The internal control imperative of the Sarbanes-Oxley
act is affecting FX risk managers’ agenda this quarter,
including an often-exhaustive process of review/rewrite
of FX policies and controls and documentation of check
points.
Against this backdrop, news from the National
Australia Bank (NAB) last wek, of a widening
unauthorized FX options-trading scandal are cause for
concern on two levels:
(1) "Debunking” the bank myth? Banks
are supposed to have better-than-corporate FX trading
and controls. Indeed, FX managers have attempted to
mimic the “bank trading” environment to help put control
parameters around more active FX and other hedge
programs.
Banks’ progress toward risk integration and
aggregation (mandated in part by regulatory
requirements) has been a model for pioneers of corporate
enterprise-risk management; and system vendors that had
been catering to banks are considered among the most
sophisticated in the corporate space.
While the reports from NAB do not invalidate these,
they certainly provides insight into what and how things
can go wrong.
That NAB’s systems failed to detect and stop the
abuse—even if collusion by four traders was at hand—is
worrisome. The most recent reports say that the losses
may have exceeded A$600 million.
That the
VaR figures disclosed by the bank in its annual
report did not even come close to this figure (NAB has
reported an average daily VaR of $7 million on its FX
positions) is equally disturbing. That’s even more so,
given the trend by treasuries to adapt VaR for exposure
identification and risk-control.
“This highlights an important component of risk
analysis which is often overlooked: scenario analysis,”
notes one Wall Street FX advisor. “The rationale behind
scenario analysis is a recognition of the limitations of
VaR analysis, particularly under conditions of financial
crisis—’the four sigma move.'"
(2) More options, more
risk? The other immediate concern is that
options trading is increasingly not just a financial
institution activity. Recent BIS data has confirmed that
the trading of FX options by nonfinancial endusers has
risen dramatically. With more nonfinancial MNCs hedging
with options, the chance for misuse, intentional or not,
is also increasing.
(1) The first takeaway is that
even the best systems may not withstand a concerted
effort to defraud.
(2) The second is that having “a system” does no
guarantee compliance. In this regard, the workflow
control and documentation mandated by SOX may help
surface procedural loopholes.
(3) Finally, it’s important to understand the market.
Unlike spot transactions, FX options pricing is less
transparent (particularly if they are not
plain-vanilla). Hence, it’s critical that MNC
treasuries, which choose to use options, also have
the in-house capability to accurately price them.
Most likely, the biggest beneficiaries will be system
vendors (perhaps with the exception of NAB’s own.
On the backoffice side, several have already adopted
the SOX control mandate as their own. On the front
end, scandals like NAB’s highlight the importance
of advanced pricing/analytics functionalities
The good news for US MNCs is that they may be less
susceptible to similar control breakdowns, since US GAAP
have more rigorously (and earlier on) enforced a
mark-to-market approach to derivatives trading. (For
non-US firms, what’s been off the balance sheet may have
also been out of (over)sight.)
A recent press release from
SuperDerivatives.com (an options-pricing software
vendor) makes an interesting point: The FX loss at NAB
may have been flushed out by the adoption of new
accounting rules, which require mark-to-market values
for derivatives.
“Access to market prices has become a key issue with
the introduction of International Accounting Standards
Board (IAS) 39,” says the vendor.
“It was inevitable that once companies implemented
IAS 39 (which will be mandatory for European and
Australian listed companies from 2005) some revaluation
discrepancies would occur and that losses would “get
flushed out.”
