7.6.2006
 
The Supervisor of Banks issues a new directive on the activity of banks and their customers in the futures contracts and options (MAOF) market
 
The Supervisor of Banks, Yoav Lehman, today sent the banks draft amendments to the directive in the Proper Conduct of Banking Business that deals with banks’ and their customers’ activity in the futures contracts and options market (known as Maof, from its Hebrew acronym). The amendment updates the directive issued in 1994, and takes into account the great changes that have occurred in the financial markets, in the types of activity, and in the risks.
The main changes proposed are:
  The directive obliges banks to require that customers active on the Maof market deposit and attach a lien on securities in favor of the bank for the fulfillment of their obligations to the bank for their activity in the Maof market, in accordance with the model of scenarios published by the Tel Aviv Stock Exchange (TASE). The securities must be liquid assets, part of the customer’s own independent means.
  The directive institutes a special framework for transactions by large customers who carry out extensive activity in the Maof market using low-risk strategies, with all the elements of the strategy held by the bank. These strategies generally combine options and the purchase of basis assets with a high rate of bank finance, or selling basis assets short. The directive sets out rules for the prudent management of the risks to the bank arising from this activity, and defines the following means for strengthening the control that the bank operates over such customers:
  ¦ A threshold level of activity will be set, and a customer exceeding the threshold will be defined as a “highly active” customer. Such a customer will have to become incorporated, to have a high level of knowledge of and expertise in the derivatives market, to have a reasonable amount of equity capital, and to refrain from engaging in financial management or investment portfolio activity on behalf of others.
  ¦ A computerized infrastructure is required that enables banks to estimate in real time their exposure due to the customer’s activity.
  ¦ The bank will measure its exposure due to the customer’s activity by using an internal model that takes into account the customer’s total assets and liabilities that constitute part of the strategy. Requirements have been set to check the validity of the internal model and for documenting the model’s methodology, etc. For example, in setting the model’s parameters, operational risk, liquidity risk, and other risks to which the customer is exposed must be taken into consideration, and not just market risk. The bank must review the situation of the high-activity customer’s total portfolio under extreme conditions (stress testing), over the range of scenarios published by the Maof clearing house.
  ¦ The model must be approved by the board of directors.
  ¦ A high-activity customer must deposit securities and attach a lien on them in favor of the bank to a value no less than the maximum exposure of the bank according to the model.
  ¦ The assets and liabilities of the customer that constitute part of the strategy must be held in a separate account.
  ¦ The directive allows the bank to make credit available to a high-activity customer to finance his activity, provided that the detailed guidelines in the directive are met, and that a maximum leverage ratio is set by the bank.
The directive also deals with the relation between banks and members of the TASE who are not members of the Maof clearing house, who settle their and their customers’ transactions via the banks. This is done in such a way as to strengthen the banks’ control mechanisms and to reduce the risk involved in their activity with such customers. In this context it was determined that non-members of the Maof clearing house will provide the bank with securities with a value no less than the exposure calculated for them and for every one of their customers according to the model of the scenarios published by the TASE, taking into account among other things, the securities which the bank is required to provide the Maof clearing house for activity by such non-members and their customers.
In addition to the draft directive regarding Maof, several amendments to other directives have been circulated to the banks (the minimum capital ratio directive, and the directive on limitations on indebtedness of a single borrower or groups of borrowers), amendments made necessary by the changed circumstances.
In the last few years these markets have undergone significant changes––in the increased scale of activities, in the extension of the range of derivative instruments traded, and in the variety of customers who engage in activity in Maof derivatives. The Maof clearing house has also introduced changes to its rules relating to the securities that banks have to provide it (since April 2004). On the other hand, the clearing house rules do not refer to the subject of securities which member banks must obtain from their customers who are active on the Maof market.
Despite the fact that the directive deals specifically with the activities of banks and their customers in the Maof market in Israel, its underlying principles can be equally well applied to customers’ derivatives activities in other markets too (e.g., in trading rooms and stock exchanges abroad).