The Monetary Board, in its Resolution No. 1416

December 29, 1995 BSP CIRCULAR NO. 102-95 The Monetary Board, in its Resolution No. 1416 dated December 13, 1995 approved the following rules and regulations on financial derivatives activities of banks, non-bank financial intermediaries performing quasi-banking functions (NBQBs) and/or its subsidiaries/affiliates engaged in financial allied activities. SECTION 1. Statement of Policy . It is the policy of the Bangko Sentral ng Pilipinas (BSP) to help deepen the Philippine financial markets. In line therewith, alternative instruments for risk management, including financial derivatives products, shall be allowed under a properly regulated environment for the protection of market participants. SECTION 2. General Authority . Any bank, NBQB, and/or its subsidiaries/affiliates may engage in financial derivatives activities upon prior approval of the BSP. cdt A bank may engage in derivatives activities both in its regular banking unit and foreign currency deposit unit/expanded foreign currency deposit unit (FCDU/EFCDU). SECTION 3. Pre-Qualification Requirements . Approval by the BSP of an application to engage in derivatives activities shall be granted upon compliance with the following requirements, whenever applicable and/or appropriate: a. Required minimum capital for the specific category of banks/non-bank financial intermediaries or net worth of P200 million, whichever is higher; b. Required net worth-to-risk assets ratio for the last sixty (60) days immediately preceding the date of application; c. Required reserves against deposit liabilities, deposit substitutes and common trust funds for the last eight (8) weeks immediately preceding the date of application; d. Required liquidity floor for government deposits for the last six (6) months immediately preceding the date of application; e. Required FCDU/EFCDU foreign currency asset cover on FCDU/EFCDU foreign currency liabilities for the last six (6) months immediately preceding the date of application; f. Limits on bank's allowable open foreign exchange position for the last six (6) months immediately preceding the date of application; g. No losses from operations for a period of six (6) months prior to the date of application; or in lieu thereof, the bank shall infuse additional capital over and above the basic minimum unimpaired capital required, equivalent to an amount computed by multiplying the average rate of return on net worth of normally operating banks/NBQBs and/or its subsidiaries/affiliates, as the case may be, during the preceding year, by the basic minimum capital required for the applicant. h. Electronic data processing capability including the appropriate computer hardware and software; i. Adequate internal control system and procedures including record keeping; j. Key officers/traders responsible for derivatives must have a minimum experience of two (2) years as office/trader in treasury, international operations and/or risk management; and k. Compliance with banking laws, orders, instructions and regulations issued by the Monetary Board and/or orders, instructions and rulings by the BSP Governor. The application to engage in derivatives activities shall be submitted to the Foreign Exchange Department of the BSP. SECTION 4. Authorized Transactions . Any bank, NBQB and/or its subsidiaries/affiliates authorized to engage in derivatives activities under this Circular may enter into any derivatives contract, whether as end-user or in the capacity of dealer/trader or as agent/broker, provided, that when such contract is entered as end-user or in the capacity of dealer/trader, either party to said contract enters into the same for hedging purposes, provided, further, that in the case of commodity- or equity-based contracts, the bank, NBQB, and/or its subsidiary/affiliate shall not take an open position at any time. SECTION 5. Risk Management Guidelines . A bank, NBQB and/or its subsidiaries/affiliates authorized to engage in derivatives activities shall adopt a policy manual that contains the minimum features and principles embodied in the Risk Management Guidelines for Derivatives attached hereto as Annex "A". Risk disclosure statements, which should at least contain the disclosure statements in the attached Annex "B", shall be provided to the clients/customers of a bank, NBQB and/or its subsidiaries/affiliates in order to advise the former of the risks involved in derivatives activities. A detailed statement on the position of the clients/customers must be sent to them periodically. SECTION 6. Accounting Guidelines . In recording derivatives activities in the books, a bank, NBQB and/or its subsidiaries/affiliates shall observe the guidelines enumerated in the attached Annex "C". SECTION 7. Reportorial Requirements . A monthly report on derivatives activities shall be submitted to the BSP by a bank, NBQB and/or its subsidiaries/affiliates authorized to engage in such activities. The report and annexes thereto, prepared in the format prescribed in Annex "D", shall be submitted to the Foreign Exchange Department (original copy) and the appropriate supervising and examining department (duplicate copy) of the Supervision and Examination Sector of the BSP, within five (5) banking days after the end of every reference month. Such report shall be considered as a major report for purposes of implementing fines in the submission of required reports pursuant to existing regulations. SECTION 8. Sanctions . In addition to the penalties prescribed in Sections 36 and 37 of Republic Act No. 7653, any bank, NBQB and/or its subsidiaries/affiliates may be liable to the following sanctions: a. Suspension or revocation of the authority to engage in derivatives activities if after due investigation, the BSP finds that the bank, NBQB and/or its subsidiaries/affiliates: (i) has violated any provision of this Circular; or (ii) is in imminent danger of insolvency, or (iii) will probably incur continuous losses if it does not stop/suspend its derivatives activities. b. Imposition of a fine in accordance with existing regulations for any delay in the submission of major reports required under this Circular or when such reports are incomplete or erroneous in any material respect. SECTION 9. Transitory Provisions . Any bank previously authorized to engage in certain types of derivatives activities may continue engaging in such activities for a period of ninety (90) days from the effectivity of this Circular: Provided, That in the case of foreign exchange swaps and forwards, the bank may continue to engage in such transactions for a period of six (6) months from said effectivity date. Upon the expiration of the aforesaid periods, such bank shall not enter into new derivatives contracts unless it has secured the prior authority of the BSP pursuant to this Circular: Provided, however, that if such previously-authorized bank has a net worth of at least P200 million, it shall continue to be so authorized until such time that its application for authority to engage in derivatives activities under this Circular shall have been acted upon and such action is that of denial. It is understood that even upon expiration of aforesaid periods, the bank may consummate derivatives contracts executed during the ninety (90)-day period, or during the six (6)-month period in the case of foreign exchange swaps and forwards. aisadc SECTION 10. Repealing Clause . All provisions of existing circulars, rules and regulations of the BSP which are inconsistent with this Circular are hereby amended, modified or repealed accordingly. SECTION 11. Effectivity . This Circular shall take effect fifteen (15) days after its publication in a newspaper of general circulation. FOR THE MONETARY BOARD (SGD.) GABRIEL C. SINGSON Governor ANNEX A RISK MANAGEMENT GUIDELINES FOR DERIVATIVES I. Foreword These guidelines, which are based on the "Risk Management Guidelines For Derivatives" issued by the Basle Committee on Banking Supervision in July 1994, are expected to facilitate the further development of a prudent approach to the risk management of derivatives. The Bangko Sentral recognizes that sound internal risk management is essential to the prudent operations of financial institutions and that supervisory tools, such as capital requirements, are not by themselves sufficient. Sound internal risk management is also essential to promoting stability in the financial system as a whole. While the precise applicability of these guidelines will depend on the size and complexity of an institution's derivatives activities, we believe that the application of the basic principles embodied therein are very relevant even for risks inherent in more traditional activities. II. Introduction and Basic Principles 1. Derivatives instruments have become increasingly important to the overall risk profile and profitability of banking organizations throughout the world. Broadly defined, a derivatives instrument is a financial contract whose value depends on the values of one or more underlying assets or indices. Derivatives activities include a wide assortment of financial contracts, including forwards, futures, swaps and options. In addition, other traded instruments incorporate derivatives characteristics, such as those with embedded options. While some derivatives instruments may have very complex structures, all of them can be divided into the basic building blocks of options, swaps, futures and forwards or some combination thereof. The use of these basic building blocks in structuring derivatives instruments allows the transfer of various financial risk to parties who are more willing, or better suited, to take or manage them. cdt 2. Derivatives are used by banking organizations both as risk management tools and a source of revenue. From a risk management perspective, they allow financial institutions and other participants to identify, isolate and manage separately the market risks in financial instruments and commodities. When used prudently, derivatives can offer managers efficient and effective methods for reducing certain risks through hedging. Derivatives may also be used to reduce financing costs and to increase the yield of certain assets. For a growing number of banking organizations, derivatives activities are becoming a direct source of revenue through "market-making" functions, and "position-taking": "MARKET-MAKING" functions involve entering into derivatives activities with customers and with other market-makers while maintaining a generally balanced portfolio with the expectation of earning fees generated by a bid/offer spread; and POSITION-TAKING, on the other hand, represents efforts to profit by accepting the risk that steps from taking outright positions in anticipation of price movements. 3. Participants in the derivatives markets are generally grouped into two categories based primarily on their motivations for entering into derivatives contracts. End-users typically enter into derivatives activities to achieve specified objectives related to hedging, financing or position taking on the normal course of their business operations. A wide variety of business enterprises are end-users. They include, but are not limited to, a broad range of financial institutions such as banks, securities firms and insurance companies; funds and specialized investment partnerships; and corporations, local and state governments, government agencies and international agencies. 4. Intermediaries, which are sometimes referred to as "Dealers", cater to the needs of end-users by "making markets" in OTC derivatives instruments. In doing so, they expect to generate income from transaction fees, bid/offer spreads and their own trading positions. Important intermediaries, or derivatives dealers, include major banks and securities firms. As intermediaries, banks have traditionally offered foreign exchange and interest rate risk management products to their customers and generally view derivatives products as a financial risk management service. 5. The basic risks associated with derivatives activities are not new to banking organizations. In general, these risks are credit risk, market risk, liquidity risk, operations risk and legal risk. Because they facilitate the specific identification and management of these risks, derivatives have the potential to enhance the safety and soundness of financial institutions and to produce a more efficient allocation of financial risks. However, since derivatives also have these basic risks in combinations that can be quite complex, they can also threaten the safety and soundness of institutions if they are not clearly understood and properly managed. 6. Recognizing the importance of sound risk management to the effective use of derivatives instruments, the following guidelines are intended to highlight the key elements and basic principles of sound management practice for both dealers and end-users of derivatives instruments. These basic principles include: cdt a. appropriate oversight by Boards of Directors and/or Management Committee and Senior Management; b. adequate risk management process that integrates prudent risk limits, sound measurement procedures and information systems, continuous risk monitoring and frequent management reporting; and c. comprehensive internal controls and audit procedures. III. Oversight of the Risk Management Process Written policies and procedures on derivatives activities must be set forth and documented in a policy manual duly approved by its Board of Directors. The manual should include the following minimum features: 1. Scope of derivatives activities and types of services and products offered to clients; 2. Authorities and Responsibilities of: a. Board of Directors b. Management Committees c. Chief Executive Officer d. Other Senior Officers e. Department Managers f. Trading or Dealing officers/staff 3. Policies and procedures to govern trading, including trading, exposure and gap limits, and documentation of transactions; 4. Policies and procedures for controlling and measuring risk; 5. Accounting policies and procedures; 6. Internal control system; 7. Internal audit policies; 8. Policy review; 9. Reporting requirements; 10. Job description of key position and minimum qualification standards; and 11. Client-oriented safety nets. A. Oversight by Board of Directors and/or Management Committee 1. The Board of Directors or appropriate Management Committee should approve all significant policies relating to the management of risks throughout the institution. These policies, which should include those related to derivatives activities, should be consistent with the organization's broader business strategies, capital strength, management expertise and overall willingness to take risk. 2. The Board of Directors or appropriate management committee shall structure a compensation package for risk management officers and staff in such a way that the said package is sufficiently independent of the performance of trading activities. aisadc B. Oversight by Senior Management 1. Senior management should be responsible for ensuring that there are adequate policies and procedures for conducting derivatives operations on both a long-range and day-to-day basis. This responsibility includes: a) ensuring that there are clear delineations of lines of responsibility for managing risk, adequate systems for measuring risk appropriately structured limits on risk taking, effective internal controls and a comprehensive risk-reporting process; b) ensuring that all appropriate approvals are obtained and that adequate operational procedures and risk control systems are in place. 2. Any significant changes in any derivatives activities or any new derivatives activities should be approved by the Board of Directors or an appropriate level of senior management as designated by the Board of Directors. 3. Senior management should regularly evaluate the procedures in place to manage risk to ensure that those procedures are appropriate and sound. C. Independent Risk Management Functions 1. An independent body shall manage the measuring, monitoring and controlling of risks consistent with established policies and procedures. It shall directly report to the Board of Directors or to the appropriate management committee. 2. The personnel performing independent risk management functions should have a complete understanding of the risks associated with all of the bank's derivatives activities. Accordingly, compensation policies for these individuals should be adequate to attract and retain personnel qualified to assess these risks. IV. The Risk Management Process 1. The primary components of a sound risk management process are: comprehensive risk measurement approach, detailed structure of limits, guidelines and other parameters used to govern risk-taking; and strong management information system for controlling, monitoring and reporting risks. 2. To enable an institution to manage its risk exposure more effectively, its risk management process for derivatives activities should be integrated into its overall risk management system using a conceptual framework common to its other activities. 3. The risk exposures in derivatives activities should be fully supported by an adequate capital position. A. Risk Measurement 1. Risk should be measured and aggregated across trading and non-trading activities on an institution-wide basis to the fullest extent possible. In derivatives activities, assessment of the following risks should be included: credit risk, market risk, liquidity risk, operations risk and legal risk (Section VI of these Guidelines), 2. Risk measurement procedures should be understood by all relevant personnel from individual traders to the Board of Directors. 3. Marking to market of derivatives positions is fundamental to measuring and reporting exposures accurately and on a timely basis. A daily report to management indicating the gain or loss on derivatives activities should be submitted. Monitoring of credit exposures, trading positions and market improvements should be done at least daily. 4. Sound risk measurement practices include analysis of stress situations and identification of changes in market behavior that could have unfavorable effects on the institution and assessment of the ability of the institution to withstand them. B. Limiting Risks 1. A sound system of integrated institution-wide limits should set boundaries for organizational risk-taking and should ensure that position which exceeds predetermined levels receive prompt management attention. Such a system should define, among others, the following limits: a. Earnings or Capital-At-Risk Limits This defines the limit on potential loss which could be expressed as a percentage of projected earnings or capital; and b. Exposure Limits This defines maximum exposure to the various derivatives products. cdt 2. Should pre-determined limits be exceeded, a report to senior management must be made for information and appropriate action. C. Reporting An accurate, informative, and timely reporting system to the appropriate level of management is essential to the prudent operation of derivatives activities. Top management should be provided with adequate and timely information, on a regular basis, to judge the changing nature of the institution's risk profile. D. Management Evaluation and Review 1. Risk management guidelines should be evaluated and reviewed regularly since any change in either the institution's activities or the market environment may have created exposure that requires additional attention. 2. The review should include assessment of the methodologies, models and assumptions used in measuring risk. Limit structures should be altered whenever necessary to reflect the institution's past performance and current position. These reviews should be made at least annually, or more often as market conditions dictate, to ensure that they are appropriate and consistent. 3. Before being involved in new products, all relevant personnel (including those in risk management, internal control, legal, accounting and auditing) should understand the product and should be able to integrate it into the institution's risk measurement and control systems. V. Internal Controls and Audit 1. A sound system of internal controls should promote effective and efficient operations, reliable financial and regulatory reporting, and compliance with relevant laws, regulations, and policies of the institution. In determining whether internal controls meet those objectives, the institution should consider the overall control environment of the organization; the process of identifying, analyzing and managing risk; the adequacy of management information systems; and adherence to control activities such as approvals, confirmations and reconciliation. Reconciliation control is particularly important where there are differences in the valuation methodologies or systems used by the front and back offices. 2. Internal auditors should audit and test the risk management process and internal controls on a periodic basis, with the frequency based on a careful risk assessment. The depth and frequency of internal audits should be increased if weaknesses and significant issues are discovered, or if significant changes have been made to product lines, modeling methodologies, the risk oversight process, internal controls or the overall risk profile of the institution. To facilitate the development of adequate controls, internal auditors should be brought into the product development process at the earliest possible stage. 3. The institution should develop internal controls for key activities which should include the following features: a. A chart of subsidiary accounts adequately describing each account and designed to complement the Manual of Accounts prescribed by the BSP. b. Written Policies/Procedures for handling/recording confirmation of and settlement of transactions; segregation of duties between the front office and back room personnel; revaluation of positions indicating sources of revaluation rates; documentation of review and approval of limits and sub-limits; and evaluation and reporting to the Board of Directors/Senior Management of audit findings/exceptions; and such other key activities the institution is engaged in. 4. Internal auditors are expected to continuously evaluate the independence and overall effectiveness of the institution's risk management functions. They should be involved in the periodic review and evaluation of all bank policies, limits, internal controls and procedures developed for the institution's key activities. 5. Bank management should ensure that a mechanism exists whereby financial derivatives contract documentation is confirmed, maintained, and safeguarded. Documentation exceptions should be properly monitored and resolved. Controls must be in place to ensure that the appropriate contract documentation is timely and properly executed and maintained. The bank should establish a process through which documentation exceptions are monitored and appropriately reviewed by senior management and legal counsel. Banks with more active derivatives businesses may consider establishing a separate documentation unit to control financial derivatives contracts and supporting documents. Such a unit may be a part of a broader documentation unit or the legal department. VI. Sound Risk Management Practices for Each Type of Risk A. Credit Risk is the risk that a counterparty will fail to perform on an obligation to the institution. Credit risk management should parallel the prudent controls expected in traditional lending activities. Policies and procedures should be formalized to address concerns such as significant counterparty exposures, concentration of credit, risk ratings, non-performing contracts, and allowance allocations. An institution should include in its credit risk policy, the credit exposures to an individual counterparty. Internal limits that are prudent in the light of its financial condition and management expertise should be established. Policies and procedures should reflect the Board of Director's risk tolerance for concentration of credit. Policies addressing credit management functions, such as risk ratings, non-performing contracts, and allowance allocations, should be consistent. Credit Approval Function 1. Management should make sure that credit authorizations are provided by personnel independent of the trading unit to ensure safe and sound management of derivatives credit risk exposure. Credit officers and approving officers should be: familiar with credit risk; analyze the impact of proposed derivatives activities on the financial condition of the customer; responsible for establishing and changing financial derivatives credit lines; and able to understand the applicability of financial derivatives instruments to the risks the bank customer is attempting to manage. 2. Credit analysis should be documented and necessary information should be provided to customer/s. Pre-settlement Risk 1. The system to be used to quantify the pre-settlement credit risk exposure should: a) take into account current exposure ("mark-to- market") as well as potential credit risk due to possible future changes in applicable market rates or prices ("add-on"); b) use a reliable source for determining the credit risk factor used to calculate the credit risk add-on; c) produce a number representing a reasonable approximation of loan equivalency, that is, the amount of credit exposure inherent in a comparable extension of credit. The mark-to-market calculation should incorporate the same controls as the mark-to-market calculation used to identify profits and losses. Prices should be obtained independently from qualified sources on a periodic basis. The traders should not be used as the source of market valuations. 2. The sophistication of credit risk measurement system should be consistent with the level of activity and degree of risk assumed in derivatives activities. An internal control system to determine potential credit risk should be in place. Settlement Risk This is the risk that an institution faces when it has performed its obligations under a contract, but has not yet received value from its counterparty. Management should establish limits and monitoring procedures for settlement risk exposures. Settlement risk limits should be established separately from pre-settlement credit limits and should consider capital adequacy, operations efficiency and credit analysis expertise. Monitoring reports should provide sufficient detail to identify credit risk arising from settlement versus pre-settlement exposure. Credit Risk Monitoring 1. Credit risk monitoring should be independent of the units that create financial derivatives exposures. The risk monitoring unit should be responsible for producing and distributing timely and accurate information about credit exposures, such as concentration of credit, credit quality, limit exceptions, and significant counterparty exposures. 2. This methodology adopted to measure and monitor credit risk should be controlled by personnel independent of the trading unit. B. Market Risk is the risk that adverse movements in the level or volatility of market prices will affect the institution's financial condition. Dealers and Active Position-Takers 1. There should be a risk measurement system that can quantify risk exposures arising from changes in market factors. These system should be structured to enable management to initiate prompt remedial action, facilitate stress testing, and assess the potential impact of various changes in market factors on earnings and capital. At a minimum, all risk measurement applications, and models should be reviewed and validated annually, and management should maintain adequate documentation to support the reliability of the validation process. 2. Statistical analyses should be used to characterize market scenarios and price behavior. Before they are used, and whenever market conditions change significantly, the analyses should be validated by a source independent of the trading desk or risk assumption unit. Limited End-Users The senior management should ensure that all significant risks arising from their derivatives activities can be quantified, monitored, and controlled. At a minimum, risk management systems should evaluate the possible impact on earnings and capital which may result from adverse changes in interest rates and other market conditions that are relevant to risk exposure and the effectiveness of financial derivatives activities. C. Liquidity Risk is the risk that an institution will not be able to, or cannot easily, exist or unwind its position at a desired market price (market/product liquidity risk); or to meet its cash flow obligations as they fall due or upon margin calls (cash flow/funding liquidity risk). 1. Management should evaluate these risks in the broader context of the institution's overall liquidity because neither type of liquidity risk is necessarily unique to derivatives activities. 2. In developing guidelines for controlling liquidity risks, an institution should consider the possibility that it could lose access to one or more markets, either because of concerns about the institution's own credit worthiness, the credit worthiness of a major counterparty or because of generally stressful market conditions. At such times, the institution may have less flexibility in managing its market, credit and liquidity risk exposures. An institution that makes markets in over-the-counter derivatives or that dynamically hedges 1 its positions requires constant access to financial markets and that need may increase in times of market stress. The institution's liquidity plan should reflect its ability to turn to alternative markets, such as futures or cash markets, or to provide sufficient collateral or other credit enhancements in order to continue trading under a broad range or scenarios. 3. An institution that participates in over-the-counter derivatives markets should assess the potential liquidity risks associated with the early termination of derivatives contracts. Many forms of standardized contracts for derivatives activities allow counterparties to request collateral or to terminate their contracts early if the institution experiences an adverse credit event or a deterioration in its financial condition. In addition, under conditions of market stress, customers may ask for the early termination of some contracts within the context of the dealer's market making activities. In such situations, an institution that owes money on derivatives activities may be required to deliver collateral or settle a contract early and possibly at a time when it may face other funding and liquidity pressures. Early terminations may also open up additional, unintended, market positions. Management and directors should be aware of these potential liquidity risks and should address them in the institution liquidity plan and in the broader context of the institution's liquidity management process. D. Operations Risk is the risk that an institution will suffer an unexpected loss due to deficiencies in information systems or internal controls. 1. The Board of Directors/Management Committee and senior management should ensure the proper dedication of resources to support operations and systems development and maintenance. The operation unit should report to an independent unit and should be managed independently of the business unit. The sophistication of the systems support and operational capacity should be commensurate with the size and complexity of the derivatives business activity. 2. Systems support and operational capacity should be adequate to accommodate the types of derivatives activities in which the institution engages. This includes the ability to efficiently process and settle the volume transacted through the business unit, to provide support for the complexity of the transactions booked and to provide accurate and timely input. Support systems and the systems developed to interface with the official databases should generate accurate information sufficient to allow business unit management and senior management to promptly monitor risk exposures. 3. Segregation of operational duties, exposure reporting and risk monitoring from the business unit is critical to proper internal control. 4. Management should ensure that a mechanism exists whereby derivatives contract documentation is confirmed, maintained and safeguarded. An institution should establish a process through which documentation exceptions are monitored and resolved and appropriately reviewed by senior management and legal counsel. The institution should also have approved policies that specify documentation requirements for derivatives activities and formal procedures for savings and safeguarding important documents that are consistent with legal requirements and internal policies. E. Legal Risk is the risk that contracts are not legally enforceable or documented correctly. 1. Before engaging in derivatives activities, an institution, in consultation with its legal counsel, should be satisfied that its counterparties have the legal authority to engage in such activities. 2. The terms of any contract governing derivatives activities should be legally sound. 3. The institution should use the international Swap Dealers Association, Inc. (ISDA) Master Agreement insofar as the same is not inconsistent with existing laws, rules and regulations. ANNEX B RISK DISCLOSURE STATEMENT FOR DERIVATIVES ACTIVITIES Similar to other financial transactions, derivatives activities may provide significant benefits and involve a variety of significant risks. Before entering into any derivative activity, you should carefully consider whether the transaction is appropriate for you in light of your objectives, experience, financial and operational resources, and other relevant circumstances. You should ensure that you fully understand the nature and extent of your exposure to risk of loss, which may significantly exceed the amount of any initial payment by or to you. In general, all derivatives activities involve risks, which include, among others, the risk of adverse or unanticipated market, financial or political developments, risk of counterparty or issuer default and other credit and enforcement risks, and risk of illiquidity and related risks. In addition, you may be subject to operational risks in the event that you do not have in place appropriate internal systems and controls to monitor the various risks, funding and other requirements to which you may be subject by virtue of your activities in derivatives and other financial markets. As in any financial transaction, you should ensure that you understand the requirements applicable to you that are established by your regulators or by your board of directors or other governing body. You should also consider the legal, tax and accounting implications of entering into any derivative activity. In entering into any derivative activity with, or arranged by, us or any of our subsidiaries/affiliates, you should also understand that _____________ is acting solely in the capacity of an arm's length contractual counterparty and not in the capacity of your financial adviser or fiduciary unless _____________ has so agreed in writing and then only to the extent so provided. Whether or not you and ___________ have established a written financial advisory or fiduciary relationship, ____________ may from time to time have substantial long or short positions in, and may make a market in or otherwise buy or sell instruments identical or economically related to, the derivative activity entered into with you; _______________________________ may also have an investment banking, corporate advisory, or other commercial relationship with the issuer of any security or financial instrument underlying the derivative activity entered into with y ou. THIS BRIEF STATEMENT DOES NOT PURPORT TO DISCLOSE ALL OF THE RISKS OR OTHER RELEVANT CONSIDERATIONS OF ENTERING INTO DERIVATIVES ACTIVITIES. YOU SHOULD REFRAIN FROM ENTERING INTO ANY SUCH ACTIVITY UNLESS YOU FULLY UNDERSTAND ALL SUCH RISKS AND HAVE INDEPENDENTLY DETERMINED THAT THE ACTIVITY IS APPROPRIATE FOR YOU. ANNEX C ACCOUNTING GUIDELINES FOR DERIVATIVES The following guidelines shall be observed by any bank/NBQB and/or its subsidiaries/affiliates authorized to engage in derivatives activities. 1. Derivatives contracts shall be recorded in the books of accounts as contingent items using the accounts prescribed in the Revised Manual of Accounts, whenever applicable. The amounts to be recorded shall either be notional or actual, depending on the nature of the contract. The purpose of the contract shall be specifically stated, i.e., for trading or for hedging. At maturity of the contract the recorded entries shall be reversed. 2. Recognition of gains or losses shall be as follows: a. For derivatives contracts entered into for trading purposes, gains and losses shall be recognized/recorded in the books at the end of every month. b. For derivatives contracts entered into for hedging purposes: i) During the life of the underlying contract/transaction, unrealized gains and losses resulting from marking-to-market shall be recorded under "Deferred Hedging Gain/Loss" account, and shall serve as an adjustment to the gain/loss of the underlying contract/transaction. Upon maturity of the underlying contract/transaction, the deferred gain/loss shall be realized, and shall then be recorded as trading gain/loss. ii) After the life of the underlying contract/transaction, gains and losses shall be recorded directly as trading gain/loss. A contract should be accounted for as a hedge when the following conditions are met: i) The underlying contract/transaction exposes the institution to risk/s (e.g., interest rate risks, exchange rate risks, market risks). ii) The institution designates the product as a hedge. iii) The derivatives contract entered into is effective as a hedge, meaning that there must be a high correlation between the gains or losses on the derivatives contract and the gains or losses caused by the change of interest rates or exchange rates on the underlying contract/transaction. For derivatives contract to qualify as a hedge of an anticipated transaction, the following two (2) additional criteria must be met: i) Significant characteristics and expected terms of the anticipated transaction must be identified; and ii) The occurrence of the anticipated transaction must be probable. c. For derivatives contracts entered into as agent/broker, the notional amount shall be recorded as a contingent item. Income therefrom shall be in the form of fees, commissions or spreads only. cd 3. Any bank/NBQB and/or its subsidiaries/affiliates shall disclose, by way of footnotes to its audited financial statements, the following: a. Accounting policy on derivatives; b. Mark-to-market policy; and c. Notional amount of outstanding contracts. Footnotes 1. Dynamic hedging refers generally to the continuous process of buying and selling instruments to offset open exposures as market conditions change (e.g., an open writer selling an underlying asset as its price falls.)