Derivatives litigation is likely to increase, said Bermuda Commercial Bank managing director Ms Audette Exel.

"Litigation is on the rise in on-shore jurisdictions and it will not be long before we see it rear its ugly head in off-shore jurisdictions,'' she said yesterday at the annual spring forum on offshore funds.

Investment houses such as Paine Weber and Bankers Trust have been victims of large lawsuits from clients, she said.

"When dealing with mutual funds all the relevant issues relating to derivatives must be thoroughly understood, you must consider financial and legal risk when looking at derivatives.'' Derivatives, extremely difficult to price, are financial instruments that derive their value from other securities.

Examples from this multi-trillion dollar market include; warrants, options, futures, swaps and structured assets.

They are very risky, as shown by the crisis of Orange County and the collapse of Barings Bank plc.

But, if used properly, derivatives are a useful hedging instrument and play an important role in financial markets, said Ms Exel.

Board of directors face liability for their use of derivatives as well as for lack of use, she said.

The role played by the custodian will ultimately increase, she added. The custodian carries potential liability as it serves as watchdog for the investor.

Senior managers must establish controls, she added.

"Every fund is dealing with derivatives, prudent managers will enter derivatives to hedge assets and protect themselves.'' Without greater understanding from inside the offshore funds market, regulators may step in, she said.

Regulators could impose stringent controls which reduce returns but, she said, banning derivatives outright would be a "major step backward''.

In January, the Risk Management Improvement and Derivatives Oversight Act of 1995 was introduced to formulate standards to be used by federal regulators of financial institutions.

Despite the prospectus, many shareholders do not know they are connected to derivatives, said Merrill Lynch Asset Management vice president and senior portfolio manager Mr. Richard Kilbride.

The three-day Institute for International Research offshore funds forum concluded yesterday at the Hamilton Princess.