Derivatives Policy, Controls and Compliance
Core concepts
A robust derivatives program rests on a board-approved policy covering objectives, authorized instruments, limits, and prohibited activities. Key controls include segregation of duties (front, middle, and back office), independent valuation, limit monitoring, counterparty approval, and reconciliation. Compliance requires adherence to regulatory reporting (e.g., trade reporting, clearing mandates), documentation standards (ISDA master agreements, confirmations), and recordkeeping.
Governance
Understand the roles of the board (policy approval, risk appetite), senior management (implementation), risk management (independent oversight, limits), internal audit (independent testing), and compliance (regulatory adherence). A strong program includes pre-trade approval, daily mark-to-market, stress testing, and exception reporting.
Traps in questions
- Assuming the front office can value its own positions-independent valuation is required.
- Confusing policy (what is permitted) with procedure (how it's done).
- Missing that segregation of duties separates trading, risk, and settlement.
- Overlooking regulatory reporting and clearing obligations.
Rule of thumb
The three lines of defense: (1) business units own risk, (2) risk/compliance provide independent oversight, (3) internal audit provides independent assurance. If a control question asks "who should do X," assign it to the appropriate line-not to the trader.
Worked example
A trader exceeds a notional limit. Correct response: the limit-monitoring function flags the exception, escalates to risk management, and the trade is reviewed/closed per policy-not self-reported and self-approved by the trader.