The guidelines impose requirements on governance, dealing conduct, risk management, internal control, internal audit and record-keeping.
The RBI (Reserve Bank of India) has finalised new guidelines aimed at strengthening governance, conduct and risk management requirements for market makers conducting derivatives business.
The central bank had issued draft guidelines for consultation in December, seeking to promote more efficient access to the derivative markets and ensure high standards of governance and conduct in OTC derivative business by market makers.
The guidelines require the board of directors and senior management of market makers to demonstrate a strong commitment to effective risk management and compliance. This includes the implementation of “adequate and effective risk management and internal control policies and procedures” commensurate with the complexity of their derivative products.
An appropriate organisation structure with clear lines of responsibility and accountability must be established, and staff and other resources for the prudent conduct of derivative business, risk management, internal control and internal audit should be in place, the guidelines say.
Written policies should be in place defining the overall framework within which the derivative business shall be conducted, and the related risks managed. The framework should set out the entity’s overall risk appetite, capital strength and capability to manage risk effectively.
The framework should also specify permitted activities, products and limits for the derivative business, and establish policies for the introduction of new OTC derivative products, which should include a process for evaluation and approval of the new products.
The guidelines set out the permitted products for market makers, prohibiting them from dealing in derivative products containing a derivative instrument as underlying, and those derivatives which they cannot price independently.
Due diligence for the introduction of a new product should include an assessment of the product’s objectives, target clients, the risks a client could face, as well as the pay-off profile, pricing, costs, fees, and measures necessary to mitigate conflicts of interest.
The guidelines require market makers to document their pricing and valuation methodologies, which should involve marking-to-market before the use of models.
In cases where a model is used for valuation – the purpose, design, input variables, underlying assumptions, quantitative algorithms and model limitations should be “adequately understood and documented”. The model should also be periodically validated through independent review and back-testing.
The guidelines include further requirements on dealing conduct – encompassing pre-trade, trade, and post-trade conduct – as well as requirements on risk management, internal control, internal audit and record-keeping.
The final guidelines are published here.