Bank to tighten derivatives trade

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Economics Correspondent

The Bank of England will shortly be asking banks to report additional information on their trade in derivatives to strengthen its supervision of the controversial financial products.

Following the Barings report, a senior director of every City bank will have to sign all supervisory returns to the Bank and approve the theoretical models their traders use in assessing the risk of derivatives.

Banks make widely different assessments of the risks involved in a particular type of derivative, over-the-counter options, according to an article in the Bank's forthcoming Quarterly Bulletin.

They therefore charge a wide range of prices for such trades, which have been the culprit in losses made by several international groups including Procter & Gamble, Metalgesell- schaft and Gibsons Greetings.

Reporting the results of a survey of banks involved in this trade earlier this year, the authors say the banks were aware of the uncertainty involved in assessing the risk of OTC options, "but it is an issue which the Bank, as a supervisor, will need to continue to monitor".

An OTC option is a contract tailor-made for the customer, offering the right to buy or sell an underlying asset at a pre-set price on or before a certain date. Companies can use options to hedge the risk involved in other transactions, but when the strategy goes wrong the losses can be limitless.

As there is no readily available information about how the risk of OTC options is assessed, the Bank of England asked 35 banks in London about their practices. "It is important for the Bank of England to know how the banks that it is supervising price and manage these products, since for many they are a significant and growing part of their business," the Bulletin article says.

The survey allowed it to pick out the banks that were pricing their OTC options very differently from their competitors, and give them closer scrutiny. The article says: "On the supervisory side, the survey was useful in identifying several banks that were pricing products very differently from the rest of the market."

Banks trading in derivatives will be required to provide additional information about their activities to comply with the EU's capital adequacy directive, which comes into force on 1 January. Banks will have to allocate capital according to risk and will be forced to report their trading books in detail.

They will also be compelled to use methods for measuring derivatives risks and pricing the contracts that are approved by the Bank of England.

The new requirements will be costly, but banks recognise that they have little choice but to comply.