Swaps cause concern: Bank will tighten supervision of financial derivative markets

THE BANK of England is tightening its supervision of financial derivative markets after conducting a survey of the potential risks.

The explosive growth of derivatives - futures, options, and especially swaps and other exotic contracts traded off regulated exchanges - has sparked special concern among regulators in the past 18 months. By 1991, the business had mushroomed to a notional principal of nearly dollars 8,000bn ( pounds 5,228bn) from dollars 1,000bn in 1986, according to the Bank for International Settlements.

The instruments are used by companies to manage risk. But the sheer size of the market has worried central bankers about the possibility of the world's inter-linked financial markets falling like dominoes if a big derivatives player suddenly defaulted on its obligations.

The Bank's survey of 19 British institutions conducted last November found no inexperience or malpractice in derivatives significant enough to pose a threat to the financial system. But the study revealed the market's deep complexity and will result in stricter Bank of England policing of firms' derivatives activities.

An internal report said: 'The interviews did clearly bring out the immense complexity of managing derivatives portfolios, making this an area where close involvement of the supervisers is merited'. The report is now circulating among regulators and City practitioners for more views.

As a result of the study's findings, the Bank will monitor more closely institutions' ability to control their derivatives portfolios. This means it will require them to give more information on such business in routine reports to the Bank of England, and will investigate further if not satisfied.

In future, at least two board members of a bank actively using derivatives, including the finance director, will be required to know and understand its overall risk position.

Banks will have to have contingency plans to replace the derivative experts they employ. Sudden resignations and the loss of highly specialist knowledge can leave a gap in expertise that may jeopardise the firm.

One special area of worry for the Bank, which it is determined to act on, concerns large, unregulated institutions including subsidiaries of US insurance companies or securities companies. These fall through its supervisory net and could disrupt the markets if they failed.

The Bank will also conduct further research on financial system risk from derivatives and is considering establishing a regular derivatives survey similar to one measuring foreign exchange activity. It will encourage banks to move to a uniform system of measuring derivatives credit exposure, and backs new, more transparent accounting rules for derivatives business.

While regulators have been afraid that derivative instruments have developed too rapidly without proper supervision, the report found that: 'Technical product innovation of a fundamental nature is currently more limited than in much of the 1980s.'

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