FIMMDA Code of Conduct for Derivatives Transactions

FIMMDA CODE OF CONDUCT FOR DERIVATIVES TRANSACTIONS

(16th AUGUST, 2007)

FIXED INCOME MONEY MARKET & DERIVATIVES ASSOCIATION OF INDIA www.fimmda.org

FIMMDA Code of Conduct for Derivatives Transactions

INTRODUCTION In India, the spot and forward foreign exchange market has been flourishing for a very long time now and had been well established with detailed guidelines and market practices already in place before 2000. Derivatives were introduced in the Indian Market in a limited way in 1997 by RBI and then supplemented further by the introduction of INR IRSs in 1999 and INR FXOs in 2003. However, it is only in the last 3 years that the market has really started accepting and using derivatives at a broad level and this has led to the significant growth in the use and spread of various kinds of derivative products in the market. It may be noted that even though the usage of derivative transactions has grown in recent past, a large amount of trading volumes is contributed to by vanilla products like Rupee IRS, FC-Rupee swaps, vanilla FC-Rupee options. Innovations have been limited to use of complexities in structures for FX leg of these transactions and variations in structures of vanilla FC-Rupee options. In the meantime, the regulatory regime for use of derivative products has undergone significant changes over time. These changes have evolved in a piecemeal fashion depending upon the requirements of a particular market and specific market conditions. There has been significant liberalization in the regulations relating to usage of Foreign exchange derivatives in recent years particularly in the wake of FEMA. The market still suffers from several structural shortcomings including lack of clear accounting and disclosure standards for derivative transactions, lack of adequate knowledge of uses and risks inherent in derivative transactions particularly those involving complex structures, legal uncertainties surrounding the use of OTC derivatives etc and uncertainties about regulations with regard to certain complex products. In this context, a need was felt to evolve a code of conduct in respect of derivative transactions particularly those involving end users to ensure a minimum common standard of market practices. Accordingly, FIMMDA assigned the task of coming out with a detailed Code of Conduct for the derivatives market to a subcommittee of its Market Practices Committee. It is expected that this code of conduct would lay out guidelines to be followed by all FIMMDA members and other market participants while undertaking derivatives transactions. Such guidelines would broadly address issues relating to (a) Suitability and Appropriateness standards and procedures, (b) standards for reasonability of rates, (c) guidelines to avoid transactions that (irrespective of accounting standards) could result in acceleration/deferment of gains or losses and (d) guidelines for introduction of new products in the market. COVERED ENTITIES All Market Participants like Authorised Dealers (ADs) and Primary Dealers (PDs) are expected to follow and implement these guidelines. All other market participants are also expected to be aware of these guidelines.

FIMMDA Code of Conduct for Derivatives Transactions

COVERED TRANSACTIONS This code of conduct will apply to all OTC Derivative products in the Indian Market. The scope of the OTC derivative transactions covered by this Code of conduct is intended to be very broad and to include, without limitation, currency swaps, interest rate swaps, commodity swaps, rate and spread locks, foreign exchange options, debt options and currency options, forward foreign exchange transactions, forward rate transactions, nondeliverable forward transactions, caps, floors, collars and swap options or any combination of these transactions. Derivative transactions also include types of transactions that are similar to any transaction referred to above that is currently or in the future becomes recurrently entered into in the financial markets and which is a forward, swap, option or other derivative on one or more rates, currencies, commodities, credit, equity, underlying asset class or other hybrid instrument or measures of economic risk or value. These transactions may be referred to herein collectively as derivative transactions and as used herein refers to any or all of these types of transactions, as the context requires. For the avoidance of doubt, this Code of conduct does not extend to exchange traded products like equity futures or equities or warrants. SUITABILITY AND APPROPRIATENESS NEED FOR ENSURING APPROPRIATENESS It is important that the transactions undertaken by the banks customers are well understood and are consistent with their internal policies as well as their risk appetite. If the customers dont understand the risks inherent in the transactions then they may be unable to anticipate the obligations that these transactions may entail in future and hence lead to potential for dispute, unacceptable level of credit losses for the bank as well as damage to the banks reputation. In general, the primary onus for ensuring the appropriateness of any transaction lies with the customer however for the above reasons, it is important for the bank as well to satisfy itself that the transactions entered into with customers are Suitable and Appropriate. WHAT IS APPROPRIATENESS? Appropriateness is a result of several factors, a few of which are listed below: The customer understands the terms, payoffs and mechanics of the transaction. The customer clearly understands the risks involved and more specifically the downside risk involved in the transaction and the circumstances in which such risks can unfold. The transaction is consistent with the customers formal/informal risk management

FIMMDA Code of Conduct for Derivatives Transactions

policy/strategy which inter-alia covers the nature and type of transactions, risk appetite and control procedures. The transaction is consistent with the stated objective of the customer and is in line with the past usage of similar transactions. The motivation of the customer for undertaking the transaction should be understood by the bank. The customer is legally capable of undertaking the transaction. GUIDELINES FOR ENSURING APPROPRIATENESS OF TRANSACTIONS The key to ensuring appropriateness is to gain in-depth knowledge about the customer. The bank should learn and understand the customers business and the nature of risks arising in it. It should also understand the customers past experience while dealing with similar products and his/her level of expertise. The banks may use a structured questionnaire form to aid their sales staff in understanding the customer profile and the same may be used for documenting such internal discussions on Customer Appropriateness. A representative format of such a questionnaire is attached in Annexure (1). The banks may use the data generated by such discussions to categorise the customers into various classes based upon their level of sophistication. Similarly, the products being offered by the bank may also be categorized into various classes based upon the level of complexity and nature of risks involved. In general, a concept of matching a class of customers with a particular type of products (as defined above) may be used to determine the suitability of a particular transaction to the customer. A representative format of such a classification is attached in Annexure (2). Such a classification process, as described above, should be undertaken by front office in consultation with certain independent control function e.g. Market Risk Management, Credit risk Management etc. The banks may also institute an exception process for approving certain transactions specifically for certain customers depending on the particular circumstances. Such a process should require written documentation of the need for the exception. The bank should also put in place a policy with regard to transactions that are deemed inappropriate by the bank for a customer but where the customer is still keen to undertake the transaction, even after the bank has disclosed its opinion to the customer. In cases where the bank is dealing with a customer through another Intermediary Bank, due to lack of credit appetite (either tenor or quantum), (the distinction from normal Inter-bank transactions being that the customer transaction is originated by the first bank), the bank should ensure a Suitability and Appropriateness review of the Intermediary Bank as its direct customer and the Intermediary Bank should ensure a Suitability and Appropriateness review of the end Customer.

FIMMDA Code of Conduct for Derivatives Transactions

RISK DISCLOSURE While ensuring suitability of the transaction to the customer, it is also important that banks adequately disclose the inherent risks in the transaction (based upon the level of sophistication and complexity of transaction) to the customer. From a best practice point of view, the banks may include such a disclosure in the term sheets given to the customers. The disclosure may (but not necessarily always), depending on the level of complexity of the transaction, include a detailed scenario analysis where the payouts from the transaction under different combinations of the underlying market factors should be spelt out clearly. Such an analysis should cover both the positive and negative scenarios, from the customers point of view, evenly and should spell out any assumptions made for the scenario analysis. The bank should refrain from undertaking any transactions where the bank is acting as a formal advisor to the customer while deciding upon the transaction. REASONABILITY OF RATES The banks should ensure that all transactions whether fresh, rollovers or modifications/ amendments of existing transactions are at prevailing Market rates. In order to arrive at reasonability of the rates/prices the banks may differentiate between transactions entered into with professional counterparties (acting as market-makers) and customer transactions, where a credit risk element is embedded in pricing of the transactions. Significant deviations from internally defined rate reasonability bands for both types of transactions should be subject to an internal review process. This process would ensure that in case of dealings with professional counterparties there is no concealment of profit or loss by dealers. While in case of customer transactions this would ensure prevention of potential disputes/litigation risk on account of excessive customer spread. TRANSACTIONS POTENTIALLY RESULTING IN DEFERMENT OF LOSSES OR ACCELERATION OF GAINS Banks should not enter in transactions at rates, strikes or reference levels that differ materially from market levels. This should apply to all transactions whether fresh, rollovers or modifications / amendments of existing transactions. Such transactions could also be materially altering normal cash flows, either by creating an advance 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.

FIMMDA Code of Conduct for Derivatives Transactions

Few examples of such transactions are enumerated below (This is not an exhaustive list): 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; 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; An option transaction where a client sells or buys a deeply in-the-money option. This will not apply to changes that are a result of a bona fide error or misunderstanding in the original Transaction. This will also not apply in case of a deal being written by the bank as a reversal of a previous customer deal. Banks should evolve their own internal guidelines to define what constitutes a Deeply in-themoney option. This could be based on the probability of exercise of the option at inception measured either by the delta of the option in case of a simple call/put option, probability of payout in case of digital options and a combination of both the above in case of barrier options. Since the probability of exercise of an ATMF option is about 50% at inception and the probability of exercise of a fully in-the-money option is 100%, an intermediate approach could be looked at for the above definition. 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 (apart from the Front Office) e.g. Market Risk, Credit Risk etc. NEW PRODUCTS PROCEDURES Banks should 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 etc. The internal note dealing with the introduction of new products should be approved by the relevant control functions as mentioned above as well as by accounting department for proper accounting treatment in banks books. If the bank is unsure about the conformity of new products vis--vis existing regulations, it may choose to bring such matters to the attention of Product Development Committee/Market Practices Committee of FIMMDA that can in turn seek necessary clarifications, if required, from the regulator.

FIMMDA Code of Conduct for Derivatives Transactions

ANNEXURE 1: APPROPRIATENESS MEMO Customer Name : _______________ Date : _______________ Products : _______________ i) Why is the customer doing these transactions? How do the transactions fit the customer's business?

ii) What is the company's general view toward derivatives and how does the company use them? Do we understand the objectives of the customer with respect to derivatives? What are they?

iii) Does the client have formal/ informal derivatives policies? What are they? iv) Does the counterparty have the legal authority to enter into derivatives transactions? Is the company allowed to use derivatives under the terms of its constituent documents? Is there any limitation on specific types of derivatives, or caveats over capacity (e.g. "only if hedging")?

v) How has the client used derivatives in the past and in what new areas are they applying derivatives? Are recent derivatives transactions consistent with the past; if not, why? vi) How sophisticated is the company? Do they have their own pricing models? Do they build their own spreadsheets? Do they have access to market data (e.g. Reuters, Telerate, Bloomberg)? vii) Is the bank appointed as an advisor to the company?

viii) At what level are derivatives approved at the company? How active is senior management in decision making and/ or monitoring derivatives activity? ix) Is there evidence of "doubling up" or similar activity to erase earlier losses? Treasury Marketing Officer Approver 1 Approver 2

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FIMMDA Code of Conduct for Derivatives Transactions

ANNEXURE 2: PRODUCT / CLIENT CLASSIFICATION The types of products should at a minimum be classified into two categories. Category, A, which includes most of the simple derivatives, like IRS, currency swaps, simple options etc. or their combinations. It is expected that generic, non-leveraged, non-complex transactions with low or predictable market risk will be categorized as Category A. In general, if a product is widely traded and understood by the market as a whole (as opposed to a specific segment of the market) it is expected that it would be categorized as Category A. Additionally this category may include structured transactions that are a combination of transactions where the economic result is a Category A-like exposure although some parts of the transaction may be more complex when viewed in isolation. Non-generic, leveraged, and/or complex transactions, which may have high, unpredictable or asymmetric market risk, should be categorized as Category B. This category may include, by way of example, transactions with non-linear payouts or terminations, transactions with multipliers or exponents, transactions where the payout formula is particularly complex etc. Category B transactions shown, on the basis of market developments, to have become capable of being treated as Category A transactions can be transferred to Category A with the consultation of the relevant Approval Group within the bank. Similarly, counterparties may also be classified into at least two categories. Category 1 could the counterparties, which are sophisticated and understand all sorts of derivatives very well and have been known to use them extensively. Category 2 would be the other counterparties who are relatively less sophisticated, may not have had too much experience in the use of derivatives etc. Category A products would then be suitable for all categories of customers while category B products would only be suitable for Category 1 customers directly and in certain situations, subject to other approvals internally in the bank to category 2 customers. There may also be different level of risk disclosures required for the different categories of products and customers and can be specified by the banks internally.