Operational Risk and Over-the-Counter Derivatives
The term "operational risk" is typically defined as the risk that results from incomplete, poor or failed internal controls, people and/or systems. Sometimes the term is used as part of a discussion about business continuity.
Operational risk is often cited as a key element of the use of over-the-derivatives. For one thing, the growth in over-the-derivatives market continues to break records, with the Bank for International Settlements reporting global use, in terms of notional amounts, in excess of $284 trillion at year-end 2005. Interest rate contracts such as forward rate agreements, options and interest rate swaps dominate, with an estimated notional amount of approximately $215 trillion. Additionally, operational snafus account for several large derivatives-related losses. Check out the Wheel of Misfortune for some interesting case studies.
A July 2006 survey conducted by Investit Intelligence confirms continued interest in the topic, with investment company COOs citing most concern about technology and operational risk.
Others feel similarly. Timothy F Geithner, president and CEO of the Federal Reserve Bank of New York described improvements such as "greater dispersion of credit and market risk, the improvements in risk management, the size of the capital cushions, and the improvements in many parts of the payment and settlement infrastructure", while cautioning market participants to "make the investments necessary to improve the operational infrastructure that underpins the credit derivatives and broader OTC derivatives market."
Why is this important to pension funds? Given the giant size of the derivatives market and their prevalent use by mutual fund managers and hedge fund managers, pension fiduciaries should be asking tough questions about operational risk policies and procedures.
Of interest may be two articles on what this author refers to as the Five C Approach to Risk Management (SM). In the absence of a disciplined, and carefully crafted, organization-wide strategy, identifying, measuring and managing derivatives-related risk is difficult at best. (Click here to read "Pension Risk Management: The Importance of Oversight" and here to read "Five Keys to Risk and Risk Management.")
If used properly, financial derivatives can provide users with flexibility, the ability to transform risk and possibly even lower costs. Evaluating, and effectively dealing with, operational risk is a big part of prudent practice.
