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GUIDELINES FOR FOREIGN EXCHANGE TRADING ACTIVITIES

January 1996

CONTENTS

INTRODUCTION

ETHICAL ISSUES FOR MANAGEMENT

Confidentiality
Trading for Personal Account
Entertainment/Gifts
Fiduciary Responsibility/Appropriateness

HUMAN RESOURCE ISSUES FOR MANAGEMENT

Selection
Training
Compensation
Stress
Substance Abuse
Gambling

TRADING PRACTICES

Traders' Responsibility for Prices
Electronic Trading Vehicles
Need to Avoid Questionable Practices
Off-Market Rates
Stop-Loss/Profit Orders

TRADER-TRADER RELATIONSHIP

TRADER-BROKER RELATIONSHIP

Name Substitution
Missed Prices and Disputes
Avoiding Disputes
Resolution of Disputes

TRADER-CUSTOMER RELATIONSHIP

Undisclosed Counterparties

OPERATIONAL ASPECTS OF TRADING

Risk Management
Accounting for Forward Transactions
Netting
New Product Development
Taping of Telephone Conversations
Deal Confirmations
Documentation
Third-party Payments
Importance of Support Staff
Audit Trail
Twenty-four Hour Trading

CONCLUSION

TRADING PRACTICES SUBCOMMITTEE

ADDITIONAL INFORMATION



INTRODUCTION

The main objective of the Guidelines is to clearly and concisely document issues that should be considered by institutions active in the foreign exchange market. These recommendations are based on the views of representatives from a number of commercial banks, investment banks, and brokerage firms participating in the foreign exchange market. The guidelines are primarily directed to managers and line personnel in the institutions actively trading foreign exchange (including commercial/investment banks and other wholesale market participants) and also to managers and staff of foreign exchange brokerage firms. Others may also find the discussion useful as much of the material can be applied generically to financial market activities. These guidelines should clarify common market practices and assist individuals in conducting their daily business activities.

This is the Committee's fourth revision of a paper first published in 1980. The Committee has published numerous "good practices" recommendations in the three years since the last revision of these guidelines. This version of the Guidelines reflects the Committee's work on several issues affecting the conduct of foreign exchange trading activities. Many of these are referenced in the document and included in the appendices.

The Foreign Exchange Committee encourages wide distribution of the Guidelines. To that end, foreign exchange professionals are encouraged to duplicate and distribute the document freely. Interested parties may also obtain current copies of these guidelines by contacting the Executive Assistant, Foreign Exchange Committee, 33 Liberty Street, New York, NY 10045, telephone (212)720-6651 and facsimile (212)720-1655.

 

ETHICAL ISSUES FOR MANAGEMENT


Confidentiality
Confidentiality and customer anonymity are essential to the operation of a professional foreign exchange market. Market participants and their customers expect to have their interest and activity known only by the other party to the transaction and an intermediary if one is used.

It is inappropriate to disclose, or to request others to disclose, information relating to a counterparty's involvement in a transaction except to the extent required by law.

A trader may have access to a considerable amount of confidential information, including the trades he or she prices and confidential material prepared within the organization or obtained from those with whom the institution does business. Such information might pertain directly to the foreign exchange market or to other financial markets. Although not explicitly stated to be confidential, it may not be publicly available.

Managers should expect that their employees will not pass on confidential information outside of their institution except with the permission of the party or parties directly involved. Nor should a trader or broker distribute confidential information within his or her institution except on a need-to-know basis. Managers should not tolerate traders or brokers utilizing confidential material for personal benefit or in any manner that might compromise their institution. In the event that confidentiality is broken, it is the role of management to act promptly to correct the conditions that permitted such an event to occur.

Management should be alert to the possibility that the changing mechanics of foreign exchange trading might jeopardize their efforts to preserve confidentiality. As technological innovations are introduced into the trading environment, managers should be aware of the security implications of such changes. For example, the use of two-way speaker phones has largely been abandoned or controlled to safeguard confidentiality. Ongoing advances in telecommunications systems, computer networks, trade processing systems and market analysis systems, and the integration of these systems within an institution can lead to inadvertent breaches of security. The potential loss of confidentiality represented by complex systems with multiple users, multiple locations, and ongoing data base or operating program changes may be further complicated when the central processing unit or software is managed by an outside vendor.

Managers should also act to protect sensitive information when visitors are present in trading rooms or brokerage operations. There is always the possibility that visitors will be exposed to confidential information such as: names of transaction participants, amounts of trades, and currencies traded. Whether or not disclosed information is put to use, and however unintentional disclosure may be, the fact that confidentiality between counterparties has been violated is grounds for concern. Visits should be prearranged and visitors should be accompanied by an employee of the host institution. A visitor from another trading institution should not be permitted to trade for his or her own institution from the premises of the host.


Trading for Personal Account
In general, managers should expect traders to give their full attention to their employing institution's business activities without being distracted by their own personal financial affairs. Managers should also expect traders to fulfill their institutional responsibilities objectively, unbiased by their own financial position.

Managers should be aware that a conflict of interest or an appearance of a conflict of interest may arise if traders are permitted to deal for themselves in those commodities or instruments closely related to the ones they deal for their institution. Such conflict could be detrimental or embarrassing to the institution, the trader, or both. It is management's responsibility to develop and disseminate a clear institutional policy on these matters and to establish procedures to avoid actual conflicts of interest. At a minimum, an institution should require senior management to give traders explicit permission to engage in trading for personal account and require traders to execute such transactions in a manner that allows monitoring by management. Some institutions have recently taken steps to prohibit traders from any trading for personal account that could give rise to the appearance of a conflict of interest.

Traders should recognize that they, too, have a responsibility to identify and avoid conflicts and the appearance of conflict of interest. A trader should bring to management's attention any situation where there is a question of propriety. In no instance should a trader use his or her institutional affiliation, or take advantage of nonpublic or exclusive foreign exchange transaction information involving a third party to create trading opportunities for personal gain.


Entertainment/Gifts
Management should assure themselves that their institution's general guidelines on entertainment and the exchange of gifts are sufficient to address the particular circumstances of their employees. Where appropriate, such general guidelines should be supplemented for trading personnel to help them avoid the dangers of excessive entertainment. Special attention needs to be given to the style, frequency, and cost of entertainment afforded traders. Many trading institutions have mechanisms in place to monitor entertainment. Although it is customary for a broker or trader to occasionally entertain market contacts at lunch or dinner, entertainment even in this form becomes questionable when it is underwritten but not attended by the host.

Foreign exchange market personnel should conduct themselves in such a way as to avoid potentially embarrassing situations and the appearance of improper inducement. They should fully understand their institution's guidelines on what constitutes an appropriate gift or entertainment as well as the bounds of law and reasonable propriety. They should also be expected to notify management regarding unusual favors offered traders by virtue of their professional position.


Fiduciary Responsibility/Appropriateness
Management should act honestly and in good faith when marketing, transacting, and administering it foreign exchange trading activities. Firms should take care to determine that the client has the capability (either internally or through independent professional advice) to understand the nature and risk of foreign exchange activities and that the client is not relying on recommendations or advice of the firm when entering into foreign exchange activities (unless a written advisory agreement has been signed by both parties). Consideration should be given to the making of risk disclosures in connection with foreign exchange trading activities. Firms should maintain policies and procedures that identify and address circumstances that can lead to uncertainties, misunderstandings, or disputes with the potential for relationship, reputational, or litigation risk. A more detailed discussion of the issues relating to fiduciary responsibility/appropriateness is contained in Principles and Practices for Wholesale Financial Market Transactions, August 1995.


HUMAN RESOURCE ISSUES FOR MANAGEMENT


As a result of the rapid growth and increasing complexity of the financial markets, trading rooms are operating on frontiers of earnings and risk, business mission and business policy. Skillful, capable people are a prerequisite for success in this demanding environment. It is a primary management responsibility to recruit, develop, and lead individuals and teams tasked to operate in this atmosphere.

The work environment for trading personnel has some very important characteristics. Trading room situations are positions of great trust. The pace of work is intense. Traders operate under strong internal pressures to make profits in a market that is open twenty-four hours a day. At the same time, the process of developing a trader has become compressed. Today, traders are either hired from other institutions or selected internally from individuals thought to have the work experience or academic training that would prepare them quickly for market-making, position-taking, or sales-related activities.


Selection
The process of selecting new employees is an important management responsibility. Managers should ensure that prospective trading room staff meet predetermined standards of aptitude, integrity, and stability for trading room jobs at all levels. Managers should exercise caution in delegating hiring decisions. To the extent possible, job candidates should be interviewed by several staff members of the institution and references should be checked. The managers' expectations concerning a trader's responsibilities, profitability, and behavior should be discussed thoroughly before a candidate is hired.


Training
The mobility of trading personnel within the financial industry has a material effect on traders' perceptions of their relationship to their employers. In some cases, it may be possible for an employee to begin trading an instrument for an institution although he or she does not have an intimate knowledge of the traditions and practices of that market or of the traditions and corporate culture of his or her current employer. This situation can give rise to misunderstandings about management's expectations of traders.

Managers should ensure that each trader is fully acquainted with the policies, procedures, and style that their institution chooses to employ in the conduct of its business. Management should consider providing complete orientation procedures for new employees at all levels and formal procedures to ensure periodic review of the institution's rules and policies by each trader. An awareness of and respect for market procedures and conventions should be encouraged. Roles, responsibilities, and authorities should be unambiguous. Procedures, technologies, and contingencies should be thoroughly explained. Risk measurements and risk reporting should be understood by all involved in trading activities.


Compensation
Compensation systems should encourage appropriate behavior, reflecting institutional goals and reinforcing organizational values.


Stress
Stress may lead to job performance problems. Managers need to be able to identify symptoms of stress among trading personnel and then act to mitigate problems. Management should consider educating trading room staff in personal stress management techniques.


Substance Abuse
Managers should educate themselves and their traders or brokers about the signs of drug use and the potential damage resulting from the use of drugs and other forms of substance abuse. Policies should be developed and clearly announced for dealing with individuals who are found to be substance abusers.


Gambling
Gambling among market participants has obvious dangers and should be discouraged.



TRADING PRACTICES


The smooth functioning and integrity of the interbank market, whether through direct dealing or electronic or voice brokers, depends on trust, honesty, and high standards of behavior by all market participants.


Traders' Responsibility for Prices
It is a management responsibility to ensure that traders who are authorized to quote dealing prices are aware of and comply with policies and procedures that apply to foreign exchange dealing.

In the interbank market, dealers are expected to be committed to the bids and offers they propose through brokers for generally accepted market amounts unless otherwise specified and until the bid or offer is (1) dealt on, (2) canceled, (3) superseded by a better bid or offer, or (4) the broker closes another transaction in that currency with another counterparty at a price other than that originally proposed. In the cases of (3) or (4), the broker should consider the original bid or offer no longer valid unless reinstated by the dealer.

If one counterparty is unacceptable to the other because of limited credit line availability, the broker may propose to substitute a "clearing institution." If both counterparties agree, this use of "switches" is an acceptable practice, but it entails certain risks. Management is encouraged to adopt the recommended principles and procedures for broker switches outlined in the Foreign Exchange Committee Letter on Name Substitution, September 23, 1993.


Electronic Trading Vehicles
In utilizing electronic trading vehicles, dealers are expected to be clear and precise in their use of dealing terminology, and alert to potential educational and structural issues or problems inherent in the adaptation of new technology. Management should actively monitor the introduction of such systems to insure proper training, timely dispute resolution, and appropriate interaction with vendors in order to refine and enhance these dealing tools. Opportunities for trade disputes are inevitable when using new systems. Users should govern themselves according to established market conventions and any departure from those conventions should be agreed upon at the time a deal is transacted.


Need to Avoid Questionable Practices
When markets are unsettled and prices are volatile, opportunities may arise for traders to engage in practices that may realize an immediate gain or avoid a loss but may be questionable in terms of a trader's reputation (as well as that of the trader's institution) over the long run. There are many kinds of questionable practices. For example, perpetrating rumors may reflect adversely on the professionalism of the trader. Reneging on deals may give rise to liability. The profitability of a given forward transaction may be distorted by delayed or inconsistent establishment of the appropriate spot rate. In the latter case, it is recommended that management adopt the standard of the middle rate at the time of the transaction.

It is unethical to manipulate market practice or convention to gain unfair competitive advantage. Management should be alert to any pattern of complaints about a trader's behavior from sources outside the institution such as customers, other trading institutions, or intermediaries. Information available within the organization should be reviewed to determine if individual traders or brokers become frequently involved in disputes over trades or tend to accept deals at rates that were obvious misquotes, accidental or otherwise, by counterparties. Complaints about trading practices may be self-serving, however, and should be handled judiciously.


Off-Market Rates
Dealers may occasionally face requests from customers to use "off-market" exchange rates. Such requests should be accommodated only after resolving issues concerning credit policy and propriety.

"Historical-rate rollovers" are an important example of off-market rate transactions. (Foreign Exchange Committee Letter "Historical-Rate Rollovers: A Dangerous Practice," December 26, 1991.) Historical-rate rollovers involve the extension of a forward foreign exchange contract by a dealer on behalf of his customer at off-market rates. The application of nonmarket rates can have the effect of moving income from one institution to another (perhaps over an income reporting date) or of altering the timing of reported taxable income. Such operations, in effect, result in an extension of unsecured credit to a counterparty.

The use of historical-rate rollovers involves two major risks: (1) either counterparty could unknowingly aid illegal or inappropriate activities, and (2) either counterparty could misunderstand the special nature of the transaction and the associated credit exposures. Given these risks, the rolling over of contracts at historical rates is a dangerous practice that should be avoided absent compelling justification and procedural safeguards. While the nature of certain commercial transactions may justify the use of historical rates with some customers, use of historical rates with other trading institutions should not be permitted. Even when used with customers, historical-rate rollovers are appropriate if (1) customers have a legitimate commercial justification for extending the contract, and (2) senior management of both the customer and the dealer institutions are aware of the transaction and the risks involved.

All dealer institutions permitting requests for historical-rate rollovers should have written procedures guiding their use. An example of such procedures is as follows:

  1. A letter from the customer's senior management (treasurer or above) should be kept on file explaining (1) that the customer will occasionally request to roll over contracts at historical rates; (2) the reasons why such requests will be made; and (3) that such requests are consistent with the customer firm's internal policies. This letter should be kept current.

  2. The dealer should solicit an explanation from the customer for each request for an off-market rate deal at the time the request is made.

  3. Senior Management and/or appropriate credit officers at the dealer institution should be informed of and approve each transaction and any effective extension of credit.

  4. A letter should be sent to senior customer management immediately after each off-market transaction is executed explaining the particulars of the trade and explicitly stating the implied loan or borrowing amount.

  5. Generally, forward contracts should not be extended for more than three months, nor extended more than once; however, any extension of a rollover should itself meet the requirements of (b), (c), and (d) above.


Stop-Loss/Profit Orders
Trading institutions may receive requests from customers, branches, and correspondents to buy or sell a fixed amount of currency if the exchange rate for that currency reaches a specified level. These orders, which include stop-loss and limit orders from trading counterparties, may be intended for execution during the day, overnight, or until executed or canceled. The growing incidence of such orders is due to widening acceptance of technical trading concepts, and increasingly sophisticated and disciplined risk management in spot, forward and derivative foreign exchange products. Fluctuations in market liquidity, multiple price discovery mechanisms, and evolving channels of distribution obscure transparency and may complicate the execution of such business. As a result, management should ensure clear understanding between their institution and their counterparties of the basis on which these orders will be undertaken. In accepting such an order, an institution assumes an obligation to make every reasonable effort to execute the order quickly at the established price. However, a specified rate order does not necessarily provide a fixed-price guarantee to the counterparty.

When a dispute arises between institutions as to whether an order should have been executed, brokers are often asked to confirm the high/low price of the day. Brokers are not the market per se and can only be used as an information source. A brokering company is one representative of the market and can therefore give trading ranges seen from within their institution, which may not be indicative of the entire market range. Consequently, that information should be treated with discretion.

Management should also ensure that their dealers and operations department are equipped to attend to all aspects of the frequently complex nature of these orders during periods of peak volume and extreme volatility. These complexities may include: conditional provisions, transaction notification, and cancellation or forwarding instructions.



TRADER-TRADER RELATIONSHIP


A current practice among trading institutions is to deal directly with each other, at least at certain agreed-upon times during the dealing day. The nature of the direct dealing relationship will vary according to the interests of the two parties. Management should ensure that the terms of each relationship are clearly understood and accepted by both institutions and that these terms are respected in practice.

A possible element of a direct dealing relationship between two institutions is reciprocity. That is, each institution in a direct dealing pair may agree to provide timely, competitive rate quotations for marketable amounts when it has received such a service from the other. Differences in institutions' relative size, expertise, or specialization in certain markets, will influence what is perceived by the two parties as equitable.

In the brokers' market, traders should not renege on a transaction, claiming credit line constraints , in an effort to "settle" a personal dispute. Instead, senior management should be made aware of a problem so that both institutions may act to address it. In all cases and at all times, traders should maintain professionalism, confidentiality, and proper language in telephone and electronic conversations with traders at other institutions.

Traders should also be certain that their market terminology is clear and understood by their counterparty. They should take steps to avoid using confusing or obscure market jargon that could be misleading or inaccurate.

Management should analyze trading activity periodically. Any unusually large concentration of direct trading with another institution or institutions should be reviewed to determine wether the level of activity is appropriate.



TRADER-BROKER RELATIONSHIP


Senior management of both trading institutions and brokerage firms should assume an active role in overseeing the trader-broker relationship. Management should establish the terms under which brokerage service is to be rendered, agree that any aspect of the relationship can be reviewed by either party at any time, and be available to intercede in disputes as they arise. Management of both trading institutions and brokerage firms should ensure that their staffs are aware of and in compliance with internal policies governing the trader-broker relationship. Ultimately, the senior management at a trading institution is responsible for the choice of brokers. Therefore, senior management should periodically monitor the patterns of broker usage and be alert to possible undue concentrations of business. Brokerage management should impress upon their employees the need to respect the interests of all of the institutions served by their firm.


Name Substitution
Brokers are intermediaries who communicate bids and offers to potential principals and otherwise arrange transactions. In the traditional foreign exchange market, the names of the institutions placing bids or offers are not revealed until a transaction's size and exchange rate are agreed upon; even then, only the counterparties gain this information. If one of the counterparties is unacceptable to the other, the substitution of a new counterparty may be agreed on. "Name substitution" (the practice of interposing a new counterparty or clearing bank between the two original parties) developed because before names are introduced in the course of a transaction each counterparty has already committed to the trade and its details. Many institutions believe that once they have revealed confidential information, they should complete a trade with the same specifications. A name substitution in a spot transaction is an acceptable practice provided that:

  • both counterparties receive the name of an acceptable counterparty within a reasonable amount of time;
  • the clearing bank is fully aware of the trade; and
  • the clearing bank is operating in accordance with its normal procedures and limits.

Under these circumstances, the bank's risk does not differ from any other trades involving the respective trading institutions. When transactions cannot be completed expeditiously, risks increase and disruptions can occur. Therefore, foreign exchange managers should clearly establish with their brokers the approach their institution will generally follow in handling specific name problems. Managers should provide their brokers with the names of institutions with which they are willing to deal or, alternatively, the names of the institutions they will virtually always reject. Brokers should use this information to try to avoid name problems. If a broker proposes a transaction on behalf of an institution not usually regarded as an acceptable counterparty, it is appropriate for that broker to make a potential counterparty aware that the transaction may need to be referred to management for credit approval (that is, the counterparty may be "referable") before the trade can be agreed to.

Name substitutions rarely occur in the brokered forward market. Participants in this market recognize and understand that a broker's forward bids and offers, even though firm, cannot result in an agreed trade at matching prices unless it comes within the internal credit limits of each counterparty. Forward dealers should not falsely claim a lack of credit to avoid trades or to manipulate prices.


Missed Prices and Disputes
Difficulties may arise when a trader discovers that a transaction thought to have been entered, was not completed by the broker. Failure to complete a transaction as originally proposed may occur for a variety of reasons: the price was simultaneously canceled, an insufficient amount was presented to cover dealers' desired transactions, or an unacceptable counterparty name might be presented. Disputes may also arise over misunderstandings or errors by either a trader or a broker.

Whenever a trade is aborted, managers and traders must recognize that it may be impossible for the broker to find another counterparty at the original price. Managers should ensure that their staffs understand that it is inappropriate to force a broker to accept a transaction in which a counterparty has withdrawn its interest before the trade could be consummated a practice known as "stuffing."

For their part, brokerage firm management should establish clear policies prohibiting position-taking by brokers and require that any position unintentionally assumed be closed out at the earliest practical time after the problem has been identified.


Avoiding Disputes
The management of both trading institutions and brokerage firms should take steps to reduce the likelihood of disputes. This can be accomplished when management assumes a key role in training new employees. Training may extend to the use of proper, clear, and common terminology; awareness of standard market practice; and adherence to the procedures of their institution. Trading institution management should also consider implementing frequent intra day reconciliations with other counterparties, including those arranged through brokers; once-a-day checks may be inadequate.

Even if these procedures are followed, disputes are inevitable and management should establish clear policies for resolution. Informal dispute resolution practices, which sometimes develop in the market, can be inconsistent with sound business practices.


Resolution of Disputes
When disputes arise or differences occur, the following guidelines for compensation apply: Differences should be routinely referred to senior management for resolution, thereby changing the dispute from an individual trader-broker issue to an inter-institutional issue. All compensation should take the form of a bank check or wire transfer in the name of the institution or of adjustment to brokerage bills. The settlement of differences should be evenhanded, allowing for compensation to go both ways.

All such transactions should be fully documented by each firm. Once a resolution has been reached, an institution should make restitution by check or some other noncash mean (for example, reduction of brokerage bill). When differences occur between a broker and dealer, the dealer is strongly urged to accept compensation directly from the brokering company and not to insist on a name at the original price.

For more detailed suggestions on the resolution of differences and disputed trades, 1989 Foreign Exchange Committee Annual Report pp. 16-17; the Federal Reserve Bank of New York "Policy Statement on the Use of Points' in Settling Foreign Exchange Contracts," August I, 1990; and the "Committee Letter on Confirmation and Dispute Resolution Practices," December 22, 1993.



TRADER-CUSTOMER RELATIONSHIP


Issues may develop in the relationship between trading institutions and their customers. As a consequence, the management of customer relationships requires a high degree of integrity and mutual respect as well as effective communication of each party's interests and objectives. Disputes may arise between a trader and a customer concerning the terms of a transaction should be referred to the appropriate level of management for resolution.

It is a normal practice for nonfinancial organizations to delegate trading authority formally to specific individuals within the organization and to advise their bankers accordingly. At the same time, trading institutions are obliged to make reasonable efforts to comply with corporate dealing authorization instructions. Trading personnel who deal with customers should be familiar with current corporate instruction, and those instructions should be readily accessible. Sales and trading personnel should bring to management's attention changes in counterparties trading patterns, significant book profits or losses, or any unusual requests.


Undisclosed Counterparties
"Know your customer" has long been a golden rule for most non-arms length financial transactions. The recent increases in the volume of foreign exchange transactions conducted through funds managers/investment dealers has resulted in substantial numbers of deals where the principal counterparties are not known at the time of transaction. Dealers should identify counterparties as soon as possible following a deal.

Management at financial institutions engaged in trading on this basis needs to be aware of the risks involved, particularly with respect to credit exposure and money laundering.



OPERATIONAL ASPECTS OF TRADING


Risk Management
Institutions should be duly aware of the various types of risk to which they are exposed when engaging in foreign exchange transactions, including:

  • Market Risk: The risk of loss due to adverse changes in financial markets (exchange rate risk, interest rate risk, basis risk, correlation risk, etc.).
  • Credit Risk: The risk of loss due to a counterparty default (settlement risk, delivery risk, sovereign risk).
  • Liquidity Risk: The risk that a lack of counterparties will leave a firm unable to liquidate, fund, or offset a position (or to do so at or near the market value of the asset).
  • Operational/Technology Risk: The risk of loss from inadequate systems and controls, human error, or management failure (processing risk, product pricing risk, valuation risk, etc.)
  • Legal Risk: The risk of loss due to legal or regulatory aspects of financial transactions (suitability risk, compliance risk, etc.).

There are also overall business risks that fall outside these categories such as reputation risk, event risk and fraud.

Sound management controls to monitor and evaluate the risk exposures associated with foreign exchange and related trading operations can help keep these exposures within management's specifications. Management needs to reinforce information tools with effective mechanisms for monitoring compliance.

Many different approaches are used by financial institutions to measure and manage the various risks arising from foreign exchange transactions. Risk Management methodologies vary in complexity. At the simple end of the spectrum one finds notional value limits by product type, by customer, and by country for controlling credit and settlement risk exposures as well as the market risk exposures incurred. On the more sophisticated end, an institution may use a combination of real time measures of value-at-risk (VAR) and scenario analysis. VAR is calculated by using often complex statistical models and simulation techniques for predicting rate volatility. These also take into account cross-currency and cross-market correlations, liquidity factors, and (in the case of credit risk) expected counterparty default rates. Management should ensure that the risk management techniques employed in their institutions are commensurate with the levels of risk incurred and the nature and volume of the foreign exchange activity being undertaken.

There are important aspects of risk management that go beyond the measurement of market and credit risk. These include:

  • adherence to company-approved accounting policies and standards for all products;
  • periodic independent reviews by internal auditors and daily oversight role of an independent risk management/compliance unit; annual review by external auditors and annual or more frequent examinations by the regulators;
  • segregation of trading room and back-office functions for deal processing, accounting and settlement;
  • independent verification of revaluation rates and yield curves used for risk management and accounting purposes;
  • documented and regularly tested disaster recovery and back-up procedures involving both systems (front and back office) and off-site facilities;
  • sufficient human resources and systems support to ensure that deal processing and risk reporting remain timely and accurate;
  • independent verbal and/or written confirmation of all trades;
  • independent daily reporting of risk positions to senior management;
  • daily reporting of traders' profit/loss to senior management;
  • new product approval and implementation procedures, which include sign-offs by legal, tax, audit, systems, operations, risk management, and accounting departments;
  • an independent valuation-model testing and approval process;
  • well-documented and appropriately approved operating procedures;
  • independent approval of customer credit limits and market risk position limits;
  • independent monitoring of credit and market risk limits; and
  • exception reporting and independent approval of limit excesses;

Risk management is not a substitute for integrity or awareness. Management should be aware of the assumptions used in its risk assessments and the need to develop the discipline, depth, and experience that ensure survivability. Risks should be weighed against potential returns and longer term organizational goals.


Accounting for Forward Transactions
Net present value accounting (NPV) is the preferred approach for marking foreign exchange forward books to market. NPV more accurately reflects the true market values of unsettled forward contracts. The well known theory of "covered interest rate arbitrage," which is the financial underpinning of forward foreign exchange markets, takes into account the time value of money. Discounting or deriving the NPV of the forward cash flows is required to evaluate the financial viability of a forward transaction. It requires the linking of the forward and spot pieces of a forward transaction while taking into account the funding costs of a forward position.

A firm's choice of accounting methods is management's prerogative; however, if management does not use NPV for valuing their foreign exchange forward books, an alternative means of controlling the inherent risks must be devised. These risks include:

  • taking "unearned" profits on the spot portion of the forward deal into income immediately and delaying the recognition of trading losses until some point in the future. NPV accounting evaluates the spot and forward pieces of a forward deal together and allows a firm to identify losses earlier.
  • inappropriate economic incentives resulting from inconsistencies between the accounting treatment applied to cash instrument transactions and other off-balance sheet instrument transactions. Variances in accounting methods may inadvertently provide an inappropriate financial incentive for a trader to engage in transactions that provide no economic value (or even negative economic value) to the firm.
  • collusion between traders who work at institutions that practice NPV accounting methods and traders at those institutions that do not. The early close out of a forward transaction (which would be based on a discounted value) could result in an immediate and unanticipated gain or loss being realized in the books of a firm not practicing NPV accounting methods.


Netting
Interest in foreign exchange netting has increased as institutions have sought to reduce counterparty credit risk exposure, interbank payments, and the amount of capital allocated to foreign exchange activity. While netting arrangements may have operational similarities, they can differ significantly in their legal and risk-reduction characteristics. Some forms of netting reduce the number and size of settlement payments while leaving credit risk at gross levels. The masking of risk, however, is not consistent with sound banking practice. Other forms of netting, such as netting by novation, can reduce credit risk as well as payment flows by legally substituting net obligations in place of gross obligations. In 1994 the Foreign Exchange Committee published the paper, Reducing Foreign Exchange Settlement Risk which defines settlement risk and offers several best practices recommendations.

Since the 1994 paper, several commercial ventures providing netting services to market participants have been launched. These ventures vary in their approach to and method for reducing settlement risk. The Committee recommends that firms considering joining or subscribing to a netting service evaluate their options carefully to insure that it will provide the anticipated level of risk reductions for the firm.

The Foreign Exchange Committee has held a long-standing interest in foreign exchange netting. Further information about the types of netting arrangements are found in the Committee's Annual Report for 1988 (p. 9), and for 1989 (p. 8). Other sources of information are the Report of the Committee on Interbank Netting Schemes of the G-10 Central Banks published by the Bank for International Settlements (BIS) in November 1990, and The Supervisory Recognition of Netting for Capital Adequacy Purposes published by the BIS in April 1993.


New Product Development
The growing complexity of new financial instruments and services requires that detailed research and documentation, together with internal cross-functional reviews and personnel training, be completed before a product is marketed. Formal programs to control the introduction of a new product help verify that the new activity is likely to be sufficiently profitable; that associated risks will be manageable, and that all legal, regulatory, accounting, and operating requirements are met. While many requirements must be fulfilled before the introduction of a product, the existence of formal, new product programs can actually speed and facilitate the product development cycle. (For further discussion, see 1988 Foreign Exchange Committee Annual Report, p. 11)


Taping of Telephone Conversations
Many trading institutions record all telephone lines used for trading and confirmation. Taping conversations in foreign exchange trading rooms and confirmation areas helps resolve disputes quickly and fairly. Whether or not traders need access to untaped lines in order to carry out unrecorded conversations on sensitive topics is a matter of management preference.

Access to tapes containing conversations should be granted only for the purpose of resolving disputes and should be strictly limited to those personnel with supervisory responsibility for trading, customer dealing, or confirmations. Tapes should be kept in secure storage for as long as is sufficient for most disputes to surface. When taping equipment is first installed, trading institutions should give counterparties due notice that conversations will be taped.


Deal Confirmations
Institutions active in the foreign exchange market should exchange written confirmations of all foreign exchange transactions including both interbank and corporate, spot, and forward. Any use of same-day telephone confirmations should be followed with written confirmations through means of immediate communication. Such timely confirmations can be provided by telex, SWIFT, fax transmissions, as well as by various automated dealing and confirmation systems. These forms of communication are more appropriate than mailed confirmations, which, particularly on spot transactions, may not arrive in time to bring problems to light before the settlement date. Trading institutions have found that the sooner a problem is identified, the easier and often less expensive it is to resolve. Prompt and efficient confirmation procedures are also a deterrent to unauthorized dealing.

In the United States brokered foreign exchange market, when both parties to a transaction are offices of institutions located in the United States, the counterparties and not the broker are responsible for confirming the transaction directly to one another. However, when a broker arranges an "international" transaction, where either one or both of the parties does not have a U.S. "address," it is the broker's responsibility to provide each of the counterparties with written confirmations of the transaction. Brokers should ensure that confirmations of spot transactions are given on the same day that a trade is consummated. Trading institutions have the responsibility to check that the confirmations provided by brokers are received and reconciled on a timely basis. They also are responsible for promptly reconciling the activity going through their nostro accounts with their trading transactions.

For further discussions, see: the "Committee Letter on Confirmation and Dispute Resolution Practices," December 22, 1993; and the Foreign Exchange Committee Letter of June 1995.


Documentation
It is in the market's best interest that participants use and support the development of market standard documentation. In addition, firms should maintain explicit policies on documentation requirements and procedures for safeguarding executed documents. Policies may address how to handle specific documents, including, but not limited to, the following:

  • corporate resolutions;
  • certificates of incumbency;
  • delegation of authority;
  • industry standard agreements;
  • risk disclosures; and
  • confirmations.


Third-party Payments
Management should have a clear policy for traders concerning the appropriateness of honoring requests for "third-party payments." A third-party payment is a transfer of funds in settlement of a foreign exchange transaction to the account of an institution or corporation other than that of the counterparty to the transaction. A subsidiary of the counterparty is a legally separate third party, but a foreign branch of an institution is not.

The normal payment risk inherent in foreign exchange the risk that funds are paid out to a counterparty but not received is most acute when the funds, in either local or foreign currency, are transferred to a party other than the principal to the transaction. These third-party payments are more susceptible than normal transactions to: (1) fraud perpetrated by a current or former employee of the counterparty who is diverting payment to a personal account, (2) fraud perpetrated by an employee of the bank who is altering the payment instructions, or (3) misinterpretation of the payment instructions whereby the funds are transferred to an erroneous beneficiary. In many cases, the ability to recover the funds paid out will depend upon the outcome of legal proceedings.

As a matter of policy, many institutions establish special controls for this type of transaction. The control procedures appropriate to address the associated risks include various measures to authenticate or verify third-party payments, such as:

  • requiring the counterparty to provide standing payment and settlement instructions;
  • requiring an authenticated confirmation on the transaction date;
  • requiring the counterparty to submit a list of individuals authorized to transact business and to confirm deals; or
  • confirming by telephone all deals on the transaction date to the individual identified by the counterparty.


Importance of Support Staff
Management's attention to a foreign exchange trading operation is usually directed toward establishing trading policies, managing risk, and developing trading personnel. Equally important is an efficient "back office" or operating staff. Details of each trading transaction should be accurately recorded. Payment instructions should be correctly exchanged and executed. Timely information should be provided to management and traders. The underlying results should be properly evaluated and accounts quickly reconciled. Time-consuming and costly reconciliation of disputed or improperly executed transactions mar the efficiency of the market, hurt profitability, and can impair the willingness of others to trade with the offending institution.

Accordingly, management must be aware of its responsibility to establish a support staff consistent with the scope of their trading desk's activity in the market. In addition, management should ensure that trading is commensurate with available back office support. It is also essential that management and staff of the back office are sufficiently independent from the traders and trading management in terms of organizational reporting lines. Finally, the incentive and compensation plans for back office personnel should not be directly related to the financial performance of the traders.


Audit Trail
Management should ensure that procedures are in place to provide a clear and fully documented audit trail of all foreign exchange transactions. The audit trail should provide information identifying the counterparty, currencies, amount, price, trade date, and value date. Such information should be captured in the institution's records as soon as possible after the trade is completed and should be in a format that can be readily reviewed by the institution's management as well as by internal and external auditors. These procedures should be adequate to inform management of trading activities and to facilitate detection of any lack of compliance with policy directives.

Recent technological innovations in trading and execution systems tend to improve data capture and allow for the creation of more precise audit records. For example, some electronic dealing systems independently generate trade data that serve as an effective audit trail. Trades executed via telex, automated dealing systems, or an internal source document provide better verification than trades executed over the telephone. An accurate audit trail significantly improves accountability and documentation and reduces instances of questionable transactions that remain undetected or improperly recorded. Management may therefore wish to emphasize such systems when considering trading room configuration and mechanics for dealing with counterparties.


Twenty-four Hour Trading
With foreign exchange trading now taking place on a continuous twenty-four-hour basis, management should be certain that there are adequate control procedures in place for trading that is conducted outside of normal business hours either at the office or at traders' homes. Management should clearly identify the types of transactions that may be entered into after the normal close of business and should ensure that there are adequate support and accounting controls for such transactions. Management should also designate and inform their counterparties of those individuals, if any, who are authorized to deal outside the office. In all cases, confirmations for trades arranged off-premises should be sent promptly to the appropriate staff at the office site.

Twenty-four-hour trading, if not properly controlled, can blur the distinction between end-of-day and intra-day position risk limits. Financial institutions involved in twenty-four-hour trading should establish an unofficial "close of business" for each trading day against which end-of-day positions are monitored.

Increasingly, during the U.S. workday, institutions in the United States are receive requests to trade from overseas traders who are operating outside their own normal business hours. Management should consider how they want their traders to respond. It is possible that, for selected counterparties, arrangements can be discussed in advance and a procedures can be established to accommodate the counterparty's needs while still identifying and protecting all parties to the transaction.



CONCLUSION


The intersection of all these topics, issues, and guidelines occurs on the trading floor. On the floor risk is assumed, clients are served, business potential is realized and principle becomes practice. As financial markets grow increasingly dynamic and the global environment increasingly complex, the role of the trading room manager has evolved beyond revenue and expense management. Individuals should be carefully chosen and empowered. The demands, responsibilities and importance of this role should not be underestimated by senior management.

 

 

TRADING PRACTICES SUBCOMMITTEE


The Foreign Exchange Committee's Guidelines for Foreign Exchange Trading Activities was revised by the Trading Practices Subcommittee, chaired by Richard Mahoney from Bank of New York and John Nixon from Tullett & Tokyo Forex International Limited. The following members of the Subcommittee provided invaluable assistance to this project:

Lloyd C. Blankfein Goldman, Sachs & Co.
James P. Borden The Chase Manhattan Bank
Anthony Bustamante Midland Bank
Kikou Inoue The Bank of Tokyo, Ltd.
David Puth Chemical Bank
Jamie K. Thorsen Bank of Montreal



In addition, the Subcommittee would like to thank the following people for their contributions:

David L. Carangelo Federal Reserve Bank
of New York
Christopher Kelson Lasser Marshall
Matthew Lifson The Chase Manhattan Bank



The Subcommittee would also like to acknowledge the contributions of the following individuals, who, through their participation in the Head/Chief Dealer Working Group, helped refine and edit this revision.

Nick Brown John Caccavale
Keith Cheveralls Paul Farrell
Scott Gallopo Geoff Gowey
David Harbison Stephen Jury
Akihiko Kagawa James Kemp
Howard Kurz Nathaniel J. Litwak
Donald J. Lloyd Varick Martin
John Miesner David O'Reilly
David Ogg Steven M. Peras
Salvatore Provenzano Ivan Sands
Jens-Peter Stein

 

 

ADDITIONAL INFORMATION


These Guidelines are regularly reviewed and updated. The Trading Practices Subcommittee welcomes your comments and suggestions. In addition, the Subcommittee stands ready to provide further guidance on the issues presented in the Guidelines. If you would like to discuss particular issues with a member of the Subcommittee or you have a suggestion on how to improve the Guidelines, please contact the Trading Practices Subcommittee, c/o Executive Assistant, Foreign Exchange Committee, 33 Liberty Street, New York, NY 10045, telephone (212)720-6651 and facsimile (212)720-1655.