
• the type of product offer of the bank in the field of derivatives.
  A preliminary analysis of the aforementioned areas should allow for increasing the effectiveness of the bank's risk management process and earlier identification of potential threats.
  In particular, the purpose of this recommendation is to draw the attention of banks and their clients to the fact that providing clients with reliable, complete, and up-to-date information about the derivatives transactions they enter into is of extremely high importance for the safety of clients and banks. Before entering into such a transaction, the bank should ensure that the client is aware of the risk incurred and the negative consequences that may arise in the event of unfavorable changes in the markets. Also, after entering into the transaction, the bank should provide the client with current information about significant changes in the value of the acquired derivative and the value of hedged positions. These actions should serve as support for clients in making informed decisions regarding the choice of instruments used to manage risks arising from their operational activities. This recommendation takes into account not only experiences derived from markets with a long tradition in derivatives management but is also enriched by Polish observations in this regard. In particular, events on the Polish market in 2008 and 2009 indicated, on the part of both banks and their clients, situations of misunderstanding the goals and effects of entering into derivatives transactions, weaknesses in risk management systems (including the lack of assessment of changes in credit risk resulting from changes in market parameters), an overly narrow understanding of the role and responsibility of transaction participants, and limited knowledge about the functioning of derivatives.

Most of the rules contained in the text of this recommendation are universal and apply to all types of derivatives. However, it should be noted that the specificity

Recommendation A Page 3 of 26 of instruments may require separate detailed rules (e.g., with regard to credit derivatives).

Interest in derivatives stems primarily from their properties:

• they allow for hedging open positions generating market risk;
• they facilitate the redistribution of risk and its transfer to those entities that wish to assume and manage it;
• they allow investing in financial markets without the need for direct access to them;
• they allow obtaining significant financial leverage, i.e., achieving high profits with low investment outlays.

However, one must remember that:

• Due to the versatility of derivatives and the possibility of their use for both hedging and arbitrage or speculative purposes, they can pose a significant threat to entities involved in transactions with these instruments. Employees entering into hedging or arbitrage transactions may, consciously or unconsciously, enter into transactions of a speculative nature. Such actions can contribute to a significant deterioration of the financial situation of entities that are parties to the transaction, as well as to market disruptions.
• The vision of benefiting from high financial leverage during periods of profit from derivatives transactions contributes to taking excessive risk. The lack of establishing appropriate limits or failing to observe existing limits, in the event of significant changes in market prices, can cause significant losses and, as a result, pose a threat to the proper functioning of the bank. The bank should ensure the existence of the aforementioned limits and verify their adequacy and proper functioning.
• Due to the specific nature of derivatives transactions, sometimes many market participants use the same investment strategy. Such a situation increases the susceptibility of markets to changes in the prices of underlying instruments and threatens the stability of these markets. Consequently, this may contribute to significant financial losses among market participants.
• In situations where mutual claims of counterparties amount to very high sums, and at the same time, a relatively limited number of entities are willing to enter into such transactions on the market, in the event of the bankruptcy of one of them, contracts become difficult to execute. Financial difficulties of one market participant may contribute to the rapid spread of crisis phenomena among other entities entering into transactions in the derivatives market.
  The Financial Supervision Commission recognizes the risks associated with derivatives transactions, which results not only from the issues described above but also from many other matters,

Recommendation A Page 4 of 26 such as, for example, the lack of homogeneous and comprehensive legal regulations, insufficient development of some underlying instrument markets, or lack of sufficient liquidity.
The supervisory approach presented in this document emphasizes the responsibility of the Management Board regarding the development of appropriate rules and procedures, supervision of trading, development of accounting rules (immediate recognition of losses, in accordance with the mark-to-market concept), control and supervision, capital protection, avoiding exceeding large concentrations, and ensuring proper relations with clients with whom banks enter into the discussed transactions. These recommendations take into account the aforementioned issues and indicate prudential guidelines that should be taken into account in the risk management process, and thus applied as widely as possible to all areas of banking activity risk. They do not aim to fully regulate the way such transactions are conducted on the Polish market, but only to indicate to banks the rules for safe conduct of operations in financial derivatives. It is expected that all banks involved in transactions in the derivatives market will comply with these recommendations.

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DEFINITIONS

1. Derivative instrument (derivative) – a financial instrument meeting the following conditions jointly:
   a) its value depends on a specific, external price parameter, for example: interest rate, price of a security, price of a commodity, foreign currency exchange rate, index based on price or interest rate, or another variable; b) usually requires no initial payment or only a small initial investment relative to the contract amount; c) its settlement will take place in the future.

Transactions in the derivatives market may be entered into:
a) through exchanges for these transactions, both domestic and global – transactions entered into on the exchange are subject to standardization and supervision by the exchange clearing house (through margin and collateral systems); transactions entered into on the exchange are usually short-term and more understandable and transparent to market participants; b) directly between counterparties (over-the-counter - OTC) – such transactions do not have standardized terms on which they are entered into; parties agree on terms according to their needs.

2. Bank Management – Bank Management Board, Bank Supervisory Board.

3. Credit (counterparty) risk – the risk of counterparty failure to fulfill obligations arising from entered into derivatives transactions. Distinguished:

• Pre-settlement risk – the risk of loss of future receivables from the derivative instrument due to counterparty insolvency.
• Settlement risk – the risk of non-settlement of the contract, i.e., failure to receive funds from the counterparty at the settlement date.

4. Concentration risk – the risk of non-performance of obligations that may significantly impact the stability and safety of the bank's operations (including from transactions in the derivatives market), resulting from significant exposure to a single counterparty or financially or organizationally related counterparties, and to a group of entities for which the probability of non-performance of obligations depends on common factors.

5. Market risk – the possibility of incurring losses as a result of changes in the price of the underlying instrument (exchange rates, interest rates, prices of financial instruments, etc.).

6. Operational risk – the possibility of occurrence of a loss resulting from inadequate or failure of internal processes, people, systems, or from external events, also including legal risk.

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7. Risk hedging using derivatives (hedging) – the use of derivatives transactions to protect against unfavorable changes in the price of the underlying instrument.

8. Derivative transaction collateral (collateral) – monetary funds or other securities from which the bank may satisfy its claims in the event of the realization of counterparty risk.

9. Counterparty1 – the party to a derivatives transaction entered into with the bank.

10. Client – the party to a derivatives transaction entered into with the bank, excluding clients with very good knowledge of markets and financial products, e.g., credit institutions, brokerage houses, investment companies, pension funds, insurance companies, central banks, etc.