HORROR stories about the staggering financial losses in derivative trading by Britain's Proctor and Gamble and the German metal company Metallgesellschaft do not seem mere coincidence. The panic they create helps to reinforce the worry of the phantom risk incurred in derivatives, something which regulators and companies are busy grappling with. Hong Kong, as a regional financial centre, will not have to wait for too long before it is confronted head-on with the same headache. The General Accounting Office (GAO), an arm of the United States Congress, estimated recently that the existing global derivative market, which has grown rapidly in the last three to five years, has reached a notional value of US$12 trillion. Apart from the phenomenal amount involved, there is worldwide concern that financial product development has outpaced regulatory systems, accounting systems and the ability of some corporates to manage the risks of derivatives. ''It [the derivatives market] is developing quicker than some companies' ability to understand the risk involved,'' said Roderick Chalmers, managing partner in Coopers and Lybrand and a non-executive director of the Securities and Futures Exchange. If the pace of development is mind-boggling, it is also a highly concentrated market, with over 80 per cent of the amount conducted by less than 15 financial institutions, the GAO said. ''This further brings about the concentration risk and adds to the danger of systemic failure and a possible domino effect,'' said Mr Chalmers. Three areas of concern were highlighted in a report by the GAO - risk management, accounting principles and regulatory gaps. Other regulators have lost no time taking precautions against the unfathomable risk. They have started by ensuring players have sufficient internal risk management systems. The Basle Committee on Banking Supervision, an international regulatory body, and the International Organisation of Securities Commissions (IOSCO), a global securities watchdog, jointly issued guidelines on risk management of derivative activities last month. The guidelines are being circulated to banks and securities firms in Hong Kong for consultation in the hope of formulating a formal code of good practice. The Hong Kong Monetary Authority is reviewing the adequacy of internal controls on derivatives trading by banks in the territory. An HKMA spokesman said that banks active in derivative trading - usually the bigger banks - already had internal control systems in place. The HKMA, therefore, did not expect banks to have much difficulty complying with the minimum standards set by the Basle committee. Market partitioners reckon that the active players are Hongkong Bank, the big US banks and a small number of big European banks, including investment banks. Union Bank of Switzerland trader Andy Yeung is relieved at the non-obligatory guidelines, preferring the non-binding advice to high-handed legislation. ''Too much regulation would stifle the development of the market,'' he said. However, the derivatives market is growing in Hong Kong. Smaller banks will not always remain on the sidelines. Brady Asia, a British supplier of computer software systems for derivatives trading, has stepped up its efforts to recruit Hong Kong clients. It has found receptive ears at some Chinese banks in the territory which are prepared to test the waters. While the guidelines are primarily a useful checklist for sophisticated players, they could be equally useful to ambitious newcomers. Mr Chalmers said: ''For those less sophisticated players who want to enter the market, the guidelines will help them to identify the issues they need to address before they start.'' Derivatives were originally meant as a hedge or protection against certain risks. However, daring new entrants can be burnt if they expose themselves to immense risks in a bid for enhanced returns without adequate knowledge of the market. Robert Nottle, chairman of the Securities and Futures Commission, said installing internal risk management control was only a first step. IOSCO is taking the issue in stages to cover all aspects of over-the-counter derivatives trading. ''More stages are coming, including the capital adequacy of derivatives and the disclosure which relates to how such activities are accounted for on books,'' Mr Nottle said. The Basle Committee last year consulted banks on the market risk of off-balance sheet items. The committee is studying the returns and will make a proposal by the end of the year, requesting banks to enlist extra capital for derivatives. ''We will take a look at the proposal before we decide on how they are introduced in Hong Kong,'' said David Carse, HKMA deputy chief executive (banking). But banks need not panic too soon. A new requirement for capital adequacy is likely to overlap with existing capital guidelines on credit risk. ''So whether a bank needs more capital because of the new rules will depend on the mix of its business,'' Mr Carse said. On the accounting side, even accountants agree that the reporting of derivatives is clearly out of step with market developments. ''It has resulted in incomplete and inconsistent reporting of financial derivatives, both in the result and balance sheet position of major institutions,'' said Mr Chalmers. ''We will also see the development of the accounting system to cope with them.''