Clearing and Settlement of Derivatives

Regulation and compliance

Derivatives are not always the best instrument to use for investment

strategies. Sometimes derivatives create what is known as contingent

liabilities, a situation where there is an ongoing actual or potential

settlement process. In other words, there is more than one settlement

amount that might create funding issues, for example VM.

Other kind of contingent liabilities relate to issues like the ability to

simultaneously close out one derivative position and open another or

to trade two opening transactions together. If this is not achieved

then there is likely to be some funding or exposure issues created.

The characteristics of derivative products may also create situations

that are beneficial to some kinds of investors but not to others. For

instance, gearing favours hedge fund strategies and speculators but

is less advantageous in risk-averse investment funds and strategies.

The nature of the derivative product is one that means regulators

and those charged with protecting other parties’ interests like trustees

will often restrict, and in some cases prohibit, the use of derivatives in

funds or the marketing of some of the products to ‘unsuitable’ private

investors.

On the other hand, the regulators and trustees see the sense in

allowing investors and fund managers to hedge against risks.

Not surprisingly breaches of rules, regulations and mandates, etc.

are not viewed lightly by the aforementioned, and a manager could

find themselves not only suffering some kind of fine but also being

barred from using the products again.

In the United Kingdom the regulator, the FSA, requires a Deriva-

tives Risk Warning to be provided to certain categories of customers.

The FSA also has regulations governing the use of derivatives by

investment schemes limiting things like exposures, ensuring the use

meets ‘efficient portfolio management’ criteria, and the type of deriva-

tive product that can be used.

In the wider context there are the European Directives that permit

the use of derivatives in various ways and the use of various prod-

ucts, and these have recently allowed a greater use of OTC derivatives

by funds.

There are specific regulations related to US markets and investors

and of course every jurisdiction has its own regulatory requirements

over exchanges, clearing houses, brokers, investment managers and

usually foreign investors.

Mutual fund mandates and unit trust’s trust deeds will make it

clear whether derivatives are permitted for use, which derivatives

122 Clearing and settlement of derivatives