The proposed regulation required a registrant’s risk management program to include certain enumerated elements: identification of risks and risk tolerance limits;
periodic risk exposure reports; a new product policy; policies and procedures to monitor and manage market risk, credit risk, liquidity risk, foreign currency risk, legal risk, and operational risk; use of central counterparties; compliance with margin and capital requirements; monitoring of compliance with risk management program; and approval of trading policies and monitoring of traders.
In response to comments received, the Commission is modifying the rule in several respects as discussed specifically below. The Commission believes that each of these changes will reduce the compliance burden on SDs and MSPs. More generally, the
Commission believes the rules allow registrants to manage their costs by relying upon existing compliance or risk management capabilities to a large extent.94 In this respect, the rules generally only require “policies and procedures” to monitor and manage the enumerated risks, but do not prescribe the content of such policies and procedures or require any specific control systems.
Risk Tolerance Limits: With respect to risk tolerance limit exceptions, the Commission agrees with commenters95 that requiring approval by risk management personnel would be more costly without materially enhancing benefits than allowing SDs and MSPs the flexibility to structure their approval process in accordance with written policies and procedures. Accordingly, the Commission has modified the rule to reflect this approach.
New Product Policy Requirement: Concerning the new product policy
requirement, the Commission notes that the rule was adapted from existing regulatory guidance in this area,96 and thus believes some SDs and MSPs already have such a policy in place; for them, the requirement would not impose any new burden. The Commission rejects the more limited alternative approach recommended by the Working Group—i.e., that before offering a new product an SD or MSP need only conduct due diligence that is
94 Comments of The Working Group, SIFMA, EEI, and MetLife, each of whom suggested that proposed
§ 23.600 be flexible enough to allow firms to adapt their existing compliance and risk management measures, and not cause firms to add entirely new compliance or risk management infrastructure.
95 With respect to exceptions to risk tolerance limits, SIFMA recommended that trading supervisors, rather than risk management personnel, should have the authority to approve risk tolerance limit exceptions because the quarterly risk exposure reports provided to a registrant’s senior management and governing body are an adequate check on decision-making by trading supervisors. Presumably, SIFMA believes trading supervisor approval presents less costs than risk management unit approval.
96 See OCC’s Comptroller’s Handbook, Risk Management of Financial Derivatives at 7 (Jan. 1997);
Federal Reserve Board’s Trading and Capital-Markets Activities Manual.
commensurate with the risks associated with a new product, and receive approval from appropriate risk management and business unit personnel within the firm. While The Working Group’s recommended approach may be less costly for some unspecified number of registrants that to date have not implemented a new product policy in line with the proposed rule and existing regulatory guidance, the Commission believes that the benefits to SDs, MSPs, and financial markets of greater scrutiny for new products, which may entail degrees of risk that are not initially evident, are sufficient to adopt the rule substantially as proposed. However, the Commission believes that SIFMA’s
recommended alternative—allowing approval of new products on a contingent or preliminary limited-time basis at a non-material risk level for the registrant to gain product experience and develop appropriate risk management processes for the product—
better addresses the unforeseen risk potential. Accordingly, the Commission considers SIFMA’s proposed alternative preferable on cost/benefit grounds to the rule as proposed and has modified the rule in line with it.
Reconciliation of Profits and Losses to the General Ledger: The Commission has responded to commenters that objected to the burden of daily reconciliation by modifying the rule to require periodic, rather than daily, reconciliation. The Commission believes this modification, increases the flexibility available to registrants to design cost-effective procedures best suited to their own circumstances.
Assessing Liquidity of Non-Cash Collateral: With respect to assessing liquidity of non-cash collateral, the Commission agrees with commenters that testing by simulated
disposition presented an unnecessary cost to SDs and MSPs97 and has adjusted the final rule to provide flexibility for registrants to design procedures to fit their own
circumstances.
Foreign Currency Risk: With respect to foreign currency risk, rather than mandating daily measurement, The Working Group recommended relaxing the rule to allow firms discretion with respect to how frequently capital exposed to fluctuations in the value of foreign currency needs to be measured. The Commission is rejecting The Working Group’s recommendation because daily measurement is necessary for effective prudent risk management because the foreign currency markets are fluid, quick moving, and potentially volatile. Given the wide availability of foreign currency pricing
information at a low cost, the Commission does not believe that the cost of daily measurement is unduly burdensome in light of the benefit of consistent management of foreign currency risk.
Monitoring of Trading Requirements: Concerning the monitoring of trading requirements, the Commission agrees with commenters that the proposed rule’s
requirement that traders be monitored to prevent the incurrence of “undue risk” is vague and thus potentially burdensome to implement. To add clarity, the Commission is revising the rule to require monitoring of trading to prevent the incurrence of
“unauthorized risk.”98
97 SIFMA recommended that the Commission not require testing of liquidation procedures by simulated disposition, but only require policies and procedures for identifying acceptable collateral and establishing appropriate haircuts, taking into account reasonably anticipatable adverse price movements, arguing that simulated disposition could be costly during periods of market stress.
98 The Working Group and SIFMA requested that the Commission remove the requirement that firms monitor traders to prevent traders from “incurring undue risk” because the meaning of the phrase is ambiguous and presumably more costly to monitor under such standard.
The Commission also agrees with The Working Group’s recommendation that the proposed rule be modified to add a materiality standard for reporting of trade
discrepancies to management. Accordingly, the Commission is modifying the rule to require that only trade discrepancies that are not immaterial, clerical errors be brought to the immediate attention of management of the business trading unit.
Use of Brokers: The Commission agrees with commenters recommending against tasking the risk management unit with reviewing brokers’ statements, monitoring
commissions or initiating broker payments; allowing these functions to be handled by operations or other control units, and presumably lowering the cost of compliance. The Commission has narrowed the rule to require risk management units to periodically audit brokers’ statements and payments only. The Commission believes that this modification retains the benefits of the rule (independent oversight of the use of brokers), while lowering the cost of compliance by not requiring modifications to current operations.