May 23 – Slides - Energy Trading Compliance Blog

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DRAFTING AND
IMPLEMENTING TRADING
POLICIES AND PROCEDURES
IN THE DODD-FRANK ERA
MAY 23, 2011
Miki Kolobara, Esq.
The Dodd-Frank Act
2
The Dodd-Frank Act injects an unprecedented
amount of uncertainty into the energy trading arena
due to:
 The misunderstood role of derivatives in the 2008
financial meltdown;
 The overambitious scope of the statute;
 The lack of detailed guidance; and
 The inconsistency between the substance of the
statute and the stated intent.
2011 © Miki Kolobara, Esq.
The Dodd-Frank Act
3
The Dodd-Frank Act is the first federal statute that
requires market participants to have a derivatives
risk management program.
It will create an unreasonable financial and
operational burden for companies that had nothing
to do with the 2008 financial crisis.
2011 © Miki Kolobara, Esq.
Trading Policies and Procedures
4
Trading/risk management policies and procedures are
generally established to govern the scope of
commodity trading and risk management activities for
energy market participants.
2011 © Miki Kolobara, Esq.
Trading Policies and Procedures
5
Trading policies and procedures should define and
specify the controls and management responsibility
associated with trading and risk management, and
provide a framework in which management can
maintain a portfolio of transactions within predefined
risk parameters.
2011 © Miki Kolobara, Esq.
Trading Policies and Procedures
6
In order to adequately identify, quantify and manage
the relevant Dodd-Frank Act risks, energy market
participants will have review and evaluate the trading
and/or risk management policies and procedures.
2011 © Miki Kolobara, Esq.
Key Elements to Include in Trading
Policies and Procedures
7
A clear directive from the governing body
(Board/Audit Committee/Risk Oversight Committee)
approving the trading and exposure management
activities, as well as the establishment of
management’s accountability with respect to the
compliance of trading and risk management activities.
2011 © Miki Kolobara, Esq.
Key Elements to Include in Trading
Policies and Procedures
8
Clear segregation of duties on the trade floor
including up-front deal flow analysis, independent
monitoring (including independent valuations, price
curves, models, and stress testing), and effective
reporting.
2011 © Miki Kolobara, Esq.
Key Elements to Include in Trading
Policies and Procedures
9
A clearly defined appetite for risk, from a corporate
viewpoint, including the exposure and position limits,
stop loss limits, approved trading strategies and
products, as well as approved markets (“trading
around assets” is not a recognized trading strategy
for the purpose of risk management or compliance).
2011 © Miki Kolobara, Esq.
Key Elements to Include in Trading
Policies and Procedures
10
A clearly outlined sequence of events for entering into
trades (including any prior review and approval by
various groups – credit, risk, tax, legal), verifying and
confirming the trades, and following up with any
further steps (such as option exercise notifications, and
calculation period resets for rate swaps).
2011 © Miki Kolobara, Esq.
Key Elements to Include in Trading
Policies and Procedures
11
Sufficient documentation should be maintained for
every swap to ensure consistent and adequate legal
and contractual protections across portfolio(s),
including the pre-execution and post-execution phase.
2011 © Miki Kolobara, Esq.
Key Elements to Include in Trading
Policies and Procedures
12
Mandatory training requirements for all trading
personnel to ensure that the most current and
appropriate regulatory requirements are timely
communicated to everyone involved in the trading/risk
management activities.
2011 © Miki Kolobara, Esq.
Key Elements to Include in Trading
Policies and Procedures
13
Strong emphasis on creating and maintaining a culture
of compliance, both internally and externally,
including, but not limited to: anti-manipulation rules
and prohibited trading strategies, price reporting
rules, exchange position limit rules, large trader
reporting requirements, and the bona fide hedge
definition.
2011 © Miki Kolobara, Esq.
Key Elements to Include in Trading
Policies and Procedures
14
Continuous and consistent enforcement, including
appropriate sanctions for violating policies and
procedures.
2011 © Miki Kolobara, Esq.
Authorized Trading Practices
15
A policy should list all authorized trading practices
and a brief explanation of every such authorized
practice.
Clarity required to define hedging.
2011 © Miki Kolobara, Esq.
Risk Management
16
A policy should have a clear statement that
management and employees involved in trading or
risk management activities at all levels of the
company have a responsibility to understand the
objectives of the risk management program, and
enforce those policies.
2011 © Miki Kolobara, Esq.
Risk Management
17
A policy should also emphasize a strong dependence
on the risk management reporting systems utilized by
the company, which will effectively monitor, control
and report the risk positions within agreed-upon limits.
2011 © Miki Kolobara, Esq.
Risk Management
18
A risk management department must have clear,
organizational segregation from the trading group to
ensure independent and non-transactionally motivated
control functions.
2011 © Miki Kolobara, Esq.
Risk Management
19
The risk management department should be
management's conduit to the risk profile of the
company through a reporting schedule defined in the
risk management policies and procedures.
2011 © Miki Kolobara, Esq.
Risk Management
20
Valuation models and analysis of all commodity/swap
related transactions must be performed according to
models, systems, and prices provided by the middle
office, and should be independent of the trading
function.
2011 © Miki Kolobara, Esq.
New Product Approval
21
A policy should clearly set out a sequence of events
for any new product approval to ensure that the
exposures associated with it are thoroughly reviewed
and understood by those approving new products.
2011 © Miki Kolobara, Esq.
Executing Trades
22
A policy should clearly outline a sequence of events to
be followed for every swap transaction, in order to
ensure that all transactions are analyzed BEFORE
they are executed.
2011 © Miki Kolobara, Esq.
Vetting the Trades
23
It should be a violation of policy for any employee to
trade swaps without ensuring that the transactions can
be appropriately captured, valued and reported.
2011 © Miki Kolobara, Esq.
Vetting the Trades
24
All swap transactions executed by traders should fall
within a company’s approved trading strategy.
2011 © Miki Kolobara, Esq.
Compliance
25
Each swap transaction should fall within a specific
trader’s approved limits, adhere to a prescribed deal
approval process, transacted using approved
instruments, and comply with all applicable laws and
regulations governing commodities trading.
2011 © Miki Kolobara, Esq.
Compliance
26
A policy should state that all traders must understand,
abide by, and stay current with all applicable rules of
the market(s) in which they trade, including applicable
exchange rules, tariffs, products being traded,
protocols and manuals.
2011 © Miki Kolobara, Esq.
Compliance
27
All traders should be required to execute an affidavit
stating that they have read, understood, and complied
with all the market rules and regulations for all
markets and products they trade.
2011 © Miki Kolobara, Esq.
Credit Risk Management
28
A policy should provide for a credit risk management
function with clear independence and authority, and
with analytical capabilities and responsibilities to:
approve credit exposure measurement standards, set
credit limits and monitor their use, and review and
monitor concentration of credit risk and risk reduction
arrangements.
2011 © Miki Kolobara, Esq.
Trading Documentation
29
To ensure an appropriate level of control, a policy
should outline the proper documentation to be used,
depending on the type of transaction or product.
 Master Agreements
 Long-Form Confirmations
 Master Netting Agreements
2011 © Miki Kolobara, Esq.
Procedures
30
A procedures manual should cover such issues as
transaction initiation, deal input, trade verifications
and confirmations, margin demands, default notices,
record retention requirements, telephone recordings,
policy exceptions, disciplinary actions, and an invoice
settlement process.
2011 © Miki Kolobara, Esq.
Ongoing Review
31
A trading or risk management policy (along with
associated procedures) should be effectively and
proactively administered as a 'living document' to in
order to minimize legal and financial exposure to the
enterprise, and to ensure that the policy properly
reflects and encompasses the most current industry
practices and standards, and the underlying rules and
regulations governing commodity and derivatives
trading and related activities.
2011 © Miki Kolobara, Esq.
Final Thoughts
32
“…[Dodd-Frank Act] increase[s] the cost of OTC
transactions in the hope that participants would
shift them to exchanges or clearing houses.”
“Historical evidence suggests that higher capital
requirements cause [those faced with such
requirements] to shift toward riskier
investments…to compensate for the higher costs
imposed by those requirements.”
Congressional Budget Office (Dec 2010)
2011 © Miki Kolobara, Esq.
Disclaimer
33
This presentation and materials herein are for
informational and educational purposes only and
must not be used or construed as legal advice for
any particular transaction, trading strategy, or
product.
The views expressed herein are solely those of Miki
Kolobara and not those of any of his employers,
clients, trade or professional associations.
2011 © Miki Kolobara, Esq.
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