Suitability and Appropriateness
While undertaking derivative transactions with or selling structured derivative products to a user, a market-maker should:
(a) document how the pricing has been done and how periodic valuations will be done. In the case of structured products, this document should contain a dissection of the product into its generic components to demonstrate its permissibility, on the one hand, and to explain its price and periodic valuation principles, on the other. The following information may be shared with the user:
(i) Description of the transaction.
(ii) Building blocks of the transaction.
(iii) Rationale along with appropriate risk disclosures.
(iv) Sensitivity analysis identifying the various market parameters that affect the product.
(v) Scenario Analysis encompassing both the possible upside as well as the downsides.
(b) analyse the expected impact of the proposed derivatives transaction on the user.
(c) Before offering any derivative product to a client, obtain Board resolution from the corporate which contains the details specified in the Comprehensive Guidelines on derivatives.
(d) identify whether the proposed transaction is consistent with the user’s policies and procedures with respect to derivatives transactions, as they are known to the market-maker
(e) ensure that the terms of the contract are clear and assess whether the user is capable of understanding the terms of the contract and of fulfilling its obligations under the contract.
(f) inform the customer of its opinion, where the market-maker considers that a proposed derivatives transaction is inappropriate for a customer. If the customer nonetheless wishes to proceed, the market-maker should document its analysis and its discussions with the customer in its files to lessen the chances of litigation in case the transaction proves unprofitable to the customer. The approval for such transactions should be escalated to next higher level of authority at the market-maker as also for the user.
(g) ensure the terms of the contract are properly documented, disclosing the inherent risks in the proposed transaction to the customer in the form of a Risk Disclosure Statement which should include a detailed scenario analysis (both positive and negative) and payouts in quantitative terms under different combination of underlying market variables such as interest rates and currency rates, etc., assumptions made for the scenarioanalysis and obtaining a written acknowledgement from the counterparty for having read and understood the Risk Disclosure Statement.
(h) guard against the possibility of misunderstandings all significant communications between the market-maker and user should be in writing/email or recorded in meeting notes.
(i) ensure to undertake transactions at prevailing market rates and to avoid transactions that could result in acceleration/deferment of gains or losses.
(j) should establish internal procedures for handling customer disputes and complaints. They should be investigated thoroughly and handled fairly and promptly. Senior management and the Compliance Department/Officer should be informed of all customer disputes and complaints at a regular interval.
It may also be noted that the responsibility of ‘Customer Appropriateness and Suitability’ review is on the market-maker.