Reference: Guideline for Federally Regulated Pension Plans
Subject: Derivatives Best Practices
The following guideline is being sent to all federally regulated pension plans.
The guideline outlines factors that the Superintendent of Financial Institutions expects federally regulated pension plans to consider when incorporating derivative instruments into their investment and risk management policies. Administrators should note that compliance with this guideline may not necessarily suffice to discharge their general duty to be prudent (i.e. meet standard of care). OSFI recognizes that administrators of pension plans may engage outside investment managers to manage investment portfolios on behalf of plans. We would ask that plan administrators share this guideline with their third party managers.
The guideline establishes the need for documented policies and procedures on the use of derivatives pertaining to investment strategy, internal control and management of market, credit, liquidity, settlement, legal and operation risks. It also requires that pension plan management satisfy itself that the plan has authorization for the funds to be invested in derivatives and that its counterparties have the legal authority to engage in derivatives transactions.
Neither derivatives nor the individual risks inherent in them are, by themselves, new. However, the growing complexity, diversity and volume of derivatives products, facilitated by rapid advances in technology and communications, poses increasing challenges to managing these risks. Administrators of pension plans that begin to make use of derivatives as limited end-users and that commence active position-taking must first have the appropriate policies and procedures in place as well as the capability to implement them. Administrators of pension plans that would like to utilize pension funds to actively take positions with derivatives are required to consult with OSFI Pension Benefits Officers to obtain best practices guideline for this activity. Pension plan management cannot utilize pension funds to act as dealers with derivative instruments. Compliance with this guideline will address these concerns.
This document may be obtained by contacting Caroline Ossa at (613) 990-7655 or by fax at (613) 952-8219.
Nicholas Le Pan
Deputy Superintendent
Policy
Index
Derivatives Best Practices
May 1997
This guideline outlines factors that the Superintendent of Financial Institutions expects administrators and management of federally regulated pension plans to consider when incorporating derivative instruments into their investment and risk management policies. Neither derivatives, nor the individual risks inherent in them are, by themselves, new. However, the growing complexity, diversity and volume of derivatives products, facilitated by rapid advances in technology and communications pose increasing challenges to managing these risks. Sound risk management policies are as important for derivatives as they are for their underlying financial instruments and should be incorporated into the written statement of investment policies and procedures of each pension plan and adapted to reflect the nature and scope of the derivatives activities the administrator uses on behalf of the pension plan and fund. This guideline applies to all federally-regulated pension plans, including any corporations in which they have a controlling interest. Administrators of pension plans that would like to utilize pension funds to actively take positions with derivatives are required to consult OSFI to obtain best practices guidelines for this activity. Pension plan managers are not permitted to utilize pension funds to act as financial market intermediaries or market makers; however, they may take proprietary positions in derivatives markets in anticipation of movements in markets.
The guideline outlines only minimum standards that an administrator must consider when derivative instruments are part of the investment profile of the pension plan and fund. Derivatives transactions must be prudent and in the best interest of the fund as well as its beneficiaries.
Definition
Derivatives are financial contracts whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as: interest rates, exchange rates, commodities, and equities. Derivatives include a wide assortment of financial contracts, including forwards, futures, swaps and options. While some derivatives instruments may have very complex structures, all of them can be divided into basic building blocks of options, forward contracts or some combination thereof.
Derivatives allow administrators and management of pension plans to identify, isolate and manage separately the market risks in financial instruments and commodities for the purpose of hedging and adjusting portfolio risks in respect of the pension plan and fund. The risks that are associated with derivatives include, for example, market risk (comprising currency, interest rate risk, equity price risk and commodity price risk), credit risk and liquidity risk.
The risks of derivatives are more directly related to the size and volatility of the cash flows they represent than they are to the size of the notional amounts on which the cash flows are based. In fact, the risks that are associated with derivatives, and the cash flows which are derived from them, are usually only a small portion of the notional amounts.
Documented Policies and Procedures
The primary components of a sound risk management process include policies and procedures that: clearly delineate lines of responsibility for managing risk, set in place adequate systems for measuring risk, create appropriately structured limits on risk taking, establish effective independent internal controls, and describe comprehensive and timely risk monitoring and reporting. These components are fundamental to both derivatives and non-derivative activities alike. The process of risk management for derivatives activities should therefore be integrated into the overall investment policy to the fullest extent possible using a conceptual framework common to the other investments and liabilities of the plan.
In addition, each type of derivative product in which a pension fund is to invest must be duly authorized by the constating plan documents and by the written statement of investment policies and procedures. The written statement of investment policies and procedures should document which individuals or units are authorized to buy or sell the product, and the use(s) to which the product will be put based on a market view consistent with the overall investment policy, i.e. prudent portfolio management.
As is the case with all risk-bearing activities, the risk exposures assumed for a pension plan in respect of derivatives activities should reflect the level of risk tolerance of the pension plan and fund taking into consideration the funding and solvency of the plan as well as the ability of the plan to meet its financial obligations.
Management Involvement
At least annually, plan management should review the adequacy of its written policies and procedures in light of the activities undertaken on behalf of a pension plan, market conditions, funds and funded status of the plan. Plan management must also ensure that derivative activities are allocated sufficient resources and staff to appropriately measure, report, manage and control risks.
Plan management should engage knowledgeable individuals or have units responsible for risk monitoring and control functions that are independent of the individuals or units that conduct the derivative activity and create or hedge the risk exposures. The responsibilities of such individuals include but are not limited to:
Where an administrator has hired an outside investment manager, the administrator has a duty to inspect and monitor the activities of the investment manager.
Administrator Involvement
The administrator should approve and annually review all significant policies pertaining to use of derivatives on behalf of the funds of the plan. As required in subsection 7.2(1) of the Pension Benefits Standards Regulations, 1985, at least once each plan year, the administrator shall review and confirm or amend the written statement of investment policies and procedures in respect of the plan's portfolio of investments and loans. The statement of investment policies and procedures sets out permitted categories of investments and loans and must specifically include derivatives if these are used by management behalf of the plan. In approving significant policies, the administrator should reflect:
The administrator should have, and ensure that investment managers have, a good understanding of the risk management policies for the plan, the derivative products in use and the risk exposure arising from those products. This can be achieved by conducting and encouraging discussions between the administrator and investment managers, as well as between investment managers and investment staff.
Inspection
The administrator should have an inspection policy that includes coverage of the plan's financial derivatives activities and ensures timely identification of internal control weaknesses and operating system deficiencies. Inspection coverage should be provided by competent professionals who are knowledgeable and experienced in derivatives matters.
The inspection function must be independent of the functions and controls it inspects. If a plan does not have a qualified internal inspection department, the administrator should engage the pension plan's auditors to perform the inspection function.
Market Risk
OSFI believes that the ability to accurately measure market risk against formal internal exposure limits in a timely fashion is a prerequisite for management control.
Market risk may be broadly categorized into four types: currency risk, interest rate risk, commodity price risk and equity price risk. Currency risk is the risk that the value of a derivative will fluctuate due to changes in exchange rates. Interest rate risk is the risk that the value of a derivative will fluctuate due to changes in market interest rates. Commodity and equity price risks are the risks that the market value of a derivative will fluctuate due to changes in the price of the commodity and equity respectively that underlie the derivative instrument.
The sophistication of the analytical approach to measuring risk should match the depth of involvement in the derivatives market and the complexity of the positions assumed for a pension plan or fund. For example, dynamic hedging of positions using options implies sophisticated and more frequent risk monitoring and control than would the use of simpler derivatives with more symmetrical payoffs (e.g. futures contracts).
The timeliness of information provided to plan management must be commensurate with the price volatility, time-horizon and turnover of the instruments and portfolios being measured.
Exposure Limits
Management should incorporate the plan's derivatives activities into the investment policy taking into account the combined market risk of all financial instruments. Policy limits approved by plan management should be consistent with the administrator's view of the maximum amount of the market value of the plan's funds that should be put at risk on an ongoing basis. The policy limits for market risk should also relate to the measures of risk used internally.
Measurement of Market Risk
The appropriateness and adequacy of the assumptions and parameters that underpin the technique for measuring market risk should be fully documented and reviewed at least annually against actual experience and updated market information.
At a minimum, risk measurement systems of end-users should evaluate the possible impact on the plan's funded status which may result from adverse changes in interest rates, exchange rates, and other relevant market conditions.
Limited End-users
A plan whose derivatives activities are limited in volume and confined to hedging risk or as an investment alternative as a limited end-user may need less sophisticated risk measurement systems than those required by an active position-taker.
Limited end-users who use derivatives with a symmetrical payoff profile to hedge investment portfolios can more easily incorporate these instruments into market risk measures that, for example, range from simple gap analysis to complex simulation models of interest rate risk.
Credit Risk
Credit risk management for derivatives activities should be incorporated into the prudent person approach for investing. Timely, meaningful reports should be prescribed and prepared in accordance with policy and procedure requirements.
A unified credit risk management function that is independent of individuals and units that execute derivatives transactions and create risk exposures should be established. The credit risk management function should have strong analytical capabilities in derivatives, and have clear authority and responsibilities that include:
Exposure Limits
Derivative credit lines should be approved using standards that are consistent with those used for other activities, and comply with the credit risk policies and consolidated exposure limits in respect of the plan. Transactions with a counterparty should not commence until a credit line has been authorized.
Plan management should ensure that credit authorizations are provided by personnel who are independent of personnel responsible for engaging in derivatives transactions.
It is important that the reputation and management sophistication of the counterparty be considered among other factors in assessing the counterparty's creditworthiness. The criteria that counterparties must meet should be explicitly outlined in the credit risk policy limits established for the plan.
Measurement of Credit Risk Exposure
Credit risk is the risk that a loss will be incurred if a counterparty defaults. Prior to settlement, the credit risk exposure of a derivative is measured as the sum of its replacement cost (or current exposure) and an estimate of the potential future exposure in respect of a plan. Replacement cost is the cost of replacing the remaining cash flows of a derivative at the prevailing prices and market interest rates. Potential future exposure is primarily a function of the time remaining to maturity and the expected volatility of the price, rate or index underlying the derivative.
The method used to measure counterparty credit risk exposure should be commensurate with the volume and level of complexity of the derivatives activity. Limited end-users may elect to use a less sophisticated method for measuring the potential future exposure (e.g., a percent of notional value times the number of remaining years to maturity) as long as other mitigating factors are in place. Examples of mitigating factors include restricting transactions to the highest quality counterparties or limiting contracts to mature, less volatile derivatives.
Plan management should receive reports that document credit risk exposure by counterparty. Such reports should include the credit risk exposures of derivatives with all other credit risk exposures of the fund to a particular customer.
Netting
In order to reduce counterparty credit risk exposure, where appropriate, bi-lateral netting agreements should be entered into on behalf of the plan with its counterparties. However, plan management should control and monitor the derivatives' credit exposures on a net counterparty basis only when
ii) there are written and reasoned legal opinions that in the event of any legal challenge the relevant courts and authorities would find the exposure to be the net amount under; a) the law of the jurisdictions where the counterparties are incorporated and the laws of any jurisdiction applicable to branches involved; b) the law governing the individual transactions; and c) the law governing any contracts or agreements required to effect netting; and
iii) procedures are in place to ensure that a regular review of the legal characteristics of netting arrangements for possible changes in law is undertaken to maintain the validity of such contracts.
The administrator should be able to demonstrate that it has exercised due diligence and prudence in evaluating the enforceability of these contracts.
Settlement Risk
Settlement risk can be defined as the risk a plan faces when obligations under a contract have been performed on behalf of the fund, but no value from its counterparty has been received. Settlement risk becomes credit risk if the counterparty defaults during the settlement cycle.
Limits and monitoring procedures for settlement risk exposures should be established in respect of a plan. Settlement risk exposure limits should be established as a subset of credit risk exposure limits as part of the credit risk management policies. In establishing these limits, management should consider the risk tolerance and level of funds of the plan, operations efficiency and credit analysis expertise as well as the operational structure and degree of finality of payment in the payment systems that are likely to be used.
Liquidity Risk
The liquidity risk of derivatives takes two forms: market liquidity and cash flow. Market liquidity will have an impact on the potential changes in market value of an instrument. If there is insufficient market activity, a plan or fund may not be able to unwind its position quickly enough to avoid serious loss. The impact of derivatives on the net cash-flow profile of a plan or fund is germane to the assessment of the ability of a plan to meet its obligations as they become due.
When market risk exposure limits have been established in respect of a plan, plan management should consider how long it would take to unwind a position (i.e., time to close) based on the length of time required to hedge or liquidate a position under normal market conditions. Where markets or products are illiquid and there is little variety or depth to hedging alternatives, longer holding periods in measuring market risk should be assumed.
As part of its cash flow and funding management policies, plan management should have procedures in place requiring staff who execute derivatives transactions to alert management to early indicators of resistance by counterparties to the plan as well as resistance, by the markets, to individual products or maturities, or by particular markets or geographic regions (e.g. evidenced by number of trades or by the size of the bid asked spread).
Legal Issues
Prior to engaging in derivatives transactions, plan management should satisfy itself that the plan has authorization for the funds to be invested in derivatives by the constating plan documents and by the written statement of investment policies and procedures. Plan management should also ensure that the counterparties to the derivatives transactions have the legal authority to engage in derivatives transactions. Where agents are involved, a plan management should take all reasonable steps to assure itself that the necessary legal authorities exist.
In addition to determining the legal authority of the plan and of the counterparty to enter into a derivatives transaction, plan management also should satisfy itself that the terms of any contract governing its derivatives activities with a counterparty are legally sound. This is especially important with respect to provisions governing (i) the timing of the termination of outstanding transactions and (ii) the calculation of settlement amounts payable to or between parties upon the termination of a transaction or an agreement.
Over-the-counter derivative transactions are predominantly arm's-length transactions in which each counterparty has a responsibility to review and evaluate the terms and conditions, and the potential risk and benefits, of prospective transactions and to obtain such additional information or independent professional assistance as it may require in connection with a particular transaction.
Operations and Systems Risk
Operating risk is the risk that deficiencies in information systems or internal controls will result in unexpected loss. Operating risks should be assessed through periodic reviews of procedures, documentation requirements, data processing systems, contingency plans, and other operating practices through the internal inspection function.
Mechanisms should be in place to assure the confirmation, maintenance and safeguarding of derivatives contract documentation. These mechanisms should also provide for exception reporting to senior management.
The design of information systems will vary according to the needs demanded by the scope and complexity of a plan's involvement in derivatives. The degree of accuracy and timeliness of information processing should be sufficient to meet a plan's risk exposure monitoring needs.
The valuation function and the buying and selling function should be separated and conducted independently by different personnel and units. Where valuation systems are automated, security arrangements should be in place to restrict access to a list of authorized personnel. The buyers and sellers of derivatives should not be permitted entry.
Active position-taker:
Commodity price risk:
Credit risk:
Credit risk exposure:
Currency risk:
Current exposure:
Dealer:
Dynamic hedging:
End-user:
Equity price risk:
Interest rate risk:
Limited end-user:
Market risk:
Market liquidity risk:
Market value:
Netting agreement:
Potential future exposure:
Replacement cost:
Symmetric payoffs: