Derivatives been around for several years, but in 1994 they burst into the headlines with unwelcome frequency. Spectacular investment losses by Proctor and Gamble Co. and Orange County have got Congress and the press thinking about another S&L Crisis and a looming financial meltdown, and the SEC, GAO, FASB, and others are struggling to keep up with the complex and fast-growing market. By all accounts, the market is huge: the "notional amount" of all contracts is at least $17 trillion, according to the GAO.
Definitions are easy: a derivative is a financial instrument that is not a security, but rather a contract, whose value is derived from an underlying security, reference rate, or index. Examples include repurchase agreements, interest rate swaps, puts, calls, coupon strips, options, forward contracts," swaptions", caps, floors, collars, and most of the "alphabet-soup" investments of recent days (CATS, STRIPS, etc). Their complexity can be overwhelming, because more than 600 types of derivatives exist so far.
Despite the headlines the SEC and other powers, so far, have resisted the urge to clamp down on the market, because they are reluctant to discourage the legitimate use of derivatives to manage risk. But some kind of increased regulation is inevitable.
In May, 1994, GAO recommended federal regulation of all major U.S. derivatives dealers, and increased requirements for internal control oversight by knowledgeable audit committees of both the dealers and their SEC-registrant customers, and increased external reporting all around. In October, FASB issued Statement No. 119, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments, which is effective for calendar year 1994 entities. (Entities with less than $150 million in assets must comply by 1995). Statement No. 119 will require increased disclosures about the amount, nature, and terms, and the objectives for holding derivatives.
Clearly, derivatives can represent an extraordinarily risky investment. Emphasizing that the responsibility for managing that risk starts and ends at the top, the AICPA recently publicized six common-sense questions for boards of directors to ask about their organization's activities in derivative financial instruments. Trustees of ERISA funds, we believe, should be keenly interested in answering these questions , because the trustees can bear the risk of imprudent investment policies personally.
Don't Buy It If You Don't Understand It
We recommend that ERISA fund trustees protect themselves with understanding and oversight. Don't allow your fund to invest in something you don't understand. Challenge the purpose of unusually complex investments. Develop formal, written guidelines for your investment managers, indicating what types of investments will be permitted. If you authorize derivative activities, limit the types and amounts involved, require extra oversight and approval by the board and require continued monitoring. Assign responsibility for compliance: have the investment managers acknowledge, in writing, that they are responsible for complying with your guidelines. Require that they report periodically on their compliance. Request that your bank custodian identify any derivatives in the portfolio, and report them separately from investment securities. Ask your bank to separately identify all investments for which a market value is not readily available, and all investments that are not readily marketable, because derivatives will generally fall into these categories. Review your fund's internal controls to ensure that they are responsive to the investments they must address. Ask the yourself AICPA's six questions (listed below) , and make sure you are satisfied with the answers.
We don't like to see an ERISA fund invested in derivatives because they increase the fund's exposure to loss. We frequently find that the investment advisors who buy these instruments can not explain the investments they are buying and, when we question them, they refer us "up the ladder" until we find someone in their research departments who understand the workings of the transaction. We think the guy who sold it to you should be able to explain it, and we get uncomfortable when he can't. In addition, ERISA funds report investments at market value, but valuation of derivatives can be difficult. We have had advisors report a derivative's market value to us with the disclaimer, "but don't ask me to find a buyer at that price". That tells us the market value might be uncertain, but it also points to greater market risk if the investment is illiquid. As a result, we are firm believers in "K.I.S.S.", or keep it simple... , and derivatives are anything but simple.
Derivatives: The AICPA's 6 Questions for Directors:
1. Has the board established a clear and internally consistent risk management policy, including risk limits (as appropriate)?
2. Are management's strategies consistent with the board's authorization?
3. Do key controls exist to ensure that only authorized transactions take place, and that unauthorized transactions are quickly detected and appropriate action is taken?
4. Are the magnitude, complexity and risks of the entity's derivatives commensurate with the entity's objectives?
5. Are personnel with authority to engage in and monitor derivative transactions well qualified and appropriately trained?
6. Do the right people have the right information to make decisions?
