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Capital Markets

Regulation: FSA queries derivatives use

The UK Financial Services Authority has questioned the spread of derivatives-based trading strategies, such as 130/30, by traditional long-only managers. The increasing use of derivatives poses a "range of risks", warns the FSA.

The regulator, which along with other UK regulators was heavily criticized for its handling of the crisis at Northern Rock, says there is a risk that managers could start using derivatives before appropriate middle-office and back-office systems and controls for risk management and compliance monitoring are developed. In its 2008 Financial Risk Outlook, published in February, the FSA says there is a risk that asset managers and clients will not be sufficiently aware of how using derivatives changes the risk characteristics of their portfolios by, for example, introducing implicit leverage, which has to be monitored against mandate restrictions.

"Using over-the-counter derivatives also introduces the need to manage counterparty risk through suitable collateralization arrangements," adds the FSA.

The FSA highlights the fact that new styles of investing, such as 130/30 funds or unconstrained equity funds, have increased in popularity, to the extent that some of these products are entering the retail market after having been established for some time among institutional investors. "It is questionable whether all asset managers have the appropriate systems and skills to manage and control the wide range of new products available to a consistently high standard," says the FSA, adding that the new areas involve "the use of skills that are in short supply and require asset managers to compete with banks, hedge funds and each other for talent".

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