FIMMDA moots pricing code for derivatives

At present, derivatives deals are priced at rates which are out of sync with market levels.

Amid concerns over wrong-selling of derivatives contracts, a code of conduct has been formulated seeks to end any practice of pricing derivatives transactions at rates that are significantly in variation with market levels.

The Fixed Income Money Market and Derivatives Association of India (FIMMDA), a body of market players, has issued a code that advises banks against entering into transactions at rates or reference levels that differ materially from market levels.

"This should apply to all transactions whether fresh, rollovers or modifications. amendments of existing transactions, the code states.

The code said such transactions could also be materially altering normal cash flows, either by creating an advance payment or by deferring a payment, resulting in a deferral or acceleration of gains or losses for tax, accounting, financing or other purposes.

"In determining whether a particular transaction is of the above nature, the transaction should be evaluated as a whole and not any single part or leg of the transaction," according to the code.

The Reserve Bank of India (RBI) recently asked select foreign banks active in the derivatives market to provide information on derivative structures sold by them after a string of companies suffered losses in derivative contracts entered into with some foreign banks. The affected companies have doubts about the pricing of the derivative products sold to them.

FIMMDA is a body that functions as the principal interface with the regulators on various issues that impact the functioning of the money and derivatives markets.

The FIMMDA code said a process that ensures pricing at market levels would ensure that in dealings with professional counterparties, there is no concealment of profit or loss by dealers. While in the case of customer transactions this would ensure prevention of potential disputes/litigation risk on account of excessive customer spread, it said.

FIMMDA has listed examples of transactions which banks should not enter into with counterparties. It includes an interest rate swap where, in exchange for an up-front payment, the counterparty agrees to pay an above-market fixed rate over time and receive an at market floating rate and a currency swap where a client pays an above-market coupon in one currency, receives a market coupon in a second currency, and is compensated at maturity by exchanging notional principal at a rate more advantageous than the trade date spot rate.

FIMMDA said these provisions will not apply to changes that are a result of a bona fide error or misunderstanding in the original transaction and also not apply in case of a deal being written by the bank as a reversal of a previous customer deal.

Banks should also put in place an internal process to ensure that amendments/modifications/rollovers of existing transactions are not undertaken with an objective of concealment/deferment of gains or losses by the counterparty but should have an economic rationale.

In case a bank wishes to enter into a transaction of the above-mentioned nature due to a legitimate customer requirement, the same should be approved internally, at a minimum, by an independent control function like market risk or credit risk and not by the front office.

FIMMDA has asked banks to put in place a framework for introduction of new products, which involves consideration of the various risks involved in the product viz., market risk, credit risk, legal risk, compliance risk and operational risk.

The internal note dealing with the introduction of new products should be approved by the relevant control functions as well as by accounting department for proper accounting treatment in the bank's books.

If a bank is unsure about the conformity of new products vis-à-vis existing regulations, it may choose to bring such matters to the attention of the product development committee/market practices committee of FIMMDA that can in turn seek necessary clarifications, if required, from the regulator.