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Funds Should Improve Derivatives Controls, FSA Says

Derivatives-trading risks aren’t properly monitored by some asset-management companies, the U.K.’s Financial Services Authority said in a draft proposal to bolster oversight of the products.

Firms have differing approaches to monitoring their risks linked to trading in derivatives, with some more effective than others, the FSA, said on its website today. The agency, which gathered the information from a survey of 12 asset-management firms, proposed guidance on how firms should manage these risks.

“Incomplete monitoring and fractured reporting of risks results makes it difficult for the firm to see a complete picture of its risks in a timely manner,” said the FSA, which did not name the firms surveyed. Companies should have “documentation showing adequate knowledge of risks in both the investment and support areas.”

Nations are seeking greater oversight of and restrictions on trading in derivatives, which regulators have blamed for exacerbating the financial crisis. The U.S. and 27-nation European Union have proposed measures to push more derivatives trading through clearinghouses, to reduce the risk that such trades pose to financial stability. The FSA is seeking comments on today’s proposal until Dec. 20.

The FSA, which focused on six areas, said it wasn’t clear to what extent companies ensured board members, fund directors and other staff in settlement and monitoring roles understood derivatives risk. Companies had different definitions of market and counterparty risk and consequently there isn’t uniform oversight, the FSA said.

“Over the past two years, much of the change within the landscape of financial services has been framed around the crystallization of counterparty risk,” the FSA said. “The bankruptcy of Lehman Brothers in September 2008 stands as a reminder of how real and systemic counterparty risk is.”

Companies should audit or review derivatives processes and ensure they do the same for any third-party providers, the regulator said. There should be a “trigger process” to review exposure to another firm or trader if they rise above certain levels, the FSA said, adding derivatives pricing should be provided by independent sources to ensure they are accurate.

Firms should ensure they use “appropriate legal documentation” such as the master agreement proposed by the International Swaps and Derivatives Association, the FSA said.

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