The Group recommends that multilateral netting by novation for derivatives market may be operationalised by CCIL with well-defined procedures of management of credit and liquidity risks that specify the responsibilities of each of the participants with CCIL. Detailed guidelines would have to be issued in regard to netting by novation through CCIL.

The Group recommends that the OTC derivatives contracts should be governed by an approved ISDA Master agreement executed between two Indian counterparties who would be free to choose the governing law to be Indian Law or otherwise. The terms of each transaction should be recorded in a written confirmation. The Group also felt that the stress should be placed upon timely exchange of deal confirmations.

The Group recommends that market-makers desirous of transacting in derivatives should obtain requisite permissions from their management (Board/Risk Management Committee) specifying various issues including the nature of risks it wishes to take upon its books including:

• Nature of Products

• Various risks involved

• Methodology adopted for estimation of such risks

• Appropriate risk limits

• Pricing methodology

• Hedging mechanism

• Adequacy of Procedures at front, middle and back offices with regard to documentation, dealing, confirmation and settlement

• Stop losses etc. for open positions

The Group recommends that market-makers should put in place appropriate risk management systems and have inter alia the following on daily basis:

• MTM of the portfolio

• MTM of various Greeks

• Value at Risk

The Group recommends that market-makers could also be required to report to their Board/Risk Management Committees/ALCO at regular intervals about the activities undertaken on various products.

The Group recommends that before entering into an option contract, for the first time, with a corporate, the bank/FI/PD needs to explain to the counterparty the risks and benefits of entering into such transactions. Such communication should be a part of the documentation of the transaction(s).

The Group recommends that banks/FIs/PDs should ensure that the Board of Directors of the corporate has:

• Drawn up a risk management policy for the corporate.

• Laid down clear guidelines for concluding the transactions.

• Institutionalised arrangements for a quarterly review of operations and annual audit of transactions to verify compliance with the regulations.

• Put in place a board resolution authorising the corporate to enter into derivative transactions

• Named the authorised signatories who would be allowed to transact on behalf of the corporate.

The Group recommends that with a view to standardisation of confirmations of option contracts to the extent possible, FIMMDA may be requested to suggest the minimum requirements in respect of a confirmation for an option. FIMMDA may also be requested to suggest the documentation for the settlement of the premium and the documentation for exercise and settlement of the option, depending upon the products and the participants.

With a view to mitigating credit risk on very long tenor exposures, the Group recommends the use of collateral that may be based on the MTM values of counterparty contracts compared with the threshold limit on exposure that each counterparty may choose to have on the other.

The Group recommends that participants may adopt suitable norms for accounting of interest rate options after the approval of their respective Boards keeping in view the following principles:

• In case the option contract has been entered into for the purpose of hedge, the premium paid/received on such option contract shall be apportioned over the period of the option, i.e., from the date of entering into the contract to the date of expiration of the option.

• In case the option contract has been entered into for other than hedge then:

  1. the premium paid/received should be immediately accounted for;

  2. the option should be marked to market on a periodical basis and the resultant gain/loss should be booked in the profit and loss account

• On exercise of an option the amount receivable/payable under the option will be apportioned over the period for which the amount is so receivable/payable.

• In case an option contract has been terminated/cancelled, the resultant gain/loss will be accounted for immediately irrespective of whether the transaction was entered into for hedge or otherwise.

With a view to adopting international best practices in accounting for derivatives, the Group recommends that ICAI may be approached to lay down detailed accounting and disclosure guidelines for derivative transactions in line with the principles put forth under FAS 133 and IAS 39.

The Group recommends that the credit conversion factors on the purchased options, based on original maturity or the current exposure method, as laid down by the RBI vide its circular DBOD.BP.BC.48/21.03.054/2002-2003 dated December 13, 2002 may be used to compute capital adequacy.The taxes applicable in respect of an option contract will be the income tax and the stamp duty. Since the chargeability of tax would depend on the facts and circumstances of each case and the nature of transaction between hedge and speculation, the Group recommends that the market participants take the opinion of tax experts on the same.

The Group recommends that derivative dealers can choose the pricing and valuation model for interest rate options according to their opinion on the suitability of the models.

The Group recommends that FIMMDA should publish the prices to be used by the banks/PDs/FIs for the valuation after polling sufficient number of market participants who are quoting the prices. Moreover, it should also publish the volatilities using a suitable model. Banks are free to use the volatilities or the prices as per their requirement. The broad policies regarding calibration of model parameters and other features like stress-testing and back-testing should follow the internationally accepted best practices as laid down by BIS.

RBI, after taking into account the Core Principles for Effective Banking Supervision of the BCBS as well as its Consultative Paper on the New Capital Adequacy Framework issued in January 2001, has prepared a comprehensive Guidance Note on Market Risk Management in October 2002 for facilitating introduction of best practices for management of liquidity risk and market risk for banking organisations in India. In this context, while appreciating the fact that the basic risks associated with derivatives transactions are not new to any banking organisation, the Group recommends that there is a need to underscore separately the risks arising out of the use of OTC instruments.

Though RBI has recently issued a circular vide DBOD.BP.BC.48/21.03.054/ 2002-2003 dated December 13, 2002 after taking into account relevant BIS principles, more sophisticated and large derivatives users may assess potential future credit risk through probability analysis for estimating the volatility of underlying variables and its expected impact on the future contract value over time. The Group recommends that under both "add-ons" and probability based approaches, the Board and the management should periodically check the validity of the underlying assumptions to ensure that exposure is consistent with the organisation's risk management policy.

Master netting agreements and various credit enhancements, e.g., collaterals, third-party guarantees, etc. require legal enforceability of netting agreements. The Group recommends that parameters such as the quality and marketability of collaterals, continuous marking to market, margin calls, custodial risk, etc. should be kept in view while managing collateral.

The Group felt that concentration of credit risk in respect of significant counterparty OTC credit exposures as also on a particular underlying of instruments are other critical areas for proper evaluation of an orgnisation's potential credit risk. Credit limits, considering both current and potential credit exposures should be established for counterparties with whom the organisation may conduct business. The Group recommends that such credit limits should be determined by persons not handling derivatives activities and those limits should be consistent with organisation's overall policies and consolidated exposures. In this connection, the Board as well as the regulator could identify the ten largest counterparties to which an organisation is exposed to subject to some minimum threshold level which has to be decided for this purpose.

The Group recommends that the institutions should determine which “greeks” are necessary to measure the market risk of the market factors being transacted and should set internal limits for each of them. The institutions should revalue all trading portfolios and calculate its exposures daily. Institutions with significant trading activities should subject their portfolios on a regular basis to stress tests also using various assumptions and scenarios.

The Group recommends that marking to market should be done on a daily basis. The Group felt that the decomposition of trading revenues (from cash and derivative instruments) according to broad risk classes without regard to the type of instrument that produced the trading income should be practised to capture the outcome of overall risk-taking by the organisation.

The Group recommends that supervisors should assess information on the valuation reserves that an institution has established for its derivatives activities and on any credit loss on derivative instruments that the institution has experienced during the period.

The Group recommends that, at a minimum, there should be guidelines and processes in place to ensure the enforceability of counterparty agreements.

The Group recommends that the Board of directors and senior management should ensure proper dedication of resources (financial and personnel) to support operations and systems development and maintenance. The Group recommends that the operations unit for derivatives activities, consistent with other trading and investment activities, should report to an independent unit and should be managed independently of the business unit.

The Group recommends that a common minimum information framework as provided in Annex VI.1 to VI.5 in this Report to be adopted for the Indian market as part of introducing best practices here.

The Group recommends that a sub-set of data-set, as provided in common minimum information framework, could be disclosed to public by all organisations dealing in derivatives activities to facilitate effective market discipline and sound and efficient functioning of financial markets.