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Total Number of Subscribers: 467 |
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Date:30th December 2008 |
Compiled by Mr. M. Sathya Kumar |
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What Derivatives
Users Need to Know About Sarbanes-Oxley As corporate treasurers strive to comply with new accounting
standards, they also need to know how Sarbanes-Oxley will affect the pricing
of derivative trades. Whether they choose to manually price these trades, or
to get a bank valuation, they have to be aware of compliance and control
issues General Principles
for Financial Reporting
Corporate derivative users are used to jumping through
regulatory hoops. Many have spent several gruelling years making sure their
treasury operations comply with Financial Accounting Standards (FAS) 133, 138
and 149. So when the Sarbanes-Oxley Act of 2002 (SOX) - the new broad-brush
corporate governance legislation - emerged from the Congressional conference
rooms, they began preparing themselves for another checklist. This time, derivative users may find themselves disappointed and
even more frustrated. Instead of setting up prescriptive lists, the SOX
legislation proposes a series of general principles to make sure corporate
officials have proper controls over financial reporting. And the legislation
has teeth. Officials who neglect their duties can be fined or even serve
prison time. "Sarbanes-Oxley establishes a new paradigm for corporate
responsibility," says Brian Kinman, partner at PricewaterhouseCoopers.
"It has created a new standard for companies regarding the reporting of
internal control effectiveness and has raised the bar for the design,
documentation and operation of internal control." The Challenge to
Derivatives Users
Dozens of papers have been written on SOX in recent months, but
none has focused on the particular challenges that SOX presents to
derivatives users. A survey of participants at a recent Reval-sponsored Web
seminar indicated that the vast majority of participants wanted to know more
about how SOX might affect the use of derivative instruments. Although the legislation challenges all companies to improve
their financial controls and documentation, derivatives users will have to
jump through some additional hoops to make sure they comply. Most treasurers
who use derivatives have already addressed some of these issues in order to
meet FASB's rulings for managing derivatives. But SOX legislation will force
them to take a fresh look at the way they price their derivatives
transactions and their control procedures. They'll also have to add some new
disclosures to their quarterly and annual reports. The two initiatives require different things of corporate
treasuries. FASB's focus was on market risk, and specified what derivatives
instruments qualify for hedge accounting treatment; SOX is more concerned
with enterprise-wide risk, and specifies an ongoing process to establish
adequate controls. The complexity of derivatives instruments themselves will lead
to greater scrutiny under SOX. Audit committee members and outside auditors
who understand the most complex corporate finance programmes often get a
queasy feeling when the D-word is mentioned. In the past, they may have been content
to simply nod their heads when derivative instruments were explained to them.
Now, however, corporate managers and auditors will have to examine internal
controls at a level of detail they never previously imagined. "Personal
liability has a dramatic effect on attention," says Ed Berko, a
principal at TRIAD Consulting Partners. "They're going to dig in more
and drill down more because their signatures are on it. They're going to say:
'I want to know this or that about the structure of the derivative, the risks
it's hedging, the model being used for its mark-to-market, its hedge
effectiveness over time, the management and procedural controls between the
front and back offices, and the conformance with trading policies and limits.
Are we covered on this? Explain it to me.'" SOX Requirements for
Derivatives Users
Corporate treasurers who are infrequent users of derivatives may
not have adequate systems, controls and processes in place. They may also be
unaware of the leverage implicit in the transactions, and could end up with
transactions that have a huge negative impact on their financial statements. SOX requires that an independent financial expert be part of the
audit committee. In most cases, this requires a person who has a strong
background in derivatives and derivative accounting - a combination typically
found in only the largest accounting firms. This expert should develop a statement that specifies what
hedging techniques and instruments should be used to support the company's
strategy. This involves detailed descriptions of the company's risk appetite,
forecasted transactions, partial term hedges and other issues. "Without
it," says Nicolas Olea, a financial risk management partner at KPMG's
Risk Advisory Service, "the company's risk policy is often left to the
whims of treasury officials, who could pursue policies that are at odds with
the board's wishes." The new legislation is likely to set additional burdens on the
already overburdened shoulders of treasury staffs. Those who have taken steps
to automate their treasury processes will find these burdens easier to bear.
Treasuries that created a proper treasury workflow and reviewed their
policies and procedures for FAS 133 will be way ahead of the game. But those
who still rely on manual processes may find themselves looking a second time
at the true costs associated with manual transactions. How to Price a
Derivatives Transaction
One of the most critical tasks facing derivative users is to
upgrade the way they price derivatives transactions. In many cases,
determining the price of a derivatives transaction is more involved than
simply checking a Bloomberg screen. When you qualify for hedge accounting, you can create an
offsetting adjustment to your exposure. But with or without hedge accounting,
your derivatives will be going on the balance sheet. Many corporate
treasuries don't bother to check valuations frequently once a transaction is
booked as a hedge. That could be a big mistake. Brett Friedman, a partner at
Risk Capital Management, recommends running a mark-to-market on all
derivatives transactions - hedges or not - at least once a week to help
treasury officials understand exactly where they stand. Treasurers that try to perform mark-to-market valuations on
their positions could be leaving themselves wide open to big mistakes.
"There's a lot of bad mark-to-market in corporate treasuries
today," says Jeff Wallace, President of Greenwich Treasury Advisors.
"It's not intentionally bad, but people are trying to do it on a quick and
dirty basis. Very few places outside Wall Street have the correct valuation
tools in place." One common method treasurers use to price a derivative
is to simply call up the bank that sold them the instrument. That technique
may or may not violate the spirit of the SOX legislation. If your auditor
feels there's some deficiency in the way you get a quote, it won't pass. But that, of course, depends on how much is at stake. An auditor
is less likely to drill down if the financial exposure is minor. Big
exposures, however, are bound to bring big scrutiny. Even a single swap that
covers 20 percent of your debt could raise serious valuation concerns in an
audit. Price Valuations:
from Banks and the Manual Route
Relying on bank valuations leaves you open to another problem:
they might not be available by the reporting dates. Corporate treasuries
should develop internal models and a quick price impugnation process to
bridge any material discrepancies. Treasurers are much better off calling up several banks to get a
price. Bankers, however, are increasingly concerned about liability issues
associated with pricing derivatives transactions and may not want to give an
auditable price. Another alternative is to buy off-the-shelf models and mark the
positions to the model. To justify this approach, however, you'll have to
document answers to several questions: What are the calculations that go into
the model? Who validates those calculations? What procedures and controls are
used when somebody in-house uses the model to get a price? Manual efforts like these can certainly be made to fit within
the guidelines of Sarbanes-Oxley. If you use the same model or call the same
banker every time, and the process is consistent, reviewable and auditable,
it may pass muster. But setting up a manual system that gives you auditable,
transparent results is only one part of the challenge. You'll also have to
establish some way to monitor that system periodically to make sure it's working. If you take the manual route, you'll have to go to great lengths
to get around the inherent limitations of spreadsheets. You'll have to find a
way to ensure that trades are entered and backed up properly. And you'll have
to find ways to establish some kind of audit trail when changes are made.
Simply protecting a spreadsheet with a password won't be sufficient. Documenting hedge effectiveness - the link between the hedge and
the exposure being hedged - will be even more problematic on spreadsheets.
Has the hedge been effective historically? To prove that with spreadsheets,
you'll have to create one worksheet for the derivative and one for the
exposure being hedged, as well a Word document that explains the underlying
hedging strategy linking the two. All that could be done manually, but it
wouldn't be pretty. The Right Controls
for Treasury Trades
The second set of headaches involves control procedures
associated with corporate treasury trades. FASB and SOX don't specify which
controls would be deemed adequate but the guiding principle behind all
control procedures is simple: the treasury officer should not be involved in
processing his or her trades. The biggest derivatives-related scandals of the
nineties occurred when traders were able to manipulate the way their trades
were reported via manual processes such as paper or voice. In an investment bank, which may have hundreds of thousands of
derivatives transactions in its portfolio, this separation of duties has been
formalized into a front office, which executes the trades, a middle office,
which values them, and a back office, which clears and processes them. Things are much simpler in the corporate treasury world, where
derivative trades typically number in the dozens rather than the thousands.
The bigger, more sophisticated treasury operations have invested in automated
processes that significantly reduce the operational risk. Ideally, a
corporate middle office function of some kind should track changes in
valuations submitted by the front office. If there's a discrepancy that can't
be explained, middle office managers should try to find out if it's a result
of a front office error, a data entry error or outright fraud. Although SOX does not require that corporate treasuries set up a
middle office or automate their control systems, the treasuries that choose
to stick with manual processes will have to watch their operations more
carefully. You'll have to make sure there's a system that collects
information from the treasury official that initiated the trade, tracks what
was sent out, received and amended, and sends that information to the back
office to be recorded. Maintaining the integrity of the data at each stage of
the game will be difficult if you're doing it on spreadsheets. Confirmation of
Trades
One of the most common internal control weaknesses involves the
way trades are confirmed. Allowing a trader to confirm his own foreign
exchange trades would be unthinkable on the investment banking side. But
that's exactly what happens in many smaller corporate treasuries. "It's
the biggest, most common internal control weakness in corporate
America," says Greenwich's Wallace. "I don't see how you can
possibly confirm your own trades and have the CFO say the internal controls
are adequate for Sarbanes-Oxley." He estimates that there are still many
companies with less than $2bn in sales that have their traders confirming
their own foreign exchange trades. And he occasionally sees the same thing at
companies larger than $2bn. Another control procedure that gets short shrift is trading
policies and limits. Companies with significant derivatives exposure will
need to write a hedging policy that states explicitly what exposures need to
be hedged and at what price. It may also determine when the company can enter
into barrier options or go above a particular fix/floating mix in certain
circumstances. You'll also have to establish some sort of trade authorization
process that determines if a particular trade meets the company's risk policy
guidelines. The policy should state who has authority to make those
decisions, what limits are to be put on individual traders and who approves
transactions beyond those limits. Simply having a process that fits the spirit of the legislation
isn't enough. Corporate officials will have to document that they are
responsible for the controls, that they know they're getting the right
information, that they've looked at those controls in the past 90 days and
determined that they're effective. Those attestations need to be sent to both
the audit committee of the company's board of director and the company's
outside auditors. External auditors will also have to attest that they've
taken their own look at the company's controls to make sure they're working
properly. Those disclosures will have to be made in a timelier manner than
in the past. Any changes or deficiencies in the controls or any other
relevant issues will need to be reported within 90 days. Conclusion
Nobody expects CFOs to be reviewing all the details of their
department's operations. But they should be making sure they have internal
checkpoints in place that ensures those details are consistent, transparent,
independently tested and secure. "Treasury should look at Sarbanes-Oxley as an opportunity
to refresh and strengthen controls, instead of simply trying to satisfy the
minimum requirements of the legislation," says Susan Skerrit, a partner
at Treasury Strategies. "They should also use the Act as the impetus for
obtaining internal support and funding for initiatives and activities focused
on implementing control and process-related best practices." While it's certainly possible to devise manual methods to meet
the requirements of both FASB and SOX, it begs an important question: is this
an efficient use of corporate resources? The additional new requirements of
SOX may inspire some treasury officials to take out their calculators and
work through their return on investment calculations one more time. Article by Jiro Okochi was head of
derivatives sales at Westdeutsche Landesbank in New York prior to starting
Reval. He has over 12 years of experience in financial markets and has been
involved in the start-up of two financial product divisions at major foreign
banks. He began his career in international equity trading at Kidder Peabody
in 1987. In 1990, he joined Security Pacific's swap desk which was ranked as
the number one swap group by Euromoney. After Security Pacific, he was part
of a team recruited to start up a new derivatives group at The Dai-Ichi
Kangyo Bank, called DKB Financial Products, Inc. Mr. Okochi next worked at
Deutsche Bank Financial Products, Inc., before again being recruited as part
of a team move to start up the Global Derivatives Fixed Income Division at
Westdeutsche Landesbank. There he was ultimately responsible for the sales
effort to financial institutions and corporations in the U.S., Canada and
Latin America |
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