Governance for Derivative Use Policies
intermediatePublished: 2026-01-01
Governance for Derivative Use Policies
Governance frameworks for derivatives define who can authorize trades, what instruments are permitted, how risks are monitored, and how compliance is enforced. Effective governance prevents unauthorized speculation, ensures proper risk management, and satisfies regulatory and fiduciary requirements.
Definition and Key Concepts
Governance Components
| Component | Purpose |
|---|---|
| Policy documentation | Define permitted activities and limits |
| Approval authorities | Specify who can authorize trades |
| Oversight structure | Assign monitoring responsibilities |
| Reporting requirements | Ensure transparency to stakeholders |
| Compliance monitoring | Verify adherence to policies |
Three Lines of Defense
| Line | Role | Activities |
|---|---|---|
| First | Trading/Treasury | Execute within policy, daily monitoring |
| Second | Risk Management | Independent oversight, limit monitoring |
| Third | Internal Audit | Periodic review, policy compliance testing |
Policy Framework Elements
| Element | Description |
|---|---|
| Scope | What activities are covered |
| Authorized instruments | Approved derivative types |
| Purpose restrictions | Hedging only vs. speculation permitted |
| Counterparty requirements | Credit and documentation standards |
| Limits | Notional, VaR, concentration limits |
| Reporting | What, to whom, how often |
| Exceptions | Process for policy deviations |
How It Works in Practice
Derivative Policy Structure
Section 1: Purpose and Scope
- Policy applies to all derivative transactions
- Covers all legal entities
- Defines hedging vs. non-hedging activities
Section 2: Authorized Instruments
| Category | Permitted | Restricted | Prohibited |
|---|---|---|---|
| Interest rate | Swaps, caps, floors | Swaptions | Inverse floaters |
| Foreign exchange | Forwards, options | Barriers | Accumulators |
| Equity | Index futures, puts | Single-stock options | Variance swaps |
| Credit | None | None | All CDS |
| Commodity | Futures for hedging | Options | Structured products |
Section 3: Approval Authority Matrix
| Transaction Size | Tenor | Approval Required |
|---|---|---|
| < $25M | < 1 year | Treasurer |
| $25M - $100M | < 3 years | CFO |
| $100M - $500M | < 5 years | Risk Committee |
| > $500M | Any | Board |
Limit Framework
Notional limits:
| Derivative Type | Maximum Notional | % of Assets |
|---|---|---|
| Interest rate hedges | $2 billion | 200% |
| FX hedges | $500 million | 50% |
| Equity overlays | $300 million | 30% |
| Commodity hedges | $100 million | 10% |
| Total | $3 billion | 300% |
Risk limits:
| Metric | Limit | Monitoring |
|---|---|---|
| 95% 1-day VaR | $5 million | Daily |
| 99% 10-day VaR | $25 million | Daily |
| DV01 | $500,000 | Daily |
| Single counterparty | $100 million | Daily |
| Credit exposure | $50 million | Weekly |
Worked Example
Organization: Regional bank with $10 billion assets
Derivative program:
- Interest rate risk management: $3 billion IRS notional
- Foreign exchange hedging: $400 million forward notional
- Mortgage pipeline hedging: $500 million options notional
Governance Framework
Board of Directors:
- Approves derivative policy annually
- Sets risk appetite and limits
- Reviews significant exposures quarterly
Risk Committee (Management):
- Meets monthly to review positions
- Approves transactions > $100 million
- Monitors limit utilization
Treasury Department:
- Executes trades within authority
- Manages day-to-day hedging
- Reports daily to Risk Management
Risk Management:
- Independent valuation
- Limit monitoring
- Exception reporting
Sample Limit Report
Daily Risk Dashboard:
| Metric | Limit | Actual | Utilization | Status |
|---|---|---|---|---|
| Total notional | $4.0B | $3.9B | 98% | Amber |
| VaR (95%, 1-day) | $5M | $3.2M | 64% | Green |
| DV01 | $500K | $380K | 76% | Green |
| Single counterparty | $100M | $85M | 85% | Amber |
| Unsecured exposure | $50M | $12M | 24% | Green |
Actions required:
- Total notional approaching limit - no new trades until rebalance
- Single counterparty Bank A at 85% - diversify next trade
VaR Reporting to Board
Quarterly summary:
| Quarter | Avg VaR | Max VaR | Limit | Breaches |
|---|---|---|---|---|
| Q1 | $2.8M | $3.9M | $5M | 0 |
| Q2 | $3.1M | $4.5M | $5M | 0 |
| Q3 | $3.5M | $5.2M | $5M | 1 |
| Q4 | $2.9M | $3.8M | $5M | 0 |
Q3 breach analysis:
- Date: August 15
- Cause: Rate volatility spike
- Duration: 1 day
- Action: Reduced IRS position by $200M
Risks, Limitations, and Tradeoffs
Governance Failures
| Failure Mode | Example | Consequence |
|---|---|---|
| Policy gaps | Instrument not addressed | Uncontrolled risk |
| Authority bypass | Trader executes without approval | Rogue trading |
| Monitoring failure | Limits not enforced | Excessive exposure |
| Documentation gaps | Trades not properly recorded | Audit/regulatory issues |
| Weak escalation | Exceptions not reported | Senior management unaware |
Policy Design Tradeoffs
| Tight Governance | Flexible Governance |
|---|---|
| More controls, slower execution | Faster execution, more risk |
| Reduced operational risk | Increased operational risk |
| May miss hedging opportunities | More responsive to market |
| Higher compliance cost | Lower compliance cost |
Regulatory Requirements
| Jurisdiction | Requirement |
|---|---|
| US (Banking) | OCC guidance on derivatives risk management |
| US (SEC) | Rule 18f-4 for registered funds |
| EU | EMIR risk mitigation requirements |
| Basel | Standards for derivatives governance |
Common Pitfalls
| Pitfall | Description | Prevention |
|---|---|---|
| Paper policy | Written but not followed | Regular testing |
| Outdated limits | Limits don't match risk appetite | Annual review |
| Insufficient expertise | Board doesn't understand derivatives | Board education |
| Siloed oversight | Risk Management excluded | Integrated governance |
| Exception creep | Too many policy exceptions | Exception tracking |
Implementation Best Practices
Policy Development
| Step | Activity |
|---|---|
| 1 | Assess current derivative use |
| 2 | Define risk appetite |
| 3 | Draft policy with stakeholder input |
| 4 | Legal and compliance review |
| 5 | Board approval |
| 6 | Training and rollout |
| 7 | Monitoring and enforcement |
| 8 | Annual review and update |
Documentation Requirements
| Document | Purpose | Retention |
|---|---|---|
| Derivative policy | Governing framework | Permanent |
| Trade confirmations | Legal evidence | Trade life + 7 years |
| Approval records | Authority verification | 7 years |
| Valuation reports | MTM documentation | 7 years |
| Limit exception memos | Deviation justification | 7 years |
| Board reports | Oversight evidence | Permanent |
Training Requirements
| Role | Training | Frequency |
|---|---|---|
| Traders | Policy, limits, procedures | Annual |
| Risk managers | Valuation, monitoring | Annual |
| Senior management | Risk overview, reporting | Annual |
| Board | Derivative fundamentals | Biennial |
| Audit | Policy testing procedures | Annual |
Checklist and Next Steps
Policy development checklist:
- Inventory all derivative activities
- Define permitted instruments
- Establish approval authorities
- Set risk limits (notional, VaR, concentration)
- Document counterparty requirements
- Define reporting requirements
- Establish exception process
- Obtain board approval
Implementation checklist:
- Communicate policy to all stakeholders
- Train trading and risk staff
- Set up monitoring systems
- Configure limit alerts
- Establish reporting templates
- Test compliance procedures
Ongoing governance checklist:
- Monitor limits daily
- Report to management monthly
- Report to board quarterly
- Review policy annually
- Conduct internal audit periodically
- Update for regulatory changes
Related articles:
- For liquidity issues, see Liquidity Considerations in Hedging Programs
- For automation, see Automation and Monitoring of Hedge Ratios