According to the Bank for International Settlements (BIS), the total notional amount of over-the-counter (OTC) derivatives contracts outstanding as at end-June 2009 was US$ 530 trillion.

Considering the values invested in these investment instruments, it is not surprising that one of the key challenges for the financial services industry is how valuations of OTC traded derivatives positions can be undertaken in a transparent and consistent fashion - particularly in view of the current regulatory frameworks that differ from market to market.

How are they traded?
Derivative contracts are either traded via specialised derivatives exchanges or other exchanges, or directly between two parties without using an exchange or another intermediary. There are three major classes of derivatives:

• Futures/forwards are contracts to buy or sell an asset on or before a future date, at a price specified today. A futures contract differs from a forward contract in that it is a standardised contract written by a clearing house that operates an exchange where the contract can be bought and sold. A forward contract is a non-standardised contract written by the parties themselves.
• Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. If the owner of the contract exercises this right, the counterparty has the obligation to carry out the transaction.
• Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.

Best practice
Under the sponsorship of the International Securities Services Association (ISSA), a working party has developed the best practice recommendation as follows:

• Primary valuation: the price should be either independently calculated by a third party, or calculated by an independent unit of the investment manager.
• Verification of valuation: this should be performed weekly by comparing the primary valuation versus either a third party independently calculated price or the price calculated by an independent unit of the investment manager (depending on which one is used for the primary valuation).
• Additional verification of valuation: this should be performed on a monthly basis using the counterparty price versus the primary valuation.

Regulatory framework
The regulatory framework in key pan-European markets, such as France, Germany, Ireland, Luxembourg and the UK, differs greatly. While the counterparty is the obvious primary valuation source, regulators are less clear on the suitable alternative, which is typically based on internal pricing models. The verification frequency also ranges from ‘adequate’ and ‘regular’ to ‘weekly’ or ‘monthly’. The best practice established by ISSA aims to be sufficiently generic to accommodate reasonable changes in regulations.

For more information, please visit www.issanet.org

Do you have a question on anything from tax to virtual trading? Email richard.mitchell@cisi.org and we will answer it next month